UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended April 30, 2004 OR |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 000-21531 UNITED NATURAL FOODS, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware 05-0376157 (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 260 Lake Road Dayville, CT 06241 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (860) 779-2800 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes |X| No |_| Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |X| No |_| As of June 10, 2004 there were 39,985,184 shares of the Registrant's Common Stock, $0.01 par value per share, outstanding.
UNITED NATURAL FOODS, INC. FORM 10-Q FOR THE QUARTER ENDED APRIL 30, 2004 TABLE OF CONTENTS Part I. Financial Information Item 1. Financial Statements Condensed Consolidated Balance Sheets (unaudited) 3 Condensed Consolidated Statements of Income 4 (unaudited) Condensed Consolidated Statements of Cash Flows 5 (unaudited) Notes to Condensed Consolidated Financial Statements 6 (unaudited) Item 2. Management's Discussion and Analysis of Financial 11 Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosure About Market 26 Risk Item 4. Controls and Procedures 26 Part II. Other Information Item 6. Exhibits and Reports on Form 8-K 26 Signatures 26 2
PART I. FINANCIAL INFORMATION Item 1. Financial Statements UNITED NATURAL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) <TABLE> <CAPTION> April 30, July 31, (In thousands, except per share amounts) 2004 2003 --------- --------- <S> <C> <C> ASSETS Current assets: Cash $ 8,802 $ 3,645 Accounts receivable, net 110,094 90,111 Notes receivable, trade 690 585 Inventories 203,715 158,263 Prepaid expenses 5,672 5,706 Deferred income taxes 6,004 6,455 Refundable income taxes -- 704 --------- --------- Total current assets 334,977 265,469 Property & equipment, net 112,125 101,238 Other assets: Notes receivable, trade, net 2,264 1,261 Goodwill 57,242 57,400 Intangible assets, net 168 1,014 Other, net 3,532 3,717 --------- --------- Total assets $ 510,308 $ 430,099 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY --------- Current liabilities: Notes payable - line of credit $ 114,514 $ 96,170 Current portion of long-term debt 4,597 4,459 Current portion of obligations under capital leases 512 903 Accounts payable 96,531 67,187 Accrued expenses and other current liabilities 24,877 26,347 Financial instruments -- 6,104 Income taxes payable 61 -- --------- --------- Total current liabilities 241,092 201,170 Long-term debt, excluding current portion 45,367 38,507 Deferred income taxes 2,247 2,247 Obligations under capital leases, excluding current portion 244 612 --------- --------- Total liabilities 288,950 242,536 --------- --------- Commitments and contingencies Stockholders' equity: Preferred stock, $0.01 par value, authorized 5,000 shares; none issued and outstanding -- -- Common stock, $0.01 par value, authorized 50,000 shares; 39,877 and 39,020 issued and outstanding at April 30, 2004 and July 31, 2003, respectively 399 195 Additional paid-in capital 97,211 86,068 Unallocated shares of ESOP (1,809) (1,931) Accumulated other comprehensive income 335 432 Retained earnings 125,222 102,799 --------- --------- Total stockholders' equity 221,358 187,563 --------- --------- Total liabilities and stockholders' equity $ 510,308 $ 430,099 ========= ========= </TABLE> The accompanying notes are an integral part of the condensed consolidated financial statements. 3
UNITED NATURAL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) <TABLE> <CAPTION> Quarter ended April 30, Nine months ended April 30, (In thousands, except per share data) 2004 2003 2004 2003 --------- --------- ----------- ----------- <S> <C> <C> <C> <C> Net sales $ 448,900 $ 363,611 $ 1,223,530 $ 1,013,050 Cost of sales 361,323 290,056 980,995 807,222 --------- --------- ----------- ----------- Gross profit 87,577 73,555 242,535 205,828 Operating expenses 71,388 61,930 199,706 173,301 Amortization of intangibles 676 130 1,142 234 --------- --------- ----------- ----------- Total operating expenses 72,064 62,060 200,848 173,535 --------- --------- ----------- ----------- Operating income 15,513 11,495 41,687 32,293 --------- --------- ----------- ----------- Other expense (income): Interest expense 1,536 1,811 5,990 5,729 Change in fair value of financial instruments -- 360 (704) 1,839 Other, net (128) (142) (358) (562) --------- --------- ----------- ----------- Total other expense 1,408 2,029 4,928 7,006 --------- --------- ----------- ----------- Income before income taxes 14,105 9,466 36,759 25,287 Income taxes 5,501 3,692 14,336 10,020 --------- --------- ----------- ----------- Net income $ 8,604 $ 5,774 $ 22,423 $ 15,267 ========= ========= =========== =========== Per share data (basic): Net income $ 0.22 $ 0.15 $ 0.57 $ 0.40 ========= ========= =========== =========== Weighted average shares of common stock 39,648 38,483 39,296 38,310 ========= ========= =========== =========== Per share data (diluted): Net income $ 0.21 $ 0.15 $ 0.55 $ 0.39 ========= ========= =========== =========== Weighted average shares of common stock 41,344 39,500 40,813 39,271 ========= ========= =========== =========== </TABLE> The accompanying notes are an integral part of the condensed consolidated financial statements. 4
UNITED NATURAL FOODS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) <TABLE> <CAPTION> Nine months ended April 30, (In thousands) 2004 2003 --------------------------- <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 22,423 $ 15,267 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 8,807 7,663 Change in fair value of financial instruments (704) 1,839 Gain on disposals of property and equipment (61) (18) Provision for doubtful accounts 2,521 1,952 Changes in assets and liabilities: Accounts receivable (22,504) (2,279) Inventory (45,345) (6,575) Prepaid expenses and other assets 1,050 (2,154) Notes receivable, trade (1,108) 31 Accounts payable 29,344 9,606 Accrued expenses and other liabilities (968) 806 Income taxes payable 61 2,651 Financial instruments (5,400) -- Tax effect of stock option exercises 3,870 846 ----------------------- Net cash (used in) provided by operating activities (8,014) 29,635 ----------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of acquired businesses, net of cash acquired (6) (43,964) Proceeds from sale of property and equipment 202 60 Capital expenditures (18,989) (14,975) ----------------------- Net cash used in investing activities (18,793) (58,879) ----------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net borrowings under note payable 18,344 (9,267) Net proceeds from issuance of long-term debt 10,204 30,954 Repayments of long-term debt (3,302) (1,282) Principal payments of capital lease obligations (759) (1,002) Proceeds from exercise of stock options 7,477 3,613 ----------------------- Net cash provided by financing activities 31,964 23,016 ----------------------- NET INCREASE (DECREASE) IN CASH 5,157 (6,228) Cash at beginning of period 3,645 11,184 ----------------------- Cash at end of period $ 8,802 $ 4,956 ======================= Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 5,788 $ 5,591 ======================= Income taxes $ 9,686 $ 4,598 ======================= </TABLE> The accompanying notes are an integral part of the condensed consolidated financial statements. 5
UNITED NATURAL FOODS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS APRIL 30, 2004 (UNAUDITED) 1. BASIS OF PRESENTATION United Natural Foods, Inc. (the "Company") is a distributor and retailer of natural and organic products. The Company sells its products throughout the United States. The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year's presentation. The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to rules and regulations of the Securities and Exchange Commission for interim financial information, including the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, certain information and footnote disclosures normally required in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. In our opinion, these financial statements include all adjustments necessary for a fair presentation of the results of operations for the interim periods presented. The results of operations for interim periods, however, may not be indicative of the results that may be expected for a full year. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended July 31, 2003. 2. INTEREST RATE SWAP AGREEMENTS In October 1998, the Company entered into an interest rate swap agreement that provided for the Company to pay interest for a five-year period at a fixed rate of 5% on a notional principal amount of $60 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. This swap had been entered into as a hedge against LIBOR interest rate movements on current and anticipated variable rate indebtedness totaling $60 million at LIBOR plus 1.50%, thereby fixing the effective rate at 6.50%. In October 2003, the counter party exercised its option to extend the original five-year term of the swap agreement to seven years. The inclusion of this option prohibited accounting for the swap as an effective hedge under Statement of Financial Accounting Standards ("SFAS") No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. The Company entered into an additional interest rate swap agreement effective August 2001. The additional agreement provided for the Company to pay interest for a four-year period at a fixed rate of 4.81% on a notional principal amount of $30 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. The four-year term of the swap agreement could have been extended to six years at the option of the counter party, which prohibited accounting for the swap as an effective hedge under SFAS 133. The swap had been entered into as a hedge against LIBOR interest rate movements on current and anticipated variable rate indebtedness totaling $30 million at LIBOR plus 1.50%, thereby fixing the effective rate on the notional amount at 6.31%. If LIBOR exceeded 6.0% in a given period, the agreement was suspended for that period. On December 29, 2003, the Company assigned and transferred all of its obligations of its two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this assignment, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as special items for the first two quarters of fiscal 2004. The Company recorded no expense and $0.4 million of expense for the quarters ended April 30, 2004 and 2003, respectively, and $0.7 million of income and $1.8 million of expense for the nine months ended April 30, 2004 and 2003, respectively, on these interest rate swap agreements and related option agreements to reflect the change in fair value of the financial instruments. The Company also entered into an interest rate swap agreement effective May 2003. The agreement provides for the Company to pay interest for a seven-year period at a fixed rate of 3.68% on a notional principal amount of $30 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. The swap has been entered into as a hedge against LIBOR interest rate movements on current variable rate indebtedness totaling $30 million at LIBOR plus 1.50%, thereby fixing the Company's effective rate on the notional amount at 5.18%. The swap agreement qualifies as an "effective" hedge under SFAS 133. The Company recorded an asset of $0.3 million as of April 30, 2004, and a corresponding amount to accumulated other comprehensive income in the statement of stockholders' equity to reflect the fair value of the instrument. 6
