US Foods Holding Corp. Q3 FY2021 Earnings Call

Good day and thank you for standing by. Welcome to the Quarterly Earnings Conference Call. At this time, all participants' lines are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. Operator provided instructions. I would now like to hand the conference over to your speaker for today, Ms. Melissa Napier. Please go ahead.

Thank you. Good morning and happy Monday. I am joined for our call today by Pietro Satriano, our CEO; and Dirk Locascio, our CFO. On today's call, we will provide an overview of our results for the third quarter and first nine months of fiscal 2021. We'll take your questions after our prepared remarks conclude. Please provide your name, your firm and limit yourself to one question. During today's call, and unless otherwise stated, we're comparing our third quarter and nine-month results to the same period in fiscal year 2020. Our earnings release issued earlier this morning and today's presentation slides can be accessed on the Investor Relations page of our website. In addition to historical information, certain statements made during today's call are considered forward-looking statements. Please review the risk factors in our 2020 Form 10-K for those potential factors which could cause our actual results to differ materially from those expressed or implied in those statements. And lastly, during today's call, we will refer to certain non-GAAP financial measures. All reconciliations to the most comparable GAAP financial measures are included in the schedules on our earnings press release, as well as in the appendices to the presentation slides posted on our website. I'll now turn the call over to Pietro.

