Executives: Katie Turner - ICR, LLC Steven Spinner - Chairman and Chief Executive Officer Michael Zechmeister - Chief Financial Officer Sean Griffin - Chief Operating

Officer
Analysts: John Heinbockel - Guggenheim Securities Charles Cerankosky - Northcoast Research Holdings LLC Karen Short - Barclays Capital Inc. Rupesh Parikh - Oppenheimer & Company Scott Mushkin - Wolfe Research Frederick Wightman - Citigroup Global Markets, Inc. Andrew Wolf - Loop Capital Markets Kelly Bania - BMO Capital Markets Shane Higgins - Deutsche

Bank
Operator: Greetings and welcome to the United Natural Foods Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation.

[Operator Instructions] As a reminder, this conference is being recorded. It is now pleasure to introduce to your host, Katie Turner. Thank you, Ms. Turner. You may begin.

Katie Turner: Thank you. Good afternoon and thank you for joining us on United Natural Foods second quarter fiscal 2018 earnings conference call. By now, you should have received the earnings release issued this afternoon. This press release and the webcast of today's call are available under the Investors section of the Company’s website, at www.unfi.com. On the call today are Steve Spinner, Chairman and CEO; Sean Griffin, Chief Operating Officer; and Mike Zechmeister, Chief Financial Officer.

Before we begin, we would like to remind everyone that comments made by management during today’s call may contain forward-looking statements. These forward-looking statements assess plans, expectations, estimates and projections that might involve significant risks and uncertainties. These risks are discussed in the Company’s earnings release and SEC filings. Actual results may differ materially from the results discussed in these forward-looking statements. In addition, in today’s earnings release and on the call, management will also provide GAAP and non-GAAP financial measures.

Explanations and reconciliations to their most directly comparable GAAP measure are located in the Company's earnings release and on the Investors section of the Company's website. And it's now my pleasure to turn the call over to Steve Spinner.

Steven Spinner: Thank you, Katie. Good evening, everyone. Today, I am excited to discuss our second quarter business highlights, and then Mike will review our financial results and update to our annual guidance.

Following our prepared remarks, Sean, Mike and I will take your questions. The broad-based momentum we've started off the year with continued throughout our second quarter. All of our significant customer channels generated strong growth, driving record quarterly sales of $2.5 billion for the second quarter. And our rate of topline and earnings growth accelerated sequentially from Q1 to Q2. Sales to our top customers from number two to number 25 increased 13% for the quarter, demonstrating that demand is growing across all of our channels and customers.

Sales mix remained a headwind and was the primary driver of lower gross margin rate compared to the prior year period. However, we are pleased with our earnings and adjusted EBITDA results. While we did leverage our expenses against our strong topline growth, we continue to have higher labor expenses in several of our distribution centers that are capacity constrained. We've taken steps in the quarter to mitigate these headwinds through additional capacity expected to be online by this fall. While we expect some of the expense to continue in the near term, we believe its effect will moderate over the next several quarters.

Our mission continues to be improving service levels to our customers. It is really exciting to be finishing our second quarter 2018 and be able to say that we believe UNFI will likely achieve over $10 billion in net sales this year, representing a significant milestone for the company. We will have grown our yearly net sales over $4 billion in fiscal 2013 with a compounded – sales compounded annual growth rate of over 13%. Net of the tax reform and the Earth Origins Market impairment and restructuring, the quarter exceeded our expectations. Several categories of products continued to grow significantly at UNFI.

Single-service beverage, salty snacks, spices and grains, nutritional bars, yogurt and protein and meal replacement powders all had substantial growth. We also saw a very strong growth across our

wellness categories: digestive health growing 70%, vitamins growing 74% and personal care growing 34% in the quarter when compared to the second quarter of 2017. And as you know, UNFI's Woodstock Farms custom snacks is a large national provider of packaged bulk snacks primarily as a private label co-packer to retailers across the country and we're pleased with Woodstock's growth. For the second quarter, e-commerce sales continued to be a focus as we extended our e-commerce solution to our fourth broadline fulfillment center. UNFI's e-commerce business is primarily comprised of delivering to brick-and-mortar e-commerce providers, UNFIEasyOptions.com, endless aisle fulfillment and fulfillment to home, on behalf of others, offers retailers a wide array of service options designed to satisfy the changing consumer purchase decisions.

The retail food industry has evolved into a three-tiered

omnichannel experience: in store, e-commerce with pickup in store and ship to home. UNFI plays in all three tiers today with a sophisticated network of distributions and fulfillment centers. Also over the last year, we talked quite a bit about UNFI Next, our emerging supplier incubation team. Our revenue with these suppliers grows faster than UNFI's overall growth rate. With almost 200 suppliers in the program and 10% of the suppliers graduating into our primary supplier management program, UNFI Next is differentiating for our supplier participants and our retailers showcasing these exciting new brands.