3. STOCK OPTION PLANS The Company grants stock options for a fixed number of shares to employees and certain other individuals with exercise prices equal to the fair value of the shares at the dates of grant. The Company has adopted the disclosure only provisions of SFAS No. 123 ("SFAS 123"), Accounting for Stock-based Compensation, and will continue to account for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees. In addition, the Company has made the appropriate disclosures as required under SFAS No. 148 ("SFAS 148"), Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provision of SFAS 123 and SFAS 148 to stock-based employee compensation: <TABLE> <CAPTION> Quarter ended Nine months ended April 30, April 30, 2004 2003 2004 2003 - ----------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income -- as reported $8,604 $5,774 $22,423 $15,267 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 895 922 2,294 2,596 ------------ ------------ ----------- ----------- Net income -- pro forma $7,709 $4,852 $20,129 $12,671 ------------ ------------ ----------- ----------- Basic earnings per share As reported $0.22 $0.15 $0.57 $0.40 ------------ ------------ ----------- ----------- Pro forma $0.20 $0.13 $0.52 $0.33 ------------ ------------ ----------- ----------- Diluted earnings per share As reported $0.21 $0.15 $0.55 $0.39 ------------ ------------ ----------- ----------- Pro forma $0.19 $0.12 $0.50 $0.32 ------------ ------------ ----------- ----------- </TABLE> The Company estimates the fair value of each option as of the date of grant using the Black-Scholes pricing model with the following weighted average assumptions used for grants in the quarters and the nine months ended April 30, 2004 and 2003: <TABLE> <CAPTION> Quarter ended April 30, Nine months ended April 30, 2004 2003 2004 2003 ----------------------------- ------------------------------ <S> <C> <C> <C> <C> Expected volatility 45.8% 62.0% 49.7% 62.0% Dividend yield 0.0% 0.0% 0.0% 0.0% Risk free interest rate 3.01% 3.3% 3.70% 3.3% Expected life 3.25 years 5 years 3.27 years 5 years </TABLE> The Board of Directors adopted and the stockholders approved the 2002 Stock Incentive Plan of the Company, which provides for grants of stock options to employees, officers, directors and others, on October 2, 2002 and December 3, 2002, respectively. These options are intended to either qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code or be "non-statutory stock options." A total of 1,400,000 shares of common stock may be issued upon the exercise of options granted under the 2002 Stock Incentive Plan. In the nine months ended April 30, 2004, the Company granted options for the purchase of 775,000 shares under its stock incentive plans. 7
4. EARNINGS PER SHARE Following is a reconciliation of the basic and diluted number of shares used in computing earnings per share: Quarter ended Nine months ended April 30, April 30, -------------------- --------------------- (In thousands) 2004 2003 2004 2003 --------- -------- --------- --------- Basic weighted average shares outstanding 39,648 38,483 39,296 38,310 Net effect of dilutive stock options based upon the treasury stock method 1,696 1,017 1,517 961 --------- -------- --------- --------- Diluted weighted average shares outstanding 41,344 39,500 40,813 39,271 ========= ======== ========= ========= There were 0 and 949,500 anti-dilutive stock options excluded from the diluted earnings per share calculation for the quarters ended April 30, 2004 and 2003, respectively. For the nine months ended April 30, 2004 and 2003, there were 2,080 and 530,861 anti-dilutive stock options, respectively. 5. COMPREHENSIVE INCOME Total comprehensive income for the three-month period ended April 30, 2004 amounted to $9,131,000 as compared to $5,774,000 in the same period in the prior year. For the nine months ended April 30, 2004 and 2003, comprehensive income amounted to $22,326,000 and $15,267,000, respectively. Comprehensive income is comprised of net income plus the increase/decrease in the fair value of the May 2003 swap agreement discussed in Note 2. 6. ACQUISITIONS On December 31, 2002, the Company acquired by merger privately held Northeast Cooperative, a natural food distributor, headquartered in Brattleboro, Vermont, which serviced customers in the Northeast and Midwest regions of the United States, for cash consideration of $14.1 million. The acquisition was financed by proceeds from the Company's line of credit. The operating results of Northeast Cooperative have been included in the consolidated financial statements of the Company beginning with the acquisition date. The Company has recorded goodwill of $13.5 million related to this purchase acquisition. On October 11, 2002, the Company acquired substantially all of the assets and assumed substantially all of the liabilities of Blooming Prairie Cooperative ("Blooming Prairie"), a distributor of natural foods and related products in the Midwest region of the United States, for cash consideration of $29.6 million. The acquisition was financed by proceeds from the Company's line of credit. The operating results of Blooming Prairie have been included in the consolidated financial statements of the Company beginning with the acquisition date. The Company recorded goodwill of $13.7 million related to this purchase acquisition. 8
The following presents the unaudited pro forma results assuming that the acquisitions discussed above had occurred as of the beginning of fiscal 2003. These pro forma results are not necessarily indicative of the results that will occur in future periods. Nine months (in thousands, except per ended share data) April 30, 2003 Pro forma ---------------- Net sales $1,093,334 ================ Income before income taxes $ 24,557 ================ Net income $ 14,829 ================ Earnings per common share: Basic $0.39 ================ Diluted $0.38 ================ 7. BUSINESS SEGMENTS The Company has several operating divisions aggregated under the distribution segment, which is the Company's only reportable segment. These operating divisions have similar products and services, customer types, distribution methods and historical margins. The distribution segment is engaged in national distribution of natural foods, produce and related products in the United States. The Company has additional operating divisions that do not meet the quantitative thresholds for reportable segments. Therefore, these operating divisions are aggregated under the caption of "Other" with corporate operating expenses that are not allocated to operating divisions. "Other" includes a retail division, which engages in the sale of natural foods and related products to the general public through retail storefronts on the east coast of the United States, and a manufacturing division, which engages in importing, roasting and packaging of nuts, seeds, dried fruit and snack items. Non-operating expenses that are not allocated to the operating divisions are under the caption of "Unallocated Expenses." Following is business segment information for the periods indicated: <TABLE> <CAPTION> Unallocated Distribution Other Eliminations Expenses Consolidated <S> <C> <C> <C> <C> <C> Nine months ended April 30, 2004: Net sales $1,192,161 $54,149 $(22,780) $1,223,530 Operating income (loss) 45,073 (3,389) 3 41,687 Interest expense $5,990 5,990 Other, net (1,062) (1,062) Income before income taxes 36,759 Amortization and depreciation 7,921 886 8,807 Capital expenditures 18,538 451 18,989 Total assets 663,845 41,132 (194,669) 510,308 Nine months ended April 30, 2003: Net sales $979,151 $49,660 $(15,761) $1,013,050 Operating income (loss) 36,794 (4,455) (46) 32,293 Interest expense $5,729 5,729 Other, net 1,277 1,277 Income before income taxes 25,287 Amortization and depreciation 6,707 956 7,663 Capital expenditures 14,383 592 14,975 Total assets 586,627 40,896 (192,258) 435,265 </TABLE> 9
<TABLE> <CAPTION> Unallocated Distribution Other Eliminations Expenses Consolidated <S> <C> <C> <C> <C> <C> Three months ended April 30, 2004: Net sales $438,455 $18,355 $(7,910) $448,900 Operating income (loss) 16,756 (1,351) 108 15,513 Interest expense $1,536 1,536 Other, net (128) (128) Income before income taxes 14,105 Amortization and depreciation 2,997 279 3,276 Capital expenditures 9,430 224 9,654 Total assets 663,845 41,132 (194,669) 510,308 Three months ended April 30, 2003: Net sales $352,908 $16,451 $ (5,748) $363,611 Operating income (loss) 12,878 (1,376) (7) 11,495 Interest expense $1,811 1,811 Other, net 218 218 Income before income taxes 9,466 Amortization and depreciation 2,308 304 2,612 Capital expenditures 3,729 25 3,754 Total assets 586,627 40,896 (192,258) 435,265 </TABLE> 8. STOCK SPLIT On March 17, 2004, the Company's Board of Directors approved a two-for-one split of the Company's common stock that was payable in the form of a stock dividend. Stockholders received one additional share of the Company's common stock for each share of common stock held on the record date of March 29, 2004. The split became effective on April 20, 2004. The applicable share and per-share data for all periods included herein have been restated to give effect to this stock split. The par value of the common stock was not affected by the stock split and remains at $0.01 per share. 9. NOTES PAYABLE On April 30, 2004, the Company entered into an amended and restated four-year $250 million revolving credit facility with a bank group that was led by Bank of America Business Capital (formerly Fleet Capital Corporation) as the administrative agent. The new credit facility replaced an existing $150 million revolving credit facility. The amended and restated secured revolving credit facility allows for borrowing up to $250 million, on which interest accrues at the banks' London Interbank Offered Rate ("LIBOR") plus 1.25%. The $250 million credit facility matures on March 31, 2008. As of April 30, 2004, the Company's outstanding borrowings under the credit agreement totaled $114.5 million with an availability of $98.7 million. 10. NEW ACCOUNTING PRONOUNCEMENTS The Company has determined that there are no recently issued accounting standards that are expected to have a material impact on the Company's consolidated financial position or results of operations. 10
