Earnings Call Transcript - UNFI Q2 2021

Operator, Operator

Ladies and gentlemen, thank you for standing by. And welcome to the UNFI Fiscal 2021 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. Please be advised that today’s conference is being recorded. It is now my pleasure to turn the call over to Mr. Steve Bloomquist, Vice President of Investor Relations. Sir, the floor is yours. Please go ahead.

Steve Bloomquist, Vice President of Investor Relations

Good morning, everyone. And thank you for joining us on UNFI’s second quarter fiscal 2021 earnings conference call. By now, you should have received a copy of the earnings release issued earlier this morning. The press release, webcast and the supplemental slide deck are available under the Investors section of the company’s website at www.unfi.com. Joining me for today’s call are Steve Spinner, our Chairman and Chief Executive Officer; John Howard, our Chief Financial Officer; Chris Testa, President of UNFI; and Eric Dorne, our Chief Operating Officer. Steve, Chris 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. With that, I’ll turn the call over to Steve.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Thanks, Steve. Good morning, everyone. And thank you for joining us on our fiscal 2021 second quarter earnings call. As you saw in this morning’s press release, we delivered another quarter of outstanding financial results. Second quarter sales grew 7.1%, second quarter adjusted EBITDA grew 57% or $74 million and second quarter adjusted EBITDA margin expanded 95 basis points. This quarter’s $206 million of adjusted EBITDA was the second highest in UNFI’s history, behind only last year’s third quarter that benefited from the significant jump in demand, as consumers began loading their pantries heading into the pandemic. This quarter also represented the fourth consecutive quarter where we’ve grown adjusted EBITDA and adjusted EPS at a significantly higher rate than we’ve grown sales. We continue to make great progress in our debt reduction efforts this quarter and improved our net debt to adjusted EBITDA leverage ratio to 3.2 times — a full two-turn improvement since last year’s second quarter. As a reminder, we have paid down almost $1 billion of debt since fiscal 2019 and are well on our way towards less than 3 times leverage. Momentum continues to build throughout our business and we are delivering strong results as we execute on our strategies. This quarter’s results are a clear validation of the great work we are doing to increase shareholder value. Our cross-selling strategy is resonating with both existing and new customers who are looking to aggregate volume. Our award-winning brands business, an important differentiator for UNFI, continues to grow, as does our professional services business, both of which help our customers succeed in today’s evolving retail landscape. Looking forward, we continue to believe that UNFI is well-positioned for continued growth and that food-at-home consumption will remain elevated for the next several years. Companies continue to push office return dates further into the future as they evaluate return-to-work strategies in light of increased productivity and work flexibility that come with working from home. At the same time, many Americans continue to manage their household budgets closely, with dining in providing a more affordable meal option and a great opportunity to connect as a family. Consumers also continue to look for better food options with ingredient transparency, and UNFI continues to lead the way forward in this important segment. We expect this backdrop will continue to provide a tailwind for us as we pursue growth within the $140 billion addressable wholesale market, of which $38 billion comes from gaining share of wallet with our current customers and an additional $78 billion from adding new customers. In addition, we continue to move forward on optimizing our distribution network, generating additional operating benefits to the Value Path initiative and investing in technologies that provide valuable insights into our future business growth and lower our cost structure. Finally, I’m pleased that we’ve extended the contract with our largest customer through late 2027, almost seven years from now. We believe this reflects the strong working relationship between the two companies and the benefit UNFI brings to their operations and growth. Let me now turn the call over to Chris to provide more context on our business performance. Chris?