As I mentioned at the beginning of the year, we expect continued confidence in the strength of our business that is reflected in our increased sales and earnings guidance for fiscal 2018, which Mike will address shortly. We believe our sourcing capabilities, our acquisitions, our very strong balance sheet and demonstrated leadership within better-for-you distribution will support our long-term growth and enable us to achieve our strategic objectives. As we discussed during our first quarter 2018 call, higher demand is continuing to pressure our supply chain as we're seeing further degradation in supplier inbound fill rates. On the expense side, we did incur higher labor costs in DCs that remain capacity constrained. Service levels continued to be challenged during the quarter.

Supplier out of stocks in the second quarter of fiscal 2018 were approximately 250 basis points unfavorable versus the same quarter in the prior year, equating to approximately $50 million in lost sales. We continue to work across supply chain teams closely with our suppliers to ensure that we are aligned on the demand signals and improve service level going forward. During the quarter, we did see a recovery in most of our distribution centers as they have adjusted to new demand, and I am quite proud of their resilience and commitment to the retailers we serve every day. The good news is we've rebalanced the most constrained distribution centers and secured additional capacity. Tight capacity brings challenges beyond warehouse operations and extends to our gross margin as we are more restricted in our ability to forward buy into rising markets and manufacturer promotions.

Additionally, our inbound freight rates have increased incrementally during the quarter, driven primarily by market supply constraints. We expect that these headwinds will continue through the balance of the fiscal year, but at a more moderated rate. I am very proud of our people. UNFI's entire organization has demonstrated their dedication to this strong period of growth. Our management and associates have worked tirelessly and around the clock to minimize service disruptions to our customers from selectors, loaders, drivers and buyers.

Based on the strength of our growth and the performance of our team of almost 10,000 associates, we are committed to attracting and retaining the best talent. Our compensation plans much reflect the competitive nature of current market dynamics while we continue to deliver shareholder value. Also, UNFI will be adding capacity at several critical markets throughout the next several years and we'll provide more color in September. Capital expenditures as a percentage of revenue or sales guidance for fiscal 2018 continues to be within the range we've previously announced. As we continue throughout our fiscal 2018, we expect our growth to continue, driven by demand for better-for-you products, more competition at retail and enabling differentiated solutions.

Consumers are shopping many different ways today. They want variety, specific attributes, exclusive brands, private label and brick-and-mortar retail. We play a role in each of these purchase options and have valuable merchandising, data insights, category management to mutually pursue high-growth opportunities. In summary, we are very pleased with our results. Our team continues to execute at a high level.

Our industry has and continues to evolve quickly, and UNFI is consistently taking decisive steps to change with it. Going forward, UNFI remains well positioned to meet the needs of our customers as we grow together. With that overview, I'll now turn the call over to Mike.

Michael Zechmeister: Thanks Steve and good evening everyone. Net sales for the second quarter of fiscal 2018 were $2.53 billion, which represents growth of 10.6% or approximately $242 million over the second quarter of last year.

As Steve said, this was a record for the company for quarterly net sales. As a reminder, our last acquisition occurred in Q1 of fiscal 2017. As a result, acquisitions did not have an impact on the comparability of our results in Q2 this year versus Q2 of last fiscal year. In Q2 of this fiscal year, we experienced modest inflation of approximately 34 basis points, which was relatively consistent with our inflation from the last quarter. This marks our seventh consecutive quarter of either modest deflation or nearly zero inflation, which continues to be a headwind to our net sales and EBITDA dollar growth.

Demand for our products continues to ramp up, resulting in a higher level of growth than we expected. We experienced broad-based growth across our significant channels during the quarter. Supernatural net sales were up 19.2% or approximately $149.7 million over last year's second quarter and represented 36.8% of total net sales, compared to 34.2% in Q2 of last year. Q2 was the highest quarterly year-over-year net sales growth in the supernatural channel since Q4 of fiscal 2013, which was benefited by an extra week. Supermarket channel net sales increased 6.4% over the second quarter last year and represented 28.8% of total net sales.

The independent channel net sales grew 5.6% versus Q2 last year and landed at 24.5% of total net sales in the quarter. Our foodservice net sales increased 6% over Q2 last year and our e-commerce net sales increased approximately 28.9% versus the second quarter of last year. Gross margin for the quarter came in at 14.70%, a 39 basis point decrease over last year's second quarter. This decrease was driven by a shift in customer mix where sales growth with lower-margin customers outpaced growth with other customers and an increase in inbound freight costs as a result of increased rates throughout the industry. Our operating expenses for the second quarter were 13.11% of net sales, an increase of 4 basis points compared to the second quarter of last fiscal year.

Included in the Q2 total operating expenses were an impairment and restructuring charges of $11.4 million related to the Company's Earth Origins Market retail business. The Earth Origins charges were comprised of $7.9 million of non-cash goodwill impairment, $3.3 million of non-cash long-lived asset impairment and $0.2 million in restructuring expenses associated with the decision to close three non-core underperforming stores. In the second half of fiscal 2018, we expect to incur an additional $2.6 million of restructuring expense related to physically exiting the three stores. Excluding these impairment and restructuring charges, adjusted operating expenses were $320.1 million or 12.66% of net sales for the second quarter of fiscal 2018, a decrease of 41 basis points as a percentage of net sales compared to Q2 of last year. This decrease in adjusted operating expenses as a percent of net sales was primarily driven by leveraging fixed costs on increased net sales and partially offset by increased labor costs incurred to fulfill the increased demand for our products.