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview We are a leading national distributor of natural and organic foods and related products in the United States. In recent years, our sales to existing and new customers have increased through the continued growth of the natural products industry in general, our acquisition of or merger with natural products distributors, and the expansion of existing distribution centers. Through these efforts, we believe that we have been able to broaden our geographic penetration, expand our customer base, enhance and diversify our product selections and increase our market share. Our distribution operations are comprised of three principal units: o Our Eastern Region, which is comprised of United Natural Foods, United Northeast (formerly Northeast Cooperative) and Blooming Prairie (formerly Blooming Prairie Cooperative); o Our Western Region, which is comprised of Mountain People's Warehouse, Inc. and Rainbow Natural Foods, Inc.; and o Albert's Organics, a produce only division, which operates in various markets across the United States. Through our subsidiary, the Natural Retail Group, we also own and operate 12 natural products retail stores located primarily in Florida. We believe our retail business serves as a natural complement to our distribution business, enabling us to develop new marketing programs and improve customer service. In addition, our Hershey Import division is a business that specializes in the international trading, roasting and packaging of nuts, seeds, dried fruits and snack items. Our net sales consist primarily of sales of natural products to retailers adjusted for customer volume discounts, returns and allowances. The principal components of our cost of sales include the amount paid to manufacturers and growers for product sold, plus the cost of transportation necessary to bring the product to our distribution facilities. Operating expenses include salaries and wages, employee benefits (including payments under our Employee Stock Ownership Plan), warehousing and delivery, selling, occupancy, insurance, administrative, depreciation and amortization expense. Other expenses (income) include interest on outstanding indebtedness, interest income, and the change in fair value of financial instruments and miscellaneous income and expenses. In order to maintain our market leadership and improve our operating efficiencies, we are continually: o expanding marketing and customer service programs across the regions; o expanding national purchasing opportunities; o consolidating systems applications among physical locations and regions; o concentrating on expanding into other channels of business; o integrating administrative and accounting functions; and o reducing geographic overlap between regions. In addition, our continued growth has created the need for expansion of existing facilities to achieve maximum operating efficiencies and to assure adequate space for future needs. We have made considerable capital expenditures and incurred considerable expenses in connection with the expansion of our facilities, including the current expansion of our facilities located in Iowa City, Iowa and Dayville, Connecticut. In June 2003, we completed the expansion of our Chesterfield, New Hampshire distribution facility to 289,000 square feet. This expansion included the consolidation of our operations from Brattleboro, Vermont to Chesterfield, New Hampshire. We are currently expanding our Iowa City, Iowa distribution facility from its existing 120,000 square feet to 260,000 square feet. This will enable us to provide enhanced service levels to our customers in the Midwest market and continue to grow our sales base in that market. We are also currently expanding our Dayville, Connecticut distribution facility from its existing 245,000 square feet to 315,000 square feet. The additional storage space in our Iowa City and Dayville facilities allows for more product diversity and the elimination of outside storage expenses. While we will experience incremental short-term costs 11
during fiscal 2004, we expect the efficiencies created by expanding our Iowa City and Dayville facilities to lower our expenses relative to sales over the long-term. Upon completion of the Iowa City and Dayville facilities' expansions, we will have added approximately 1,037,500 square feet to our distribution centers in the last 5 years, which represents a 75% increase in our distribution capacity. In addition, we continue to increase our leading market share of the growing natural products industry by expanding our customer base, increasing our share of existing customers' business and continuing to expand and further penetrate new distribution territories, particularly in the Midwest market. The acquisition of Blooming Prairie Cooperative's Iowa City, Iowa and Mounds View, Minnesota distribution facilities has provided us with an immediate physical base and growth platform with which to broaden our presence in the fast growing Midwest market. The expansion of our Chesterfield, New Hampshire distribution facility has enabled us to service existing and new customers, to provide more product diversity, and to better balance products among our distribution centers in our Eastern Region. Critical Accounting Policies The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The U.S. Securities and Exchange Commission has defined critical accounting policies as those that are both most important to the portrayal of our financial condition and results and require our most difficult, complex or subjective judgments or estimates. Based on this definition, we believe our critical accounting policies include the following: (i) determining our allowance for doubtful accounts, (ii) determining our insurance reserves and (iii) assessing goodwill and intangible assets. For all financial statement periods presented, there have been no material modifications to the application of these critical accounting policies. Allowance for doubtful accounts We analyze customer creditworthiness, accounts receivable balances, payment history, payment terms and historical bad debt levels when evaluating the adequacy of our allowance for doubtful accounts. In instances where a reserve has been recorded for a particular customer, future sales to the customer are conducted using either cash-on-delivery terms, or the account is closely monitored so that as agreed upon payments are received, orders are released; a failure to pay results in held or cancelled orders. Our accounts receivable balance was $110.1 million and $90.1 million, net of the allowance for doubtful accounts of $6.4 million and $5.1 million, as of April 30, 2004 and July 31, 2003, respectively. Our notes receivable balances were $3.0 million and $1.8 million, net of the allowance of doubtful accounts of $3.2 million and $2.8 million, as of April 30, 2004 and July 31, 2003, respectively. Insurance reserves It is our policy to record the self-insured portion of our workers' compensation, health insurance and automobile liabilities based upon actuarial methods of estimating the future cost of claims and related expenses that have been reported but not settled, and that have been incurred but not yet reported. Any projection of losses concerning workers' compensation and automobile liability is subject to a considerable degree of variability. Among the causes of this variability are unpredictable external factors affecting litigation trends, benefit level changes and claim settlement patterns. If actual claims incurred are greater than those anticipated, our reserves may be insufficient and additional costs could be recorded in the consolidated financial statements. Assessing goodwill and intangible assets valuation Statement of Financial Accounting Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets, requires that companies no longer amortize goodwill, but instead test goodwill for impairment at least annually and between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. We have elected to perform our annual tests for indications of goodwill impairment as of July 31 of each year. Impairment losses are determined based upon the excess of carrying amounts over discounted expected future cash flows of the underlying business. The assessment of the recoverability of long-lived assets will be impacted if estimated future cash flows are not achieved. For reporting units that indicated potential impairment, we determined the implied fair value of that reporting unit using a discounted cash flow analysis and compared such values to the respective reporting units' carrying amounts. 12
