Feb 26, 2013
Executives
Scott Eckstein - Director of Account Services Steven L. Spinner - Chief Executive Officer, President and Director Mark E.
Shamber - Chief Financial Officer, Principal Accounting Officer, Senior Vice President and Treasurer
Analysts
Edward Aaron - RBC Capital Markets, LLC, Research Division Meredith Adler - Barclays Capital, Research Division Karen F. Short - BMO Capital Markets U.S.
Kelly A. Bania - BofA Merrill Lynch, Research Division Andrew P.
Wolf - BB&T Capital Markets, Research Division Stephen W. Grambling - Goldman Sachs Group Inc., Research Division Scott Van Winkle - Canaccord Genuity, Research Division Jason DeRise - UBS Investment Bank, Research Division Sean P.
Naughton - Piper Jaffray Companies, Research Division
Operator
Ladies and gentlemen, thank you for standing by and welcome to the United Natural Foods Fiscal 2013 Second Quarter Results Conference Call. [Operator Instructions] Today's conference is being recorded, February 26, 2013.
I would now like to turn the conference over to Scott Eckstein from Financial Relations Board. Please go ahead.
Scott Eckstein
Thank you, operator, and good morning, everyone. By now, you should have all received a copy of this morning's press release.
Anyone still needs a copy, please contact Joe Calabrese in our New York office at (212) 827-3772. We'll send you a copy immediately following this morning's conference call.
With us this morning from management is Steve Spinner, President and Chief Executive Officer; and Mark Shamber, Chief Financial Officer. We'll begin this morning with opening comments from management and then we'll open the line for questions.
As a reminder, this call is also being webcast today and can be accessed over the Internet at www.unfi.com. Before we begin, as usual, we would like to remind everyone about the cautionary language regarding forward-looking statements contained in the press release.
That same language applies to comments made on this morning's conference call. Additionally, in today's press release and on today's call, we'll provide both GAAP and non-GAAP financial measures, including operating expenses, operating income, net income and earnings per diluted share.
Presentation of these non-GAAP financial measures is not intended to be considered in isolation or as a substitute for any measure prepared in accordance with GAAP. For a complete reconciliation of GAAP to non-GAAP financial measures, please refer to our earnings release issued earlier today, available on our corporate website, www.unfi.com, under Investors.
With that, I'd like to turn the call over to Steve Spinner. Steve, please go ahead.
Steven L. Spinner
Thanks, Scott. Good morning, everyone, and thank you for joining us this morning to discuss UNFI's second quarter and first half fiscal 2013 results.
Demand for UNFI's products and services continue to be strong. For the first half of our fiscal year, our net sales grew 14%, again reflecting the dynamic and expanding organic natural and specialty industry.
While we have now lapped the onboarding of Safeway, our sales during the second quarter grew an impressive 12.3% compared to the prior-year quarter. Additionally, when you consider the impact of very modest inflation at approximately 2%, all data points to very strong and continuing growth.
In looking at the industry data for 2012 recently published by SPINS, 97% of U.S. households bought natural products and 70% bought USDA certified organic products, reflecting a very nice increase over prior year.
In fact, SPINS also commented during their annual review that natural and organic products continue to outpace overall store growth across all channels. On top of that, non-GMO, gluten-free and other third-party certified products grew in excess of 15%.
And other product categories such as organic produce, natural supplements and organic yogurt product categories, continue to grow significantly. These trends reflect continued positive growth in the categories supported by UNFI for the next year.
As you know, for the last 18 months, we've talked a lot about gross margin compression and expense control. And in the second quarter, our gross margin was consistent with our first quarter margin, although our gross margin compared to the prior-year quarter declined 62 basis points.
Gross margin shift continues to be driven by several factors including: one, our retailer base continues to shift towards a lower gross margin customers. In looking at our customer mix change during the second quarter and compared to the prior year quarter, supernaturals grew to 37.2% from 36.5% of our net sales.
Supermarkets grew 25.4% from 25%, and independents declined to 32.7% from 34%. Interestingly, all 3 channels are growing rapidly with supernaturals leading growth during the quarter with 14% sales growth over the second quarter of the prior year.
And our independents are also growing nicely and UNFI is deeply committed to this very important customer base. We recently completed our first national recruiting, training and on-boarding of independent territory managers who are now focused on expanding retail sales in geographies across the U.S.
New lines of SKUs and the rollout of our proprietary iUNFI handheld technology will fuel continued growth in the independent channel. Two, as I first mentioned in our November call during our first quarter of fiscal 2013, we began to face higher than normal supplier out of stocks.
This environment continued during the first half of the second quarter. And with higher out of stocks, manufacturers reduced promotional spending and again, UNFI moved freight around the country to support delivering higher service levels.
We believe this issue has subsided as manufacturers have geared up production to meet increasing demand. Three, finally, with the majority of our business price on a cost-plus basis, lower levels of inflation of at or below 2% also places pressure on UNFI's gross margin.
We typically buy into rising markets which enhance our gross margin. I am pleased with the stability in our gross margins sequentially this year and continue to be bullish towards controlling gross margin as UNFI's business model evolves.
From Q1 to Q2 2013, gross margins stabilized. More importantly, our operating expenses fell at a great rate -- at a rate greater than the year-over-year decline in our gross margin which drove our operating margin of 4 basis points on an adjusted basis.
Operationally, we continue to shine. Our warehouse and transportation teams have delivered exemplary service while driving down cost.
During the second quarter of fiscal '13, our operating expenses, excluding the impact of Auburn, Washington, labor action, were down 65 basis points to 13.8% of sales. This was a milestone for us as we continue to confirm that UNFI's shifting customer base can be supported through a very efficient cost model.
