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Demand Planning and Replenishment is used for inventory management. We
originally planned on implementing DPR in the operating companies, in
conjunction ...
OPERATOR: Good day everyone and welcome to today's Sysco Corporation third quarter fiscal year 2007 earnings release conference call. As a reminder, today's conference is being recorded.
At this time for opening remarks and introductions, I would like to turn the conference over to Mr. Rick Schnieders, Chief Executive Officer and President, please go ahead sir.
RICK SCHNIEDERS, PRESIDENT, CEO, SYSCO CORPORATION: Thank you Operator. I would like to welcome everyone joining you us this morning. Sysco had a very positive quarter, and we are pleased you took the time to be part of our conference call.
We will start things off with Kirk Drummond taking care of a few administrative items. Then I will give my thoughts on our third quarter results, and move into comments about our positioning beyond fiscal 2007. After that Ken Spitler will update you on key business initiatives, followed by John Stubblefield, who will provide an overview of our financial performance during the quarter. Finally I will wrap things up with a few closing remarks, which will be followed by the question and answer session. I will either answer the questions myself or pass them along since I am traveling, and not in the same room as my colleagues.
With that said I will turn things over to Kirk.
KIRK DRUMMOND, SVP-FINANCE, TREASURER, SYSCO CORPORATION: Thanks Rick. First please make note the 2007 SYSCO Analyst Day will be held in Boston on September 20th and 21st. We are hosting a delicious dinner served by legal sea foods on the evening of September 20th, followed by a day of detailed review of our operations and business plans on September 21st. We forwarded a preliminary communication to the Analyst investors on our distribution list, so please contact us if you have not received an e-mail on the topic.
Now I will read our Safe Harbor language. Statements made in the course of this presentation that state the Company's or management's intentions, hopes, beliefs, expectations or predictions of the future are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and actual results could diver materially.
Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the Company's SEC filings, including but not limited to, risk factors contained in the Company's quarterly report on Form 10-Q for the quarter ended December 30th, 2006, and in the Company's press release issued this morning.
Finally, I need to address a couple of accounting pronouncements that impacted the third quarter results. Please understand that all comparisons given during the call refer to changes between quarter 3 fiscal 2007 and quarter 3 fiscal 2006, unless otherwise noted. This is the final quarter where we are noncomparable to the prior year on reported sales due to the effect of EITF 04-13.
As a reminder, this accounting pronouncement involves revenue recognition in situations where you purchase product from a customer, and then later resell the product to the same customer. The result of this change in accounting principle lowered our reported sales growth in quarter 3 from 6.3% to 5.3%, or approximately $76.7 million. The lower sales raised our reported gross margins as a percent of sales by 17 basis points, and raised our operating expense ratio by 13 basis points.
The second item relates to accounting for our corporate owned life insurance policies under the cost method. This is the third of four quarters we are noncomparable on this issue. In quarter 3 of fiscal '06, we reported a $4.1 million gain from the increased value of corporate owned life insurance. With the change in accounting method, we did not reflect a gain or loss in this year's corresponding quarter.
With that out of the way, I will turn things back over to Rick.
RICK SCHNIEDERS: Thank you Kirk. Let me start by saying I am pleased with our strong performance in the third quarter. We showed both strong sales and earnings growth. Sales grew by 5.3% including the impact of the accounting change, and net earnings grew by 15.2%.
The industry faced adverse weather conditions in the quarter. We overcame this challenge, particularly in the last two months of the quarter to post strong sales growth and there is positive momentum as we head into the final quarter of the fiscal year. We can continue to outpace the growth of the market, and to take market share from our competition. Our margins held strong in the quarter, and we saw great expense leverage. Strong sales growth, solid margins and leveraged costs all contributed to our solid growth in net earnings. Looking beyond fiscal 2007, I want you to take away three key points from this call.
First we are the largest and most profitable food service distributor in North America, and we fully expect to remain in that position. Second, we will expand our lead by continuing to invest in our future. Third, the pace of change that we are undergoing while leading the industry is important. Our strategy is to provide the lowest total procurement cost in the industry for our customers. This includes competitive pricing, but also focuses on lowering customers cost through ease of ordering, fewer errors, and unmatched service levels and reliability. To support that strategy we are in the process of implementing several business initiatives.
As these initiatives are rolled out and achieve critical mass, they will uniquely position us to take market share in a new industry landscape. So how will we accelerate our growth, and even further increase our lead over our competition. Our strategic business initiatives provide the foundation for this. Ken Spitler will give a more detailed update of the key initiatives in a minute.
From a high level, sourcing will leverage our purchasing power to lower our cost of goods, which which can use to further penetrate existing customers and attract new ones. Supply chain and integrated delivery initiatives will help lower our operating cost. We can use the resulting lowered cost of goods and expenses to expand our margins, and enlarge our available pool of profitable customers. As for the timing of when we will see benefits from our key business initiatives, I need to emphasize that the initiatives are long-term in nature.
We are committed to maintaining our strong financial performance, while we are implementing these initiatives on a wider scale. These initiatives are layered and you will see increasing benefits over time. We are managing the pace of these changes so to not throw too much at the operating companies at one time. We must insure that our sales force and our customers, recognize and embrace the compelling reasons for these changes. What is in it for them has to be a key communication in planning and implementing these changes.