Total goodwill as of April 30, 2004 and July 31, 2003 was $57.2 million and $57.4 million, respectively, with goodwill for the Distribution operating segment totaling $45.6 million and $45.7 million as of April 30, 2004 and July 31, 2003, respectively. Results of Operations The following table presents, for the periods indicated, certain income and expense items expressed as a percentage of net sales: <TABLE> <CAPTION> Quarters ended Nine Months Ended April 30, April 30, ----------------------------- ------------- -------------- 2004 2003 2004 2003 ----------------------------- ------------- -------------- <S> <C> <C> <C> <C> Net sales 100.0% 100.0% 100.0% 100.0% Cost of sales 80.5% 79.8% 80.2% 79.7% ----------------------------- ------------- -------------- Gross profit 19.5% 20.2% 19.8% 20.3% ----------------------------- ------------- -------------- Operating expenses 15.9% 17.0% 16.3% 17.1% Amortization of intangibles 0.2% 0.0% 0.1% 0.0% ----------------------------- ------------- -------------- Total operating expenses 16.1% 17.1%* 16.4% 17.1% ----------------------------- ------------- -------------- Operating income 3.5% 3.2% 3.4% 3.2% ----------------------------- ------------- -------------- Other expense (income): Interest expense 0.3% 0.5% 0.5% 0.6% Change in fair value of financial instruments 0.0% 0.1% (0.1)% 0.2% Other, net (0.0)% (0.0)% (0.0)% (0.1)% ----------------------------- ------------- -------------- Total other expense 0.3% 0.6% 0.4% 0.7% ----------------------------- ------------- -------------- Income before income taxes 3.1%* 2.6% 3.0% 2.5% Income taxes 1.2% 1.0% 1.2% 1.0% ----------------------------- ------------- -------------- Net income 1.9% 1.6% 1.8% 1.5% ============================= ============= ============== </TABLE> * Total reflects rounding Quarter Ended April 30, 2004 Compared To Quarter Ended April 30, 2003 Net Sales Our net sales increased approximately 23.5%, or $85.3 million, to $448.9 million for the quarter ended April 30, 2004 from $363.6 million for the quarter ended April 30, 2003. This increase was due to our organic growth and the implementation of our primary distributor agreement with Wild Oats Markets, Inc. ("Wild Oats Markets") during the quarter. For the quarter, growth in the independently owned natural products retailers and mass market distribution channels was approximately 9% and 20%, respectively, compared to the same period in the prior year. Growth in the supernaturals distribution channel was approximately 44% compared to the same period in the prior year. Sales to our largest customer, Whole Foods Market, Inc. ("Whole Foods Market") represented approximately 24% of net sales for the quarters ended April 30, 2004 and 2003. Our current distribution arrangement with Whole Foods Market expires on August 31, 2004. We are currently in discussions with Whole Foods Market to continue our relationship upon expiration of the existing agreement. Gross Profit Our gross profit increased approximately 19.1%, or $14.0 million, to $87.6 million for the quarter ended April 30, 2004 from $73.6 million for the quarter ended April 30, 2003. Our gross profit as a percentage of net sales was 19.5% and 20.2% for the quarters ended April 30, 2004 and 2003, respectively. This decrease in gross profit as a percentage of net sales in comparison to the quarter ended April 30, 2003 was primarily the result of the change in our sales mix to supernaturals, as we implemented our primary distributor agreement with Wild Oats Markets during the quarter. 13
Operating Expenses Operating expenses, excluding special items, increased approximately 14.2%, or $8.8 million, to $70.4 million for the quarter ended April 30, 2004 from $61.6 million for the quarter ended April 30, 2003. As a percentage of net sales, operating expenses, excluding special items, decreased to approximately 15.7% for the quarter ended April 30, 2004 from approximately 16.9% for the quarter ended April 30, 2003. The approximately $8.8 million increase in operating expenses, excluding special items, for the quarter ended April 30, 2004 was due primarily to an increase in our infrastructure to support our continued growth. Operating expenses for the quarter ended April 30, 2004 included a special item of $1.0 million in start-up and transition costs for certain equipment rental and labor costs incurred in connection with the implementation of our primary distribution agreement with Wild Oats Markets, which had staggered effective dates up to and including March 15, 2004. Operating expenses for the quarter ended April 30, 2003 included special items of $0.3 million in costs incurred related to the expansion of our Chesterfield, New Hampshire distribution center. Operating expenses, including special items, increased approximately 15.3%, or $9.5 million, to $71.4 million from $61.9 million for the quarter ended April 30, 2003. As a percentage of sales, operating expenses, including special items, decreased to 15.9% for the quarter ended April 30, 2004 from 17.0% for the quarter ended April 30, 2003. Operating Income Operating income, excluding special items, increased $4.7 million to $16.5 million for the quarter ended April 30, 2004 from $11.8 million for the quarter ended April 30, 2003. As a percentage of sales, operating income, excluding special items, improved from 3.3% for the quarter ended April 30, 2003 to 3.7% for the quarter ended April 30, 2004. Operating income for the quarter ended April 30, 2004 included a special item of $1.0 million of start-up and transition costs for certain equipment rental and labor costs incurred in connection with the implementation of our primary distribution agreement with Wild Oats Markets. Operating income for the quarter ended April 30, 2003 included special items of $0.3 million related to the expansion of our Chesterfield, New Hampshire distribution center. Operating income, including special items, was $15.5 million for the quarter ended April 30, 2004 and $11.5 million for the quarter April 30, 2003. Operating income, including special items, as a percentage of sales, improved to 3.5% for the quarter ended April 30, 2004 compared to 3.2% for the quarter ended April 30, 2003. Other Expense (Income) Other expense, excluding special items, decreased $0.3 million to $1.4 million for the quarter ended April 30, 2004 from $1.7 million for the quarter ended April 30, 2003. At $1.5 million, interest expense for the quarter ended April 30, 2004 was $0.3 million lower than for the quarter ended April 30, 2003. The decrease in interest expense was due to the novation of two of our interest rate swap agreements in December 2003, which served to lower our effective interest rate, partially offset by higher debt levels in fiscal 2004 as a result of our acquisitions of Blooming Prairie and Northeast Cooperative in fiscal 2003 and an increase in inventory levels to support the growth in the business. Other expense (income) for the quarter ended April 30, 2003 included special items of $0.4 million in expense, related to the change in the fair value of financial instruments. Other income, including special items, remained relatively consistent for the quarters ended April 30, 2004 and 2003, at $0.1 million. Other expense, including special items, decreased from $2.0 million for the quarter ended April 30, 2003 to $1.4 million for the quarter ended April 30, 2004, a decrease of $0.6 million, or 30.6%. This decrease was primarily due to the decrease in the change in the fair value on our interest rate swap agreements and related option agreements. On December 29, 2003, we assigned and transferred all of our obligations of our two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this assignment, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as a special item through the second quarter of fiscal 2004. Income Taxes Our effective income tax rate was 39.0% for the quarters ended April 30, 2004 and 2003. The effective rate was higher than the federal statutory rate primarily due to state and local income taxes. 14
Net Income Net income, excluding special items, increased $3.0 million to $9.2 million, or $0.22 per diluted share, for the quarter ended April 30, 2004, compared to $6.2 million, or $0.16 per diluted share, for the quarter ended April 30, 2003. Net income, including special items, increased $2.8 million to $8.6 million, or $0.21 per diluted share, for the quarter ended April 30, 2004, compared to $5.8 million, or $0.15 per diluted share, for the quarter ended April 30, 2003. As we announced on June 1, 2004, we have updated our guidance for our fiscal year ending July 31, 2004 to reflect the implementation of our primary distribution agreement with Wild Oats Markets, the novation of certain of our interest rate swap transactions and the continued growth of our business. Special Items The following table presents, for the periods indicated, a reconciliation of income and per share items excluding special items to income and per share items including special items: - ------------------------------------------------------------------------- Quarter ended April 30, 2004 Pretax Per diluted (in thousands, except per share data) income Net of tax share ---------------------------------- Income, excluding special items: $ 15,115 $ 9,220 $0.22 Special items - Income (Expense): Wild Oats Markets, Inc. primary distributorship start-up and transition related costs (included in operating expenses) (1,010) (616) (0.01) - ------------------------------------------------------------------------- Income, including special items: $ 14,105 $ 8,604 $0.21 ========================================================================= - ------------------------------------------------------------------------ Quarter ended April 30, 2003 Pretax Per diluted (in thousands, except per share data) income Net of tax share --------------------------------- Income, excluding special items: $ 10,162 $ 6,199 $0.16 Special items - Income (Expense): Interest rate swap agreements (change in fair value of financial instruments) (360) (220) (0.01) Costs related to the expansion of our Chesterfield, New Hampshire distribution center (included in operating expenses) (336) (205) (0.01) - ------------------------------------------------------------------------- Income, including special items: $ 9,466 $ 5,774 $0.15* ========================================================================= * Total reflects rounding The start-up and transition costs of the new Wild Oats Markets primary distributorship were for certain equipment rental and labor costs. The non-cash items from the change in fair value on interest rate swap agreements were caused by unfavorable changes in interest rate yield curves. The costs related to the expansion of the Chesterfield facility were primarily labor related. On December 29, 2003, we assigned and transferred all of our obligations of our two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this novation, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as a special item through the second quarter of fiscal 2004. We entered into interest rate swap agreements in October 1998, August 2001 and May 2003. The October 1998 and August 2001 agreements were "ineffective" hedges as a result of the options held by the counter parties that may extend the original term of the interest rate swap agreements. Applicable accounting treatment requires that we record the changes in fair value of the October 1998 and August 2001 agreements in our consolidated statement of income, rather than within "other comprehensive income" in our statement of stockholders' equity. 15