Looking into the numbers during the quarter, there were several interesting data points. First, our transportation expenses, which are driven largely by fuel, had significant improvement versus the second quarter in the prior year.
And this was accomplished by several factors, including continued fixed-price fuel contracts, service reroutes which drive down miles traveled, technology which monitors truck engine idle time and increasing the freight on each load we dispatch. Also on the inbound freight side of our business, UNFI's recently implemented Transportation Management System, or TMS, is fully online and working as designed.
Second, in our warehouses, we have been quite successful in implementing strategies that improve productivity through warehouse layout, accuracy and safety. And during the quarter, we had several warehouses that achieved record throughput.
I'm extremely proud of our operations team as they demonstrated an incredible discipline towards achieving our vision of reducing operating expenses at a rate that is faster than the customer mix driven decline in our gross margin. It's also important that we address our recently ended labor action at Auburn, Washington.
I'm very pleased that we were able to bring the 9 weeks strike to an end. This was a very difficult situation for everyone involved, and UNFI was determined to ensure that all Associates were and are treated equally and fairly across all of our divisions and distribution centers.
Additionally, we had to assure our customers that they could rely on us for service during the extremely important holiday retail season. During the quarter, UNFI incurred cost of approximately $3.6 million which included temporary labor, hired labor, security and cost associated with bringing our team back to work.
I expect there to be modest costs related to this issue in our third quarter as the strike did not end until mid February. While costly, in some respects UNFI, we made long-term decisions that were in the best interest of our constituents.
With the new 5-year agreement and terms that are consistent with our company's national benefits, wages and work rules, we believe that our response to the strike and ultimate resolution were appropriate. Our capital expenditures during the quarter were 1.1% of net sales and were driven primarily by construction at our new Denver facility expected to open early summer 2013.
CapEx will continue to ramp up as a percentage of sales as we build new capacity to support our growth. New buildings are in the planning stages in Wisconsin, New York State, Northern California and the Pacific Northwest.
With growth expected to be in the low double-digits over the next several years, UNFI must add capacity to satisfy demand for our products and services. We are quite fortunate to have a level of growth that makes new construction necessary.
Additionally, I'm quite pleased with the progress we are making on the technology front. Migration to a single item number across the U.S., national data warehouse and inventory demand planning are in the works and progressing throughout the next 12 months.
And also, with the success of our warehouse management system rollout in Richfield, Washington, we are now planning for the implementation of 2 centers per year. Environmentally, we are excited to be launching a new solar project on the roof of our Moreno Valley, California, location.
This new power plant furthers our commitment towards reducing our carbon footprint by 5% over 5 years. Net income increased 18.8% during the first half of fiscal 2013 compared to the first half of fiscal 2012, and our operating margin increased 11 basis points versus the prior year to 2.6%.
We are also revising fiscal 2013 GAAP guidance to a range of $2.12 to $2.18 from previously provided $2.14 to $2.24 per diluted share, an increase of approximately 14% to 17% over 2012. The revision is not a reflection of any challenges in our back half 2013 and points directly to the impact of our Auburn, Washington, labor action which is expected to cost up to $5.6 million this year or approximately $0.07 per share on a nonrecurring basis.
In fact, adjusting for Auburn, UNFI is performing ahead of projections. I am really confident that we have a strong team in place to manage through these opportunities.
Our associates are incredibly passionate about delivering long-term success through innovations, disciplined while always upholding our important goals of increasing market share, driven to operational excellence and committed to the principles of One Company, sustainability and philanthropy. And now, I'll turn the call over to Mark Shamber to discuss our financials for the period.
Mark?
Mark E. Shamber
Thanks, Steve, and good morning, everybody. Net sales for the second quarter of fiscal 2013 were $1.45 billion which represents growth of 12.3% or approximately $159 million over the prior year second quarter net sales of $1.29 billion.
Excluding the $14 million in incremental sales from the 3 acquisitions that closed in the first quarter, our sales increased by 11.2%. Inflation continued to moderate both sequentially and on a year-over-year basis for the quarter coming in at 1.98%, a 17 basis point decline from Q1, and a more than 50% decline from last year's second quarter inflation of 4.36%.
Year-to-date, net sales of $2.86 billion yielding sales growth of $351 million or 14% over the first half of fiscal 2012. Excluding the acquisitions, our year-to-date growth is 13%.
For the second quarter of fiscal 2013 the company reported net income of $22.6 million or $0.46 per diluted share, an increase of approximately 2.8% or $0.6 million over the prior year. Net income for the second quarter of fiscal 2013 was $22 million -- or sorry, for the second quarter of fiscal 2012 was $22 million or $0.45 per diluted share.
Earnings-per-share increased by 2.2% as EPS growth was impacted by the higher average share count in fiscal 2013. On a channel basis, both supernaturals and supermarket sales increased by 14.4% in the second quarter, with supernaturals representing approximately 37% of sales and supermarkets representing 25% of sales.
Sales growth in the independents channel was 7.9%, but declined from a mix standpoint due to the slower growth and, for the quarter, represented approximately 33% of sales. Foodservice comprised approximately 3% of sales after growing by 23.4% in the second quarter.
A 16.7% gross margin for the quarter showed a 62 basis point decline over the prior year's second quarter gross margin of 17.3% and was flat sequentially. As Steve mentioned, major drivers of our lower gross margin were fewer opportunities to buy and the price increases due to lower inflation, the continued shift in the growth mix of business towards supernaturals and conventional supermarkets with limited or no service components, as well as increased sales of customers private label brands.
In addition, while the issues in the first quarter associated with our TM -- transportation management system, or TMS, are behind us, we have the carryover effect for some of the products we moved in the first quarter as we sold through that inventory and continued those efforts into November. Finally, we're generating lower backhaul income due to higher year-over-year inbound cost.