We believe the initiatives are going to take us a long way into the future. In fact, we are already seeing strong results in the early stages where we have begun implementation, and we are very excited to move forward. Along those lines, we announced some organizational changes last February.
The most important change was naming Ken Spitler as President and Chief Operating Officer effective July 1, and the associated integration of our strategy teams into the organization. Under Ken's leadership, we will bring a more integrated approach to the marketplace. His responsibilities will expand from managing our broadline business, to managing all operations, including broadline, Sigma, and the specialty companies, as well as the merchandising function.
And moving the Strategy group into the business signals we are moving into an implementation phase where the strategy is embedded in the business. Ken will now provide an update on Sysco's business initiatives.
KEN SPITLER, EVP, PRESIDENT NORTH AMERICAN FOODSERVICE, SYSCO CORPORATION: Thanks Rick. At the operating company level we focused very hard on cost control to leverage our sales growth and grow our margins.
This quarter we are pleased with our expense control and margin management. We expect to continue strong leverage growth in future quarters. Over the past few months we fielded questions about how our key business initiatives interrelate. I will go through some of the key initiatives individually, and explain any interdependence with others. We have several key initiatives, most of which are still in the early stages of implementation. Some are interrelated while others are independent.
Let's talk about sourcing and supply chain management, including the Redistribution Centers, which we refer to as RDC, Transportation Management, or TMS, and the Demand, Planning and Replenishment center, or DPR. I will get into more detail on these three projects later. For sourcing we are currently in the middle of the second group of product categories being converted to consolidated purchasing, which represents about 1.3 billion of annual purchases.
Implementation of the first set of product categories, which represented about 300 million of annual purchases went very smoothly, and we are pleased with the savings we have seen. While participation at the operating company level has exceeded expectations this is hard work and it takes time and effort to do it right. It requires changes for our operations, suppliers, sales force, and customers. The first wave and a half have been successful, and has encouraged us to move forward. We are very confident in the results we will achieve from sourcing.
Our supply chain initiative is compromised of three key areas, the redistribution centers, the transportation management system, and demand planning and replenishment. Although they can offer the highest operational efficiencies when they are bundled together, each initiative provides independent benefits to the operating companies, and is being rolled out in the field separately. We don't have to wait for an RDC in a particular region, in order to implement TMS or DPR at the operating company level and gain benefits.
The first RDC is fully operational. We are now handling about 1.2 million cases per week in the Northeast RDC, and expect to reach our goal of 1.3 million cases by the end of Q4 fiscal 2007. In addition to improved operating efficiencies from the higher case volume, we are experiencing lower inventory levels across the northeast region, and have not invested any capital for warehouse expansion in the region during the past several years. By refining some processes, we have increased the capacity, and are now are re-evaluating the optimal number of cases to route through the RDC. We can do this without investing additional capital in the building.
The second RDC in Alachua, Florida is in the construction phase, and we expect it to be up and running sometime in Q3 of fiscal 2008. There will be initial startup costs associated with the project, which will be less than the cost for the first RDC. We expect to significantly shorten the pay back period, and to reach the optimal throughput faster than the first RDC. The main drivers will be the large number of common suppliers between the two RDCs, and our plan to begin operating the dry cooler freezer sections of the warehouse simultaneously, rather than sequentially as it was for the first RDC.
Our Transportation Management System is used to manage inbound freight costs by providing centralized visibility to all lanes of freight into and out of the region. We are now using TMS to bid out freight lanes, in order to lower our inbound freight costs. We are very pleased with the initial results, and will continue to roll this out to all our operating companies. We expect TMS to be implemented across all operating companies by the end of the summer.
Demand Planning and Replenishment is used for inventory management. We originally planned on implementing DPR in the operating companies, in conjunction with placing an RDC in their region, but saw that we could capture benefits independent of the RDC. We have begun rolling out DPR across the country, and expect it to be implemented by the end of calendar 2008.
Those are the key initiatives. I want to reiterate that we are very pleased about the expense leverage we are seeing in the field, and we expect these trends to continue as the initiatives are rolled out to more operating companies.
Now John will review the Q3 financial results. John.
JOHN STUBBLEFIELD, EVP, FINANCE/ADMIN, SYSCO CORPORATION: Thanks Ken. I am going to talk about sales, margins, operating expenses, and earnings performance in the third quarter. As Rick mentioned, we are pleased with the third quarter results. Including the impact of EITF 04-13, sales grew 5.3% in the quarter, and 7% year-to-date.
Again including the impact of the accounting change, we averaged about 4% sales growth during the first month of the quarter, whereas we averaged approximately 6% growth during the the last two months of the quarter, giving a solid momentum heading into the final quarter of the fiscal year.
Acquisitions contributed 0.5% to sales growth in quarter 3, while food cost inflation as measured by the change in our cost of goods was 2.9%. Our business review process and initiative to increase customer contact personnel continued to improve. We conducted about 12,000 business reviews in quarter 3, and continued to see mid-teen sales growth at these customers. Overall we have increased customer contact personnel about 4.6% over the same time last year.