Fuel cost for Q2 of fiscal 2018 increased three basis points as a percentage of distribution net sales compared to Q2 of last year 2017 and represented 44 basis points of distribution net sales. Our diesel fuel costs per gallon increased by approximately 14.3% compared to the second quarter of last year, which compares to the Department of Energy’s national average price per gallon for diesel in Q2, which increased 17.4% or $0.44 a gallon compared to the second quarter of last year. Our lower diesel fuel cost increase per gallon compared to the national reported average was primarily due to unfavorable fuel locks, which expired during Q2 last fiscal year. Compared to the first quarter of fiscal 2018, our diesel fuel costs per gallon were up 9% or $0.23 per gallon. For the same period, the Department of Energy’s national average price per gallon for diesel was up 8.1%.

Share-based compensation expense represented 26 basis points of net sales in Q2, a six basis point improvement compared to 32 basis points in the second quarter of last year. On a dollar basis, share-based compensation expense was down $0.8 million to $6.6 million compared to $7.4 million in Q2 last year. Q2 operating income was $40.2 million, a decrease of $6.1 million from $46.3 million in Q2 last year. Excluding restructuring and impairment expenses adjusted operating income was $51.4 million and increase of $5.2 million or 11.2% compared to Q2 last fiscal year. Interest expense in Q2 of $4.2 million was $0.2 million lower than Q2 of last year primarily due to less debt year-over-year and partially offset by an 97 basis point increase in our floating interest rate exposure.

At the end of Q2, we had fixed interest rates on approximately 69% of our debt leaving approximately 31% of our debt with floating rate exposure. For the second quarter of fiscal 2018, the Company reported net income of $50.5 million, an increase of approximately $25 million over the second quarter of last year. Q2 earnings per diluted share was $0.99 compared to $0.50 in Q2 of last year. Given the new 21% corporate tax rate that went into effect on January 1 resulting from the Tax Cuts and Jobs Act tax reform, the Company's anticipated fiscal 2018 blended federal statutory tax rate is expected to be approximately 27.0%. Excluding the impact of impairment and restructuring charges the effect of this component of the tax reform on Q2 results was a benefit to net income of approximately $7.3 million or $0.14 per diluted share.

Included net income and also a result of tax reform was one-time non-cash benefit of $21.9 million or $0.43 per diluted share related to the preliminary remeasurement of our net deferred income tax liabilities. The including this one-time non-cash provisional tax benefit resulting from the tax reform and the restructuring impairment charges, the Q2 adjusted earnings per diluted common share was $0.71 and increase of $0.21 or 42% over Q2 last year. Adjusted EBITDA for the second quarter of fiscal 2018 was $73.3 million, an increase of 8.5% from $67.5 million in the same period last fiscal year. Adjusted EBITDA margin was 2.90 of that sales down five basis points from Q2 last year. We had free cash flow of $26.6 million in the second quarter of fiscal 2018 compared to free cash flow of $90.7 million in the second quarter of last year.

Total working capital at the end of Q2 was $1.1 billion, up 2.5% versus Q2 of last year, compared to net sales growth of 10.6% over the same period. Despite the solid working capital performance relative to net sales growth, the increased size of our business, combined with our commitment to high service levels, has led us to carry higher inventory levels than previously expected. As a result, free cash flow for fiscal 2018 is now estimated to be in the range of $120 million to $150 million, down from the previous range of $155 million to $185 million. Our capital expenditures for the second quarter were approximately $10.3 million or 0.41% of net sales, a decrease of 18 basis points from 0.59% of net sales in the second quarter of last year. As a reminder, on October 6, 2016, we announced that our Board of Directors authorized a share repurchase program for up to $200 million of our common stock.

In the second quarter, we repurchased approximately 403,000 shares for $15.8 million or an average cost per share of $39.21. This compares to the market average share price in Q2 of approximately $46.10. The share repurchase impact on diluted EPS in Q2 was approximately $0.01. Year-to-date, we have repurchased approximately 565,000 shares at a cost of $22.2 million or an average price of $39.36 per share. Our strong balance sheet continues.

At the end of the second quarter, our debt to adjusted EBITDA leverage, excluding operating leases, was 1.44 times, down 38 basis points compared to the second quarter of last year. Outstanding lender commitments under our credit facility were $882 million, excluding reserves with available liquidity of approximately $590 million, including cash and cash equivalents. At the end of Q2, available liquidity under our credit facility was approximately $141 million higher than Q2 last year. Based on UNFI's performance to date, the impact of the tax reform act and the outlook for the remainder of fiscal 2018, the company is raising its net sales and EPS guidance, which was provided on December 7, 2017. For fiscal 2018 ending July 28, 2018, the company now estimates annual net sales to increase 8.0% to 9.5% versus fiscal 2017 and exceed $10 billion for the first time, finishing in a range of approximately $10.01 billion to $10.16 billion.