Chris Testa, President

Thanks, Steve, and good morning, everyone. On today’s call, I’ll provide additional color on our fiscal 2021 second quarter performance and discuss the key trends we’re currently seeing in our business. I will also highlight the drivers that continue to differentiate UNFI, giving us confidence in our ability to drive long-term market share growth. As you saw in this morning’s press release, total sales for the quarter increased 7.1% or $450 million compared to last year’s second quarter. Excluding retail, our wholesale growth rate was 6.5%. For perspective, we believe UNFI’s growth was about 200 basis points higher than Nielsen’s retail syndicated data when accounting for the 400 basis points difference in retail versus wholesale inflation and our 80 basis points foodservice channel headwind. Our second quarter sales growth also accelerated 110 basis points compared to the 6% sales growth in our first quarter. We believe there are several reasons for this sales growth expansion. The first is UNFI’s unique ability to cross-sell. Our cross-selling efforts generated approximately $90 million in incremental sales for the quarter, bringing our total incremental revenue from cross-selling to nearly $500 million since the SUPERVALU acquisition. Looking forward, we see a path to delivering a cumulative $1 billion in cross-selling revenue by the end of our fiscal 2022, as we continue to gain traction with larger wins. As we mentioned on the last call, we believe that there’s a $140 billion addressable market for UNFI, including $38 billion of upside opportunity by cross-selling and gaining further penetration with our existing customers. We are gaining momentum and cross-selling remains an exciting key benefit for our customers and UNFI. The second reason for our Q2 sales growth was revenue gained from new customers. Our sales teams have been aggressively capitalizing on our opportunities to drive sales gains across all parts of the store and we’re winning business every week across all categories, including fresh and general merchandise, center-store grocery, frozen and others. UNFI has the portfolio and distribution footprint to compete with local and national wholesalers, and provide customers with the advantage of our scale. We also continue to invest in our people and expertise. To that end, we’ve hired Dorn Wenninger as our SVP of Produce. Dorn comes to us from Walmart Mexico, and he’s already hit the ground running. He’s another great example of talent we’ve added over the past year to accelerate growth for our customers and UNFI. The third reason driving our outsized growth is the change in consumer behavior at retail. Mackenzie has reported that roughly 10% of people have changed their primary grocery store during the pandemic, largely based on proximity to home. UNFI customers have benefited from this — especially independents who tap into an additional growing consumer preference to shop smaller-footprint stores. We have and will continue to support all of our customers, particularly as the future of work remains uncertain, but likely does not entail everyone returning to work in the same fashion they did pre-pandemic. Also, the rising importance of e-commerce is changing how consumers interact with our stores. We estimate that 70% of independents and a larger percent of chains now offer e-commerce solutions to their customers. And UNFI provides the digital platforms and necessary support to help our customers succeed. By point of fact, we have onboarded hundreds of new customers onto our e-commerce platform solution since the start of the pandemic and have many more in the pipeline. Moving forward, we believe these consumer trends will continue and UNFI is uniquely positioned to adapt to changing consumer behavior by servicing a diverse customer base through an unmatched portfolio of products, programs and services. Turning to our sales performance by channel. Second quarter sales to chains were up 6.5% and to independent retailers were up 9%. Both channels were ahead of the syndicated data I cited earlier when adjusting for inflation and both experienced accelerated growth versus Q1 2021. Our continued growth with customers in these sales channels is the result of the factors I just mentioned. Specifically with chains, we have had cross-selling gains with natural customers that had begun to use UNFI to support their captive conventional distribution. And we have won new business with many independents that are now UNFI customers. Wholesale sales in the natural channel were up 7.2% compared to last year’s second quarter, which was the combination of greater sales to existing stores as well as sales to stores open less than one year. And finally our other channel grew slightly — strong gains in our e-commerce business more than offset the softness in foodservice and military. Second quarter e-commerce sales increased 97% led by new business and sales growth to the largest e-commerce player who is now a top 25 customer for UNFI. Speaking of e-commerce, we