Landec Corp

F:LDE

Earnings Call Transcript 2019-Q2

[Operator]

Good day, ladies and gentlemen, and welcome to the Landec Second Quarter Fiscal 2019 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Molly Hemmeter, President and CEO of Landec Corporation. Please go ahead.

[Molly Hemmeter, executive]

Thanks, Jonathan. Good morning, and thank you for joining Landec's Second Quarter of Fiscal Year 2019 Earnings Call. With me on the call today is Greg Skinner, Landec's Chief Financial Officer.

During today's call, we may make forward-looking statements that involve certain risks and uncertainties that could cause actual results to differ materially. These risks are outlined in our filings with the Securities and Exchange Commission, including the company's Form 10-K for fiscal year 2018.

As a leading innovator in diversified health and wellness solutions, Landec is comprised of 2 businesses: Lifecore, our contract development and manufacturing, or CDMO business; and our Landec Natural Foods, or LNF business, which with the recent acquisition of Yucatan Foods now includes 5 brands that offer plant-based products with 100% clean ingredients. These brands include our flagship brand, Eat Smart packaged fresh vegetables and salad products; and our emerging Natural Food brands that include O Olive Oils & Vinegars, Now Planting pure-plant meal solutions and Yucatan and Cabo Fresh guacamole and avocado products.

During fiscal year 2019, we have made significant strides in both of our operating businesses. At LNF, we launched the Now Planting brand with a line of pure-plant soups targeted for the plant-based consumer. We also completed the acquisition of Yucatan Foods and entered the high-growth guacamole category. This acquisition accelerates the transformation of LNF from a packaged fresh vegetable business to a branded Natural Foods business by providing critical mass to our emerging Natural Food brand portfolio. And just this week, we announced that we met our commitment to reformulate all Eat Smart products to contain only 100% clean ingredients by the end of calendar year 2018.

At Lifecore, we delivered another quarter of strong revenue growth. Landec's recent investments in our specialty CDMO business to provide additional aseptic filling capacity continues to position Lifecore for future and ongoing growth.

For the second quarter of fiscal 2019, Landec consolidated revenues were $124.9 million, consistent with the low end of our revenue guidance for the quarter. Landec earnings per share was below guidance because of acquisition-related costs but in line with earnings per share guidance at breakeven excluding acquisition-related costs. Lifecore's second quarter results were consistent with plan, generating revenues of $15.4 million and a gross profit of $5.7 million. Lifecore revenues and gross profit both increased 9% compared to the second quarter of last year. And Landec's Natural Foods business revenues were $109.5 million and increased 1% in the second quarter compared to the second quarter of last year. Revenues in the second quarter were negatively impacted by the hurricane that reduced the availability of green beans and by our previously disclosed lower than originally expected salad kit sales due to private label initiatives in the mass channel and a reduction in the number of salad rotations for this fiscal year in the club channel.

Gross profit in our Natural Foods business was $10.9 million in the second quarter, $1.2 million higher than second quarter of last year due primarily to more favorable produce sourcing, except for green beans, partially offset by increased labor, freight and packaging costs in our packaged fresh vegetable business.

Our Lifecore strategy has been to accelerate growth and profitability by expanding the Lifecore business beyond its historical capabilities as a premium supplier of hyaluronic acid, or HA. We have achieved this with the completion of Lifecore's transition to a fully integrated CDMO, providing differentiated fermentation, formulation, aseptic filling and final packaging services for difficult-to-handle pharmaceutical products. We will continue to expand Lifecore's CDMO development pipeline to drive future commercial product sales.

The installation of Lifecore's new $16 million multipurpose filling line was completed during the first quarter of fiscal 2019, and validation began during the second quarter with commercial production projected to begin in fiscal 2020. The new line will further enhance Lifecore's growth strategy as a CDMO, which is specifically designed to align Lifecore's capabilities with the growing needs and market expectations of its partners. This investment provides Lifecore the incremental capacity to fill commercial quantities of drug products in vials, which expands the breadth of products and markets that Lifecore will be able to address. Although the new line will be primarily utilized to fill vials, it can also be used to fill syringes, which provides significant versatility and increased capacity utilization.