It is important to note that our sales growth did not come at the expense of margins, which increased 19 basis points over last year, including the favorable impact of EITF 04-13. We saw solid performance across most segments, particularly at the Specialty companies and Sigma. We continue to leverage sales growth in the operating companies as total operating expenses came in 4 basis points lower, including EITF 04-13.
Lower pension and stock compensation expenses were largely offset by higher expenses related to incentive compensation, strategic business initiatives, and the accounting for our company owned life insurance. Keep in mind that last year we did not achieve our performance targets for the corporate portion of the incentive bonus, and subsequently we had reduced incentive pay last year across the organization. We are seeing strong results this year, so incentive compensation will continue to be higher in quarter 4, representing 25 to $30 million increased cost over the fourth quarter last year.
Our earnings growth was the result of solid performance in all aspects of the business. We grew sales and increased market share in the third quarter without sacrificing margin. We are seeing efficiency gains as the operating companies continue to leverage their sales growth. We are also seeing positive results in working capital, especially through inventory management. Inventory days sales outstanding for this quarter was 16.74 versus 17.02 last year, based on Sysco's internal calculation method.
Now, Rick will share his closing remarks.
RICK SCHNIEDERS: Thank you John. As you have heard we had a good quarter with strong sales growth and expense leverage. Now let me remind you of the three points I started with. Number one, we are the largest and Missouri profitable food service distributor in North America, and we expect to stay that way. Second, we will expand our lead by continuing to invest for the future, while at the same time achieving strong current results. And third, we are very carefully pacing our change so these initiatives deliver the maximum benefit.
Operator, we will now take questions.
OPERATOR: Thank you. The question and answer session will be conducted electronically. (OPERATOR INSTRUCTIONS) We will take our first question from Mark Husson from HSBC, please go ahead sir.
MARK HUSSON, ANALYST, HSBC: I just want to ask a question about the gross margin, and if you take out the effect of the EITF 04-13, the gross margin growth was about 2 basis points in the quarter. And you say that it was good at Sigma and specialty, and with only 2 basis points to play with that means that broadline was down. Can you just talk about the dynamic on gross margin, and you know, at what stage you expect to see maybe some of the central buying stuff actually feed in, or is it?
RICK SCHNIEDERS: John Stubblefield, do you want to pick that up please.
JOHN STUBBLEFIELD: Yes, Mark you are on target in terms of where the various segments came in. You know, when we look at gross margins across the organization, mix does have an impact. Broadline companies was just very slightly down for the quarter, not significant at all, so we are again quite pleased with how that performance stacks up, vis-a-vis the overall business. MARK HUSSON: So just go back to sort of dynamics, it looks like the industry overall is slowing down in terms of sales. And you know, clearly your sales growth is not quite as fast as it had been in the recent past. And yet it looks like against gross margins on going up, you say you are not investing in driving sales. Could you, I know we have asked this question a million times over the last ten years, but at some stage you are talking about getting some gross margin from central procurement which may be used to sharpen up the sales line. Is it beginning to get to that point where you need to use that?
RICK SCHNIEDERS: Well, Mark I will start here, and ask any of my colleagues to pitch in. One thing I want to underscore without sounding like we are whining, but the weather this year in January and part of February, was as broad the bad weather was as broad as we have seen. And we had snowstorms that would go from New Mexico all the way to the East coast. That really did have an impact on our business and impact on the industry itself. So I think weather in terms of sales growth was a significant contributor, and it really picked up nicely toward the end of the quarter, and as we have said the momentum ended fourth quarter is good.
From a gross margin perspective, you know, and using some of the sourcing, I know we have talked about it for ten years, but the sourcing initiative as you know is quite new to us, and we indicated in the script that we are very pleased with what we are seeing, in terms of the benefits from the sourcing initiative, recognizing that $300 million is roughly 1% of our purchases, so still pretty small. But the trends of our purchases, so still pretty small. But the trends that we are seeing in the, you know, the activities of those small groups of those first six, and then into the second phase, the benefits, the results we are seeing from that initiative is very, very powerful.
And, you know, we are, as we indicated also in the script, we are prepared to as we get more comfortable with what is happening in regard to sourcing, we are prepared to spend strategically some of the savings that we are experiencing. And so yes, I think that what we're going to see from the sourcing initiative is direct gross margin improvement and sales improvement, you know, starting in the near future here, but we have said very carefully, you know, we are pacing this, it is layered in, and, you know, it will take time. But early results are very, very positive.
JOHN STUBBLEFIELD: Rick, this is John. Let me just add a bit to that. You are right, the results to this point have been very positive, but just so the folks out there can understand something of the process, you know, as we go through this consolidated purchasing exercise, it requires a significant number of product changes throughout the whole organization. That means we have to get the product into the operating companies, and in many cases, most cases, those products then have to be introduced to the customer base, and the customer base has to be accepting of that. We are having very good results with that beginning to happen. As you also said, it only represents about 1% of our purchases.
So the impact not only is it small in magnitude, but it is also as it begins to work its way through the system, does take some time. The only reason I emphasize that is we begin to move to the second wave, it is going to take again time for that process to work its way completely through to the customer, until we begin seeing those benefits show up both the Sysco and our customer.
MARK HUSSON: That is very helpful. We are not famous on being patient, so thanks for explaining it.