will soon be introducing a new platform called Community Marketplace. This will be an exciting extension of our Easy Options B2B e-commerce solution that will provide UNFI customers additional access to growing on-trend local brands. Similar to other e-commerce marketplaces, sales on UNFI’s proprietary Community Marketplace will bypass traditional distribution through our DC network and allow for smaller emerging brands to be ordered and shipped directly to retail customers throughout the U.S. This will give our customers access to an even broader assortment of items, with flexible order sizes and convenience to order from multiple sources online in one place. For existing UNFI suppliers interested in expanding their portfolios or for newer brands and suppliers looking for a gateway into UNFI, they gain immediate opportunity to access UNFI’s more than 30,000 unique customer locations, and benefit from a fast and easy onboarding that could eventually lead to broader distribution in our DC network. In short, we believe Community Marketplace is the disruptive digital innovation needed to connect growing brands with our customers to ultimately bring end consumers more freedom of food choice. We’re finalizing the details and I look forward to sharing more on our next call. Our strong topline results include another quarter of growth in our retail business, where same-store sales increased 15.3%. E-commerce at Cub continues its robust growth trajectory, increasing by nearly 190% at Cub. Last month, one of the two Cub stores that were damaged during last year’s civil unrest in Minneapolis reopened and included several new offerings and departments based on input from the community. Cub maintains its long-held number one market share position in the Minneapolis market and we’re very proud of our commitment to serving communities that depend on us. We expect the second store to reopen in the next 30 days. Another sales growth driver was our Brands+ private brands business, which grew 7.3% in the second quarter. Within the portfolio, our largest brand, Essential Everyday, grew double digits driven by gains with larger customers and better in-stock levels relative to many national brand alternatives. Our inbound fill rates for our own brands have been averaging 1,000 basis points higher than national brands. Our Field Day brand, exclusively distributed via our natural independent customers, has seen over 30% growth this fiscal year, fueled by support in core grocery categories and new items. Across the entire Brands+ portfolio, innovation continues to be the focus with approximately 200 new item launches planned for this fiscal year. To this end, we’ve seen tremendous growth from products like Woodstock’s organic frozen avocados, which quickly became the number two ranked new item in the frozen fruit category in the U.S. natural channel. We have a strong long-term plan for this portfolio that capitalizes on the upside opportunity with existing, as well as new customers, and positions Brands+ as a point of difference for UNFI and our customers. Moving beyond our product offerings, we continue to expand our professional services portfolio to offer customers unique solutions beyond selling groceries to them. One recent example involves bringing digital currencies such as Bitcoin to our customers’ stores through a relationship with Coin Cloud. Coin Cloud is a small-footprint kiosk that empowers consumers to buy, sell or trade digital currency with cash without the need for a bank account or debit card. To date, we’ve signed 80 contracts and see potential to grow to 4,000-plus UNFI locations. This is just one example of new services we’re adding to our current portfolio, including more traditional services like store design, merchandising and payment processing. In total, UNFI offers 150 types of services to keep our customers’ stores relevant, to drive retail sales and to help them lower their costs. Lastly, on the operations side, we continue to move forward with optimizing and expanding our distribution center network to better service our customers and deliver operating efficiencies. In Pennsylvania, our work is well underway on our new Allentown campus, which will be operational in time to ship Key Food early next fiscal year. Our new Riverside, California facility and a major expansion in Ridgefield, Washington are complete and fully operational. We introduced automation in portions of both of these distribution centers, where we expect to experience a 100% increase in throughput as measured by units picked per hour, which will yield expense savings in addition to improving our order accuracy and lowering operational credits. Given the truly differentiated business model, which includes aggressively growing our wholesale business while monetizing our unique assets like brands, e-comm and services, we’re optimistic about the rest of the year and our prospects beyond fiscal 2021. As Steve said, we’re running on all cylinders and we truly are. With that, I’ll turn the call over to John.