Thank you, Melissa. Good morning, everyone. Third quarter results were in line with expectations. Volume for the quarter was up 18% over prior year and 6% below 2019 as the industry continued to recover. EBITDA margins were up slightly as we continue to successfully manage through both higher-than-normal product and labor inflation. This performance resulted in strong cash generation, which contributed to further deleverage from the prior quarter. Since the industry is demonstrating that it is well on its way to recovery, we are shifting our discussions and our goals to be more in line with our pre-pandemic strategy. First, to profitably grow market share with our Great Food Made Easy differentiation. Second, to optimize gross profit margins. And third, to execute with an intense focus on operational efficiency. But first, let me start, as I usually do, with a brief update on the industry on slide 3. Industry foot traffic at restaurants in the third quarter was largely in line with the prior quarter despite the surge in COVID cases due to Delta. This underscores our view that industry demand is resilient, and that demand for eating out or taking out at restaurants is largely past COVID. In fact, as seen by the chart on the right, Technomic is now calling for the entire industry to recover to pre-pandemic levels across restaurants and other customer types alike by 2024. Based on our own current trends, we are confident that US Foods will recover ahead of the industry with our volume returning to 2019 levels some time in 2022. This reaffirms our continued ability to gain market share. Now let me turn to our volumes on slide 4. Restaurant volume for the third quarter was generally in line with the second quarter, and the slight dip in growth rate that you see in the third quarter is attributable to COVID-related staffing challenges in a handful of markets. If not for these challenges, we believe we would have achieved higher volume and market share gains, gains that are fueled by our differentiated Great Food Made Easy platform. October volumes to restaurants are trending slightly higher than the third quarter. Hospitality volume continues to recover, while volume to healthcare was flat for the reasons that I mentioned on our last call. Some lingering restrictions on visitors have hurt food consumption in hospitals, while Senior Living has yet to recover to pre-pandemic occupancy rates. We think recovery in Senior Living is simply a matter of time, given the favorable demographics of an aging population. Lastly, we continue to have great success finding larger multi-geography customers across healthcare, hospitality, and chains. For the two years combining 2020 and 2021, we are on track to add $1 billion in net incremental business across these three customer types, some of whom will onboard in 2022. This $1 billion is net of any exits over the last two years, including strategic exits as we continue to optimize our portfolio. The single most important reason cited by these large customers for switching to US Foods continues to be our service model, which makes it easier and simpler for customers to do business with us. I will now update you on the elements of our strategy starting on page 5, with how Great Food Made Easy will continue to drive market share gains with target customers. Recall that Great Food Made Easy consists of three elements: innovative products, industry-leading technology, and a selling and service model based on a team of experts that support our sellers, what we call team-based selling. Let's start with innovative products. We had yet another successful Scoop launch, featuring labor-saving products that are highly relevant to customers in this tight labor market. This was the tenth anniversary of Scoop, and since then we have launched 540 exclusive, innovative products, of which 80% are still sold somewhere in our network, a remarkable stick rate. Also of note, on the product side during the quarter, we rolled out Tender by Design, an innovative and proprietary beef program that we inherited with the acquisition of Food Group. In the sub-category that we launched, we saw a 300-basis-point increase in market share, and we expect further market share gains as we expand the lineup. Turning to technology for the second element of the Great Food Made Easy platform, we continue to expand our leadership position with frequent releases of enhancements, including a recent update that provides customers with real-time inventory visibility during the ordering process, which is critical in this environment of supply volatility. Recent third-party research with customers reaffirmed our lead in technology in our industry with customers rating the US Foods mobile app significantly better with a Net Promoter Score several times higher than the competition. Representative quotes from the survey include: easier to navigate, most logical setup, and able to show all breadth of products and ways to save money. Lastly, on the third element of our differentiation platform, our team of experts. Fast Company named US Foods one of the 95 brands that matter in recognition of the seminars, playbooks, and expertise that we delivered to customers to help them navigate the pandemic. Having now just covered how Great Food Made Easy is driving EBITDA growth and market share gains, I'm turning to page 6 to cover the second and third elements of our strategy that is optimizing gross profit margins and driving operational efficiency. Let's start with our efforts to optimize gross profit. As Dirk will cover shortly, gross profit per case for the quarter was the highest it has been in recent years. Despite some headwinds from unfavorable customer and product mix, contributing to this expansion in gross profit has been: first, our ability to manage and pass through inflation; second, continued growth in private label brands; and third, the continued optimization of terms and customers in our portfolio. For the quarter, private label as a percent of total sales in our legacy US Foods broadline business was 36.6%, which represents almost a 140-basis-point increase compared to Q3 of 2019. And we still see plenty of opportunity for further growth in private label penetration, which will further expand gross profit margins. We also continue to optimize our portfolio of customers, negotiating better terms, bringing on new, more profitable business, and where warranted exiting customers at the low end of the profitability range. New business in healthcare, hospitality, and national chains that I referred to and that we brought on this year is coming in at margins that are three times higher than the existing base. Still on page 6, I want to update you on the third and last element of our strategy, an intense focus on operational efficiency. In supply chain, while the challenging labor environment persists, we have made significant progress in our hiring, and our headcount for drivers and selectors is now above 2019 and close to our staffing targets. The resulting high penetration of new warehouse and driver associates, not surprisingly, was a headwind to productivity in the quarter. But we do expect to return to 2019 productivity levels by mid-2022, as the tenure of the workforce returns to more normal levels. In addition, we continue to make progress on our supply chain efficiency roadmap. Since the beginning of the year, we have reduced assortment by 15%, which not only contributes to higher service levels for customers but also to higher productivity in the warehouse. With staffing now in a better position, we have resumed the deployment of our new picking technology, which we started in 2019, and we now expect to complete that by the middle of 2022. This technology has demonstrated improvement in productivity, especially of new associates, as well as service to customers. And lastly, we have resumed the roll out of more efficient receiving methods, which we had also paused. On the delivery side, with greater stability on the customer ordering front, we can now put greater focus on continuing to optimize routing. Taken together, these efficiency initiatives will help bring distribution expense closer to historical levels. Lastly, on the sales and administrative side, we still expect to retain two-thirds of the $180 million in fixed cost savings that we announced last year, with most of the reinvestment showing up as an expansion in our sales force, which will drive market share. We're very pleased with the level of sales talent we are attracting. Our tools, our unique products, and our culture make us a very attractive choice for sellers. I will now move to slide 7. For a quick update on the Smart Foodservice and SGA Food Group acquisitions, which are both performing at or above expectations. We call that: the rationale for the Smart Foodservice acquisition was two-fold. One, the opportunity to expand our presence in the Cash & Carry market, which is growing at roughly twice the delivery market with higher margins. On that front, we continue to secure real estate for expansion into new geographies. And two, the revenue synergies that come from existing customers in existing markets. The fact that same-store sales at our nearly 80 Chef's Stores, open at least one year, are ahead of 2019 levels provides some support for that thesis. And on the synergy front, we are beginning to see reductions in cost of goods and improvements in private label penetration. Lastly, we expect 2021 EBITDA for our Cash & Carry business to exceed 2019. Turning now to Food Group. Recall the rationale for that acquisition was to complete our footprint in the important and growing Pacific Northwest region. It was notable we recently won a significant national customer due to our strong presence in the Pacific Northwest, which was the result of this acquisition. We have now completed six warehouse system conversions and all have gone fairly smoothly. We expect to have seven warehouses completed by year-end and all complete by early 2022. With the continued progress on integration, synergy capture remains on track. By the end of 2021, we will have captured approximately $40 million of the projected $65 million in synergies. And as I mentioned earlier, we are now starting to see some of the revenue benefits across the entire US Foods network from center-of-plate capabilities that came with this acquisition. I would now like to turn the call over to Dirk to discuss our third quarter results and our outlook.