RICK SCHNIEDERS: Thanks Mark.
OPERATOR: Thank you. We will it take our next question from Ajay Jain, UBS, please go ahead.
AJAY JAIN, ANALYST, UBS: Hi, good morning.
RICK SCHNIEDERS: Morning Ajay.
AJAY JAIN: It seems like the inflation that you are experiencing seems a lot lower compared to the broader inflation trends, the third party data seems to show a big sequential increase in the March quarter, and so I am wondering if there are any specific factors that would, you know, kind of explain the divergence between the overall inflation trends and the figures that you are reporting?
RICK SCHNIEDERS: Well, of course the inflation that we report is directly related to the goods that we sell. So the product mix that we sell would have some impact on that. And then other practices that, you know, happen within the the organization, you know, in sourcing certainly will have some impact on that in the future. It may moderate for a given time period, our inflation rate versus the rest of the industry or versus the food industry in general.
We anticipate that we will see higher inflation here in the next couple of months, probably representative of some of the figures you are seeing elsewhere. But we are still confident that we're able to manage the little higher rates of inflation than we have seen. And, you know, when we look at inflation we kind of like that sweet spot of 2 to 2.5%, that works well for us. So we are roughly in that range today. We may see higher product, we may see product categories that are a little higher than that, going into the fourth quarter, some of those categories like produce for instance, can move up or down pretty quickly based on what is happening, what the weather particularly in a very short timeframe. A lot of moving parts to inflation.
JOHN STUBBLEFIELD: Ajay, this is John. And that 2.9% that we quoted is quarter-over-quarter, quarter this year versus quarter last year, as opposed to sequential. And we do show a sequential rise in the third quarter from I believe it was 2.6 for the second quarter. So we are seeing that sequential rise, and again the numbers we talk to are quarter-over-quarter.
AJAY JAIN: Okay. I was also wondering if you could confirm the spending in Q3 on the various corporate initiatives, is it still at a run rate level of around 10 to 11 million?
RICK SCHNIEDERS: Yes, that is about right. Now, the comparisons however are, you know, as we get into the third and fourth quarter this year, the comparisons are, you know, begin to shrink. Third and fourth quarter of last year, we were ramping up the expenses related to the strategy initiatives.
AJAY JAIN: Okay. So in effect it might represent a tailwind in Q4?
RICK SCHNIEDERS: A bit, I wouldn't, you know, it isn't going to be huge, roughly you are right, it's about 10 million, and so it won't be a huge number, but it will be a bit of a tailwind.
AJAY JAIN: Okay. Also just on share repurchases it looks like the share buy backs year-to-date are lower than fiscal '06 over the same period. Can you confirm the level of share buybacks for the quarter, for Q3 that is?
JOHN STUBBLEFIELD: Rick, this is John, I will take that question if you wish. Last year if you recall we bought in very heavy in the first two quarters of the year. Then if you looked at where we ended up the year we tailed off pretty significantly in the third and fourth quarter. This year we have bought on a, if you want to use the word, a more measured pace through the first three quarters. Our anticipation is we will end up where we would expect to end up, you know, year versus year. So no real change in our outlook in terms of share repurchase.
AJAY JAIN: Okay, great, thank you. And lastly, I recall that you did a forward buy on fuel last year, which would I think the intent was to cover you through the end of calendar year '06. Can you comment at all John, as far as whether or not that fixed price fuel contract is actually benefiting you right now in the current environment?
JOHN STUBBLEFIELD: Well, it is. I will ask Ken for a little more color around that.
KEN SPITLER: Yes, it is benefiting us right now. We had actually, I think that is the way to describe it is just a forward buy, and of course with the fuel prices it is now it is very beneficial to us right this moment.
JOHN STUBBLEFIELD: You know, if you just looked at it from a gross standpoint, about 50% of our fuel increase in this quarter is due to actually extended deliveries, more miles driven, sales are up, more cases being delivered. And the other roughly half is due to price. So which is really a turnaround, in terms of what we have seen in the past quarter. So I believe to Ken's point we are seeing the benefit of locking in a significant part of our purchases through the balance of the calendar year.
RICK SCHNIEDERS: Keep in mind that is only 60 to 65% of our fuel.
JOHN STUBBLEFIELD: Yes.
AJAY JAIN: Okay, thank you very much.
RICK SCHNIEDERS: Thank you Ajay.
OPERATOR: We will take our next question from Jason Whitmer from Cleveland Research Company, please go ahead.
JASON WHITMER, ANALYST, CLEVELAND RESEARCH COMPANY: Hi, good morning.
RICK SCHNIEDERS: Morning. Rick, I hear you say repeatedly you are pleased with this quarter, and I think you have said that for the last couple years. I think if you are honest with yourself, the market doesn't really agree with you on that. Looking backward and I am not sure what the disconnect might be between those two, can you share your thoughts internally about that, and compare that to maybe the next two to three years, maybe what really some of the biggest changes might be that we can watch and, you know, hold you accountable for, maybe the best opportunities within all of that? Yes, great question Jason. And in fact what I would say about this quarter, if you look at the overall margin response by the operating company, you look at the expense leverage at the operating level, and you look at the overall sales growth, and I would say that this is perhaps overall, then you look at cash flows and inventory management, this is probably the best managed quarter that we have had had in the last three or four. So I feel very good about where we are as an organization.