John Howard, Chief Financial Officer (CFO)

Thank you, Chris. Good morning, everyone. On today’s call, I’ll provide additional context on our quarterly financial performance, balance sheet, capital structure and full year outlook for fiscal 2021. As Steve and Chris said, we’re very pleased with our operating momentum in this quarter and the strong performance. We set second quarter records for net sales, which totaled $6.9 billion, adjusted EBITDA which came in at $206 million and adjusted EPS of $1.25 per share. Second quarter gross margin rate expanded 12 basis points versus last year’s second quarter, driven by a margin mix benefit from greater retail sales growth relative to wholesale sales growth, as well as lower levels of promotional spending in our retail operations. Gross margin rate for our wholesale and other businesses was approximately flat as a decrease in shrink expense, which last year included about 7 basis points of expense associated with customer bankruptcies, was offset by lower levels of supplier-related income. Second quarter operating expense rate declined 82 basis points to 12.59% of sales, including 45 basis points associated with the reduction in bad debt expense versus last year’s second quarter that included three customer bankruptcies. The remaining improvement was driven by our Value Path productivity initiatives and strong leverage of the fixed and semi-fixed portions of our cost structure. Our second quarter results also included the benefit of lower health and welfare costs based on lower usage levels during the pandemic. As COVID vaccination levels increase and doctor visits and medical procedures return to pre-pandemic levels, we expect our benefit cost to return to pre-pandemic levels as well. Our 57% growth in second quarter adjusted EBITDA on a 7% increase in sales translated to a 95 basis point year-over-year expansion in our adjusted EBITDA margin, the fourth consecutive quarter we grew year-over-year adjusted EBITDA at a significantly higher rate than sales. Excluding the impact of last year’s customer bankruptcies, second quarter adjusted EBITDA margin grew approximately 45 basis points. These results again demonstrate our ability to translate topline performance into even stronger bottom-line growth, which we believe will continue to generate significant shareholder value. On a GAAP basis, we reported $1 in earnings per share, which included $0.25 per share in after-tax charges, primarily related to advisory fees for our transformational Value Path initiatives and the acceleration of unamortized debt issuance costs and original issue discount tied to the $150 million term loan prepayment made early in the quarter. Our adjusted EPS, which excludes the impact of these items and several smaller adjustments, totaled $1.25. Turning to the balance sheet, our total outstanding net debt finished the quarter at just under $2.5 billion, the lowest quarter-ending level since the SUPERVALU acquisition. We generated $265 million in net cash from operating activities in the quarter, which led to a reduction in total outstanding net debt of nearly $250 million. Free cash flow in the second quarter included the anticipated working capital recapture as we sold through inventory that had increased for the holiday selling season. Our year-to-date net debt reduction now totals approximately $115 million. Our net debt to adjusted EBITDA leverage improved to 3.2 times and benefited from both lower debt levels and higher trailing 12 months adjusted EBITDA compared to the first quarter. As Steve mentioned, this leverage ratio has improved by two full turns since the second quarter of fiscal 2020. In addition to lower debt levels, we recently took two other steps to lower our annual interest expense. Early in the second quarter, we borrowed $150 million on our asset-based revolving credit facility and reduced the balance on our term loan by an equal amount. Then following the end of the second quarter, we took advantage of favorable credit markets and successfully re-priced the term loan, lowering the interest rate by 75 basis points. Based on the second quarter ending balances, these two actions will reduce annual interest expense by approximately $11 million, which equates to about a $0.13 annual increase in earnings per share. We believe the operating environment will continue to benefit from food-at-home consumption, which combined with our year-to-date results and the anticipated continued build of benefits from our acquisition synergies and Value Path, gives us a high degree of confidence in our ability to achieve our fiscal year 2021 operating guidance. We are reaffirming our full year guidance for net sales, which we continue to expect to be in the range of $27 billion to $27.8 billion. And we now expect to finish towards the upper end of the previously provided ranges of $690 million to $730 million for adjusted EBITDA and $3.05 per share to $3.55 per share for adjusted EPS. We’re maintaining our previous guidance of $250 million to $300 million for capital expenditures and approximately $250 million of net debt reduction, both of which include this year’s investments in our new Allentown distribution center to support Key Food. Last, we now expect to finish the year with a net debt to adjusted EBITDA leverage ratio of approximately 3.3 times. Although we don’t provide quarterly earnings guidance, I do want to comment briefly on our expectation for the third quarter. As a reminder, our third quarter results in fiscal 2020 benefited from the unprecedented stock-up surge as COVID-driven demand began to spread. While we expect continued elevated demand and strong absolute levels of performance in the back half of fiscal 2021, we do expect our fiscal 2021 third quarter sales, adjusted EBITDA and adjusted EPS to be below prior year levels. However, we remain confident and optimistic in our full year outlook as reflected in our expectation to finish the year towards the upper end of our ranges for adjusted EBITDA and adjusted EPS. Increasing value for our shareholders remains a priority and focus of UNFI. With our differentiated business model and large addressable market, we remain confident in our ability to grow our business and generate meaningful free cash flow. In the near term, we will continue to use our free cash flow to further reduce debt and improve our leverage. Thank you for your time this morning and for your interest in UNFI. And with that, let me turn the call back to Steve.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Thanks, John. As John discussed, we remain laser-focused on driving our business forward and are committed to increasing shareholder value. We’re pleased with our year-to-date performance and remain confident we’ll deliver on our full year outlook. Since our last call, we released our 2020 ESG report. We’re proud of the progress we’re making and have launched an ambitious 2030 agenda built around the theme, Better for All. This past year, UNFI has improved its CDP Climate Change response score to an A- through purposeful actions and enhanced disclosures. We’ve announced new paid parental leave benefits. We’ve delivered the equivalent of 19 million meals to those in need and achieved a 7% year-over-year improvement in food waste diverted from landfills. Just to name a few longer-term goals, we’ve challenged ourselves to reduce food waste by 50% by 2025, achieve zero waste to landfills from DCs by 2030, reduce our distribution center energy intensity by 30% by 2030 and donate the equivalent of over 200 million meals to those in need by 2030. Corporate citizenship is very important to us and part of what makes UNFI a special company. We’re dedicated to serving our customers while doing right for those in need, all while being sensitive to our impact on the planet and the environment. To that end, we’ve expanded a zero-emissions all-electric trailer pilot with 53 new trailers that will operate in California. We also remain focused on succession and continue to evaluate candidates to serve as UNFI’s next CEO. COVID has made the process a bit more complicated and the Board has asked me to extend my timeline in order to ensure that we continue to have a comprehensive process. I’m committed to staying until I can turn the reins over to our new CEO. Our business is strong, our future is bright and I’m confident UNFI will have a new and exciting leader later this year. Our associates deliver results every day, safely and efficiently, and I want to thank them for all their hard work during the quarter. In conclusion, I’m very pleased that fiscal 2021 is unfolding largely as we had originally anticipated. Our optimistic full year outlook demonstrates the confidence we have in our people and business. And as I stated on our last call, I continue to believe that UNFI’s best days lie ahead. With that, we’re ready to take your questions. Thank you.

Operator, Operator

Your first question comes from the line of Edward Kelly from Wells Fargo.