Thank you, Pietro. And good morning, everyone. I will start on slide 9. Our third quarter financial results were in line with our expectations and demonstrate the strength of our business. Sales increased compared to Q2, and our volume was in line with the prior quarter. As Pietro mentioned, a slight decrease in the third quarter restaurant volume growth versus 2019 is attributable to COVID-related staffing challenges that impacted our industry and also impacted our business. Our Q3 trends were similar to traffic trends from various industry data sources and commentary from several restaurant chains. During the third quarter, we also experienced additional food cost inflation, namely in protein categories such as beef and pork. In addition, after seeing food cost inflation moderate in July, these costs accelerated again in August and September. Our team continued to do an excellent job of managing that inflation and effectively passing it through to the customers. This resulted in continued strong gross profit per case performance. In fact, even stronger than Q2 and, as Pietro noted, was the highest gross profit per case in recent years. During the quarter, we successfully filled most of our open warehouse and transportation roles, and as Pietro said, are close to hiring and staffing targets. We are focused on increasing the productivity of those hired in recent months. Our supply chain costs are expected to be high in Q4, given the large number of more recent new hires with significant improvement in costs by mid-2022 as productivity improves through training and experience. Inbound product supply from vendors also remains a challenge. Strong gross profit is offsetting some of the labor cost headwinds that we and others in the industry continue to face. Our operating cash flow was strong for the quarter and we used that cash to further reduce our debt and leverage. We're focused on effectively managing through the challenging COVID environment and related supply chain labor and product availability challenges. At the same time, we're balancing that as we look to the future by continuing to enhance our digital platform, supply chain technology, and processes to our operating model and continuous improvement focus in line with our pre-pandemic strategy. We saw improved restaurant volumes in October, which indicates there is strong underlying customer demand to accelerate our restaurant growth further, as we also continue the recovery back to 2019 levels in healthcare and hospitality. Moving to slide 10, net sales for the quarter were $7.9 billion, up 35% from the third quarter of 2020. Food cost inflation for the quarter was 11.5%, driven by further inflation mainly in proteins. Adjusted gross profit for the quarter was $1.3 billion, up 30% from the prior year. Our adjusted gross margin decreased by 70 basis points as a result of the inflation, much of it being in proteins. We generated strong gross profit per case, again this quarter, as we continued to experience product cost inflation. As I mentioned last quarter, inflation benefits our gross profit dollars, while it's typically a headwind to gross margin rate. With over 11% year-over-year food cost inflation in the third quarter, primarily in commodity categories, our gross margin as a percent of sales was compressed, yet our gross profit per case is the best we have seen in recent years. That's ahead of 2019 and even stronger than Q2. We're pleased with our gross profit performance, again in Q3, especially given the freight headwinds impacting us and others in the industry. The actions we're taking on pricing, growing private label, and optimizing our customer mix are showing up in our results. As long as food cost inflation continues, we expect to manage through it effectively to increase gross profit dollars. Adjusted operating expense in the third quarter was $988 million, up 28% versus the prior year. As a percent of sales, adjusted operating expense was 12.5%, down from 13.2% the prior year for an improvement of 70 basis points. While food cost inflation is the headwind to our gross margin rate, it is a benefit to operating expense as a percent of sales. Just as a point of reference, our OpEx as a percent of sales is about 50 basis points lower than it was in the third quarter of 2019, largely due to the significant food cost inflation. We continue to experience additional supply chain labor inflation this year, largely as expected coming into Q3. During our last call, I mentioned that we expected additional labor inflation this year of about $20 million to $30 million, mostly in half two, above and beyond the approximately $50 million of normal annual supply chain labor inflation we experienced. The $20 million to $30 million in half two, or $40 million to $60 million annualized for 2022, is still our best estimate of the incremental inflation. We continue to use hiring and retention bonuses, and have increased wages in additional markets during the quarter, driven by the broader market wage rates increasing in those markets. We now expect most of this year's incremental labor inflation to be permanent, and we expect the impact we are seeing to be comparable to others in and outside of the industry. We continue to think that inflation in future years, however, will revert to more normal levels, and thus, the higher inflation in the current year to be transitory. We do expect productivity to offset some of the incremental inflation. In this environment, we're also having success