We have said this many times before, that we in order to keep the trend line going the way it has over the last 37 years, we had to make some big decisions about investments. The first of those was the RDC, and then in the related projects around that TMS and DPR. And then kind of to complete the circle, you know, the sourcing and the integrated delivery work we are doing, particularly the sourcing at this point which dovetails very nicely into that whole supply chain efficiency, that the RDC is designed to improve. So you know, we had to make those investments, we were up front about those investments. They are big, they take longer, they cost more than we anticipate going in sometimes. But we are as we indicated in the call, we are very gratified at what we are seeing, in terms of the results of those big initiatives.
So great on the ground operating leverage, great operating decision making taking place at the local companies, and then the response to the larger initiatives, the initiatives that really are designed to keep our progress going into the future. You know, it just frankly Jason feels very, very good right now. The sourcing, and again we have been very careful about talking about pace here. And that is exactly right, but, you know, it takes a lot of time, there are a lot of moving parts, a lot of folks have to be engaged, and it is also gratifying to see the operating companies and how they are embracing the major changes, such as the RDC and the sourcing initiative. This is hard stuff.
And they are just, they know that it is the right thing to do, the feedback we are getting from them is very positive, and we get all kind of feedback. And you know, they help us design as we go. So you know, in terms of your question going forward, the next two to three years, we feel very good about where we are, and very good about our positioning, vis-a-vis the entire industry.
So we are very upbeat at this point. Not to say that, you know, everything doesn't happen as quickly as we would want. This is, we carefully use the term layering, we are very cautious, our operating companies have to make changes, our marketing associates have to make changes, our customers have to make changes, our suppliers do, so all of that has to be orchestrated in such a way that it comes out in the end, that it all works to everybody's benefit in the end.
JASON WHITMER: As you make these changes, it seems like there is quite a lot of them, specifically through sourcing, what gives you the confidence, even maybe control as you switch, particularly suppliers that you can get the quality consistency you have always had, or even the availability as there are different guys frankly you are doing business with on the back end?
RICK SCHNIEDERS: Yes, that is absolutely true. One of the things that we do early on in the process, you know, we have the largest quality assurance team in the food world, if you will. About 185 folks strong that are out in the plants, in the fields and warehouses every day checking on our product.
And we have specifically required that we have quality assurance folks in to look at the plants, look at the product, to be very, very careful that we indeed are getting what we expect early on from the suppliers. So that's, that we have a great deal of confidence in frankly.
JASON WHITMER: And last question, have you had any early feedback, I know it's early, but early feedback from the restaurant customers as some of these items or suppliers might change?
RICK SCHNIEDERS: Yes. You know, the feedback, the push back, let me put it that way Jason, from the customers across the board has been less than we anticipated. And where we have gotten push back, we have been very quick, the operating companies and the supplier representatives, we have been very quick to get out in the field, and talk with those customers, show them the product, make sure that they understand what we're trying to do ultimately.
What we are trying to do is design a smoother, more efficient supply chain, and drive costs down for everybody in the system. That is the message we are taking to our customers, this is hard, but it's, we need to do it, and in the end it's good for everybody along the supply chain. Sure, Sysco, but also for all of our customers.
JASON WHITMER: Great, thanks.
RICK SCHNIEDERS: Thank you.
OPERATOR: (OPERATOR INSTRUCTIONS) We will take our next question from Steve Chick from JPMorgan, please go ahead sir.
STEVE CHICK, ANALYST, JPMORGAN CHASE & CO.: Hi, thanks.
RICK SCHNIEDERS: Hey Steve.
STEVE CHICK: Hey. I guess maybe a question for John, or with the MA served as a percentage of your broadline sales, it looks about flat for the quarter year-over-year, and given, you know, the mid-teens growth that you seem to still be getting from business reviews, and it looks like you have accelerated the head count, you know, the increase is there and you are on-track, why don't we see the MA served percentage actually increasing as a percentage of the mix.
JOHN STUBBLEFIELD: Well, actually there is a very good reason for that, at the beginning of the year we were reclassed, we go through a classification every year of customers about what we call a street customer, what we call a program customer, what we call a contract customer. So we went back through, there are good internal reasons for the reason we do that. I won't go into that now. But we reclassed a lot of customers from street to contract for various reasons, and most of it has to do again, with the way we internally handle them. Some of that I think is in, I don't have that number in front of me, but I could get it for you some time Steven if you want it. So we reclassed some down.
STEVE CHICK: Okay. Yes, you know, because I know the reclass is, you know, sometimes cause nuances with the numbers and so forth. If I look at the mix percentage that you reported today, just look at the last year number you are reporting today, to me it looks like broadline to MA served piece is growing at about the same rate that your broadline sales are growing, and I guess I would have expected that growth rate to be higher.
RICK SCHNIEDERS: Well, I think there are again a lot of things going on. But one individual situation that I would bring our attention to is our emerging chains initiative that has now been in place for about two years. Another example of where when we focus as this organization we can be very successful in the emerging chains work we have been doing, we now have five folks dedicated to working with the smaller newer chains. The work that they have been doing has been quite successful. We are not only growing our street sales, we are growing emerging chains, and we continue to be aggressive where appropriate in our corporate multi-unit account business.