This compares to previous guidance of an increase of 6.2% to 7.8% over fiscal 2017 net sales. The company now estimates earnings per diluted share for fiscal 2018 to be in the range of approximately $3.27 to $3.35, an increase of approximately 28% to 31% over fiscal 2017 earnings per diluted share of $2.56 compared to the previous estimate of $2.72 to $2.80. Adjusting for restructuring and impairment charges and the impact of one-time preliminary remeasurement of U.S. net deferred tax liabilities resulting from the tax reform, the company estimates adjusted earnings per diluted common share for fiscal 2018 to be in the range of approximately $3.06 to $3.14, an increase of approximately 20% to 23% over fiscal 2017. The company now expects its fiscal 2018 GAAP effective tax rate to be in the range of 23.8% to 24.3% and its fiscal 2018 adjusted effective tax rate to be in the range of 33.0% to 33.3% compared to the previous guidance of 40.0% to 40.3%.

Capital expenditures for fiscal 2018 are expected to remain in the range of 0.6% to 0.7% of estimated fiscal 2018 net sales. At this point, I'll turn the call over to the operator to begin the question-and-answer session. Operator?

Operator: Thank you. [Operator Instructions] Our first question comes from John Heinbockel with Guggenheim Securities. Please go ahead.

John Heinbockel: Steve, let me start with, what’s the pipeline look like for new business wins? And do you have the capacity right now to bring that type of business onboard? So are you aggressively prospecting it or you sort of need to wait until you have capacity?

Steven Spinner: No John. Certainly, if you look at our overall growth, we're doing really well as it relates to both growth within our existing customer base as well as there are some new wins embedded in our current run rate. We are always out looking for the right new business, and we do have some capacity constraints in some markets, we think we're addressing those. So I would say that we generally speaking, we can be out there looking for new business. In some markets, we would have to be – the timing would have to work in a way that says we'll have to wait until some capacity comes on board.

But the other side of it is, we've got a lot of DCs in a lot of markets and where necessary, we find a way to make it work.

John Heinbockel: Maybe just as a follow-up to that, thinking about bringing more capacity online, particularly in new facilities, so what's the timing of that? I assume we're out to next fiscal year. And could we have a multiyear period here where CapEx is running – annual CapEx is running kind of in the $150 million range temporarily or not that high?

Steven Spinner: Yes, I mean look, if you look back over time, right, I think that gives you a pretty good window into kind of lumpiness of our CapEx growth. We have capacity that we've secured that will be online in this fiscal year and is embedded in our guidance for this fiscal year. Will there be some capacity that we have to add in 2019 and 2020.

Yes, Might some of them be new buildings? Yes. But I wouldn't want to give any other color to that until we get to kind of our 2019 guidance. Mike, you wanted to add something?

Michael Zechmeister: Yes. John, we’ve said long-term that we would expect our CapEx as a percent of sales to be 1%. And if you look back over the last five years, it's about 1%.

Now that's comprised of fiscal 2014 and 2015 where we were adding new warehouses and we were certainly well above 1%. But that, combined with the last few years, we've been well under 1%. That's how you get to that 1%. Now going forward, well, as Steve said, we'll be bringing on new capacity where we need it, and so that percentage is likely to go up above 1% here in the next couple of years.

John Heinbockel: Okay, thank you.

Operator: Our next question comes from Chuck Cerankosky with Northcoast Research. Please go ahead.

Charles Cerankosky: Good afternoon, everyone or good evening.

Steven Spinner: Hey, Chuck.

Charles Cerankosky: Could we talk about mix a little bit? If you – if we look at those top customers, numbers 2 through 25, what percent of the sales do they represent? And then in looking at overall sales mix, could you talk about your effort to sell more perishables in the mix and how that was in the quarter?

Steven Spinner: Yes.

While they look for the first part of your question, I can comment on kind of fresh. Fresh is still growing nicely within the company. Obviously, with the kind of increase in growth that we've had over the last couple of quarters, we've been a little bit kind of focusing our time on getting capacity and hitting production in our warehouse and keeping the fill rate up. So I think we probably took our eye off the ball a little bit on fresh. But it's still growing nicely across the country not only in the broadline division but in our Tony's division, and our Albert's division as well.

As far as the percentage of sales and customers 2 through 25?

Michael Zechmeister: Yes, Chuck, this is Mike. If you look at our top 25 customers, that represents a little over 70% of our total net sales and we've given you what our top customer is.

Charles Cerankosky: Okay. All right. Thank you.

Operator: And our next question will come from Karen Short with Barclays. Please go ahead.

Karen Short: Hey, thanks. Just to clarify something. Obviously, your topline is unbelievably good.