with margin increases on a number of customers and ultimately expect the margin increases to offset most of the incremental permanent labor inflation. We will continue to optimize customer terms to offset the labor inflation. On slide 11, adjusted EBITDA was $291 million for the quarter, a 39% increase from the third quarter of 2020. The P&L outcome was largely aligned with our expectations. Gross profit did outperform our expectations since we didn't initially plan for the level of additional food cost inflation in our outlook, and that was offset by higher OpEx from increased supply chain costs largely due to the productivity impact from the higher number of new hires and hiring costs. Adjusted EBITDA as a percent of sales was 3.7%. As I mentioned earlier, we are seeing improvements in case volume growth in October and expect the 2022 recovery in restaurant volume in select markets plus market share gains will make up for the slower recovery in hospitality and healthcare volume. On volume, we're optimistic the October re-acceleration continues as COVID cases continue to decline. As we look ahead to Q4, we expect the EBITDA drivers to be similar to Q3 with good gross profit as long as inflation continues and continued high supply chain costs. That said, we expect total EBITDA dollars at levels below Q3, largely because Q4 is typically a seasonally lower volume quarter and to a much lesser extent due to higher supply chain costs from the on-boarding of many supply-chain new hires and the impact of the signing bonuses and continued on-boarding of new sellers that we've talked about previously. Specifically on volume, historically, we've sold roughly 6 to 7 million fewer absolute cases in Q4 than Q3. This year we also have an incremental negative volume impact of about 100 basis points in the quarter, if you're comparing to 2019, due to the way the New Year's holiday falls on the calendar, which helps Q1 2022. The seasonally lower volume and holiday timing impact is significant in terms of EBITDA impact when it comes to comparing Q4 EBITDA expectations to Q3. We and others in the industry typically see an improvement in gross profit per case due to the additional holiday business and related product mix. We aren't sure how much volume the industry will see in Q4 from holiday gatherings, potentially impacting the significant benefit we can have on volume and gross profit rates. So we're watching that closely. Likely to be better than 2020, but not back to the levels in 2019, meaning gross profit may not see quite the rate tick up this year that we have historically experienced versus Q3. Just as a reminder, if you're comparing Q4 volume to 2020, also remember that 2020 had an extra week in the fourth quarter. Earlier, Pietro mentioned that our current best estimate continues to be a return to pro forma 2019 case volume levels sometime in 2022. We also have our sights firmly on returning to 2019 pro forma adjusted EBITDA, and then growing from there based on M&A, synergies, top-line growth, including the $1 billion in net new customer wins as Pietro referenced, plus gross profit expansion and cost savings. Finally, adjusted net income in the third quarter was $119 million and adjusted diluted EPS was $0.48 compared to $0.19 in the prior year. Turning to slide 12, operating cash flow for the first nine months of the year was $520 million compared to $533 million in the prior year. The prior year still had the benefit of working capital management actions we took when COVID set in and that had not fully unwound by the end of Q3. Year-to-date operating cash flow in 2021 is in line with the pre-pandemic amounts through the first three quarters of 2018 and 2019, demonstrating we are effectively converting our EBITDA to operating cash. Our business generates a significant amount of operating cash flow each year and we expect to grow that cash flow with EBITDA. We'll use this cash to reinvest in our business and reduce total outstanding debt. In the third quarter, we proactively paid down an additional $100 million of total debt incremental to our standard debt payments, and have reduced our net debt approximately $300 million and nearly three turns year-to-date. Our leverage ratio decreased further in Q3 to 4.8 times due to the net debt reduction and the significant improvement in adjusted EBITDA. Our target leverage ratio remains between 2.5 and 3 times, and we're well on our way towards that target. We expect to continue to make progress against the target via additional debt reduction and increased EBITDA. To close, we are focused on the continued recovery of our business. However, as Pietro said at the outset, since the industry has demonstrated it's well on its way to recovery, we're shifting much more of our focus back to our pre-pandemic strategy: one, to profitably grow market share with our differentiated Great Food Made Easy; two, to smartly optimize our customer margins and mix; and three, to bring an intense focus to operational efficiency. We expect this focus will lead to our volume recovering well ahead of the Technomic outlook and further improving our gross profit and OpEx, resulting in healthy earnings growth and a strong capital structure. We will continue to use the strong cash flow to invest in our business and reduce debt, as we look to 2022 and beyond. We're optimistic on our ability to profitably grow our business and deliver value for our shareholders. Operator, at this time, we can now open the call for questions.

