UNITED NATURAL FOODS INC annual report, FY2014

Business Context and Reporting Period

United Natural Foods, Inc. (UNFI) filed its Form 10-K for the 52-week fiscal year ended August 2, 2014. UNFI distributes natural, organic and specialty food and non-food products primarily in the United States and Canada through 32 distribution centers serving more than 40,000 customer locations. The company also operates retail, manufacturing and branded-product businesses.

Whole Foods Market remained UNFI’s largest customer, representing approximately 36% of fiscal 2014 net sales. The company completed the $206.2 million acquisition of Tony’s Fine Foods on July 15, 2014, adding specialty protein, cheese, deli, foodservice and bakery distribution capabilities in the Western United States.

Key Financial Metrics

Metric	Fiscal 2014	Fiscal 2013	Change
Net sales	$6.794 billion	$6.064 billion	+12.0%
Gross profit	$1.128 billion	$1.025 billion	+10.0%
Gross margin	16.6%	16.9%	Down 30 bps
Operating income	$210.8 million	$185.5 million	+13.6%
Operating margin	3.1%	3.1%	Flat
Net income	$125.5 million	$107.9 million	+16.3%
Diluted EPS	$2.52	$2.18	+15.6%
Cash flow from operations	$62.4 million	$44.3 million	+$18.1 million
Capital expenditures	$147.3 million	$66.6 million	+121.3%

Net sales growth included 10.2% organic growth, approximately $62.9 million from Trudeau Foods, approximately $45.3 million from Tony’s, and approximately 2% food-price inflation. Fiscal 2013 included an additional week, which contributed approximately $118.7 million of sales.

Income before taxes was $207.4 million, and the effective tax rate was 39.5%, compared with 38.1% in fiscal 2013.
Fiscal 2014 included $14.6 million of share-based compensation expense and approximately $1.5 million of Tony’s acquisition costs.
Cash and cash equivalents were $16.1 million at year-end, versus $11.1 million in the prior year.
Working capital increased to $854.5 million from $717.0 million, primarily because of higher inventories and accounts receivable.
Inventory was $834.7 million, and accounts receivable were $449.9 million, net of allowances.
Total assets increased to $2.297 billion from $1.730 billion, while stockholders’ equity increased to $1.243 billion from $1.099 billion.

Liquidity, Debt and Commitments

The amended revolving credit facility was increased to $600 million and extended to May 21, 2019. At August 2, 2014, borrowings were $415.7 million, letters of credit were $33.6 million, reserves were $2.8 million and remaining availability was $135.3 million.
On August 14, 2014, after the fiscal year-end, UNFI entered into a $150 million real-estate-backed term loan. Quarterly principal payments of $2.5 million began November 1, 2014, with maturity on the earlier of August 14, 2022 or 90 days before termination of the revolving facility.
Fiscal 2014 financing activities provided $295.4 million, primarily reflecting gross revolving-credit borrowings of $853.9 million less repayments of $568.3 million.
Contractual obligations totaled approximately $812.1 million, including $415.7 million of notes payable, $289.3 million of non-capitalized lease obligations, $32.6 million of diesel-fuel commitments and $29.4 million of inventory purchase commitments.
The company was not subject to its springing fixed-charge coverage covenant at fiscal year-end because availability remained above the applicable threshold.