Gross margin for the first half of fiscal 2013 was 16.7% compared to 17.6% in the prior year, a decline of 85 basis points, again, driven by the factors I just noted along with the additional freight expense we incurred in the first quarter associated with higher manufacturer out of stocks. Our operating expenses for the quarter were 14% of net sales compared to 14.4% for the same period last year.
This represents a 40-basis-point improvement over the prior year, as operating expenses as a percentage of net sales continue to benefit from the mix shift in our business, positive trends in our self-insurance areas, along with continued execution by the general managers in our broadline distribution centers. As an example, we've increased our warehouse throughput by almost 5% over the prior year, led by our distribution centers in Atlanta, Georgia, under Doug Tatum and Chesterfield, New Hampshire, led by Chris Richmond.
As was covered in this morning's press release, the strike and related contingency planning at our Auburn, Washington, distribution center negatively impacted expenses by $3.6 million in the quarter or 25 basis points. We expect additional strike-related cost in the range of approximately $600,000 to $1 million to impact the third quarter as the strike did not end until mid-February.
Similar to the first quarter, we incurred $0.9 million in noncash, straight-line rent expense associated with our new Denver, Colorado area distribution facility. Year-to-date, these nonrecurring expenses are $1.6 million which is in line with the full year guidance provided during our September 11, 2012, earnings call discussion.
Excluding the portion of our Canadian business which involves the use of third parties for deliveries in certain regions, diesel fuel had a positive impact of 9 basis points in operating census in comparison to the second quarter of fiscal 2012 as fuel represented 72 basis points of distribution net sales in the quarter. Fuel in the second quarter decreased by 10 basis points versus the first quarter as our fuel expense decreased by 9.6% sequentially due to our continued focus on reducing cost and miles traveled by a rerouting and increase in the cube on our trucks.
Our diesel fuel prices in the second fiscal quarter increased by approximately 1.1% from the prior year's second quarter while the Department of Energy's national average was up approximately 1.9% over the prior year. Share-based compensation expense totaled $3.2 million in the quarter compared to $2.5 million in the prior year second quarter.
Share-based compensation expense represented 22 basis points as a percentage of net sales in the quarter, a 2-basis-point increase over the prior year. GAAP operating income for the second quarter was 2.7%, a 21-basis-point decline over the prior year.
Adjusting for the $3.6 million and 25 basis points associated with the Auburn strike, operating income was 2.9%, a 4-basis-point improvement over fiscal 2012 second quarter. Inventory was $674 million at quarter's end as days inventory on hand averaged 53 days for the second quarter, an improvement of about 1.5 days over the prior year's second quarter when we were at 55 days.
The lower average days on hand resulted primarily from lower inventory levels going into the holidays due to the supplier out of stocks we've highlighted previously. Our service levels improved throughout the quarter as suppliers were able to address many of the issues and we started to build back our inventory in those areas.
As a result, sequentially, inventory levels increased a bit more than 4 days compared to the first quarter of fiscal 2013. DSO for the second quarter increased sequentially by 0.5 day to 22 days due to a higher concentration of supermarket business in the quarter.
Capital expenditures were $15.5 million or 1.1% of net sales for the quarter, which is within our target range for fiscal 2013. Year-to-date, capital expenditures are $20 million or 70 basis points of net sales, consistent with past year as a greater portion of our CapEx is planned for the second half of the fiscal year.
Outstanding commitments under our credit facility were $208 million at quarter end with available liquidity of approximately $286 million, including cash and cash equivalents. Our leverage increased modestly to 0.8x on a trailing 12-month basis due to the normal investment and inventory for this holidays.
As discussed in this morning's press release, we are reaffirming our net sales guidance for fiscal 2013 with a range of $5.88 billion to $5.98 billion which represents a 12.3% to 14.2% increase in total net sales over fiscal 2012. In addition, we are narrowing and lowering our GAAP diluted earnings per share guidance for fiscal '13 to a range from $2.12 to $2.18 per diluted share and establishing non-GAAP guidance in a range from $2.15 to $2.21 per diluted share.
This reflects the impact of the items that have occurred in the first half of fiscal 2013. Our previous GAAP earnings guidance was $2.14 to $2.24 per diluted share.
As a reminder, included in our fiscal 2013 earnings guidance is approximately $5 million to $5.5 million of nonrecurring expenses associated with our new Aurora facility and a new facility for our Albert's Organics division, of which $3.5 million to $4 million are duplicate, primarily non-cash rent payments with the remaining balance comprised of relocation costs to consolidate the existing facilities in the back half of fiscal 2013. At this point, we'll turn the call back over to the moderator for the question-and-answer session.
Operator
[Operator Instructions] And our first question comes from the line of Ed Aaron with RBC Capital Markets.
Edward Aaron - RBC Capital Markets, LLC, Research Division
I was hoping you could maybe start by just discussing in a little bit more detail how sales kind of trended through the quarter. And then what you may be seeing kind of thus far into Q3?
Steven L. Spinner
Ed, sales have been relatively consistent and we feel pretty comfortable that despite a lower inflation number and lapping Safeway, that if you look at the net sales growth year-over-year, we're actually doing fairly nicely and feel pretty comfortable that it's going to certainly continue through the end of the fiscal year.
Edward Aaron - RBC Capital Markets, LLC, Research Division
And then next on -- just on the gross margin. In your prepared remarks, you sounded like you were relatively pleased with where that checked out in the quarter kind from a stability perspective relative to Q1.
But I kind of thought maybe we'd see something higher just given the improvement that you had seen kind of exiting your first quarter. Could you maybe just talk a little bit more about how that number shook out relative to kind of your own expectations going into the quarter?