And you've got a little bit more leverage in the second quarter. I mean, we all know what the problems were in the first quarter. You explained some of it for this – or you explained most of it for the second quarter. But I guess, what I was wondering is, one, are you still expecting leverage in the third and fourth quarter? Because I think you previously indicated you would. And I guess when I back into your earnings guidance, I look at – I'm looking kind of it flat operating margins in the second half so it doesn't really show any real improvement from 2Q into 3Q or 4Q.

So I just want to make sure I'm right about that. And then I had a follow-up.

Michael Zechmeister: Yes, Karen. It’s Mike. There are a variety of things going on there.

One of the things we said at Q1, which I think is still true today, is that when the business ramps up like it has, it takes us a little bit of time to assimilate that extra business and normalize our costs. And we pointed last quarter to some increased costs as that business ramped up and we did this quarter as well with labor. And so it generally takes us about 4 to 6 months to normalize on an increase. And so that comes into play a little bit here. But we certainly do expect to get some leverage benefit in the back half, and that should translate through to the bottom line.

Karen Short: Okay. And then just a second question was on actual dollars that you will get incrementally from the tax reform. Could you give that number and then maybe just give some directional commentary on what you think or how you think you'd allocate that? It sounds like it's probably capital but just to be clear.

Michael Zechmeister: Yes, when we say dollars, there are two main components of the tax reform, as you know. There is the federal rate reduction to 21% that kicked in on January 1.

And that has a real cash benefit to us, given our blended rate for the year. That benefit to us in Q2, excluding the impact of Earth Origins, was about $7.3 million. If you went to the GAAP impact, the all-in impact, it's about $6.5 million. Now you might recall back in January when I indicated that the annual impact of the change from a cash standpoint was going to be $16 million to $18 million for us, I'd say we're still in that range. The second component of the reform that impacts us significantly was the reevaluation of our deferred tax assets and liabilities.

And in the quarter, that impacted us positively by $21.9 million. Now we're going to give a little bit of that back as we go. And at the end of the year, we'd expect that number to be around $20 million. But that's non-cash and so there are dollars associated with that.

Karen Short: Okay.

And so in theory, the application for some of that will be to CapEx or is that not the right way to think about it?

Michael Zechmeister: Yes, I think that we're going to look at in a couple of different ways, not necessarily specifically tied to tax reform. One is certainly capital, so growth drives the need for expansions and new buildings. Two, we always look at our wage rates to make sure that we're competitive in attracting and retaining our top talent. And that's certainly something that we're looking at all the time. So I – if I had to point to two places, I would say it's buildings, infrastructure and making sure we have the right competitive wage rates, primarily in our warehouse and transportation.

Karen Short: And do you think you have that now or do you think there's a gap that needs to be filled?

Steven Spinner: No, listen, I think we look at it regularly. The world is changing and it's a little more competitive. Keep in mind that our kind of average pay rate is far above minimum wage, it always has been. But as minimum wage increases and unemployment goes down, we always have to assess our wage structure. But we always do it, keeping shareholder value at the top of our consideration as well.

Karen Short: Great. Thank you so much.

Operator: Our next question comes from Rupesh Parikh with Oppenheimer & Company. Please go ahead.

Rupesh Parikh: Good afternoon, and thanks for taking the question, and also congrats on nice quarter.

Steven Spinner: Thanks Rupesh.

Rupesh Parikh: So staying on the topic of tax reform, how should we think about the tax rate post this year?

Michael Zechmeister: I provided some insight to that back in January. We don't think any differently today than we did back then. What happens next year relative to this year is you get – you don't have the benefit of the one-time restatement of deferred tax assets and liabilities, do have a full-year of the cash tax savings at the corporate rate down at 21%. So this year, we only get seven months' worth of that lower cash tax benefit.

Next year, we get a full-year of that. And so we certainly said that, that will be the big driver of our tax rate reduction for next year. And we've said that if you thought about us as a 40% taxpayer, that you would expect 11 to 13 percentage points' worth of reduction in our tax rate off of that rate in fiscal 2019 and going forward.

Rupesh Parikh: Okay. Great.

And then just going back to your commentary on free cash flow. I understand the inventory increase just due to the – I guess, you guys are trying to improve the service levels. The AR balance also increased meaningfully year-over-year, so just curious if there's anything there or if it's just timing.

Michael Zechmeister: Yes, AR and AP both did increase as well. We've transitioned into our shared service center and seen some changes there that we're getting after.

But the AR and the AP – actually, the AR/AP offset is a little bit positive to working capital.

Rupesh Parikh: Okay. Great. And then my last question, too. So Steve, you mentioned that you're going to be adding more capacity later this year.

So I was just curious what the nature of that capacity is. Is that addition to your distribution centers or just trying to get a feeling for what you guys are doing about capacity?

Steven Spinner: Go ahead Sean.

Sean Griffin: Yes. Hi, Rupesh. This is Sean.

And in the remainder of FY2018, any capacity expansion will be expanding our existing footprint within our DC. So we're not talking about new buildings, we're talking about adding more capacity in contiguous buildings with leases. That's kind of what we're doing.