The floor is now open for questions.

Hi. Good morning, guys. Profit per case this quarter was obviously very good. Case growth was a little bit lighter than what we and I think probably others expected. I was hoping you could talk a bit about the cadence of case growth during the quarter versus where June was. Maybe give a little color by customer type, including independents, and then talk about the staffing challenges and the impact that had. Is it possible to quantify sort of what amount of volume is being left on the table by that to give us a better sense as to where the business really should be running right now?

Sure, Ed. I'll start with that. Ultimately through the quarter, if you look at the way Q2 continued and then into Q3, our cadence is not that dissimilar to what you've probably seen from industry traffic data sources and a number of the chains where June was the strongest, then July similar, some softening in August and early September, and then really some pickup toward the end of September, and that's continued into October. So ultimately, that's similar across a number of our markets, especially around restaurants and hospitality. What we're seeing is almost all of the slowing of the volume recovery is around staffing challenges in certain of our markets. From an end-demand perspective, or any impacts on end demand from the Delta variant, that appears to be pretty insignificant. So as COVID cases decline, our staffing continues to improve. We're optimistic that the re-acceleration we're seeing in October continues through the balance of the year and into 2022. That's positive as we look ahead.

Is there any way to quantify the staffing component impact?

We're not going to comment on a specific impact of foregone volume. What we're seeing in our markets is that customer demand and consumer demand appears to be there. The challenges we've had don't appear to be dissimilar to others, and we are seeing in markets where our staffing was stronger that those markets are growing in double digits. So we're confident that as we get further through this and past this, there's plenty of business out there and that we can meaningfully accelerate our growth rate.

Great. Thank you.

Your next question comes from the line of Rahul Gretta. Your line is open. Please go ahead.

Good morning, guys. Thanks for taking my question. Just going back to slide 6, this initiative sounds familiar. What is an evolution or enhancement of an existing project versus what are the new projects with their own paybacks embedded within these initiatives? Also wanted to check if these projects require investment before return or can improvement be expected without incremental near-term investment in these initiatives?

This is Pietro. So a number of the distribution levers you're going to go after in terms of warehouse productivity and delivery productivity are levers that we continue to push on and continue to improve on, which is why there's a certain amount of familiarity to what we talked about. However, what I would call out is, especially on some dimensions, the assortment rationalization, some really good progress compared to historical norms. In terms of your question about investment, the one or two technologies that I talked about in terms of picking technology really are very modest investments and the payback is pretty immediate.

I understand.

Your next question comes from the line of Lauren Silberman. Your line is open. Please go ahead.

Thanks for the question. Just on gross profit per case up year-over-year and sequentially, you guys called out inflation, private label, and optimization in terms and mix. How are you thinking about the sustainability of gross profit per case from here, thinking into 2022 as perhaps you see some inflation come down? And then I understand your commentary on the uncertainty around the holiday performance. Would you expect fourth-quarter gross profit per case to be at least as high as Q3?

Hi, Lauren, thanks for the questions. We do believe that the higher gross profits are sustainable, though the exact level depends on what happens with inflation. We think the combination of factors, including pricing, private label growth, and customer mix optimization, together with the environment of higher labor cost challenges, all contribute to stronger gross profitability. We're confident in our ability to maintain a higher level, even though it may move around a little from quarter to quarter. I won't speculate an exact amount for Q4. With holiday timing, think of it as really a Q4 2021 effect and it doesn't change how we think about recovery into 2022 and beyond. From what we're preparing, there will probably be more activity, which is encouraging for demand and people getting out more. That bodes well for the continued recovery into 2022.

Great. And it looks like sales per case was up a bit more than gross profit per case this quarter. Anything you can share about the dynamics there and what's driving that?

That's really more around the categories in which inflation came in. In the third quarter a lot of it came from proteins and those categories tend to be a fixed markup per case or per pound. So you don't necessarily see gross profit go up quite at the same level as sales. There's nothing fundamentally different beyond that.

Great. Thanks so much.

Your next question comes from the line of Mark Carden. Your line is open. Please go ahead.

Good morning. Thanks a lot for taking my questions. On the inflation front, is there a point at which you would typically become concerned that elevated inflation could start leading to demand destruction? Do you see this being much of a risk, and if inflation hits a certain point for a certain period that customers basically shift more of their spend to food at home?

We haven't seen that. As you've seen from industry data and our own data, consumer demand continues to be very healthy. The increase in digital ordering and take-out has helped demand for food away from home. A couple of data points that lead us to be confident: one, growth in food away from home relative to food at home continues to close the gap and the expectation by industry analysts is that the lines will cross sometime in 2022 or early 2023, with more dollars being spent away from home than at home. Second, the inflation between food away from home and food at home has really narrowed over the last several quarters. The protein inflation we're seeing is being seen in both food away from home and food at home. If there is substitution, it will likely be within the sector, perhaps shifting away from more expensive proteins toward less expensive proteins. So we feel pretty good about the outlook.