Mark E. Shamber
Yes. I mean, I really wish that I could.
I was really pleased that we had a sequential improvement. And it really demonstrated that we could continue to drive cost out of the system at the rate that's greater than potential decline in gross margin.
So I felt very good about that. I do feel as though we should be able to start to see some increase in gross margin.
It's certainly not going to be significant over the next year or so as we kind of settle into the new model. But I certainly wouldn't want to provide any guidance to that.
Edward Aaron - RBC Capital Markets, LLC, Research Division
Okay. And then a last question for me and I'll pass it on.
I think in the first quarter, you had accrued for kind of below normal incentive compensation levels. How do those accruals look in the second quarter?
Steven L. Spinner
Yes. I mean, we -- I would say that what we were below in Q1, we have it clawed back.
But we are sort of moving towards target for Q2. So there was no change from the accruals in Q2.
Everybody tracked towards sort of the same level that they had planned from a budget standpoint. But whatever they were sort of short in Q1, they did not make up.
Edward Aaron - RBC Capital Markets, LLC, Research Division
So Q2 was a more normalized number?
Mark E. Shamber
Yes.
Operator
Our next question comes from the line of Meredith Adler with Barclays Capital.
Meredith Adler - Barclays Capital, Research Division
I'd like to start just talking a little bit -- you mentioned a number of capital projects. Maybe you could just talk a little bit about the timing of those projects?
I think some of them, you mentioned before but maybe go through all of it and then what you think the cost for each facility were in aggregate will be?
Steven L. Spinner
The only project that's really going to be completed and have any significant cost in this fiscal year is Denver. As we look out to 2014, we'll have the cost of 2 facilities, one that we've already announced which is in Wisconsin.
We've announced that location. We haven't announced the second location yet.
As far as the guidance for 2014, we really haven't provided any kind of look into what our CapEx is going to look like next year.
Mark E. Shamber
I mean, we're still -- at this point, we're in the heart of our planning process from that respect, Meredith. And so I think, there's some decisions that we need to come to as we look at the facilities as to whether they're going to be owned, whether they're going to be sale of leasebacks, whether they're going to be leases and that really dictates what the CapEx associated with those locations is, because an owned facility can be anywhere in the range of $40 million to $60 million of CapEx where a strictly leased facility might be in the midteens to $20 million.
So until we make a final decision on those locations and actually identify, as Steve mentioned, a second location, it's difficult to really set some parameters for CapEx for fiscal '14.
Steven L. Spinner
Generally speaking, the general rule we're using is if the market is a big growing market that we're going to be in for a long time, our preference is going to be to buy it, just because it's far cheaper on the long-term to own it than to lease it. If it's a market that, looking out 10, 15 years, we're just not sure, then our tendency would be to lease it.
Mark E. Shamber
And we also are factoring into our equation some of the expectations about the leasing rules changing, at least from a balance sheet presentation and that does factor into the decision.
Meredith Adler - Barclays Capital, Research Division
Great. And then I have a question about the ability to continue to make progress on expenses.
I think you highlighted 2 facilities in particular, Atlanta and Connecticut, I think, that did not, [indiscernible].
Steven L. Spinner
Atlanta and Chesterfield in New Hampshire on a throughput standpoint.
Mark E. Shamber
We still have a pretty big gap between the highest performing DCs and the lowest performing DCs. Now, some of that is driven by market and size of the DC because, certainly, as common sense would lead you, the larger the DC, the greater it is to become more productive.
But we still have plenty of opportunities operationally in a lot of our DCs to further enhance our operating costs. We have a deployed labor management throughout the DCs but we're still really in the early innings of engineered labor standards.
And engineered labor standards tend to have the greatest savings and productivity increases than any other technology we've installed.
Meredith Adler - Barclays Capital, Research Division
And would you say that there's a process to share best practices, a formal process?
Steven L. Spinner
There is. All of our operations are nationalized.
They're no longer regional. So they all pass up through general managers that run our DCs up through regional operations managers and up to our nationalized operations group.
So there's a tremendous amount of standardized procedures already in place. Just a matter of getting the technology deployed as fast as we can.
Meredith Adler - Barclays Capital, Research Division
And then I don't know if you want to comment at all about -- mostly companies doesn't want to -- about the result of the labor actions? And you've made a comment about wanting to make sure that the pay and benefits was matched across the country?
Did that require you to do anything different anywhere else or was that all just focused on Auburn?
Steven L. Spinner
No, no. It was only focused on Auburn.
We were not going to allow our Auburn associates to have anything that was better than what we did in the rest of the country because in the rest of the country, we believe that we've got a great environment with much lower than average industry turnover. And we're just -- we're not going to be in a position to have an environment where one group of associates has benefits or wages that are much greater than everybody else, other than adjusting for geography.
Meredith Adler - Barclays Capital, Research Division
Okay. And they -- it came to that agreement eventually?
Steven L. Spinner
Well, we were out for 9 weeks so it took us a while to get there, but ultimately we did.
Operator
Our next question comes from the line of Karen Short with BMO Capital Markets.
Karen F. Short - BMO Capital Markets U.S.
Just looking at your guidance. I know your prior guidance, you indicated that incorporated the worst-case scenario on Auburn, and in this press release you say there's maybe an incremental $600,000 to $1 million in expenses associated with Auburn.
So that's kind of a $0.01 to earnings by my math. So I get your low end -- I get the change in your guidance on the low end.
I guess I'm not sure what was affecting the high end because the high end was at $0.04 -- or is $0.04.
Steven L. Spinner
Sorry, you lost me on the back part. I mean, I think that we -- to -- as to why it came down, is that what you're trying to...