Rupesh Parikh: Okay. Great.

Thank you.

Operator: Your next question is from Scott Mushkin with Wolfe Research. Please go ahead.

Scott Mushkin: Hey guys. Thanks for taking my questions.

So I had a housekeeping issue and maybe I'm the only one. But you actually cut out when you gave the supernatural growth, at least for me. And I was wondering, is that 19.2%? Did I hear that right? I just did not hear it.

Michael Zechmeister: Yes. The growth in supernatural was 19.2% over.

Scott Mushkin: Okay. Perfect. Okay. So then my second question goes to the growth rates that you're seeing across your business besides what's going on with Whole Foods-Amazon. I mean, it's pretty significant.

I'm trying to understand the underpinnings of it. I mean, if we look at some of those core customers, which we know intimately, they're not growing nearly as fast. And so I was wondering if you could talk to us about why the 13% plus and the top 25 x Whole Foods Amazon, and how sustainable that is. I mean, the marketplace isn't growing that fast, they're not growing that fast. So I was just wondering if you could give us a little color.

Steven Spinner: Yes. Scott, I’ll take that one. So as you know, we've been working hard to what we call building out the store, which is selling more to existing customers. And so in the case of our supernatural, even though our reported number is 19% and that's actually what it is, if you actually take out the new categories that we have taken on recently, the supernatural growth is actually very similar to the growth of our customers 2 through 25.

Scott Mushkin: Okay, and then…?

Steven Spinner: And so the second part of the question is why are they lowering so rapidly at 13%? And it's a matter of certainly, those retailers seem to be getting it right as it relates to a product differentiation, product attributes, price point, and we are taking on larger portions of those customers' overall business mix.

So it's really hard using UNFI's numbers to say exactly what's happening in the store itself because obviously, as we add SKUs or categories, that that will make the number look larger.

Scott Mushkin: So Steve, are you seeing these top 25 customers actually accelerate their store growth? I mean, take like Wegmans, for instance, you kind of understand what their comp is from being in the marketplace. Obviously nowhere near what you guys are reporting. So are you taking obviously more share of what they're selling? And are you seeing square footage growth ramp up again with some of these guys?

Steven Spinner: Yes, I mean I obviously can’t talk about any one customer individually – yes I would tell you that across the customer base, I think it's probably a combination of a couple of things that are happening. It's new store growth, its expansion of SKUs that we're delivering into their footprint and the stores themselves performing well.

Scott Mushkin: And then my final question is you're going to have to put more capital in the ground obviously in part because of how fast your number one customer is going to probably grow. What are your protections? I mean, obviously, you have a long-term contract there, but how else can you approach this as you commit more capital to, more or less to them, not only to them, but more or less to them?

Steven Spinner: I mean, if we're growing in customers 2 through 25 at 13%. We need the buildings. We need the capacity regardless as to what's happening at our largest customer. I think there's going to be a point in time where we'll start to think about the question that you raised.

But we're a fairly long ways from there. And so we'll kind of wait and see how the dynamics of the industry continue to change and we adjust with it. We have the most built-out intricate complicated supply chain with our space, and we need to make sure that we can continue to provide the kinds of services that we do today in the most efficient manner, and the only way to do that is to be smart about how we build buildings, expand the buildings, lease buildings versus buy buildings. So there's a lot of triggers that we have within our arsenal that we'll toll as we need to.

Scott Mushkin: Great, thanks for taking my questions.

I appreciate it.

Steven Spinner: Okay.

Operator: Our next question comes from Greg Badishkanian with Citi. Please go ahead.

Frederick Wightman: Hey, guys.

It’s actually Fred Wightman on for Greg. You talked about elevated freight costs for a few quarters now, and I think you mentioned they also increased incrementally in the quarter. So how are you thinking about those rates for the rest of the fiscal year and going forward?

Sean Griffin: Hey, Fred. It’s Sean. Well, we certainly did see an uptick – a pretty significant uptick in terms of our inbound freight expenses.

That will take some time to cycle through. As you know, many of our customers are cost-plus customers. We're taking the expense in this cycle and will be passing that through, through the remainder of the year. We're not exactly sure where this is going to go. That the transportation industry is under a lot of pressure, capacity is scarce.

The labor market is difficult. And we're prepared to move forward in the back half. We think we got it covered.

Steven Spinner: I'd add a couple of comments to that. On the outbound freight side, we've been able to do a lot with our loads and routes and increased our drop sizes in a way that we've been able to protect ourselves from a lot of the escalation in costs that you hear throughout the industry.

So on the outbound side, we've actually performed quite well.

Frederick Wightman: Okay, perfect. And then if we look at the potential steel and aluminum tariffs that are being discussed, I mean, is that something could represent an incremental headwind to leasing rates going forward or to your costs? Or is that really just not something that would impact?

Steven Spinner: I don't think that we've contemplated it yet Fred, certainly in terms of our fleet. We would presume to have some incremental expenses there but really can characterize that.