Edward Kelly, Analyst (Wells Fargo)

Yeah. Hi, guys. Good morning.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Ed, good morning.

Edward Kelly, Analyst (Wells Fargo)

Steve, my first question was on the Whole Foods contract. Any more details you can provide? I think the economics were essentially the same, which I’m not sure was the case the last time you extended it. And then it’s been extended for seven years now; I thought last time maybe it was extended for longer. So any additional thoughts you can provide there?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Sure. Thanks. I am unbelievably proud of what we’ve accomplished in this negotiation because it really demonstrated to us and to Amazon and Whole Foods how important the programs are and how important the companies are to each other. If you remember, those of you who have been around for a while, we typically negotiated with Whole Foods every five years and now we’ve got a whole new process, because Whole Foods is no longer independent. So we’re dealing with two parties. One way to look at it is in the old world, even though we had a 10-year contract, we were really negotiating a brand new one every five years, which to me meant we effectively had a five-year cadence. Now we have a seven-year agreement, and so that’s a spectacular result. For those who follow Amazon, you know that those kinds of contracts are really unusual and so we feel really fortunate to be able to get that done. As far as the economics, you’re 100% right. They’re essentially the same as the agreement that we currently have in place. And just for perspective, seven years is a long time. It’s one of the longest contracts that we have throughout the entire company. For perspective, Amazon in 2014 was about $80 billion; I think they did $386 billion last year, so roughly six times growth. To be able to have a customer that exhibits that kind of growth is something that is really good for our shareholders.

Edward Kelly, Analyst (Wells Fargo)

Great. And then just the second question for you on consumer product vendor promotions and what you’re seeing out there in the marketplace today. Has that picked up at all? Remind us what a normalization in that sort of means for your P&L and then as we look at the gross margins, I know shrink helps, but I guess the vendor stuff hurts. As we sort of think about the world normalizing, can you sustain flat wholesale gross margins when we net all this out?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Well, we don’t guide to gross margin specifically. But what I would tell you is there are far more tailwinds than headwinds generally as it relates to gross margin. If you think about general fill rates, they are still lagging where they were pre-pandemic, and when suppliers are having a hard time meeting demand, there is obviously a lack of promotional activity as well. Retailers are seeing that in their retail margins, because since there’s less promotional activity, they have a higher retail margin. But because we do have margin that we earn in promotional periods, when we start to get fill rates back, when manufacturers start promoting again, when retailers start promoting again, that will be an opportunity for UNFI to capture incremental margin. We don’t disclose the exact value associated with it, but it’s a meaningful tailwind for us. The other factor is inflation. Inflation has been running in roughly a 100-basis-point range and we expect that once we come out of COVID, as products return to the shelves and retailers bring back items manufacturers discontinued, we’ll start to see input cost pass-throughs — and that’s a positive for us as well.

Edward Kelly, Analyst (Wells Fargo)

All right. Thank you.

Operator, Operator

Your next question comes from the line of Rupesh Parikh from Oppenheimer.

Rupesh Parikh, Analyst (Oppenheimer)

Good morning. Thanks for taking my question and congrats on the nice quarter. So I guess — just starting with the guidance, you guys now expect EBITDA and EPS to be at the higher end of the range, but you didn’t change your sales expectation. So just curious why you still believe in the current sales range and you haven’t adjusted that. Also the Key Food contract — I was just curious in terms of what contributions you expect related to Key Food this year and what percent of impact next year?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Well, I can start with the Key Food —

John Howard, Chief Financial Officer (CFO)

Go ahead, John.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

I’ll start with the Key Food. Key Food is not going to start till our next fiscal year, into 2022.

John Howard, Chief Financial Officer (CFO)

Yeah. Appreciate it. That’s going to be part of the comments. So Key Food will be in FY ’22, as we continue to invest in the Allentown facility. As we think about the sales and EBITDA numbers that we’re seeing right now, we feel comfortable from a topline perspective with the range that we provided. What we’re seeing is, when we think about the first half of FY ’21 and what we are forecasting for the back half, we’re seeing continued improvement and value coming from the leverage and scale that comes from UNFI and we’re seeing continued value from our Value Path and productivity initiatives that are flowing through our margin and SG&A, OpEx. We’re seeing all of that flow through our P&L. So that’s why we’re holding the sales in that range but guiding toward the upper end on the EBITDA and EPS. And of course, UNFI is also getting the benefit of the interest actions we took as well.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Rupesh, what I would tell you is good management teams look out two years in advance, and this is a good management team. We made a lot of strategic decisions a couple of years ago and what’s proving out is close to what we expected: to grow our bottom-line EBITDA at a rate considerably faster than our topline. That’s exactly what’s happening as a result of initiatives to increase productivity, optimize the network and provide a higher level of service to our customers. From a revenue perspective, Chris gave some terrific analogies to explain wholesale revenue growth versus retail revenue growth and that’s where a lot of people get confused, because retail revenue growth has retail margin embedded in it. The important note is that UNFI on a net basis is growing considerably faster than the market itself.