From an optimization standpoint, have you had to de-list many incremental independent locations while optimizing your trucking routes throughout the last quarter?

I understand. In a handful of markets, we had to rationalize the amount of demand we were able to serve; that was sometimes due to driver shortage and sometimes due to selectors. We also had a number of facilities where COVID impacted staffing and we had a one- or two-week setback in our ability to serve customers. But in other markets, when competitors had issues, we benefited and saw increases in market share.

Great. Very helpful clarity, and best of luck.

Your next question comes from the line of Nicole Miller. Your line is open. Please go ahead.

Thank you. Good morning. I might have misunderstood on the Q4 commentary. I think you said EBITDA commentary about down sequentially. Restaurants traditionally have a better Q4 and I don't see that historically in your numbers, so did I misunderstand that?

No, you did not. In our business, historically Q1 and Q4 absolute volume is lower for us than Q2 and Q3. That's the seasonal pattern and part of why Q4 EBITDA is typically below Q3.

You talked about 6 to 7 million sequentially seasonally on absolute volumes, and there was one other timing item. Can you address that item, whether it was one-time? And does this translate to EBITDA being lower in the fourth quarter than the third quarter?

Yes. As a reference, typically we sell 6 to 7 million fewer cases in Q4 than Q3. On top of that this year, when comparing to 2019, New Year's and Christmas both fall in the last week of 2021, which has an additional negative impact of about 100 basis points in the fourth quarter of this year, and that timing will help Q1 next year. So the lower Q4 EBITDA versus Q3 is seasonal and related to timing and some incremental costs from hiring and bonuses.

On the sales or business returning to normal mid-2022 and the labor question: where are you hiring from? Is this a productivity unlock from learning enhanced technologies, or are you hiring outside the industry and teaching basics?

Just to clarify, when we talk about 2022 we're referring to the volume outlook, which is largely a function of hospitality and healthcare recovering toward 2019. Selectors and drivers are different occupations. Drivers require commercial licenses; this has been a headwind predating the pandemic. We're aggressively recruiting drivers and have credit programs where selectors can train to become drivers, which helps retention. Selectors often come from other warehouse environments, and while our environment is fast-paced and high-volume, their background provides a foundation. The training focuses on our methods in the warehouses and our industry, which may be different from where they come from, but at least they have a sense of the environment they'll be working in.

That does. Thank you. Appreciate it.

Your next question comes from the line of Jeffrey Bernstein. Your line is open. Please go ahead.

Great. Thank you. I have two questions. First, from a top-line perspective: you mentioned Technomic suggesting the industry would get back to 2019 sales levels by 2024, which seems conservative. You mentioned you'd achieve that by 2022. As you think about it relative to your forecast, would you prioritize the biggest benefit being further penetrating existing accounts, net new business you're adding, or M&A? Given elevated leverage, is M&A an option near term? We're trying to prioritize why you believe you'll recover faster than the broader industry across these buckets.

Part of our view comes from observed results so far. Our restaurant business has recovered more quickly than the broader industry, and that's where we've seen market share gains. The growth will come from the right business: existing customers where we can grow share of wallet and new business that fits our footprint and SKU coverage. The work we've done optimizing the portfolio includes renegotiating terms and exiting customers where we couldn't find a fit. It's about growing in a healthy fashion that expands margins both in absolute dollars and in EBITDA margins.

Understood. On the inflation side, many investors see foodservice distribution as a good place in a high-inflation environment because you can generally pass through inflation to customers. How confident are you in continuing to pass it along, given inflation now in the low double-digits? Any concern as it approaches these levels, and thoughts going into Q4 and 2022 relative to the 11% plus in Q3?

Jeff, we are confident in our ability to pass it through, as you've seen for two quarters in a row. Our processes and customer base and contract structures set us up well for that. We did see inflation moderate a little into October, but as noted previously, we saw a similar moderation in July and then it picked up again. We'll continue to watch it. Operators are thoughtful and creative in how they manage food costs, and our differentiated model helps them. It's harder to predict exactly what happens in 2022, but our focus is helping operators manage through it while ensuring our processes allow us to pass through inflation. About 70% of our customer base provides a pretty direct pass-through, which is an advantage and one of the key enablers of strong gross profit in Q2 and Q3.

If you saw some moderation in commodity inflation in October, would you expect year-over-year inflation to subside in Q4 if trends continue? Or is there something unusual in last year that might keep the year-over-year inflation percentage higher in Q4 versus the 11% in Q3?