STEVE CHICK: Okay. Separate question, sometimes you give us a little more granularity on operating costs, you know, for instance what the year-over-year benefit to earnings from lower stock option expense and you know, pension and fuel, and you give us a little more detail on the incentive comp swing. John, do you have those handy?
JOHN STUBBLEFIELD: Let me try to address that. Not to get into a proforma presentation here, but in prior guidance that we have given for pension specifically is that the expense will be about $14 million less for the quarter. Stock option expense, the guidance was about 8 million less for the quarter.
And you know, we spoke of the strategy cost being higher in the second quarter over last year about $11 million, 10 to $11 million, and that in the third quarter we would begin lapping those costs, and that build up that we have seen over the last couple quarters. And that, you know, many of these costs as Rick said are now being transitioned into the business side of the operation. And that, you know, going forward, you know, we are not going to report those costs out discretely, just so we don't get caught up in all that proforma discussion.
What I would suggest you do, and we did set out in the third quarter that we did have higher compensation costs, when we have something exceptional we do talk about that, that is why in this fourth quarter we wanted to be sure and set out for you what that fourth quarter impact would be for that incentive cost, because it is an exception to what happened last year.
And I got to tell you next year we are not going to be able to talk about it, because it's not going to be that sort of exception. What I will also guide you to is we will on May the 10th file our Q for the third quarter, and any additional color that we can give around that, we will certainly put that in the Q.
STEVE CHICK: That is helpful, what was the, did you say what the fourth quarter color on IC comp was helpful, you know, what was the, did you say with the third quarter benefit was?.
JOHN STUBBLEFIELD: I am sorry.
STEVE CHICK: The current quarter?
JOHN STUBBLEFIELD: No, we did not. And again, what we tried to give you a sense of, is that those things that we had set out specific in guidance, that is pension and option expense, was offset by our strategy cost and our incentive cost comp for the quarter, as well as last year we had the effect of a small gain, $4 million, on our company owned life insurance. So when you put all that together it offsets those tailwinds, if you will, that we had from the first two items.
STEVE CHICK: All right, I will take a closer look at that. Can you give us an update on where the tax audit stands?
JOHN STUBBLEFIELD: Yes, we have for all practical purposes come to the end of that audit. We are in the process of reviewing the issues that have been brought to us by the service and again, we will have some further clarification in the Q on May the 10th. However I will say from a management perspective, we are still very confident in our position, and we will look to see what additional color we give around in the Q.
STEVE CHICK: Okay, thanks guys.
RICK SCHNIEDERS: Thank you Steve.
OPERATOR: We will take our next question from Meredith Adler from Lehman Brothers, please go ahead.
MEREDITH ADLER, ANALYST, LEHMAN BROTHERS: Hey guys, a couple questions. You have talked about moving some of those business, strategic business costs into the business itself. How long do you think it takes for you to generate enough earnings from those initiatives to cover the incremental costs?
RICK SCHNIEDERS: Well, again, as we have said that we are at the very beginning stages of this, we are pacing the change as it goes forward. Without giving any, you know, specific timetable I would say that the, it is a short, relatively short period of time, let me define relatively short period of time, 6 to 18 months. So we feel that we will recoup those costs, in what we consider to be a short period of time.
MEREDITH ADLER: And so the initiatives that you have talked about, you have given us lots of cute acronyms, those are the same things you are talking about, that you have asked the strategy people to go to the business and implement, is that right?
RICK SCHNIEDERS: Yes, so sourcing for instance, we have talked a lot about that. The plan all along was that we would have within the strategy department, if you will, sort of an incubation spot where ideas coming in from the operating companies would be vetted. And then we would disseminate those ideas out in the field. So the strategy piece itself and going forward this will be even more true, the strategy piece and the strategy department will be smaller, and the work that has to be done so the work like in sourcing, the implementation has to be done within the business itself.
So in sourcing we have moved, you know, strategy Joe Barton has moved into what we call the BSCC our merchandising department, integrated delivery, and we have talked before about our Optimum Pull for instance, where we have a standardized process today for pulling product, selecting product at night. Well, initially that was sort of coordinated if you will, within the strategy department, but then it gets handed off to Gary Cullen the VP of Corporate Operations, and gets handed off to the VP's of Operations within the operating companies. They are doing the work. The work is happening out in the field. That has been the plan all along, that will continue to be the plan.
So the strategy area for lack of a better term right now, is kind of the incubator, where good ideas come into. We make sure they make sense in the organization, we make sure they are connected appropriately across the organization, but then they get handed off to the business for the business to implement, and that is what is happening today in sourcing, and in integrated delivery, our operational piece of the business too.
MEREDITH ADLER: Okay. Another question I have, you did talk a little bit about the centralization of procurement is challenging, because you are changing the SKUs, that is going to impact customers, and presumably the commission sales people will feel some of the impact.
Do you have to do anything in terms of pricing or raising commissions to make sure that the organization is comfortable with these changes? I know you said that so far the acceptance has been better, but it this seems to me to be a very big change from decentralized to centralized, maybe you could just talk about managing those risks?