Frederick Wightman: Great.

Thanks.

Operator: Our next question comes from Andrew Wolf with Loop Capital Markets. Please go ahead.

Andrew Wolf: Good afternoon and congratulations on the quarter. I wanted to ask you on the sequential improvement in the leveraging.

Sales getting some margin – operating margin expansion. I understand that sounds like you're managing better against the demand surge, but you know look breakdown internal sales growth I mean it accelerated. So I assume it might have kind of surprised you even this rate of acceleration and given you raised your guidance sales. So and the other thing so I want to ask about that, is that all of it or just basic economics of a nice increase in drop size also driving that? And the follow-up, if you're willing to go there, is could you quantify how much the excess labor to try to meet the demand surge, how much that impacted your operating margin, so we can get a sense of how the business were to leverage if you were staffed up for it.

Steven Spinner: Yes, Andy, I think there's a couple of things there.

First of all, we did get leverage across our fixed costs, so you're right about that. We did improve our loads and routes in a way that increased our drop sizes, which gives us a little leverage. And we did take on additional costs that were unexpected as a result of the ramp-up even further in demand for the products. So I think those things are all true. As far as labor goes, that's been the area where we've seen an increase result of demand on the products, goes beyond just the ramp-up in business.

We've taken on over time, we've taken on temporary labor to help us out. And that's in the range of 10 bps to 15 bps of a headwind to us on our EBITDA margin coming through OpEx.

Andrew Wolf: Gotcha. Thanks that’s very helpful. And could you give us a sense also may be not quantitatively but qualitatively, of kind of the incremental profit margin and contribution margin across the segment.

I mean I think some people of the sense that when you mix the way you mixed, it's going to hurt your operating margin. Clearly, it didn't. So I mean, is it fair to say the effects of drop size, for example, leverage across the segments? And so that's part of the reason, the operating margin expands despite where the growth is?

Steven Spinner: Yes, when you think about margin on our business, the levers that impact margins the most are not necessarily driven by channel. They're driven by scale that the customer provides, they're driven by assortment of products, and they're driven by the level of procurement that the customer asks for. So we see a variety of different needs across different channels and segments.

Those are the kind of the things that affect us on a margin standpoint. Certainly, as you get down to EBITDA margin, when we can leverage or fixed cost and technology infrastructure by increasing load size, increasing drop size, that makes a big difference. So that's where – that's when you have a lot of scale, you can also get a better leverage from because the chances are we've got higher drop sizes and so that's…

Andrew Wolf: Okay. Gotcha. Great.

Thank you.

Operator: And our next question comes from Kelly Bania with BMO Capital Markets. Please go ahead.

Kelly Bania: Hi, thanks for taking my questions. I just wanted to clarify on the guidance raise.

When you look at your adjusted EPS guidance now $3.06 to $3.14 relative to where it was last quarter, was that – is it basically entirely due to tax? Or I guess, I'm just trying to understand, did your…

Michael Zechmeister: Yes. Let me sort that out for you a little bit, Kelly. So clearly, the GAAP guidance includes all the changes. And that's the full tax reform, the two primary pieces being the restatement of deferred tax assets and liabilities and the lower federal rate of 21% that kicked in January 1. And then it's the Earth Origins impairment or restructuring charges.

So those are the things that are all in the GAAP number. When you drop down to adjusted, the two pieces that get pulled out are the Earth Origins impairment and restructuring charges of about $11.4 million in the quarter. And you also pull out the restatements of deferred tax assets and liabilities, which was $21.9 million in the quarter. So those are the two pieces that get pulled out to get to adjusted EPS. So adjusted EPS has included in it the corporate tax rate changed down to 21% that went into effect on January 1.

That’s the part that stays in adjusted because that's the ongoing benefit that will continue into next year. Clearly, that benefit for us in fiscal 2018, is a benefit for seven months. As we get into eighth fiscal 2019, it will be benefit for 12 months, so we’ll certainly see an increase related to that part of the tax reform going into next year. Hopefully, that helps.

Kelly Bania: I think that will make sense.

I was just curious, I mean, if it weren't for changing your tax rate guidance, your adjusted tax rate guidance, would you be updating guidance for earnings?

Michael Zechmeister: Yes, we'd still be better.

Kelly Bania: I guess, can you quantify the magnitude of it because it seems like you would still be within the prior range, maybe at the high end, I don't know. I guess I’m just trying to understand. Clearly, sales is very strong, you're raising the guidance. Just trying to understand how much of that is really flowing through to operating income or is that outlook for operating income for the year?

Michael Zechmeister: Yes, I think if you did the math off the midpoints of where we were and where we're at, you'd see a couple of said increase.

Kelly Bania: Okay. And in terms of – there was some – a lot of articles over the last couple of months about one of your customers maybe putting some fees on their suppliers. And just curious if, in general, if any one of your customers are doing something like that, if there's an impact for you? Or is that just a pure pass-through? Is there any opportunity for you to maybe participate in that or just a pass-through?