At full capacity, the new dual filling line has the potential to generate $40 million to $50 million of incremental product revenues annually. Revenues and net income contribution will vary due to the product mix manufactured on the new line during any given year.

In our Landec Natural Foods business, we have been focused on its transformation from a packaged fresh vegetable company to a branded Natural Foods company. Our strategy has been to accomplish this by expanding our food product line with on-trend plant-based products that contain 100% clean ingredients, deliver higher gross margins and exhibit less sourcing volatility than our historical bagged vegetable product offerings.

This transformation has evolved rapidly as we have been diligently working on multiple fronts. Our first move towards this vision was the launch of our salad kit business. We disrupted the salad kit market and grew revenues for that business from 0 to $185 million in just 5 years. We then embarked on a project to reformulate all Eat Smart products to 100% clean ingredients, including salad toppings, dressings and dips by the end of calendar year 2018, and we have met this commitment. All Eat Smart products now contain only 100% clean ingredients.

In March 2017, we acquired O Olive Oils & Vinegars. Following this acquisition, we constructed an in-house vinegar facility and completed a brand refresh, resulting in an over 200% distribution gains for our O vinegar product.

And just last quarter, we innovated and launched the Now Planting brand to specifically target the plant-based consumer and disrupt the soup category with fresh pure-plant soups.

The acquisition of Yucatan Foods in early December has accelerated the transformation of our vision and strengthened our position within the Natural Foods market. With Yucatan Foods, we add 2 guacamole brands with 100% clean ingredients, Yucatan and Cabo Fresh, to our portfolio of natural food brands. The Yucatan brand provides traditional authentic Mexican taste that can typically be found in the deli department of retail stores. The Cabo Fresh brand targets plant-forward consumers, offering new flavor experiences with guacamole and is typically found in the produce department.

The guacamole category in the U.S. is approximately $375 million in consumer retail dollars and is growing at an estimated 20% according to IRI data for the 52 weeks ended October 7, 2018. Category growth is projected to continue as current household penetration of guacamole is estimated at only 21% within the U.S.

The LNF emerging Natural Food brands now including O, Now Planting, Yucatan and Cabo Fresh on a pro forma basis are projected to comprise 13% to 15% of LNF revenue or approximately $70 million to $75 million in annual revenue had we owned Yucatan Foods for all of fiscal year 2019, with Eat Smart packaged fresh vegetables and salad kits representing the largest portion of the Natural Food business.

As they scale over time, the emerging brands are expected to contribute a greater percentage of total profitability, with gross margins growing to over 30%. This compares to a gross margin of 10% to 12% of the packaged fresh vegetable business, which is subject to sourcing and cost volatility.

Before I go into more details on our key areas of focus over the next 12 to 24 months, let me turn the call over to Greg for some financial highlights from our second quarter of fiscal 2019.

[Gregory Skinner, executive]

Thank you, Molly, and good morning, everyone.

Revenues in the second quarter of fiscal 2019 increased 2% to $124.9 million compared to $122.5 million in the year ago quarter. The increase was primarily due to a $1.3 million or 9% increase in revenues at Lifecore and from a $1.1 million or 1% increase in LNF revenues. The company recorded a net loss of $584,000 or a $0.02 loss per share in the second quarter in fiscal 2019 compared to net income from continuing operations of $414,000 or $0.02 per share in the year ago quarter. The decrease was a result of, first, $807,000 of acquisition-related expenses; second, a $776,000 increase in operating expenses primarily due to the launch of Now Planting soups during the second quarter of fiscal 2019; third, a $600,000 increase in the fair market value of the company's Windset investment during the second quarter of fiscal 2019 compared to a $1.3 million increase in the year ago quarter; and fourth, a $266,000 increase in interest expense. These decreases in net income were partially offset by a $1.7 million increase in gross profit resulting from a $1.2 million increase at LNF and a $461,000 increase at Lifecore.