The changes in fair value are dependent upon the forward looking yield curves for each swap. The May 2003 agreement is an "effective" hedge and therefore does not require this treatment. We believe that our October 1998 and August 2001 agreements are special items that are excludable as non-recurring items. First, we only intend to enter into "effective" hedges going forward. This stated intention began with the May 2003 agreement. Second, we believe that the October 1998 and August 2001 agreements may distort and confuse investors if the change in fair value cannot be treated as a special item because their inclusion directly impacts our reported earnings per share. A change in fair value, whether positive or negative, can significantly increase or decrease our reported earnings per share. For example, we recorded a positive change in fair value for the first quarter of fiscal 2004 that increased our diluted earnings per share by $0.01, and in the first quarter of fiscal 2003, we recorded a negative change in fair value that decreased our diluted earnings per share by $0.05. If we were prohibited from excluding this item as a special item, it would artificially inflate our reported earnings per share and thereby mislead investors as to our results of operations and our financial condition. Nine Months Ended April 30, 2004 Compared To Nine Months Ended April 30, 2003 Net Sales Our net sales increased approximately 20.8%, or $210.4 million, to $1,223.5 million for the nine months ended April 30, 2004 from $1,013.1 million for the nine months ended April 30, 2003. This increase was primarily due to our organic growth, as well as sales from the acquired businesses, which resulted in growth from the independently owned natural products retailers and mass market distribution channels of approximately 18% and 19%, respectively, compared to the same period in the prior year. We acquired Blooming Prairie Cooperative, a distributor of natural foods and products in the Midwest region of the United States, in October 2002, and Northeast Cooperative, a distributor of natural foods and products in the Northeast region of the United States, in December 2002. The higher growth rate in the percentage of sales to supernaturals was due to the continued growth of business with Whole Foods Market and the implementation of our primary distributor agreement with Wild Oats Markets during the third quarter of fiscal 2004. Fiscal 2004 sales growth to supernaturals for the nine months ended April 30, 2004 was approximately 23%. Sales to our largest customer, Whole Foods Market represented approximately 25% and 24% of net sales for the nine months ended April 30, 2004 and 2003, respectively. Our current distribution arrangement with Whole Foods Market expires on August 31, 2004. We are currently in discussions with Whole Foods Market to continue our relationship upon expiration of the existing agreement. Gross Profit Our gross profit increased approximately 17.8%, or $36.7 million, to $242.5 million for the nine months ended April 30, 2004 from $205.8 million for the nine months ended April 30, 2003. Our gross profit as a percentage of net sales was 19.8% and 20.3% for the nine months ended April 30, 2004 and 2003, respectively. The decrease in gross profit as a percentage of net sales in comparison to the nine months ended April 30, 2003 was due in part to lost discounts in the first two months of the first quarter of fiscal 2004 resulting from an accounts payable systems implementation, operational issues within certain regions of our produce division and an increase in the supernaturals business as part of our overall sales mix. Operating Expenses Operating expenses, excluding special items, increased approximately 15.5%, or $26.7 million, to $199.3 million for the nine months ended April 30, 2004 from $172.6 million for the nine months ended April 30, 2003. As a percentage of net sales, operating expenses, excluding special items, decreased to approximately 16.3% for the nine months ended April 30, 2004 from approximately 17.0% for the nine months ended April 30, 2003. The approximately $26.7 million increase in operating expenses for the nine months ended April 30, 2004 was due primarily to the inclusion of approximately two and a half months of operating expenses related to Blooming Prairie and five months of operating expenses related to Northeast Cooperative that were not included in fiscal 2003, along with increased operating expenses associated with the continued growth of our business. Operating expenses for the nine months ended April 30, 2004 included a special item of $1.6 million in start-up and transition costs for certain equipment rental and labor costs incurred in connection with the implementation of our primary distribution agreement with Wild Oats Markets, which had staggered effective dates up to and including April 1, 2004. Operating expenses for the nine months ended April 30, 2003 included special items of $1.0 million related to the transition of Wild Oats Markets to a new primary distributor, consisting primarily of severance and expenses related to the transfer of private label inventory and costs incurred related to the expansion of our Chesterfield, New Hampshire distribution center. Operating expenses, including special items, increased approximately 15.7%, or $27.3 million, to $200.8 16
million for the nine months ended April 30, 2004 from $173.5 million for the nine months ended April 30, 2003. As a percentage of sales, operating expenses, including special items, decreased to 16.4% for the nine months ended April 30, 2004 from 17.1% for the nine months ended April 30, 2003 as operating expenses grew at a slower rate than sales. Operating Income Operating income, excluding special items, increased $9.9 million to $43.2 million for the nine months ended April 30, 2004 from $33.3 million for the nine months ended April 30, 2003. As a percentage of sales, operating income, excluding special items, improved to 3.5% for the nine months ended April 30, 2004 up from operating income of 3.3% for the nine months ended April 30, 2003. Operating income for the nine months ended April 30, 2004 included a special item of $1.6 million in start-up and transition costs for certain equipment rental and labor costs incurred in connection with the implementation of our primary distribution agreement with Wild Oats Markets, which had staggered effective dates up to and including April 1, 2004. Operating income for the nine months ended April 30, 2003 included special items of $1.0 million related to the transition of Wild Oats Markets to a new primary distributor, consisting primarily of severance and expenses related to the transfer of private label inventory and costs incurred related to the expansion of our Chesterfield, New Hampshire distribution center. Operating income, including special items, was $41.7 million for the nine months ended April 30, 2004 and $32.3 million for the nine months ended April 30, 2003. Operating income, including special items, as a percentage of sales, increased to 3.4% for the nine months ended April 30, 2004 compared to 3.2% for the nine months ended April 30, 2003. Other Expense (Income) Other expense, excluding special items, increased $0.4 million to $5.6 million for the nine months ended April 30, 2004 from $5.2 million for the nine months ended April 30, 2003. Interest expense for the nine months ended April 30, 2004 was $6.0 million compared to the $5.7 million for the nine months ended April 30, 2003. This increase in interest expense was primarily due to higher average debt levels following our acquisitions of Blooming Prairie and Northeast Cooperative in fiscal 2003 and our increase in inventory levels to support the growth in the business. Other expense (income) for the nine months ended April 30, 2004 and 2003 included special items of $0.7 million in income and $1.8 million in expense, respectively, related to the change in the fair value of financial instruments. Other expense (income), including special items, changed by $2.4 million resulting in income of $1.1 million for the nine months ended April 30, 2004 in comparison to expense of $1.3 million for the nine months ended April 30, 2003. This decrease was primarily due to the decrease in the change in the fair value on our interest rate swap agreements and related option agreements. On December 29, 2003, we assigned and transferred all of our obligations of our two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this assignment, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as a special item through the second quarter of fiscal 2004. Income Taxes Our effective income tax rate was 39.0% and 39.6% for the nine months ended April 30, 2004 and 2003, respectively. The effective rates were higher than the federal statutory rate primarily due to state and local income taxes. Net Income Net income, excluding special items, increased $5.9 million to $22.9 million, or $0.56 per diluted share, for the nine months ended April 30, 2004, compared to $17.0 million, or $0.43 per diluted share, for the nine months ended April 30, 2003. Net income, including special items, increased $7.1 million to $22.4 million, or $0.55 per diluted share, for the nine months ended April 30, 2004, compared to $15.3 million, or $0.39 per diluted share, for the nine months ended April 30, 2004. Special Items The following table presents, for the periods indicated, a reconciliation of income and per share items excluding special items to income and per share items including special items: 17