John Howard, Chief Financial Officer (CFO)

And Rupesh, just to build on that, we’re confident in the guidance we provided. We feel good about our numbers and our outlook for FY ’21 and that’s why we are providing the guidance.

Rupesh Parikh, Analyst (Oppenheimer)

Okay. Great. And then just one follow-up: since we don’t have comparable financials for the prior for Q3, so you look at the operating expense this quarter around $860 million or so. Is that the right baseline to think about going forward? Also you called out a reduction in benefit expense this quarter. Can you quantify that temporary benefit for the quarter?

John Howard, Chief Financial Officer (CFO)

We generally don’t provide quarterly detailed guidance. If I think about modeling the back half, focus on the upper end of that EBITDA and EPS range. We manage the entire P&L but wouldn’t provide the quarterly breakdown for OpEx or the exact temporary benefit quantification by quarter.

Rupesh Parikh, Analyst (Oppenheimer)

Okay. Great. Thank you. I will pass it on.

Operator, Operator

Your next question comes from the line of John Heinbockel from Guggenheim.

John Heinbockel, Analyst (Guggenheim)

Hey, Steve. I am curious — you talked about the $90 million of cross-sell revenue. Roughly speaking, what was the contribution from new accounts as part of that $450 million? And what does the pipeline look like — is it predominantly independents versus chains, and how should we think about the mix?

Chris Testa, President

Hey, John. The $90 million was incremental for the quarter and our cumulative cross-selling incremental revenue is close to $500 million since the acquisition. The pipeline literally has thousands of opportunities in it ranging across categories and sizes. The wins we saw this quarter were not concentrated in any single category or channel. They’re occurring in independents, chains, e-commerce and across produce, meat, general merchandise, center store, natural and conventional. Key Food is significant; there aren’t many customers like that, but every day we’re also winning smaller opportunities across all channels and categories.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

John, I’d add two things. One, some of our fastest growth is in conventional distribution with retailers that have captive facilities, either because we’re closer to those stores or we can serve them more efficiently. More importantly, retailers are thinking about supply chain differently today than they did a year ago. The focus is on aggregating volume to fewer partners, which drives down their cost and allows them to focus on keeping consumers in their store or on their site. The strategic acquisition of SUPERVALU and our migration toward being a wholesaler of scale that can provide everything a retailer needs will benefit UNFI for years.

John Heinbockel, Analyst (Guggenheim)

And then a follow-up on the cross-sell: going from $500 million to $1 billion by the end of fiscal ’22 implies $500 million incremental over six quarters, which seems a bit less than this quarter’s pace. Is that conservatism or do you expect cross-sell to slow and then pick up again?

Chris Testa, President

John, that $1 billion projection wasn’t meant to be strict financial guidance for each quarter; it’s a reasonable estimate based on our run rate and what we’re adding each quarter. We don’t expect it to slow down — we think it’s a fair estimate based on current momentum.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

We’re just starting to get really strong at fresh. We’ve made additions to our leadership team and infrastructure in produce and protein. We’re now among the largest in protein and produce across the country. Filling remaining holes will further drive cross-selling over the next couple of years.

John Heinbockel, Analyst (Guggenheim)

Okay. Thank you.

Operator, Operator

Your next question comes from the line of Greg Badishkanian from Wolfe Research.

Spencer Hanus, Analyst (Wolfe Research, covering for Greg Badishkanian)

Good morning. This is Spencer Hanus on for Greg. The industry is facing pretty tough comps over the next few weeks. Any color on how much of the sales growth you’re expecting the industry to retain? And post-COVID, how are you thinking about what your customer mix will look like?

Chris Testa, President

Good questions. It’s been a volatile environment. When we laid out guidance, we expected grocery to remain elevated throughout the fiscal year. We still believe that. As we head into a post-pandemic world, we expect work-from-home to be a tailwind and continued shopping closer to home to persist, which benefits our independent and chain customers in suburban areas. E-commerce importance will continue to grow and we expect elevated levels vs. pre-pandemic for some time. What was the other part of your question?

Spencer Hanus, Analyst (Wolfe Research, covering for Greg Badishkanian)

If you think longer term about retailers with captive distribution, do you think they will move to a more capital-light model and rely more on third parties like UNFI?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Retailers are sophisticated and will evaluate the most efficient route to market. If using a third party like UNFI is the most efficient, they’ll do that — and we’re seeing that happen. Some retailers that previously thought they needed captive networks are now reassessing, especially when third parties can provide scale and broader services.