Revenues in the first 6 months of fiscal 2019 increased 5% to $249.6 million from $238.2 million in the same period last year. The increase was primarily due to a $9.6 million or 5% increase in revenues at LNF and a $1.8 million or 7% increase in Lifecore revenues. The company recorded a net loss of $395,000 or $0.01 loss per share during the first 6 months of fiscal 2019 compared to net income from continuing operations of $2.8 million or $0.10 per share in the same period last year. The decrease was a result of, first, a $1.8 million decrease in operating income at LNF before acquisition-related expenses due to a $699,000 decrease in gross profit from increased labor, packaging and freight costs and from a $1.1 million increase in operating expenses due primarily from consulting and other expenses associated with our cost-out initiatives and from expenses surrounding the launch of Now Planting; second, $807,000 of acquisition-related expenses; third, a $1.6 million increase in the fair market value of the company's Windset investment during the first half of fiscal 2019 compared to a $2.2 million increase in the first half of last year; and fourth, a $620,000 increase in interest expense. These decreases in net income were partially offset by a $1.1 million decrease in income tax expenses.

With the acquisition of Yucatan, we are updating our fiscal 2019 guidance. We now expect consolidated revenues to grow 6% to 8% in fiscal 2019 compared to fiscal 2018. The additional Yucatan revenues will be partially offset by the effects of the hurricanes during the second quarter and by lower-than-expected growth of salads this fiscal year.

For fiscal 2019 compared to fiscal 2018, we expect Lifecore revenues to grow 14% to 16% and LNF to grow 5% to 7%. We now expect consolidated earnings per share to be $0.25 to $0.29 after accounting for the projected loss of $0.15 to $0.16 per share from the acquisition of Yucatan in fiscal 2019 due to acquisition-related costs, interest on new debt, lower gross profit on acquired inventory and integration-related costs, coupled with the change in the fair market value of our Windset investment now forecasted to be $2.5 million, which is $1.5 million lower than originally projected. In addition, we are currently forecasting fiscal 2019 cash flow from operations of $26 million to $30 million and capital expenditures of $40 million to $45 million.

For the third quarter of fiscal 2019, we expect revenues to be in the range of $156 million to $159 million and net income to be $0.03 to $0.04 per share. The net income guidance for the third quarter reflects acquisition-related costs, additional interest expense, integration costs and lower gross profit on acquired inventory from the Yucatan acquisition due to accounting rules that require you to step up the value of the inventory acquired to its fair market value, which is basically its sales price less a sales commission.

Turning to our financial position. After the acquisition of Yucatan, we have approximately $145 million of debt, which translates into a debt-to-equity ratio of approximately 0.57 and a debt to tangible asset ratio of 0.43. Our leverage ratio at close was approximately 3.7. Our current covenant is 4.5 or less, which means we have borrowing capacity in excess of $30 million at close.

The third and fourth quarters of our fiscal year are when we generate a large majority of our cash flow from operations, and therefore we expect our leverage ratio to decrease and our borrowing capacity to increase by fiscal 2019 year-end. Our covenant stays at 4.5 until December 2019 and then drops to 4.0 and stays at that level until December 2020. We have ample cash available to operate and grow our businesses going forward.

Let me turn the call back to Molly.

[Molly Hemmeter, executive]

Thanks, Greg.

Our top priorities over the next 1 to 2 years are: first, to work with the Hackett Group to identify and quantify and implement cost savings initiatives in our LNF business; second, to integrate the Yucatan team and operations into our LNF business; and third, to invest in continued growth of our 3 growth platforms, Lifecore, Eat Smart salads and LNF emerging Natural Foods.

Reducing cost in our food business operations is of foremost importance. We are challenged by rising labor, fuel and tariff costs, and simultaneously, we continue to invest in new capabilities and technologies as well as continue to invest in on-trend products to enable long-term growth. Rising costs and our investments in growth are reducing our bottom line profit in the short term. As such, we have hired a third-party, the Hackett Group, to identify additional cost-out opportunities above what we have planned internally and have increased the scope now to include Yucatan Foods. Through the efforts of the Hackett Group and our internal resources, we expect to realize a positive net impact beginning during our fourth quarter fiscal 2019 and with the full year impact in fiscal year 2020 and beyond.