Meredith Adler - Barclays Capital, Research Division
Well, the Auburn -- the incremental Auburn that you've call out is about $0.01 a share. So I can understand why you came down on the low-end but on the high end, you're bringing your guidance down by $0.04.
So I'm just wondering what else might [indiscernible].
Steven L. Spinner
I think the answer is that the Auburn cost in aggregate, were $5.5 million versus an estimate of $2 million to $3 million. And so that -- I think, that's the difference.
Mark E. Shamber
Yes. I mean, I think the strike went on longer than we had envisioned, and so while we had some factor of expense in there, it ended up -- I think at the end of the day, it ended up exceeding, at least certainly as we go into Q3, what we had initially projected and/or it ate into some of -- as I talked about things going right and things going wrong and setting the guidance range, I mean, I think it took away some of the flexibility for any risk in the back half of the year.
So we would have to have everything go perfectly in the back half to have left the guidance at the high-end of the range. And so we took it down with the expectation that's not all going to play out favorably.
Karen F. Short - BMO Capital Markets U.S.
So just to paraphrase, I mean, you could have fine-tuned your guidance at the first quarter earnings release but you didn't really feel a need to because you haven't really figured out what the total cost would be but you still thought you would be within the range?
Steven L. Spinner
Yes. And then I think if you look at the guidance, for the most part, we're still in that range.
We've just narrowed it as we would normally do at midyear. I think the difference this year is that we took the high-end down whereas in past years, we really raised the lower end.
Karen F. Short - BMO Capital Markets U.S.
Right, okay. And then on the supplier shortages, I don't know -- if you said it, I missed this.
Did you give any color on what the dollar impact might have been this quarter? I know you said it kind of lasted halfway through the quarter [indiscernible] impact in gross margins?
Mark E. Shamber
We really didn't because it was really only a phenomenon during part of the quarter and we have seen some steady improvement. So we really try not to quantify it.
Karen F. Short - BMO Capital Markets U.S.
Okay. But you think that we're past that now?
Mark E. Shamber
Yes.
Karen F. Short - BMO Capital Markets U.S.
Okay. And then, just looking at the top line or the organic growth rate in supernaturals and independent, it did seem to decelerate, I mean, not materially, but there was a deceleration on the 1- and 2-year basis, is there anything you can kind of point to there?
The inflation...
Mark E. Shamber
You're talking -- did you say on the supernatural or the supermarket? I am sorry.
I missed the first part.
Karen F. Short - BMO Capital Markets U.S.
No, supernatural and on the independent. Your supernaturals is 16% in the first quarter, 14% in the second.
Independent, I'm splitting hairs a little bit, 9% and then 8%. I don't know, maybe it's just inflation more than anything?
Mark E. Shamber
It wouldn't be inflation so much sequentially, I mean, that would more come into plan year-over-year. It could have been a factor, new store openings.
At the end of the day, we have not seen any real change in the overall growth rate.
Operator
Our next question comes from the line of Kelly Bania with Bank of America.
Kelly A. Bania - BofA Merrill Lynch, Research Division
Just another follow-up question on the non-GAAP EPS guidance for the year. Can you just remind us, I think, on how much the Auburn expenses are in there or not?
Mark E. Shamber
So the non-GAAP does not -- I mean, all the -- I'll put it this way is that the only expenses that are excluded in the non-GAAP are the intangible write-down that occurred in Q1, the unclaimed property settlements that occurred in Q1 and then the tax NOLs that we took back in Q1. So all the Auburn expenses, the $4.6 million that we've incurred to date, are included in the range.
So they're not backed out of that number.
Kelly A. Bania - BofA Merrill Lynch, Research Division
Got it. And they're just coming in a couple of million higher than originally expected?
Mark E. Shamber
Yes. I mean, there probably a little bit more than a couple of million higher than originally expected but we -- to Steve's comments, we've had some great results on the operations side which have offset where those expenses have come in higher than planned.
Kelly A. Bania - BofA Merrill Lynch, Research Division
Right. And then, maybe you've mentioned this, but can you just comment on the service levels that you were able to kind of maintain out of that Auburn facility during the quarter?
Mark E. Shamber
Yes. I mean, remarkably, the day of the strike, we probably had 30-some-odd percent service level.
In other words, we could service 30% of the demand and within 3 days, we were at 100% of the demand. And we had done, I think, a pretty good job communicating what was going to happen, how it was going to happen, but within 2.5 days, we were at 100% of capacity which is remarkable.
It was expensive to do it but we had to do it and I think it's ultimately what got us to the resolution that we did.
Operator
Our next question comes from the line of Andy Wolf with BB&T Capital Markets.
Andrew P. Wolf - BB&T Capital Markets, Research Division
Just on the guidance and, I mean, another way to look at it is convert the old guidance, add in $0.03, for your -- sounds like your estimate for the strike at that point, take the new guidance, add in $0.06 for the strike and then basically, it looks like you've done what you've done in the past which is bring up the bottom end a few pennies and kept the high end where it is on an x strike basis. I just want to make sure that my math is right and that sort of sounds like -- it kind of confirms your thought -- what your -- your message, I guess, that the business is kind of trending on plan.
Steven L. Spinner
Yes, I mean, I think that's right, Andy. I mean we've -- as much as the expenses are coming higher, if you -- due to the strike or as part of the strike, we've gotten the efficiencies elsewhere.
So yes, I mean, if you're -- I mean, we're not trying to back the strike out of the non-GAAP but to what you were saying, yes, if you took the strike out and took the other -- the items that we are considering nonrecurring, we would be higher and we would be look -- we would be sort of raising the range accordingly.
Andrew P. Wolf - BB&T Capital Markets, Research Division
Yes, I just want to -- yes, okay, fine. A follow-up on the non-cash rent, I think you said that's associated with Denver and then you've said Wisconsin.