Spencer Hanus, Analyst (Wolfe Research, covering for Greg Badishkanian)

Got it. Thank you.

Operator, Operator

Your next question comes from the line of Jim Salera from Northcoast Research.

Jim Salera, Analyst (Northcoast Research)

Hi, guys. Thanks for taking my question. I wanted to drill down a little bit on operating margin. You’ve done impressive improvements both year-over-year and quarter-over-quarter. How much of that is temporary benefit from easing COVID-related operational issues in warehouses and how much is sustainable from the consolidation and automation investments across the distribution network?

Eric Dorne, Chief Operating Officer (COO)

This is Eric. I’ll start and then John can add. First, acknowledge the team’s efforts around COVID and safety protocols. What you saw was a reflection of consolidation stabilization in the Pacific Northwest; our DCs there have become fully operational, which reduced OpEx. We’ve also introduced our Operational Excellence Program as part of Value Path, which is beginning to show results. We’re confident in the trajectory, but we’re still in the middle innings of optimization.

John Howard, Chief Financial Officer (CFO)

When we think sequentially, we saw a 3.2% increase in sales from Q1 to Q2 but a 30% increase in EBITDA. Some of that was driven by Q1 challenges, particularly in the Pacific Northwest, which have substantially subsided. The rest comes from additional productivity, Value Path initiatives, and some timing of benefits in health costs that will normalize later in the year. It was a very strong quarter and demonstrates sequential improvement in EBITDA.

Spencer Hanus, Analyst (Wolfe Research, covering for Greg Badishkanian)

Looking forward, do you think there’s room for improvement? Historically wholesalers have achieved EBIT margins above 2%. Do you think UNFI can sustainably reach an EBIT margin of 2% to 2.5% as you complete more optimizations?

John Howard, Chief Financial Officer (CFO)

Without providing specific forward-looking guidance, I’ll say we still have productivity initiatives and Value Path opportunities in front of us through FY ’23. We also have a large component of synergies tied to system standardization that will be a significant tailwind as we progress. So yes, there are still meaningful opportunities to continue improving our EBITDA margin.

Eric Dorne, Chief Operating Officer (COO)

We’ve only really optimized a couple of regions so far — the Pacific Northwest and Southern California — and we have more to go. We continue to invest in automation and operational excellence, and we expect more productivity improvements as those initiatives scale.

Spencer Hanus, Analyst (Wolfe Research, covering for Greg Badishkanian)

Perfect. Thanks, guys.

Operator, Operator

Your next question comes from the line of Matt Fishbein from Jefferies.

Matt Fishbein, Analyst (Jefferies)

Hi. Good morning. Just a clarification: SG&A stepped down sequentially from Q4 and Q1 levels, even though sales were higher this quarter. Is that driven by trapped costs coming offline in the Pacific Northwest and route consolidation? Also, what parts of Value Path have been implemented that would explain operating margin improvement this quarter, and what inning are you in with those initiatives?

Eric Dorne, Chief Operating Officer (COO)

For the Pacific Northwest we’re in the middle innings of optimization. One DC was brand new and another had a large remodel — staff have become fully productive and we’ve eliminated most third-party labor support. For Value Path, progress includes private brand sourcing, optimizing delivery frequency with customers, distribution center productivity under our Operational Excellence program, and administrative footprint consolidation. We’re in the middle innings on many of these initiatives with a clear line of sight to additional benefits over the next couple of years.

Operator, Operator

Your next question comes from the line of Karen Short from Barclays.

Cait Howard, Analyst (Barclays, covering for Karen Short)

Hi. Good morning. Can you share any update on fill rates currently and where you think they will go over the next few quarters?

Chris Testa, President

Hi, Cait. Fill rates remain below historical pre-pandemic levels, but we did see sequential improvement of about 400 basis points across the business, largely driven by larger CPG suppliers catching up to demand. We’re still below historical norms, and most suppliers’ sentiment is that fill rates will continue to improve over the course of the summer, with better fill rates as we move through the summer months.

Cait Howard, Analyst (Barclays, covering for Karen Short)

Great. Thanks.

Operator, Operator

Your next question comes from Eric Larson from Seaport Global Securities.