Simultaneously with reducing costs in our LNF business, we will be focused on integrating Yucatan into LNF. We believe immediate synergies exist between the Yucatan Foods and the LNF sales organizations. Yucatan Foods will leverage the experience of the LNF sales team within club stores and the produce department of retail stores, while LNF will leverage the Yucatan Foods sales team experience in the deli department of retail stores. Over time, the newly combined sales organizations will be able to expand distribution of all LNF products throughout the fresh store perimeter, as this real estate continues to evolve to attract the plant-forward consumer.

In addition to increased sales and distribution, there are other synergistic opportunities to drive future growth and profitability. In the medium term, we will evaluate the potential for Yucatan Foods to leverage LNF's refrigerated logistics fleet to reach their customers at lower cost while delivering equal or higher product quality and service levels. Longer term, numerous opportunities also exist for product innovations that leverage capabilities among the Landec Natural Food portfolio of brands.

Landec may also be able to leverage the Yucatan Foods relationships and footprint in Mexico to secure lower-cost sourcing and manufacturing for its Eat Smart products.

Along with the cost savings initiatives and integrating Yucatan, we continue to invest in our growth platform. At LNF, we have invested and continued to invest in creating a profitable business that is truly differentiated in the market as a company focused on innovating and distributing on-trend plant-based foods with 100% clean ingredients. We have cultivated strong internal innovation capabilities with proven success in launching new products and disrupting market in partnership with our strategic customers. This has been demonstrated with our entry into the multi-serve salad kit category, our disruption of the single-serve salad kit market and our most recent launch of our Now Planting soups.

We have further bolstered our near-term and future growth potential with the select acquisition of O Olive & Vinegar and Yucatan Foods. Each of these acquisitions contribute high-quality plant-based products that will contribute to LNF's future growth and profitability and can benefit from LNF's innovation, selling and supply chain capabilities.

Over decades, we have invested in refrigerated supply chain that allows us to rapidly deliver fresh short shelf-life foods throughout North America, providing the capability to service our customers with high quality on-trend fresh products.

At Lifecore, we have invested and continue to invest in accelerating growth and profitability by expanding the Lifecore business beyond its historical capabilities as a premium supplier of hyaluronic acid. We have achieved this by investing in business development capabilities to expand into new markets and the infrastructure and equipment to enable Lifecore's transition to a fully integrated CDMO that provides differentiated fermentation, formulation, aseptic filling and final packaging services for difficult-to-handle pharmaceutical products. Most recently, we invested in the installation of Lifecore's new $16 million multipurpose filling line, and this line will further enhance Lifecore's growth strategy as a CDMO, which is specifically designed to align Lifecore's capabilities with the growing needs and market expectations of its partners.

In summary, Landec is committed to growing both of its businesses, Landec Natural Foods and Lifecore Biomedical. Over the years, we have successfully grown Lifecore revenues to create a profitable CDMO business of scale. At LNF, we have continued to innovate 100% clean plant-based products in high-growth segments that add profitability while reducing volatility due to sourcing challenges. This includes our salad kits, olive oils, vinegars and pure-plant soups. And with the recent acquisition of Yucatan Foods, Landec Natural Foods business adds another double-digit growth platform, a lower-cost infrastructure in Mexico and a higher-margin product offering that exhibits less sourcing volatility, all of which contribute to and advance our progress in driving future, more predictable profitability.

We are now open for questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Anthony Vendetti from Maxim Group.

[Anthony Vendetti, analyst]

So it looks like the emerging brands group within the Natural Foods business is driving the growth. Can you talk about what's particularly driving that? Because you're guiding now $70 million to $75 million and the run rate looked like it was $65 million to $70 million. So is it Yucatan that's going to drive more of that growth? Is it O Olive and Now Planting? Is it all 3?