You break Durbin, Wisconsin, or is --I guess, is Wisconsin part of that or do we start to get non-cash rent for -- in Wisconsin as well or does that $0.01 a quarter go away or does it increase? Can you just give us a sense of the -- how the [indiscernible]?
Steven L. Spinner
As it stands right now, we haven't set what the plan is for Wisconsin. I think, if anything, we're probably leaning towards either owning it or engaging in a sale leaseback, and depending on when we might sell that facility, we'd determine whether or not we'd have any non-cash deferred rent for Wisconsin.
But I would expect that there's nothing from Wisconsin impacting fiscal '13. And probably, when we get to the third quarter earnings call, we'll be in a position to sort of layout what our approach will be in Wisconsin and what impact it will have on -- in how we'll treat that, whether it's going to be owned or a sale leaseback.
But nothing so far associated with Wisconsin has hit the P&L. And I wouldn't anticipate any non-cash deferred rent associated with Wisconsin in fiscal '14 -- or fiscal '13 to the extent that we go the sale leaseback route.
Andrew P. Wolf - BB&T Capital Markets, Research Division
And then, staying on those 2 centers, just operationally, it's my understanding, both areas, Denver and the Midwest, are -- have these economies of scale because they're above capacity. So I mean, do these things -- x -- soon as you -- within a month or whatever it takes, I mean, it sounds like versus let's say a Greenfield, these are going to actually add to margins straightaway.
Is that how we should kind of think of those?
Steven L. Spinner
Well, Denver is just a complete building replacement. Today, we operate out of 4 different buildings in Denver and we're migrating into a single building.
So obviously, there's a tremendous amount of operating efficiencies that we get by not having to transport the product back and forth or send independent loads versus segregated -- versus combined loads. So in the Denver scenario, just pure operational efficiencies.
In the Wisconsin scenario, we're actually building the building based on a formula that brings us much closer to the customer. So your statement is correct about Wisconsin, because we're essentially taking what we currently deliver out of Iowa, in that market, and moving it into the market.
So there's a tremendous amount of savings related to doing that. Very similar to what we did when we opened Texas and eliminated all the miles that we used to incur because we service Texas from Denver.
Andrew P. Wolf - BB&T Capital Markets, Research Division
Mark, I think you made -- you said backhaul income was down and I just didn't understand your explanation. Could you go over that?
Mark E. Shamber
Well, I was saying that we were making less from a backhaul standpoint because we're incurring higher expenses. We talked about in the first quarter, in particular, where we are moving things around multiple times as part of the supplier issues that we had.
So we're still feeling some of that in the second quarter. Because when you move things around and handle them a second time versus just backhauling them into a location, you incur that additional expense but you're not able to pass it on.
So it's the same statement we made in Q1.
Steven L. Spinner
I mean, basically, what happens is we have a very sophisticated cross dock system where we try to buy a full truckload from as many suppliers as we can. We bring them into a consolidation point in the East and the West, which is one of our DCs, and then we aggregate mixed loads of products to go out to our DCs in full truck load.
And that obviously gives us the ability to keep the freight on the inbound and the outbound extremely low. But when we run into service issues, we can't wait to get an aggregated truckload to send back out to the facility.
So in a lot of scenarios we have to send it out in LTL or less-than-truckload. And that is the most expensive way to do it.
But when you're backed into a corner, do you fill the orders and move the freight LTL or do you wait to consolidate the load, sometimes we just got to bite the bullet and spend the money.
Andrew P. Wolf - BB&T Capital Markets, Research Division
And would -- is that all, that inefficiency, is that all showing up in which item -- expense line item, COGS or expense comps?
Mark E. Shamber
COGS, all COGS.
Andrew P. Wolf - BB&T Capital Markets, Research Division
Okay, that's helpful. Last thing I want to ask is on this handheld technology for the independents.
Could you just elaborate? It's the first I've heard of it and a little on what it is.
Is there much investment for you or the independent and what are the capabilities it's going to get in the dock or...
Steven L. Spinner
Yes. I mean, a couple of years ago, we started down the path of providing independents with technology that would make it really easy for them to order from us and very easy for them to use data from us, whether it be suggested retails, average movement, average suggested retail margin.
And so we talked a little bit about this Wowzaville website that we rolled out probably 18 months ago. And at the same time, we deployed an iPod Touch, iPad, iPhone technology that gave our retail customers a Web-enabled mechanism to scan products at the shelf to place orders directly with us.
And we now have about, I guess, just under 2,000 units deployed. And they're deploying rapidly.
And there'll be several iterations of deployment as we add more functionality to the handhelds, including being able to place orders from non-UNFI vendors. So we partnered with another technology provider for retailers who only want to use one piece of technology.
They can run those orders through a third party and the UNFI piece comes to us and the other vendors goes directly to that vendor so that the retailer can use one technology to place all their orders. So it's exciting, and all those costs are included in our IT expense and have been for the last 2 years or so.
Operator
Our next question comes from the line of Stephen Grambling with Goldman Sachs.
Stephen W. Grambling - Goldman Sachs Group Inc., Research Division
I guess what I'd like to actually talk to is the guidance on the back half and anything that you can talk to in terms of what's embedded in your assumptions for inflation, as well as anything we should be aware of by product type that's going on?
Steven L. Spinner
Sure. I think from an inflation standpoint, that's relatively straightforward.
I mean we've talked before that we think that inflation will probably continue into the low 2s where we finished the second quarter just under 2% on a weighted average standpoint. I would expect that the third quarter is likely in that range of 2% to 2.25%, maybe a little bit under 2% depending on when any price increases hit.