<TABLE> <CAPTION> - ------------------------------------------------------ --------------- ------------- ------------- Nine months ended April 30, 2004 Pretax income Per diluted (in thousands, except per share data) Net of tax share --------------- ------------- ------------- <S> <C> <C> <C> Income, excluding special items: $37,616 $22,946 $0.56 Special items - Income (Expense): Wild Oats Markets, Inc. primary distributorship transition related costs (included in operating expenses) (1,561) (952) (0.02) Interest rate swap agreements (change in fair value of financial instruments) 704 429 0.01 - ------------------------------------------------------ --------------- ------------- ------------- Income, including special items: $36,759 $22,423 $0.55 ====================================================== =============== ============= ============= </TABLE> <TABLE> <CAPTION> - ------------------------------------------------------ --------------- ------------- ------------- Nine months ended April 30, 2003 Pretax income Net of tax Per diluted (in thousands, except per share data) share --------------- ------------- ------------- <S> <C> <C> <C> Income, excluding special items: $28,106 $16,965 $0.43 Special items - Income (Expense): Interest rate swap agreements (change in fair value of financial instruments) (1,839) (1,108) (0.03) Costs related to loss of major customer (included in operating expenses) (574) (346) (0.01) Costs related to the expansion of our Chesterfield, New Hampshire distribution center (included in operating expenses) (406) (244) (0.01) - ------------------------------------------------------ --------------- ------------- ------------- Income, including special items: $25,287 $15,267 $0.39* ====================================================== =============== ============= ============= </TABLE> * Total reflects rounding The non-cash items from the change in fair value on interest rate swap agreements were caused by favorable and unfavorable changes in interest rate yield curves during the nine months ended April 30, 2004 and 2003, respectively. The costs related to the transition of a major customer, Wild Oats Markets, to a new primary distributor during the nine months ended April 30, 2003 consisted primarily of severance and expenses related to the transfer of Wild Oats Markets' private label inventory. For the nine months ended April 30, 2004, the start-up and transition costs of the new Wild Oats Markets primary distributorship were for certain equipment rental and labor costs. On December 29, 2003, we assigned and transferred all of our obligations of our two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this novation, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as a special item through the second quarter of fiscal 2004. We entered into interest rate swap agreements in October 1998, August 2001 and May 2003. The October 1998 and August 2001 agreements were "ineffective" hedges as a result of the options held by the counter parties that may extend the original term of the interest rate swap agreements. Applicable accounting treatment requires that we record the changes in fair value of the October 1998 and August 2001 agreements in our consolidated statement of income, rather than within "other comprehensive income" in our statement of stockholders' equity. The changes in fair value are dependent upon the forward looking yield curves for each swap. The May 2003 agreement is an "effective" hedge and therefore does not require this treatment. We believe that our October 1998 and August 2001 agreements are special items that are excludable as non-recurring items. First, we only intend to enter into "effective" hedges going forward. This stated intention began with the May 2003 agreement. Second, we believe that the October 1998 and August 2001 agreements may distort and confuse investors if the change in fair value cannot be treated as a special item because their inclusion directly impacts our reported earnings per share. A change in fair value, whether positive or negative, can significantly increase or decrease our reported earnings per share. For example, we recorded a positive change in fair value for the first quarter of fiscal 2004 that increased our diluted earnings per share by $0.01, and in the first quarter of fiscal 2003, we recorded a negative change in fair value that decreased our diluted earnings per share by 18
$0.05. If we were prohibited from excluding this item as a special item, it would artificially inflate our reported earnings per share and thereby mislead investors as to our results of operations and our financial condition. Liquidity and Capital Resources We finance operations and growth primarily with cash flows from operations, borrowings under our credit facility, operating leases, trade payables, bank indebtedness and the sale of equity and debt securities. On April 30, 2004, we entered into an amended and restated four-year $250 million revolving credit facility with a bank group that was led by Bank of America Business Capital (formerly Fleet Capital Corporation) as the administrative agent. The amended and restated credit facility provides for improved terms and conditions that provide us with more financial and operational flexibility, reduced costs and increased liquidity. The new credit facility replaced an existing $150 million revolving credit facility. Our amended and restated secured revolving credit facility allows for borrowing up to $250 million, on which interest accrues at LIBOR plus 1.25%. The $250 million credit facility matures on March 31, 2008. This increased credit facility will support our working capital requirements in the ordinary course of business and provide capital to grow our business organically or through acquisitions. As of April 30, 2004, our borrowing base, based on accounts receivable and inventory levels, was $221.9 million, with remaining availability of $98.7 million. In April 2003, we executed an amendment to our previous loan and security agreement, which released and discharged real estate mortgages on certain real property. Additionally, in April 2003 we executed a term loan agreement in the principal amount of $30 million secured by the real property that was released in accordance with the aforementioned amendment. In December 2003, we amended this term loan agreement by increasing the principal amount by $10 million to $40 million, under the existing terms and conditions, to fund the expansion of our distribution centers in Iowa City, Iowa and Dayville, Connecticut. The $40 million term loan is repayable over seven years based on a fifteen-year amortization schedule. Interest on the term loan accrues at LIBOR plus 1.50%. Proceeds received from the term loan were used to reduce the outstanding balance on our former $150 million credit facility on which interest accrued at the New York Prime Rate or LIBOR plus 1.50%. We continue to believe that our capital requirements for fiscal 2004 will be in the $24 to $28 million range, and that we will finance these requirements with cash generated from operations and the use of our existing credit facilities. We believe that our future capital requirements will be similar to our anticipated fiscal 2004 requirements, as we continue to invest in our growth by upgrading our infrastructure and expanding our facilities. Future investments in major acquisitions are expected to be financed through either equity or long term debt negotiated at the time of the potential acquisition. Net cash used in operations was $8.0 million for the nine months ended April 30, 2004 and was the result of net income and the change in cash collected from customers net of cash paid to vendors, offset by a $45.3 million investment in inventory and a $5.4 payment to novate the "ineffective" swap agreements. The investment in inventory relates to increasing inventory levels to meet the needs of Wild Oats Markets and other organic growth as we implemented our primary distributor agreement with Wild Oats Markets during the third quarter, and supporting increased sales with wider product assortment, combined with our ability to capture purchasing efficiency opportunities in excess of total carrying costs, and our acquisitions of Blooming Prairie and Northeast Cooperative. Days in inventory improved to 47 days at April 30, 2004 compared to 49 days at April 30, 2003. Days sales outstanding at April 30, 2004 improved to 22 days compared to 23 days at April 30, 2003. Net cash provided by operations was $29.6 million for the nine months ended April 30, 2003 and was also due to the change in cash collected from customers, net of cash paid to vendors, and partially offset by increased inventory levels of $6.6 million as a result of increased sales. Working capital increased by $29.6 million, or 46.0%, to $93.9 million at April 30, 2004 compared to working capital of $64.3 million at July 31, 2003. Net cash used in investing activities was $18.8 million for the nine months ended April 30, 2004 and was due primarily to costs incurred in the expansion of our Iowa City, Iowa and Dayville, Connecticut facilities, compared to $58.9 million for the same period last year that was due primarily to the purchase of substantially all the assets of Blooming Prairie and Northeast Cooperative and the expansion of our Chesterfield, New Hampshire facility. Net cash provided by financing activities was $32.0 million for the nine months ended April 30, 2004 due primarily to the $10.2 million in additional long-term debt and borrowings under our $250 million secured revolving credit facility, and proceeds from the exercise of stock options, partially offset by $3.3 million in repayments of our long-term debt. Net cash provided by financing activities was $23.0 million for the nine months ended April 30, 2003, due primarily to increased borrowings on our line of credit, offset by repayment of long-term debt of $1.3 million. 19