[Molly Hemmeter, executive]

Yes. So it's -- all 4 brands are driving that growth. However, it's the Yucatan and Cabo Fresh brands that are kind of the critical mass of that revenue. So if you look at the Landec Natural Foods revenue on a pro forma basis annualized, LNF emerging brands, so those 4 brands, are about $70 million to $75 million in revenue. $55 million to $60 million of that is the combination of the guacamole products, which is Yucatan and Cabo Fresh, with the remainder being O Olive & Vinegar and Now Planting. And it's really, Anthony, the reason we did -- one of the reasons we did the Yucatan Foods acquisition was to bolster kind of the mass of this emerging food brand because the purpose of these brands, in addition to answering the consumer need, is also to provide us with a revenue stream of a critical mass that is going to contribute higher gross margins to the business over time. We need to scale these emerging brands in order to deliver that higher margin, but that's really the strategic financial purpose of these 4 brands.

[Anthony Vendetti, analyst]

And then just as a follow-up, the base organic before the acquisition of Yucatan and Cabo Fresh, the base business, it looks like now the Natural Foods base business is expected to be flat to just up maybe low single digits. What happened in the base business that you've lowered that a little bit?

[Molly Hemmeter, executive]

Two things happened in our salad business that we talked about on the last call. We are -- we did expect a little bit higher salad sales this year than we are getting. In the mass channel, we had a customer shift to more private label strategy that affected our sales there. And in the Club channel, we didn't get the rotations that we were expecting this year. And those rotations, by the way, are every 4 months. And so you have to go -- and you don't know until before the rotation. So you go into every year, you have to forecast what you think you're going to get, and they change every year. And you don't know until that rotation starts much before that you're going to get it. So those were the 2 things that did affect in our salad business. And then the third thing that did happen is our sales on green beans were lower, and green beans is a very profitable business for us overall. And green beans because of the hurricanes early on in the year, we had to prorate those and unfortunately short some of our customers that resulted in lower sales than expected.

[Anthony Vendetti, analyst]

Okay. And then just shifting gears to Lifecore. You mentioned, Molly, on the call, $40 million to $50 million and annual revenue capacity is now online with the expansion. Is that online immediately? Or is it now -- now that it's online, it's going to take 6 to 12 months to get customers to fill that capacity?

[Molly Hemmeter, executive]

Right. We're running trials on it now. It won't be fully commercial until fiscal year '20. And so that's when it'll go commercial, and that's just -- remember, we have to go through the FDA approval process for new products, so that's what we're going through right now. And then in fiscal year '20, we'll have that capacity. We won't be fully utilizing it. But that new line does give us the capacity to continue to evolve our product development pipeline and grow those products.

[Anthony Vendetti, analyst]

And by fiscal year 2020, what is your total capacity for Lifecore at that point?

[Gregory Skinner, executive]

For aseptic filling?

[Anthony Vendetti, analyst]

Yes.

[Gregory Skinner, executive]

Yes. Well, in total, we could do, well, right now, I'm doing the math in my head, over $100 million.

[Anthony Vendetti, analyst]

Over $100 million. Okay. And then just lastly, Greg, this is -- you filed a Form D beginning in December. Officers and directors purchased a little over $19 million in stock. Is that correct? Any more details on that?

[Gregory Skinner, executive]

Wow. That's news to me. I'm trying to think of what that would be.

[Anthony Vendetti, analyst]

It sounds high, I know. So I'm wondering if it's some insider that owns a large stake was the driver of the majority of that or...

[Gregory Skinner, executive]

Yes. I would have to look into that, Anthony. It could be -- I'm not going to speculate. I was -- I did not see that, so but let me look at that and I'll get back to you.

[Operator]

Our next question comes from the line of Gerry Sweeney from Roth Capital.

[Gerard Sweeney, analyst]

Just another question on the salad side of business. What's -- are we looking at it being flat? Or would it actually be negative this year? And correct me if I'm wrong, I think part of it was not only the mass channel and the club issues you discussed, but also you had a much faster penetration rate in fiscal 2018 so it sort of pulled some of those sales forward. So maybe we can start there.

[Molly Hemmeter, executive]

That's exactly right. We're still expecting some growth in our salad business this year, about 2%. And you're right on that we achieved more growth than expected last fiscal year. In fiscal year '18, we gained tremendous distribution, more aggressively than we thought we were and achieved a growth of 23%. So if you add the 2% this year to that 23%, over 2 years, we've gone 25%, which is still a 12% to 13% annual growth rate.