Eric Larson, Analyst (Seaport Global Securities)

Thanks, everybody, and congratulations on a good quarter. Steve, I may have heard this incorrectly, but you mentioned wholesale inflation was around 100 basis points. Many CPG companies are taking pricing up and there seems to be a lag to how that comes in. Could you comment more on how you see inflation later this fiscal year and into next fiscal year, and how that might translate into your results? Would it increase promotional activity and how would you view that?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

You’re right that wholesale inflation has been modest recently — roughly in the 100-basis-point range. However, we expect inflation to ramp up more materially into fiscal ’22 based on what we see in the pipeline and rising input costs. At the same time, as product returns to shelves and manufacturers try to regain market share, we expect promotional activity to increase. That combination — higher inflation and more promotions — is a tailwind for UNFI because we earn margin on promotional periods and the math generally works in our favor in that environment.

Eric Larson, Analyst (Seaport Global Securities)

Excellent. And a longer-term question: you’ve optimized some distribution systems already, but you still have many to go. Will that require a lot more capital, or is it mainly consolidating existing facilities? Also, have you quantified the upside to EBITDA or margin from completing these optimizations?

Eric Dorne, Chief Operating Officer (COO)

We are still evaluating the network given cross-selling, additional demand and protecting capacity for growth. We’re early in planning beyond the markets we’ve already optimized. Automation utilization across the network is a focus. Over the coming months we’ll share more detail, but we’re not quite there yet to provide specific quantified targets.

Eric Larson, Analyst (Seaport Global Securities)

Okay. Thank you.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

From a commonsense perspective, operating fewer DCs in a market reduces duplicate inventory, overhead and equipment, and allows more volume per facility which yields leverage and higher EBITDA. Our optimization is focused on that dynamic.

Eric Larson, Analyst (Seaport Global Securities)

On the capital side, is this more consolidating existing facilities or greenfield builds?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

It’s primarily consolidation and optimization of existing facilities today. It’s not a Greenfield, large-capex play in the near term. We’re comfortable operating in the roughly 1% of revenue CapEx range and have been disciplined with that number.

Operator, Operator

Your final question comes from the line of Kelly Bania from BMO Capital Markets.

Kelly Bania, Analyst (BMO Capital Markets)

Hi. Good morning.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Hi.

Kelly Bania, Analyst (BMO Capital Markets)

Just wanted to follow up on inflation again and what you’re seeing at wholesale versus retail. Are there differences across channels at retail in terms of inflation?

Chris Testa, President

Kelly, the biggest driver of the gap between wholesale and retail inflation is promotional dollars — or the lack thereof. Retailers have not been spending typical promotional dollars; that drives higher retail margins relative to wholesale. Those promo dollars also flow through us and impact our margin when they return. We’re not seeing a specific channel driving the gap; the difference is largely promotional spending and the related pricing actions by retailers.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

There’s also been retailers taking price, which is embedded in that gap. The gap between retail and wholesale is roughly 300 to 400 basis points due to retailers taking price and the lack of promotions.

Kelly Bania, Analyst (BMO Capital Markets)

Okay. You said wholesale inflation was about 100 basis points historically — and you expect that to ramp up. Thanks. A follow-up on Whole Foods: in the past you negotiated every five years. Will this new seven-year contract be renegotiated in seven years, or will you renegotiate halfway through as before?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

This will be renegotiated in seven years. In the old world we had a 10-year agreement but negotiated at the five-year mark; now we have a full seven-year contract without those mid-term renegotiations.

Kelly Bania, Analyst (BMO Capital Markets)

One last question on DC optimization: at Investor Day you laid out a vision of fast-turn and slow-turn inventory flowing differently. Has that vision changed? How does that logistics model compare to what you’re implementing and when will product be moving on single trucks in the way you described previously?

Steve Spinner, Chairman and Chief Executive Officer (CEO)

The vision remains the same: get product on one truck where possible to drive economies for us and for customers. We are implementing that in some markets; it’s still a multi-year journey. We’ve added automation to handle slower-moving, each-pick inventory in some DCs. Migrating to singular IT platforms is a precursor to one-invoice, one-truck execution, and we’ve made a lot of progress. COVID did delay some activities, but the strategy hasn’t changed and we are continuing toward that goal.

Kelly Bania, Analyst (BMO Capital Markets)

Thank you.

Steve Spinner, Chairman and Chief Executive Officer (CEO)

Well, thanks everybody for joining us. It was a great quarter. I really want to thank our team of over 30,000 associates around the U.S. and Canada. The work they did to get product delivered every single day through weather and COVID and so many other things was just amazing. The strategy that we’ve put in place is working. Our customers are telling us it’s working and they are showing us that it’s working with what they’re buying from us and what they continue to buy from us. So terrific quarter, we anticipate having a really good year and thank you for being with us today.

Operator, Operator

Ladies and gentlemen, this does conclude today’s conference. Thank you for your participation. You may now all disconnect.