I don't know that it will necessarily subside; October is one data point that indicates the month exited the quarter without a lot of incremental growth above where Q3 left off. It's hard to know and we'll continue to watch as we go into Q4.

Your next question comes from the line of John Glass. Your line is open. Please go ahead.

Thanks very much. Going back to comments about returning to pre-COVID operations and optimizing customer mix and warehouse initiatives: is there a way to quantify what those can do from a savings perspective? From the gross side, what have you realized so far in gross margins as you've shed unprofitable customers? How should we think about how that could benefit the margin structure in the business?

We haven't quantified the specific impacts at this point, but a few pieces I can share: these are the components driving improvements. We're balancing top-line growth and margin expansion, which we did from 2015 to 2019 by about 90 basis points of EBITDA margin improvement. From a customer mix perspective, while healthcare and hospitality remain below 2019 in some areas, our net new business wins come in at higher margins and our pricing actions and customer mix are having a meaningful positive impact on margins and EBITDA in recent quarters. Private label growth is another driver; private label is almost twice as profitable as manufacturer brands, and we've made significant progress and see opportunities to continue growing. From a supply chain perspective, we've made progress but are midstream on a number of initiatives. Assortment rationalization, for example, simplifies operations and helps service levels, and in a vendor availability environment it's a win-win.

Thank you. One follow-up: you cited inefficiency from new workers. Is there a way to quantify what percentage of warehouse or drivers are new today versus normal pre-pandemic, so we understand the opportunity and challenge?

We haven't broken out specific percentages now or historically. It is meaningfully more given the hiring we've done in recent months. Ramp-up for warehouse selectors tends to be in the neighborhood of three to six months to get closer to full productivity, and drivers can take a little longer. Since we're at roughly 2019 staffing levels and our focus remains on select markets, we feel well-positioned to reduce supply chain costs and improve productivity through mid-2022.

Thank you.

Your next question comes from the line of John Heinbockel. Your line is open. Please go ahead.

I'll start with a strategic question and then another. When you think about the supply chain opportunity, how aggressively can you pursue it while balancing top-line market share potential? You don't want to go too fast and impact customer experience. Talk about balancing that and how quickly you can move. In sizing it, is the ultimate supply-chain opportunity in the ballpark of the proactive cost-outs a year ago or is it much smaller?

We think we have a great opportunity in operational effectiveness and efficiency, and the recent additions to our leadership team will help us pursue that aggressively. There doesn't have to be a trade-off between customer experience and efficiency: for example, assortment rationalization can improve both customer service and operational efficiency. The work we did when we consolidated single-site area divisions into multi-site areas was administrative; the current opportunities are primarily variable operational costs. Part of the upside is natural productivity gains as new drivers and selectors gain tenure, and on top of that we will layer technology and other initiatives that we paused during COVID. Given staffing levels are nearing 2019, we're in a good position to resume those initiatives.

Is there a way to size the ultimate supply chain opportunity? Does it rise to the level of the cost reductions you did last year?

It's materially significant, but we're not prepared at this point to size it. Stay tuned.

Okay. Lastly, what are you seeing with lines per stop and pieces per stop?

Good news on both. We're seeing lines per stop increase and cases per line increase. Lines per stop are a good proxy for our ability to gain share of wallet, and cases per line are a good proxy for customer demand. We've seen both go up over the last few months, reflecting the quality of new customers and our continued portfolio optimization.

Thank you.

Your next question comes from the line of Alex Slagle. Your line is open. Please go ahead.

Thanks. Good morning. You mentioned some freight pressures. Can you comment on the magnitude of that headwind in Q3 and how you see it evolving into Q4 and 2022? Anything different about how you're managing these headwinds versus what you've done in the past? And the portion of inbound freight where you're using third parties — any color there would be great.

Freight continues to be a headwind, driven by tightness in the overall freight market. It's meaningful but less than the impact of the overall supply chain labor pressures. We learned from the 2018 freight tightening and put plays in place; we've executed many of those in 2021, but it's challenging because freight costs have continued to increase. We've made significant progress and are closing some of the headwind as the year has gone on, and we continue to work through it to be well-positioned as the environment steadies. We balance cost and service: some product we pick up with our own trucks and some we contract with third parties. In this environment we've leaned on strong third-party partners to ensure loads are picked up and arrive on time. This situation likely continues into 2022 and it's not something that will go away imminently, but we can control making sure we get product and making progress on the P&L as we work through it.

When product costs start to drop, is there the ability to capture incremental margin because of lags in contract repricing or timing with non-contracted customers?