[Gerard Sweeney, analyst]

And as we look out to fiscal 2020, my sense was you also had some optimism that growth would maybe go back, not trying to project guidance or anything but maybe accelerate a little bit more into maybe the mid-single-digits type growth. Is that a fair assumption?

[Molly Hemmeter, executive]

We are. We're looking forward to 2020, and it's a little too early to tell. But we will be launching some new products in the second half of fiscal year, so we're looking to renewed growth in our salad category next year. But I just want to wait to see how our new innovations go during the second half year before we give any specifics on it.

[Gerard Sweeney, analyst]

Okay. And then jumping over to Yucatan. Obviously, it jump starts -- or I should say, accelerates the emerging Natural Foods business, but it hasn't been that long that it's been formally under your ownership and so this may be a little bit early. But as we look out to fiscal 2020, pushing that into your channel that -- on the -- I guess, on the club as well as the supermarket channel, what are the biggest challenges? Is it getting the Yucatan products in there? Is it displacing others? And do you have any benefits of maybe having multiple products in the channels now? Any type of information or additional thoughts on that?

[Molly Hemmeter, executive]

Yes. So I think a lot of the challenge we have is going to be, one, on timing. We will have to displace other competitors, but we have a lot of positive data that the Yucatan Foods team has collected that show our velocities do stack up well against competitors and that our taste is preferred. So I think we have a good story to tell going in. But obviously, in this business, there's a big timing issue, and customers only reset once or twice a year and have already committed to other brands. So a lot of -- just like what we're seeing in the salad business is you get kind of this chunky growth, right. We get 23% one year and 2% the next year, and it's really -- a lot of it is due to the sell-in periods of our customers. So I think that's going to be the challenge is kind of trying to project what the timing will be of the incremental distribution. But I feel very confident about the quality of the product and our sales force to execute on it.

[Gerard Sweeney, analyst]

Got it. The timing point is very helpful, so appreciate it. And then also, finally, just maybe a little bit on the cost-out side. I know you've been working with Hackett. Have there been actual drag on margins because of Hackett? Or has that been offset by improvements that they've been finding, so offsetting some of the costs?

[Molly Hemmeter, executive]

Yes. I'll start and I'll let Greg add to it if he wants to. So there are incurred costs from the Hackett Group this year actually just imploring their services to just evaluate our operations. So there is a drag on costs in the near-term investing in that. We do expect to see some contribution in the fourth quarter of this year that is a net positive from that, and it's looking promising for fiscal year '20 and beyond that we're going to see more positive results from those cost-out initiatives that will really improve the gross margin more fiscal year '20 and beyond.

[Operator]

Our next question comes from the line of Chris Krueger from Lake Street Capital.

[Chris Krueger, analyst]

Just had a question on Yucatan. Is there any near-term marketing or advertising efforts as it relates to the NFL Playoffs and Super Bowl parties and things like that? Because I follow an avocado company that there's always a lot of activity in avocados in general in the month of January.

[Molly Hemmeter, executive]

Yes. So typically we have -- they have a pretty heavy promotional strategy during exactly those events. So whether it's Mardi Gras or Super Bowl, those are some really high events, and we produce a lot leading up to those events to prepare. So most definitely, you're right on we do some promotional efforts. We also promote heavily when we first gained new distribution. And we've recently gained some -- right before we acquired Yucatan Foods, they did gain new distribution. So in the first 3 to 6 months just to gain awareness from consumers and let them know it's on shelf, they also promote. So we are seeing some pretty heavy promotions now with that new distribution and through some of these events that you mention that are coming up. So yes, heavy promotional time.

[Chris Krueger, analyst]

Okay. In the last couple of years, you'd spent a lot of effort getting out of low-margin SKUs. Is that still continuing? Or is that largely over?