Sean Griffin: Well I'm not sure which fees you're referring to. Obviously, many, many of our customers have fees associated with slotting or manufacturers' promotions. And we frequently handle the administration or processing those fees.

And we do make a little bit of money on that, but we also obviously incur some costs to do it as well. But I'm not sure I've seen anything outside of the – what is typical. We are not experiencing any nor are we incurring any additional fees, any incremental fees and have not over the last several quarters.

Kelly Bania: Got it. And just also want to clarify and make sure I understand the comment about the freight and passing that on.

I guess, does that work in the form of a freight surcharge? Is that how we should think about it? When did that take hold? And how do you feel about your suppliers being able to absorb a cost like that at a time like this when they're already out-of-stocks, their working capital is going up, too. So just curious how you feel or what you're may be seeing already and how they're dealing with that.

Steven Spinner: For us, it's a straight pass-through in our cost of goods. There's just a lag here where when the rates go up, it takes us a little bit of time to be able to work that through. So that’s why we saw the headwind on our inbound in Q2.

But as Sean said, we ought to be able to work through that and get it into our costs so that's not a headwind going forward.

Kelly Bania: Okay, and then the last one for me, I guess, similar to last quarter, your guidance for the year implies maybe a slowdown relative to where you are. I mean, is that – are you seeing something to that effect? Or are you just trying to plan conservatively? Or at what point do you get – do you plan a little bit more so that you can try to have those labor expenses more in line with where sales are really tracking

Michael Zechmeister: Yes. I mean, I think we generally plan conservatively. We do lap some business in the fourth quarter of the year.

But we just feel like that's a good number and one that we're comfortable with.

Kelly Bania: Okay, thanks.

Operator: Our next question comes from Shane Higgins with Deutsche Bank. Please go ahead.

Shane Higgins: Yes, good evening.

Thanks for taking my questions. On your out-of-stocks, they stepped up to about $50 million. I think you said during the quarter. That's about double what they were in the first quarter. Is that kind of a level that you guys anticipate in the third quarter? I mean, how are your vendors mitigating that?

Michael Zechmeister: Well, I'm not sure which number you're referring to, but the first quarter and the second quarter were actually relatively similar in terms of the total supplier fill rate issues.

But still, when you look year-over-year, $50 million in lost sales is a pretty significant number. Now fortunately, if suppliers are aligned with – everybody's interests are aligned. I mean, they want to have the product. So it's either a capacity issue within the supplier, it's making it keep up with the demand but ultimately, I think they will.

Sean Griffin: Yes, these cycles generally correct.

It has certainly been a circumstance here presently where it's taking longer than we had expected. But we think that we can get through it towards the back half of 2018 and then we'll see some improvement.

Michael Zechmeister: Yes. By the way, we just saw what you were referring to. In the first quarter was 250 basis points and this quarter was 250 basis points.

I'm not sure where the difference between $25 million and $50 million came from, but it's probably closer to $50 million. But we just need to check that out.

Shane Higgins: Okay. No, I appreciate that. And then a question on the free cash flow guide.

You guys did lower that by about $35 million, but I just want to make it clear. You guys do expect a $16 million to $18 million cash tax benefit from tax reform. Is that correct? And then if so, that $50 million delta between your old guidance and the new guidance, is that all working capital?

Michael Zechmeister: Yes, because you're thinking about it the right way. We certainly had – actually, the working capital performance up 2.5% versus sales growth of 10.6% wasn’t bad, but we are seeing increase in inventory, along with the increased size of our business and the need to protect our service levels.

Shane Higgins: Okay.

I’m just trying to understand just thinking out into next year if you might be able to drive some incremental free cash by maybe bringing down working capital or if that might be an opportunity?

Michael Zechmeister: Yes, we're continuously working on opportunities to improve our working capital. We made some pretty good progress over the years. But with the unexpected increase in demand, we've got – as Steve said, one of our top priorities is to preserve high service levels for our customers, and sometimes, that means taking on a little bit of extra inventory, make sure we can get through the demand.

Shane Higgins: Got it and then just a last question for me is, obviously, you guys talked about how capacity constrained you are in some of the challenges there. Do you guys have any opportunities to rationalize any less profitable business to possibly create some capacity?

Michael Zechmeister: Let me make one point of clarification.

We're only capacity limited in a few of our markets. We are not capacity limited across the country. And so you raised a great question and that is something that we look at all the time. But we're focused on building out the store. We're focusing on selling more to existing customers, and you need the infrastructure and the capacity to do that.

But I want to make sure that we don’t characterize our network as being at capacity. We have several markets that are at capacity. We're addressing those, but plenty of capacity throughout the balance of the network.

Shane Higgins: Got it. Thanks.

Thanks for taking questions. End of Q&

A
Operator: This concludes our question-and-answer session. I would like to turn the floor back to management for any closing remarks.

Steven Spinner: Thanks for joining us on this exciting quarter. Have a terrific night.

Operator: The conference has now concluded. Thank you for attending today's presentation and you may now disconnect your lines.