Yes, there is some opportunity when inflation declines. Volatility creates opportunities for pricing actions. We're balancing pricing fairly with customers and managing against a tight supply backdrop. Over time, slow and steady inflation helps grow gross profit dollars, but periods of volatility create both challenges and opportunities.

Thank you.

Your next question comes from the line of Peter Saleh. Your line is open. Please go ahead.

Thanks for taking the question. You mentioned reduced assortment several times. Are you actively reducing assortment and SKUs? If so, how early are you in the process? Should we expect more reduction in Q4 into 2022, or as sales come back to 2019 levels, does assortment come back into the warehouses? I have a follow-up.

Assortment rationalization is ongoing. We pushed it this year prompted by supply volatility and by operational efficiency opportunities. It's an ongoing process. Please go ahead with your follow-up.

The other question would be, just on the assortment reductions so far, have you seen any sort of sales impact to date? And do you expect anything going forward?

We typically remove duplicative SKUs in the middle of the curve or the very long tail, and we work closely with our salespeople and customers on that. We have not seen any sales impact from that work to date.

Thank you.

Your next question comes from the line of Kelly Bania. Your line is open. Please go ahead.

Hi. Good morning. Wanted to ask about the hospitality segment. It looks like it came in at Q3 pretty similar to where you exited Q2, maybe down about 29% or 30% and pretty stable. How did that compare to internal expectations? What cadence or pace of recovery are you expecting from here, and how are you benchmarking performance of that segment? Also, what seasonality should we expect in that segment as we look into Q4?

Looking at slide 4, hospitality continues to make progress toward 2019. Factors that need to work themselves out include staffing at large park properties, which limits guest capacity; less inbound international travel; domestic travel is recovering but patterns fluctuated; and the return to office and business travel, which seems to be picking up. We see all three of these returning to pre-pandemic levels over time. Also, as hospitality opens up, customers are engaging with us for business opportunities and we're optimistic our pipeline and market share gains will more than make up any shortfall from industry dynamics.

We have a follow-up question from Edward Kelly. Your line is open. Please go ahead.

Thanks for letting me back in. I wanted to ask about the added cost associated with labor, which you said is $40 to $60 million annually as a more permanent cost. How's visibility on that? With investor anxiety on labor and inflation, you have your labor force where you need it to be — do you feel visibility on that number is now good?

Good question. Yes, we feel the visibility is quite good. That was one of the things we wanted to be clearer on versus last quarter. While we don't know the exact final amount, we think that range is a very good estimate. We're also gaining confidence from the success we're having in margin improvements with customers. We expect to offset most if not all of this year's incremental inflation with customer margin improvements through actions already negotiated or in progress for 2022. From an overall earnings power perspective, we don't see this as a permanent inhibitor; it's something we'll manage through next year.

To bridge to OpEx per case in 2022 versus 2019, is the best way to take $50 million in annual labor inflation, add the $40 million to $60 million, then subtract some of the $130 million in cost savings and that gives an OpEx per case number versus 2019? Or are there other things to consider?

You're identifying the big pieces: inflation (normal and incremental), and productivity improvements as we return to 2019 productivity, plus incremental productivity from initiatives. The $130 million in fixed cost savings is largely fixed and administrative; very little of that is in variable distribution costs like drivers and selectors. So attribute little of the $130 million to distribution savings; focus on the inflation plus the productivity levers.

Last question: does the product scarcity and difficulty getting product help accelerate pass-through to customers versus normal timing?

Yes, separate the two: normal food cost pass-through can be quick, given weekly to monthly contract resets. For non-contracted situations, product supply issues can make pass-through happen quickly. On the labor side, we've been actively engaging with customers and have had constructive discussions; we've already reached agreement on margin changes representing close to half of that $40 million-plus number, either in place or moving in the coming months. So good progress and we expect to continue addressing the incremental inflation through pricing.

Great. Thank you.

There are no further questions at this time. I would like to turn the call back to Mr. Pietro Satriano for closing remarks. Please go ahead, sir.

Thank you. I'd like to close by thanking our 26,000 associates who, amidst what is still a difficult environment, have continued to do a phenomenal job of serving our customers and generating the results we discussed today. Our three-pronged strategy of profitably growing market share by leveraging Great Food Made Easy, optimizing gross margins, and bringing a relentless focus to operational efficiency continues to show progress. That progress is the result of the great work by our management team and all our associates. Thank you for joining us today and have a great week.

This concludes today's conference call. Thank you all for joining. You may now disconnect.