[Molly Hemmeter, executive]

I'd say right now, we're largely finished with that effort. Although each year during our budgeting process, we look at the size of the lower-margin business and say what size is the right size for that business. And I guess, the overall driving factor of that decision is capital. So what we don't want to do is invest in capital to expand our walls and our real estate in our Landec Natural Foods business to manufacture more lower-margin business, right. So as we look at it, we continue to grow our salad business and our other brands. If we have to reduce the lower-margin business to produce more higher-margin business with the same capital to increase our overall return on invested capital, we're going to do that. So the big chunks, I think, for now we're finished dissolving and letting go of. But each year, we're going to rightsize that with the thought process outlined in mind.

[Chris Krueger, analyst]

Okay. Recently, I know there's been a recall of your Salad Shake-Ups! kit. Has anybody reported any illnesses or anything negative? And in general, is it material?

[Molly Hemmeter, executive]

Yes. Thanks for bringing that up, so we can address that on the call. And so we have not had any reported illnesses, and there is no material financial effect from the recall.

[Chris Krueger, analyst]

Okay. Last question, just to clarify for your 6% to 8% revenue growth guidance, that's off the $524.2 million continuing operations sales from last year, correct?

[Gregory Skinner, executive]

Yes.

[Operator]

Our next question comes from the line of Mike Petusky from Barrington Research.

[Michael Petusky, analyst]

So I guess, a question around the salad, future of salads. You alluded to maybe new product launches later on over the next couple quarters. It feels like last year you got great growth out of the expanded distribution, but Sweet Kale sort of lost its mojo in terms of growth. And I guess what I'm wondering is, I mean do you have enough juice in terms of expanded distribution opportunities? Or do you need to get another home run like Sweet Kale to kind of reignite growth there?

[Molly Hemmeter, executive]

I think we have a bit of opportunities in both. We have some expanded distribution opportunities in accounts, but I would say most of our opportunities are increasing the number of SKUs per store on shelf. So now that we've created these strategic relationships with our customers and they have the Sweet Kale salad and a couple other of our salads and they're doing extremely well, now we need to start creating more shelf space with our brand. And so I think that's the biggest opportunity going forward. And that's why the innovations coming out in the second half of the year we're hoping will augment that SKU per store count.

[Michael Petusky, analyst]

Okay. Great. And then just a question around sort of the recent acquisition and what -- an opportunity that seems like it opens up to you but it doesn't seem like you guys are talking about going in this direction. Avocados, I think, are one of the holy grail foods for people that are on kind of low-carb diets, whether it's ketogenic or paleo or whatever. It feels like there's some overlap between some of that low-carb direction that a lot of people are going in, in terms of their eating habits and some of what you guys have built over the past 1.5 years especially. And I'm just wondering, is there any opportunity in your view to market yourselves in that direction? I looked and some of your soups would qualify, and I'm just curious if that's anything on the longer-term horizon.

[Molly Hemmeter, executive]

Yes. So strategically, we're really gearing our strategy around plant-based products and 100% clean ingredient, and those 2 factors are directly in line with the low-carb diet. So and people on low-carb diets basically are looking for a lot of plant-based ingredients. So I would say, we're completely in line with that. If we have any specific marketing campaigns on low-carb, not that I'm aware of. So I think our entire brand portfolio supports that direction for people. And I think the people on those types of diet know that and are specifically looking for plant-based and 100% clean products.

[Operator]

[Operator Instructions] Our next question comes from the line of John Walthausen from Walthausen & Co.

[John Walthausen, analyst]

With your initiative with Hackett Group, can you help me understand where their particular focus is and help us understand whether there have been some particular successes that they've been able to achieve on the cost side?

[Molly Hemmeter, executive]

Sure. So their focus is actually very broad. So they're focused on looking at our entire refrigerated supply chain and -- from soup to nuts. And we gave them that challenge to do that because part of the strategy -- we have 2 parts of our strategy. One is our innovation and making sure we're developing and delivering on-trend products that are plant-based and 100% clean. But to do that, we have fresh products, and we need an extremely efficient refrigerated supply chain. And that's not an easy thing to do. And in order to stay competitive and grow this business and be able to reinvest in this business, we have got to get money out of our supply chain. So we're going everywhere from our growing practices and our growing techniques all the way through delivered to the customer. We have had some initial hits, where we're seeing a lot, is in adding on automation to our processes. Before, we had all the wage increases. Adding automation didn't always make sense because there just wasn't a return on investment. But we are seeing now that with the wage increases that are coming through and the money it takes to install automation is coming down that we need to make these investments. And so, well, that's one of the big areas you're going to see in fiscal year '20 is capital in order to automate a lot of our existing manual processes that will bring down our gross margin, and ROI on these is pretty significant. So that's one of our big areas.