RICK SCHNIEDERS: We think of it more as consolidated rather than centralized, because again the work takes place in the field. The marketing associates are already beginning to see even though it's, you know, 1% of our purchases roughly, the marketing associates are already beginning to see benefits, particularly as they are able to talk with their customers about the overall benefit of the sourcing initiatives, the benefits that they will enjoy as time goes on.
So I think that, you know, the one thing, we have got a a lot of sales people as you know, we have over 8,000 sales people on the streets every day, the challenge is just making sure that each of them has the right message to convey to our customers. So that is really the biggest part.
By and large the marketing associates I think are beginning to see, you know, the direction we are headed, and the positive direction that it is. So you know, it is hard, but it's as I said the organization has accepted it very well, and not only accepted it, but kind of looking forward to the next steps that we are going to take.
KEN SPITLER: Rick, can I add something to that?
RICK SCHNIEDERS: Sure.
KEN SPITLER: I mean, we have been very concerned that marketing associates wins on this, so we have a very elaborate rollout process and a tracking process, and one of the things that we wanted to make sure is MA wins on these sourcing items, which we track and make sure that it is one of the directions that we have given our operating companies that they are benefiting also from the sourcing product, which again it is not a hope and a wish, we have a process of rolling it out, and we have a process of tracking it it to make sure that it happens. So the last thing we want is them to be unhappy with this.
RICK SCHNIEDERS: And Meredith as Ken said the big win for the marketing associate is for them to be able to sell more product to our customers, that is the big win.
MEREDITH ADLER: Okay. Final question, obviously you continue to do some very small acquisitions, maybe you could talk a little bit about the environment, I know you had a higher goal for growth coming from acquisitions, then what is your appetite for doing anything larger, if if there was anything out there larger to do?
RICK SCHNIEDERS: We always are looking at, and looking for acquisition opportunities, large and small. We continue to do a number of smaller acquisitions. So our appetite is, as it has been, and that is that we are continuing to look for good acquisitions, good quality acquisitions, to help grow our business.
MEREDITH ADLER: Okay, great, thank you very much.
RICK SCHNIEDERS: Thank you.
OPERATOR: We will take our next question from John Heinbockel from Goldman Sachs, please go ahead.
JOHN HEINBOCKEL, ANALYST, GOLDMAN SACHS: Yes, Rick, I wanted to drill down a little bit on a few of the things on the coordinated purchasing. What is determining what categories you attack first or next, what is the kind of the rationale for the order you hit these in, and how big might the $1.3 billion second wave, you know, how big relatively speaking might the third wave be, and when do you get there?
RICK SCHNIEDERS: You know what, I am going to turn those questions over to Larry Pulliam, who is in the room there in Houston, Larry is directly involved day to day on all of those sourcing initiatives. So the decisions in regard to what's next, I will start however John by telling you the first six items that we started with, are kind of criterion was that they be nonemotional. One thing we found out there is nothing that is nonemotional, everything is emotional. But as we have said, we have worked through that very positively. But related to other criteria, let me ask Larry Pulliam to respond to that question.
LARRY PULLIAM, EVP, MERCHANDISING SERVICES, SYSCO CORPORATION: Yes, John, I guess I need to kind of explain what we call the process. Because the process is very important to us in selecting the right items, and making sure we move at the right pace. I think it kind of dictates kind of how we move forward.
First of all, I think you know we have an enterprise-wide system called Sysco Uniform Systems and we have access to just tons and tons of data. We have transactional data from every broadline of the company, to every customer, and from every supplier. So the process kind of starts with analyzing the data.
We want to look at things where we can have, you know, relatively high impact, we want to look at things that are already selling on a national basis, you know, we don't want to spend a lot of time, for example sourcing a product that has a lot regional exposure, let's take briskets, briskets sell very heavily and the South and the Southeast, but that's not an item that has broad appeal over at Sysco operating companies, so we would avoid items like that. Our tendency is to move forward with commodity-like products that have national exposure, and can have meaningful impact across the Company.
So it this process that I refer to basically is a step by step checklist if you will, of just about everything that we have learned about handling a source item. It includes, we talked earlier about the quality assurance process, and how it is impacted into sourcing, it includes quality assurance, it includes pricing, it includes just about everything we have talked about on the call today. While some would say that the process slows us down a bit I would say it gives us the right information at the right time, in order to insure we are successful with it.
So we pick the products, to answer your question directly, based upon broad appeal, based upon the national scope of the products, and we go in, we have a detailed analysis of each of the items that we break out. How deep will we go, John, I think it's a great question. We never plan to source 100% of the products. We don't know exactly what the final number is going to be though when we talk about it around here we can easily see, you know, that 20% or 30% of our volume number coming in to fruition, typical in Sysco we are also finding other benefits that could possibly stretch deeper in to the organization.
For example we may have a standardized sourcing process here at corporate for the nationally scoped items, we could even move into regions, and have the regions source some products, we have already seen where some operating companies have taken the process, and moving it in to their operations to help the processes at the op co level. So we are pretty gratified about that. In fact, it was interesting, we recently had a meeting for our council of Presidents, and Joe Barton gave a presentation, he asked from the group people to stand up who has been a part of the sourcing process.