And then, as we look into the fourth quarter, it's a little bit wider range, but it's probably 2% to 2.5% because we're just not seeing significant levels of price increases flowing through at least as we sit here today. So that's it from an inflation standpoint.
As it relates to products, I mean there's really some of the familiar trends that we've seen, whether it's the Greek yogurt, it's the product with a lot of the coconut waters, things of that nature, probiotics, I mean there's really -- gluten-free continues to be a strong category. There's not anything within specific product categories that's recent, that's really shifted from a trend standpoint.
Steven L. Spinner
The fastest growing category of products for most taking into account that's off a relatively small base is the non-GMO certified products. I think they grew at over 18% in calendar '12, which was the fastest growing category that had some kind of certification.
Stephen W. Grambling - Goldman Sachs Group Inc., Research Division
As a quick follow-up, maybe if you can just discuss what's embedded within gross margin and SG&A or any kind of guidance you can give there?
Steven L. Spinner
Yes. I mean, we honestly try to stay away from that so it gives us the flexibility as to where certain events might happen.
But I mean I think, from our perspective, the expectation that gross margin is relatively consistent sequentially, that with the third quarter typically being a little bit stronger from the independent side of the business, that there may be a modest 10 basis points type of item expansion if the independents keep with historical pattern, where there are larger percentage of sales in the third quarter. Correspondingly, though, if we get the gross margin expansion on the independents additional volume, we typically have higher expenses.
Stephen W. Grambling - Goldman Sachs Group Inc., Research Division
That's very helpful. One last one before I jump.
In terms of your leverage standpoint still being very far below the target of 2%, 2.5%, how do you think about how you would deploy that and taking on debt going forward?
Steven L. Spinner
Well, number one, I would say that we don't have a target of 2% to 2.5%. I think we're comfortable with 2% to 2.5%, but it's certainly not a target.
Mark E. Shamber
I think that's in the range that we prefer not to exceed versus that's a target range.
Steven L. Spinner
But to answer your question, I think we're most comfortable having a lot of flexibility with our balance sheet, whether it be for M&A to invest in inventory. We feel that, that's the most efficient use of our financial strength at this point.
Now, at some point in the future, if we didn't find good M&A candidates, we'd have to consider other options, whether it be a dividend or stock buyback, but we are just not prepared to do that yet.
Stephen W. Grambling - Goldman Sachs Group Inc., Research Division
And in terms of the M&A, is that still focused in Canada? Is that kind of the place that you'd be looking to see the most opportunity?
Steven L. Spinner
Well, I mean, we made a couple of acquisitions in Canada over the last year, 2 in particular. They were relatively small.
And we'll continue to do that. And I think we're starting to see some modest activity here in the U.S.
on the specialty side which would make sense for us, but certainly nothing that is imminent.
Operator
Our next question comes from the line of Scott Van Winkle with Canaccord Genuity.
Scott Van Winkle - Canaccord Genuity, Research Division
Most of my questions have been answered, but, Steve, you mentioned a field sales training effort, and I apologize if I'm not quoting you correctly. Is this something new and something focused on independents that is trying to grow that base?
Steven L. Spinner
Yes, Scott. In the past, we hired regionally.
So as somebody retired or left or demand increased, we left it up to the regions to determine when they would hire, how they would hire. And we did a lot of work and we basically came to the conclusion that one of the ways to grow our independents is to add more value to them.
And the only way -- or the best way to add more value to them is to let them see their UNFI territory manager more frequently, because historically, we had a lot of scenarios where territory managers were only getting to the retailers maybe once a month. And so our view was if we hire a national class, train them nationally and then deploy them regionally with the goal of getting our trained territory managers to be in the retailers more frequently that we would see a lift.
And so we went to the college campuses and we hired graduating kids with degrees in Food Science and Nutrition, and we put out a new class, I guess, about 4, 5 months ago. I think we put 15 or 16 of them out in the first class and we're going to do it again this summer.
It's been incredibly successful. So it's certainly something that we're going to continue.
Scott Van Winkle - Canaccord Genuity, Research Division
And then on the strike, post strike, obviously you have your staff back and things are running smoothly. Was there any customer disruption that would be noted during the strike period that's been corrected since?
Steven L. Spinner
Yes, there were some disruptions certainly because in the first couple of days we were not running at capacity. Fortunately, we had communicated out to them, they knew it, but certainly a lot of the customers were nervous and they probably had a week of being put in a situation where service was not what they were used to.
We certainly didn't lose any customers during that time period. I'm sure we had some scenarios where customers started buying from a competitor just to ensure that if there was a complete meltdown that they would be able to get product.
But from everything that we can see, we are fully back to normal. So customers that were there are there today.
Operator
Our next question comes from the line of Jason DeRise with UBS.
Jason DeRise - UBS Investment Bank, Research Division
It's Jason DeRise, UBS. It wouldn't be a conference call if I didn't ask about expectations for inventory days going forward and if you thought the free cash flow would be up or down for this year?
So that's what I'm asking.
Steven L. Spinner
Well, one thing's for sure is that over the past couple of years, we've tinkered around with our inventory in an effort to get it reduced. And what we've learned through that process is we just don't have the technology that gives us the ability to lower the inventory without destroying the service levels.
So that will never happen again. However, we are deploying our new inventory optimization technology this year and the driver of putting in the technology is to increase our service level and get our inventory days down.
And inventory optimization gives us the ability from any single geography within the United States to buy product, to manage inventory using an algorithm, a very complicated algorithm that looks at demand forecasting, so that we don't have to blindly build inventory to cover service expectations, that we can use some basis, whether it be an algorithm, as I said earlier, or past 3 years trend. And that technology will be installed within the next 12 months.
Mark E. Shamber
Right. And it's going into our Western region this fiscal year and they're probably going to move into the Eastern region in fiscal '14.