In October 1998, we entered into an interest rate swap agreement that provided for us to pay interest for a five-year period at a fixed rate of 5% on a notional principal amount of $60 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. This swap had been entered into as a hedge against LIBOR interest rate movements on current and anticipated variable rate indebtedness totaling $60 million at LIBOR plus 1.50%, thereby fixing the effective rate at 6.50%. In October 2003, the counter party exercised its option to extend the original five-year term of the swap agreement to seven years. The inclusion of this option prohibited accounting for the swap as an effective hedge under Statement of Financial Accounting Standards ("SFAS") No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. We entered into an additional interest rate swap agreement effective August 2001. The additional agreement provided for us to pay interest for a four-year period at a fixed rate of 4.81% on a notional principal amount of $30 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. The four-year term of the swap agreement could have been extended to six years at the option of the counter party, which prohibited accounting for the swap as an effective hedge under SFAS 133. The swap had been entered into as a hedge against LIBOR interest rate movements on current and anticipated variable rate indebtedness totaling $30 million at LIBOR plus 1.50%, thereby fixing the effective rate on the notional amount at 6.31%. If LIBOR exceeded 6.0% in a given period, the agreement was suspended for that period. On December 29, 2003, we assigned and transferred all of our obligations of our two "ineffective" interest rate swaps to a third party at a cost of $5.4 million plus accrued interest. As a result of this assignment, these "ineffective" swaps will no longer be included as a special item for future fiscal periods. These "ineffective" swaps were included as special items for the first two quarters of fiscal 2004. In May 2003, we entered into an additional interest rate swap agreement. The agreement provides for us to pay interest for a seven-year period at a fixed rate of 3.68% on a notional principal amount of $30 million while receiving interest for the same period at the LIBOR rate on the same notional principal amount. The swap has been entered into as a hedge against LIBOR interest rate movements on current variable rate indebtedness totaling $30 million at LIBOR plus 1.50%, thereby fixing our effective rate on the notional amount at 5.18%. The swap agreement qualifies as an "effective" hedge under SFAS No. 133. IMPACT OF INFLATION Historically, we have been able to pass along inflation-related increases. Consequently, inflation has not had a material impact upon the results of our operations or profitability. SEASONALITY Generally, we do not experience any material seasonality. However, our sales and operating results may vary significantly from quarter to quarter due to factors such as changes in our operating expenses, management's ability to execute our operating and growth strategies, personnel changes, demand for natural products, supply shortages and general economic conditions. RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS We have determined that there are no recently issued accounting standards that are expected to have a material impact on our consolidated financial position or results of operations. Use of Non-GAAP Results Financial measures included in this Management's Discussion and Analysis of Financial Condition and Results of Operations that are not in accordance with generally accepted accounting principles ("GAAP") are referred to as non-GAAP financial measures. To supplement our financial statements presented on a GAAP basis, we use non-GAAP additional measures of operating results, net earnings and earnings per share adjusted to exclude special items. We believe that the use of these additional measures is appropriate to enhance an overall understanding of our past financial performance and also our prospects for the future as these special items are not expected to be part of our ongoing business. The adjustments to our GAAP results are made with the intent of providing both management and investors with a more complete understanding of the underlying operational results and trends and its marketplace performance. For example, these adjusted non-GAAP results are among the primary indicators 20
management uses as a basis for our planning and forecasting of future periods. The presentation of this additional information is not meant to be considered in isolation or as a substitute for net earnings or diluted earnings per share prepared in accordance with generally accepted accounting principles in the United States. A comparison and reconciliation from non-GAAP to GAAP results is included in the tables above. Certain Factors That May Affect Future Results This Form 10-Q and the documents incorporated by reference in this Form 10-Q contain forward-looking statements that involve substantial risks and uncertainties. In some cases you can identify these statements by forward-looking words such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "should," "will," and "would," or similar words. You should read statements that contain these words carefully because they discuss future expectations contain projections of future results of operations or of financial position or state other "forward-looking" information. The important factors listed below as well as any cautionary language in this Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations described in these forward-looking statements. You should be aware that the occurrence of the events described in the risk factors below and elsewhere in this Form 10-Q could have an adverse effect on our business, results of operations and financial position. Any forward-looking statements in this Form 10-Q and the documents incorporated by reference in this Form 10-Q are not guarantees of futures performance, and actual results, developments and business decisions may differ from those envisaged by such forward-looking statements, possibly materially. We disclaim any duty to update any forward-looking statements, all of which are expressly qualified by the statement in this section, until the effective date of our future reports required by applicable laws. Any projections of future results of operations should not be construed in any manner as a guarantee that such results will in fact occur. These projections are subject to change and could differ materially from final reported results. We may from time to time update these publicly announced projections, but we are not obligated to do so. Acquisitions We continually evaluate opportunities to acquire other companies. We believe that there are risks related to acquiring companies including overpaying for acquisitions, losing key employees of acquired companies and failing to achieve potential synergies. Additionally, our business could be adversely affected if we are unable to integrate our acquisitions and mergers. A significant portion of our historical growth has been achieved through acquisitions of or mergers with other distributors of natural products. Successful integration of mergers is critical to our future operating and financial performance. Integration requires, among other things: o maintaining the customer base; o the optimization of delivery routes; o coordination of administrative, distribution and finance functions; and o the integration of management information systems and personnel. The integration process has and could divert the attention of management and any difficulties or problems encountered in the transition process could have a material adverse effect on our business, financial condition or results of operations. In addition, the process of combining companies has and could cause the interruption of, or a loss of momentum in, the activities of the respective businesses, which could have an adverse effect on their combined operations. There can be no assurance that we will realize any of the anticipated benefits of mergers. We may have difficulty in managing our growth The growth in the size of our business and operations has placed and is expected to continue to place a significant strain on our management. Our future growth is limited in part by the size and location of our distribution centers. 21
There can be no assurance that we will be able to successfully expand our existing distribution facilities or open new distribution facilities in new or existing markets to facilitate growth. In addition, our growth strategy to expand our market presence includes possible additional acquisitions. To the extent our future growth includes acquisitions, there can be no assurance that we will successfully identify suitable acquisition candidates, consummate and integrate such potential acquisitions or expand into new markets. Our ability to compete effectively and to manage future growth, if any, will depend on our ability to continue to implement and improve operational, financial and management information systems on a timely basis and to expand, train, motivate and manage our work force. There can be no assurance that our personnel, systems, procedures and controls will be adequate to support our operations. Our inability to manage our growth effectively could have a material adverse effect on our business, financial condition or results of operations. We have significant competition from a variety of sources We operate in competitive markets, and our future success will be largely dependent on our ability to provide quality products and services at competitive prices. Our competition comes from a variety of sources, including other distributors of natural products as well as specialty grocery and mass market grocery distributors. There can be no assurance that mass market grocery distributors will not increase their emphasis on natural products and more directly compete with us or that new competitors will not enter the market. These distributors may have been in business longer than us, may have substantially greater financial and other resources than us and may be better established in their markets. There can be no assurance that our current or potential competitors will not provide services comparable or superior to those provided by us or adapt more quickly than we do to evolving industry trends or changing market requirements. It is also possible that alliances among competitors may develop and rapidly acquire significant market share or that certain of our customers will increase distribution to their own retail facilities. Increased competition may result in price reductions, reduced gross margins and loss of market share, any of which could materially adversely affect our business, financial condition or results of operations. There can be no assurance that we will be able to compete effectively against current and future competitors. We depend heavily on our principal customer Our current distribution arrangement with our largest customer, Whole Foods Market, is effective through August 31, 2004. Whole Foods Market accounted for approximately 24% of our net sales during the quarters ended April 30, 2004 and 2003, and 25% and 24% for the nine months ended April 30, 2004 and 