We counted, there was 134 people from Sysco that had been involved in the process building up to this point. So I would say op cos are involved in the process, we have a very analytical way of deciding what the numbers are, and we are now utilizing the information and the pace that our operating companies can absorb, our customers can absorb, and our suppliers can absorb.
JOHN HEINBOCKEL: It sounds like the third wave might be about the same size as the second, or it's not going to be a lot bigger, it it might be the same size or a little smaller?
LARRY PULLIAM: I suspect it will be about the same size. We feel fairly good with the pace we are going new, we will just move that across the enterprise.
JOHN HEINBOCKEL: Broadly speaking how price elastic do you think your customers are, I know some are, some aren't, some product categories, they are and they aren't, but broadly speaking, is there a good way to measure, you know, how elastic they are, and how much of this has to be, or should be invested in the business?
LARRY PULLIAM: You know, John, I think it is a great question. I think it is something that we also talk around here. We also have a project going on on the demand side through Jim Hope, the Group President of that group, he is actually trying to find answers to those ,questions through voice of the customer and analyzing data, and looking at product, looking at how they sell and where they sell, so I can say that we don't have the answer yet, we know it is a good question, and we are seeking the answer to that question.
RICK SCHNIEDERS: We are John to your point, we are kind of providing it also from the way you were thinking about it is, we have to look at specific customers based on their needs, we have to look at specific products in terms of the elasticity. We want to know which, obviously which products are more elastic, and which are not. And so that is the way we are looking, we're looking at it at a very detailed basis, and as Larry said, it will take us a while to get a better sense of how it looks more broadly across the organization, what the elasticity looks like more broadly.
JOHN HEINBOCKEL: Do you think half is it fair to think that maybe half the savings get reinvested in some form, just pick that as, half to you and half to the customer, or do you think it skews one way more than the other?
RICK SCHNIEDERS: You know, we don't know the answer to that question. I mean, in relative terms without confirming that number, you are thinking in the right way. We don't know the answer to that. We actually have some work going on right now to determine what the right sharing might be, and I would also go back to your previous question, and just say that we will do that on a very discrete basis, you know, kind of customer by customer, item by item. So you know we are learning as we go here, but thinking about it the way you are thinking about it, is the right way to think about it.
JOHN HEINBOCKEL: Okay, thanks.
RICK SCHNIEDERS: Thank you.
OPERATOR: We will take our final question from Andrew Wolf of BB&T Capital Markets, please go ahead.
ANDREW WOLF, ANALYST, BB&T CAPITAL MARKETS: Thank you, good morning. I have a bunch of follow ups to many of the questions. First on your sales trend, when you describe it going from 4 to 6%, is that on the reported basis so, you know, essentially would include the 0.9% kind of penalty? It is a reported basis, so if that were maintained it would be about 7% now. JOHN STUBBLEFIELD: That is accurate.
ANDREW WOLF: Okay, good. Secondly on the bonus accrual, which you did call in the first two quarters as cumulatively I think 15 million, could you speak to as whether it is running around the same rate, 7, 8 million a quarter in the third quarter?
JOHN STUBBLEFIELD: You know, that is directionally correct. Again, I ask you to look at the fourth quarter to the guidance we have given you.
ANDREW WOLF: Okay. And to that I mean so you are running around, let's round it to 20 million. You are up a lot on bonus accrual through the third quarter, does that, so when you talk about the 25 to 30 million in the fourth quarter, is that just to point out that is the absolute head wind, or you are saying that is sort of guidance, that is going to be in addition to the 20 you're already up, you're going to be up another 25 to 30?
JOHN STUBBLEFIELD: Andy with great respect, and as it is with all our conference calls, you want me to build your model again for you. Again, directionally you have got where we are for cost through the three quarters, and specifically what our costs are for the the fourth quarter for incentives.
ANDREW WOLF: Okay, thanks. On the inflation front, you know, it is good to hear there is some pricing power in the channel. What about the, this freeze in California where, you know, produce prices, you know, looking at the PPI jumped 30% plus given your business there, how did you handle that?
RICK SCHNIEDERS: Well, Andy that i a great question, because that's what happens in the produce business, you have a freeze and for some limited amount of time, you have a relatively large spike in a given category of product, specifically in this case, produce. So it has an impact on our business, but we don't buy all of our produce from California either, we are buying product from other parts of the country.
So tomatoes for instance, you know, it would not impact the tomato crop to any great extent. So that is what happens, you get these kind of wild swings in some of the more sensitive categories, the most sensitive would be produce, then I think the second might be the dairy category.
So we are not showing 30% increases, but our produce inflation is higher than the rest of the organization right now. But that could turn around next month, and probably will.
ANDREW WOLF: All right. Thank you very much.
RICK SCHNIEDERS: Okay. Andy, thank you. And Operator, that was the last question, as I understand it, and I would like to take this opportunity to thank everyone that was on the call, and all who asked questions.
And Mark Palmer and Kirk Drummond will be available for questions by telephone. Please give us a call at your convenience. Thank you all, have a good day!
OPERATOR: Once again ladies and gentlemen that will conclude today's conference, we thank you for your participation, you may now disconnect.
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Labels: Inventory Management