Jason DeRise - UBS Investment Bank, Research Division
Okay. And through better forecasting technology, the inventory will better align with what the sales demand is but it still needs to be in the 50-day range or the effect will be that [indiscernible].
Steven L. Spinner
Our expectation is once we have it deployed, we'll be much more prepared to get our inventory down. We certainly believe that the inventory today is a factor of a lack of technology, a lack of demand planning more than it is we have to have 50 days of inventory.
Now, the model itself is slow-moving inventory so it's never going to be in the 30-day range. But we do feel that there is quite a bit of room for us to move towards over the next couple of years.
Mark E. Shamber
But I don't think you're going to see us put specific targets out, Jason, until we've got it up and running for a bit and ensure that the parameters that we're setting are based on what we need and not trying to hit a target for reduction in inventory. [indiscernible] hit that target.
Steven L. Spinner
And we turn it on supplier by supplier so it will take a while.
Jason DeRise - UBS Investment Bank, Research Division
Is there getting to be a point -- and maybe this is 10 years down the road, but is there a point where you would put in minimum drop sizes for some of the independents and things like that to help streamline?
Steven L. Spinner
Actually we have that today. We have minimum drop size.
Jason DeRise - UBS Investment Bank, Research Division
It's very small, right. There's not much of a hurdle as I understood it but maybe that's not right.
Steven L. Spinner
It's a relatively small minimum drop requirement, but our average drop size is not the issue because we've got a very, very large average drop size. I would say that the bigger issue on average drop is more in the supermarkets than it is in the independents.
Jason DeRise - UBS Investment Bank, Research Division
And can I ask one other question just on the demand side. I guess you gave some of the steps from SPINS about the adoption rate of Natural Organic, specialty and so on.
In the past, you guys have talked about the crossover shopper. So I don't know if there's anything that you've done seeing for those people that have always been consumers if they're consuming more or if most of this growth has been new customers into the category?
Steven L. Spinner
It's a good question. I haven't seen the latest data on -- they usually do a survey which looks at if you're an Organic shopper, are you buying more?
And if you're buying more how much more are you buying? So I don't know the answer to that question, but we should know that.
We will check that out.
Operator
Our final question comes from the line of Sean Naughton with Piper Jaffray.
Sean P. Naughton - Piper Jaffray Companies, Research Division
Steve, just first for you, I think you mentioned something about private label in your prepared remarks as a mild headwind. Just if you could clarify those remarks.
Maybe I heard them incorrectly. And then maybe talk about the growth in that category relative to the national brand?
And then secondly, Mark, maybe you could just give us an update on how you're building -- or how you're thinking about plan for fuel moving forward over the next couple of quarters?
Steven L. Spinner
Sure, actually, Shawn, it was in my comments that the private label is referenced. To the second part of that question, probably won't talk about their growth because we don't highlight as to whose brands they are and what rate they're growing.
If the companies choose to do that, we'd leave that to them. But what presents a little bit of a headwind from our perspective on the private label standpoint is that a, we're only able to sell it to that particular customer who's buying it from us, but it also, typically, doesn't have any opportunity to buy in the promotions because the products are not promoted.
So a lot of what we do when promotions are, we'll buy additional volumes of that promotion and carry that inventory. Once the promotional period ends and have opportunity to make additional margin, that completely disappears in the scenario where there's private label because their product is never promoted, never goes off invoice.
And then to your second question, with regards to fuel, I mean we've been relatively range bound from a pricing standpoint. If I was to go back probably at this point, almost the last 24 months, we've been anywhere from $3.70 to $4.10, $4.20 a gallon for diesel.
And I think as we sit here today, we're almost right in the middle of that in the high $3.90. So I mean I think from our standpoint, there's no real significant changes in the assumptions for the back half.
We would expect to see pricing rise depending on what the weather conditions are in the Northeast, but see prices rise through March then have them come off in April and May before they start to rise again starting around Memorial Day. Range bound wise, we're probably still and the expectations are still in that $3.70 to $4.20 a gallon.
Sean P. Naughton - Piper Jaffray Companies, Research Division
It sounds like private label, potentially, picked up a little bit as a percentage of the mix in the quarter?
Steven L. Spinner
Yes. We've seen an increase in some of the customers whose Private Label they're selling more of it.
Yes.
Sean P. Naughton - Piper Jaffray Companies, Research Division
Just lastly on the backhaul, on the impact to lower backhaul income, is that something we should suspect to continue moving forward or it's those -- or have most of the issues been ironed out or very difficult to forecast at this point in time? Just curious what the potential impact could be on that line item moving forward?
Mark E. Shamber
Well, I would think that -- I mean, our expectations that supplier out of stock levels are back into historical ranges that we would stop seeing the negative impact on the backhaul income side because we're not having to move product around multiple times. So there's no expectation that will resurface into the back half of fiscal '13 and hopefully not into the holiday season in first half of fiscal '14.
But I think Steve, in his comments in saying that we move the product around in order to ensure the service level for the customer, to the extent that there are service-level issues with suppliers going forward, we will experience a repeat of that because we'll incur what cost we need in order to get the product to the customers. But we don't anticipate anything in the back half of the fiscal year.
Operator
At this time, I'd like to turn the conference back to management for any closing remarks.
Steven L. Spinner
Thank you for joining us this morning. We continue to be bullish about growth in our industry as consumers migrate towards a healthier lifestyle.
We look forward to reporting our third quarter results in the next several months. Thanks again and have a great day.
Operator
Ladies and gentlemen, this concludes our conference for today. If you'd like to listen to a replay of today's conference, you may do so by dialing 1 (800) 406-7325 or 1 (303) 590-3030 and entering the access code of 4602426 followed by the pound sign.
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