[John Walthausen, analyst]

Well, now I've never been in one of your facilities, so I guess, I'm probably just kind of speculating in the dark. Is part of the cost of those operations the amount of waste that's created? And do you measure what the waste is? And do they have sort of a benchmark of what an operation like yours should be seeing in terms of waste?

[Molly Hemmeter, executive]

Yes. We have very specific measurements on all the waste through our supply chain, and we do pretty good in that regard in all honesty. Our yields through the plants are extremely high, and that's not a place I see a lot of savings come out of. If you have ever toured our facilities, if you go to our Hanover plant, remember, we've built that plant in the last several years, and that's kind of our starship facility, which is fully automated. And there's not a lot of headcount on the floor. And that contrasts with our Guadalupe plant, which is our older plant, and we haven't had a lot of space there and we haven't fully automated that. And a lot of our volume is still going through our Guadalupe, California plant, and that's where we see most of our automation opportunities.

[John Walthausen, analyst]

Okay. That's helpful. So the issue is -- because I know Hackett does a lot of benchmarking. The issue is really labor utilization is too high across the company.

[Molly Hemmeter, executive]

I'd say that's the biggest issue. There's other smaller continuous improvement activities that we're also finding. And every little thing we find makes a difference, so we have a long list of projects we're going after that they've been able to identify. But I'd say the biggest impact is going to be when we're able to automate our Guadalupe facility further.

[John Walthausen, analyst]

Okay. The other question on another direction is as you've been initiating some of these growth things, particularly on the Natural Foods side and the acquisition of Yucatan, the debt is going up, which it seems to me might make it more difficult to divide the 2 businesses, which seems fairly important for realizing shareholder value. Can you help me understand what the strategy might be on your debt structure to move towards the ability to do that?

[Gregory Skinner, executive]

Well, as far as just the overall strategy on the debt, after the acquisition, obviously, you're going to be at your peak. And going forward, we're going to be generating free cash flow, so we'll be paying down our debt. $100 million of it is term, which is going to be paid off just based on the term at $10 million a year. And our obviously objective with the free cash flow is to pay down the line of credit. We have ample room under our covenants. Our covenant is 4.5 per year. At close, which should be pretty much the peak of the leverage ratio, we're at 3.7. So we had ample cash at that time to invest in the capital that we need divesting going forward. So does that answer your question?

[John Walthausen, analyst]

Well, it does. And I guess, the other part of it is, of course, as I see it, the O Olive and the Yucatan, it seems as though investing in the food business including some acquisitions is part of it, and that consumes capital. So while if you were doing a standstill, yes, you can see the paydown in debt. But I'm just trying to understand whether there's a strategy, perhaps selling a stub of Lifecore to kind of realize the value there and kind of upstream some additional equity capital into Landec. Yes, I don't know. I'm just trying to understand how you can realize some of the kind of broader strategic objectives you are with the level of debt that you have.

[Gregory Skinner, executive]

Well, at this point, we don't see that the current debt will preclude us from doing any potential strategic initiatives going forward.

[Operator]

And this does conclude the question-and-answer session of today's program. I'd like to hand the program back to management for any further remarks.

[Gregory Skinner, executive]

Yes. Hi, this is Greg Skinner. Well, I've got an answer to Anthony's question before, it had to do with the Reg D filing, I believe he said it was. That was the actual filing for the issuance of the stock in the Yucatan transaction to the owners. Two of which that own most of the stock are employees of the company, so that's what that filing was.

[Molly Hemmeter, executive]

Okay. That concludes our call today. And I just want to thank everyone for joining us today and your continued interest in Landec. Have a good day.

[Operator]

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.