2003, respectively. As a result of this concentration of our customer base, the loss or cancellation of business from Whole Foods Market, including from increased distribution from its own facilities, could materially and adversely affect our business, financial condition or results of operations. We sell products under purchase orders, and we generally have no agreements with or commitments from our customers for the purchase of products. No assurance can be given that our customers will maintain or increase their sales volumes or orders for the products supplied by us or that we will be able to maintain or add to our existing customer base. With the implementation of our primary distribution agreement with Wild Oats Markets during the third quarter of fiscal 2004, our sales to Whole Foods Markets as a percentage of our total net sales may decline over the next twelve months, and our sales to Wild Oats Markets may increase as a percentage of our total net sales over the next twelve months. Our profit margins may decrease due to consolidation in the grocery industry The grocery distribution industry generally is characterized by relatively high volume with relatively low profit margins. The continuing consolidation of retailers in the natural products industry and the growth of super natural chains may reduce our profit margins in the future as more customers qualify for greater volume discounts, and we experience pricing pressures from both ends of the supply chain. Our operations are sensitive to economic downturns The grocery industry is also sensitive to national and regional economic conditions, and the demand for our products may be adversely affected from time to time by economic downturns. In addition, our operating results are particularly sensitive to, and may be materially adversely affected by: o difficulties with the collectibility of accounts receivable; 22
o difficulties with inventory control; o competitive pricing pressures; and o unexpected increases in fuel or other transportation-related costs. There can be no assurance that one or more of such factors will not materially adversely affect our business, financial condition or results of operations. We are dependent on a number of key executives Management of our business is substantially dependent upon the services of Richard Antonelli, President of our Western Region and Director, Dan Atwood, President of United Natural Brands, Senior Vice President and Secretary, Rick D. Puckett, Chief Financial Officer, Steven H. Townsend, Chair of the Board of Directors, President and Chief Executive Officer and interim President of our Eastern Region, and other key management employees. Loss of the services of any officers or any other key management employee could have a material adverse effect on our business, financial condition or results of operations. Our operating results are subject to significant fluctuations Our net sales and operating results may vary significantly from period to period due to: o demand for natural products; o changes in our operating expenses, including in fuel and insurance; o management's ability to execute our business and growth strategies; o changes in customer preferences and demands for natural products, including levels of enthusiasm for health, fitness and environmental issues; o fluctuation of natural product prices due to competitive pressures; o personnel changes; o supply shortages; o general economic conditions; o lack of an adequate supply of high-quality agricultural products due to poor growing conditions, natural disasters or otherwise; o volatility in prices of high-quality agricultural products resulting from poor growing conditions, natural disasters or otherwise; and o future acquisitions, particularly in periods immediately following the consummation of such acquisition transactions while the operations of the acquired businesses are being integrated into our operations. Due to the foregoing factors, we believe that period-to-period comparisons of our operating results may not necessarily be meaningful and that such comparisons cannot be relied upon as indicators of future performance. 23
We are subject to significant governmental regulation Our business is highly regulated at the federal, state and local levels and our products and distribution operations require various licenses, permits and approvals. In particular: o our products are subject to inspection by the U.S. Food and Drug Administration; o our warehouse and distribution facilities are subject to inspection by the U.S. Department of Agriculture and state health authorities; and o the U.S. Department of Transportation and the U.S. Federal Highway Administration regulate our trucking operations. The loss or revocation of any existing licenses, permits or approvals or the failure to obtain any additional licenses, permits or approvals in new jurisdictions where we intend to do business could have a material adverse effect on our business, financial condition or results of operations. Union-organizing activities could cause labor relations difficulties As of April 30, 2004, we had approximately 3,765 full and part-time employees. An aggregate of approximately 398, or 11%, of the employees at our Auburn, Washington, Iowa City, Iowa and Edison, New Jersey facilities are covered by collective bargaining agreements. These agreements expire in March 2006, June 2006 and June 2005, respectively. We have in the past been the focus of union-organizing efforts. As we increase our employee base and broaden our distribution operations to new geographic markets, our increased visibility could result in increased or expanded union-organizing efforts. Although we have not experienced a work stoppage to date, if additional employees were to unionize, we could be subject to work stoppages and increases in labor costs, either of which could materially adversely affect our business, financial condition or results of operations. Access to capital and the cost of that capital We have a secured revolving credit facility with available credit under it of $250 million at an interest rate of LIBOR plus 1.25% maturing on March 31, 2008. As of April 30, 2004, our borrowing base, based on accounts receivable and inventory levels, was $221.9 million with remaining availability of $98.7 million. In April 2003, we executed a term loan agreement in the principal amount of $30 million secured by real property that was released in accordance with an amendment to the loan and security agreement related to the revolving credit facility. The $30 million term loan is repayable over seven years based on a fifteen year amortization schedule. Interest on the term loan accrues at LIBOR plus 1.50%. In December 2003, we amended this term loan agreement to increase the principal amount from $30 million to $40 million under the existing terms and conditions. In order to maintain our profit margins, we rely on strategic investment buying initiatives, such as discounted bulk purchases, which require spending significant amounts of working capital. In the event that our cost of capital increases or our ability to borrow funds or raise equity capital is limited, we could suffer reduced profit margins and be unable to grow our business organically or through acquisitions, which could have a material adverse effect on our business, financial condition or results of operations. 24
Item 3. Quantitative and Qualitative Disclosure About Market Risk Our exposure to market risks results primarily from fluctuations in interest rates on our borrowings. As more fully described in the notes to the consolidated financial statements, we use interest rate swap agreements to modify variable rate obligations to fixed rate obligations. There have been no material changes to our exposure to market risks from those disclosed in our Annual Report on Form 10-K for the year ended July 31, 2003. Item 4. Controls and Procedures (a) Evaluation of disclosure controls and procedures. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended) as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in timely reporting material information required to be included in our periodic reports filed with the Securities and Exchange Commission. (b) Changes in internal controls. Since the Evaluation Date, there have not been any significant changes to our internal controls or in other factors that could significantly affect those internal controls. 25
PART II. OTHER INFORMATION Items 1, 2, 3, 4 and 5 are not applicable and have been omitted. Item 6. Exhibits and Reports on Form 8-K Exhibits - -------------------------------------------------------------------------------- Exhibit No. Description - -------------------------------------------------------------------------------- 10.1 Amended and Restated Loan and Security Agreement, dated April 30, 2004, with Fleet Capital Corporation. Certain schedules, exhibits and similar attachments to this Agreement have not been filed with this exhibit. The Registrant agrees to furnish supplementally any omitted schedule, exhibit or similar attachment to the Securities and Exchange Commission upon request. - -------------------------------------------------------------------------------- 31.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - CEO - -------------------------------------------------------------------------------- 31.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - CFO - -------------------------------------------------------------------------------- 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - CEO - -------------------------------------------------------------------------------- 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - CFO - -------------------------------------------------------------------------------- Reports on Form 8-K March 2, 2004 The Company announced its financial results for the fiscal quarter ended January 31, 2004. March 19, 2004 The Company announced a two-for-one split of the Company's common stock. * * * We would be pleased to furnish a copy of this Form 10-Q to any stockholder who requests it by writing to: United Natural Foods, Inc. Investor Relations 260 Lake Road Dayville, CT 06241 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. UNITED NATURAL FOODS, INC. /s/ Rick D. Puckett ------------------------------ Rick D. Puckett Chief Financial Officer (Principal Financial and Accounting Officer) Dated: June 14, 2004