Material Changes Versus the Prior Comparable Period

Sales increased across all customer categories. Conventional supermarket sales rose 16.9% to $1.755 billion and increased to 26% of total sales from 25%. Whole Foods sales rose 9.7% but remained approximately 36% of total sales.
Gross margin declined from 16.9% to 16.6%, reflecting severe weather, Canadian-dollar weakness, supply-chain challenges and continued mix shift toward lower-margin supernatural-chain and conventional-supermarket business.
Operating expenses increased 9.2% but declined to 13.5% of sales from 13.8%, benefiting from expense controls, higher fixed-cost coverage and channel mix.
Fiscal 2014 had no restructuring or asset-impairment expense, compared with $1.6 million in fiscal 2013. Fiscal 2013 also included $6.3 million of Auburn labor-action costs and a $4.9 million unclaimed-property settlement charge.
Other expense declined to $3.4 million from $11.4 million, helped by a $4.8 million non-cash gain related to land acquired for the Sturtevant, Wisconsin facility. This compared with the prior-year $4.9 million unclaimed-property settlement charge.
Operating cash flow improved, but cash conversion remained constrained by a $97.8 million increase in inventories and a $70.7 million increase in accounts receivable.
Investing cash outflow increased substantially to $352.8 million, driven by $147.3 million of capital expenditures and acquisitions, principally Tony’s.

Fourth-Quarter Information and Outlook

For the fourth quarter of fiscal 2014, net sales were $1.765 billion, gross profit was $290.2 million, income before taxes was $53.9 million, net income was $33.4 million and diluted EPS was $0.67. The filing does not provide a separately stated fourth-quarter operating margin.

Management expected fiscal 2015 net sales to grow over fiscal 2014, supported by new customers, additional products sold to existing customers, Tony’s specialty offerings and food-price inflation similar to fiscal 2014 levels.
Management expected growth to continue to be concentrated in the lower-gross-margin supernatural-chain and conventional-supermarket channels and planned to offset margin pressure through supply-chain and technology efficiencies.
Management expected fiscal 2015 operating cash flow of approximately $75 million to $125 million annually for fiscal 2015 and fiscal 2016.
Fiscal 2015 capital expenditures were expected to be approximately $165 million to $180 million, excluding potential proceeds from a planned Prescott, Wisconsin sale-leaseback transaction.
The national warehouse-management and procurement-system rollout was expected to reach all existing broadline distribution centers by the end of fiscal 2017.

Risks, Contingencies and Unusual Items

Customer concentration is material: Whole Foods Market accounted for approximately 36% of sales, and its distribution agreement expires September 25, 2020.
UNFI operates in a low-margin, highly competitive industry exposed to retailer consolidation, direct manufacturer distribution, pricing pressure, fuel costs, inflation or deflation, supply shortages and economic weakness.
The Tony’s purchase-price allocation remained preliminary, including valuation of fixed assets and intangible assets and a post-closing working-capital adjustment. Tony’s generated $45.3 million of fiscal 2014 sales, and its earnings were not significant to consolidated earnings.
Management identified risks related to integrating Tony’s, executing planned acquisitions, expanding distribution capacity and achieving expected technology-related savings.
The company is primarily self-insured for workers’ compensation and automobile and general liability risks. Related accruals totaled $18.9 million at year-end.
Food safety, product recalls, environmental and transportation regulation, cybersecurity incidents, labor actions and distribution-network disruptions could materially affect results.
Management reported no pending material legal proceedings. The filing states that accrued and reasonably possible losses from ordinary-course claims were not material.
The independent auditor concluded that the financial statements and internal controls were effective, but Tony’s internal controls were excluded from the fiscal year-end assessment. Tony’s represented approximately $261.9 million of assets, including $145.1 million of goodwill and intangible assets.

Important Facts for Investors to Verify

Whether Tony’s integration, customer retention and specialty-food expansion produce the expected revenue and margin benefits.
Whether continued growth in lower-margin channels can be offset by operating efficiencies without further gross-margin deterioration.
Progress and total cost of the warehouse-management, procurement and transportation-technology rollout.
Inventory and receivables growth, cash conversion and the effect of working-capital requirements on future borrowing needs.
Revolving-credit availability, covenant headroom, variable-rate exposure and the impact of the $150 million post-year-end term loan.
Dependence on Whole Foods Market and the terms and renewal prospects of the distribution agreement through 2020.
Fiscal 2015 capital spending, planned distribution-center openings and any proceeds from the proposed sale-leaseback transactions.