US Foods Holding Corp

NYSE:USFD

Earnings Call Transcript 2017-Q4

[Operator]

Hello, my name is Dan and I’ll be your conference operator today. At this time, I'd like to welcome everyone to the US Foods Fourth Quarter and Fiscal 2017 Earnings Call. [Operator Instructions] Thank you.

I now like to turn the call over to Ms. Melissa Napier, Senior Vice President, Treasurer and Investor Relations. Please go ahead.

[Melissa Napier, SVP of IR and Treasurer]

Thanks, Dan. Good morning, everyone. Joining me for today’s earnings call are Pietro Satriano, our Chairman and CEO; and Dirk Locascio, our CFO. Pietro and Dirk will provide a business update and speak about our performance in the quarter and for our fiscal year. We’ll take your questions after management's prepared remarks conclude. Please provide your name, your firm and limit yourself to one question.

During today’s call and unless otherwise stated we are comparing our fourth quarter and full year results to the same periods in fiscal year 2016. Our earnings release issued earlier this morning and today’s presentation slides can be accessed on the Investor Relations page of our website.

In addition to historical information certain statements made during today’s call are considered forward-looking statements. Please review the risk factors in our latest Form 10-K filed with the SEC for potential factors which could cause our actual results to differ materially from those expressed or implied in those statements. And lastly, I would like to point out that during today’s call we will refer to certain non-GAAP financial measures. Reconciliations to the most comparable GAAP financial measures are included in the schedule on our press release.

I’ll now turn the call over to Pietro.

[Pietro Satriano, President and CEO]

Thanks, Melissa and good morning everyone. Hope everyone is well and welcome to our fourth quarter and yearend earnings call.

So, let's begin on Page 2 with an overview of our results. Q4 was a very good quarter 9.4% growth in adjusted EBITDA and 8.8% for the year which range adjusted EBITDA as a percent of sales to 4.8% a 20 basis point increase compared to prior year.

The quarter's results were driven by growth with independent restaurants of 7.1% growth in private label of 100 basis points and strong gross profit performance which grew $0.12 per case more than operating cost per case.

And this despite significant headwinds in the freight industry which were a drag on gross profit. Moving to the balance sheet in the fourth quarter as our sponsors KKR and CD&R sold the remaining US Foods’ stock meaning that we are now 100% publicly owned. And as a part of that transaction we repurchased 10 million shares ending the year with a 3.4 leverage ratio down from 3.8 a year ago.

So, let's turn to Page 3 for more detail analysis of our volume performance. We were very pleased with our growth with independent restaurants which has continued to get stronger for the quarter absolute growth was 7.1% while organic growth was 5.2%.

Only timing this shift about 50 basis points or so of growth from Q1, 2018 to Q4 of 2017 for a normalized run rate in the fourth quarter closer to 4.7% this is still our best performance in almost two years and in line with what we expect to see going forward.

Growth in healthcare and hospitality turned down slightly, as we began to wrap the addition of Brookdale in the last year's fourth quarter. Our pipeline is healthy and we expect to grow at a rate closer to market in the back half of the year. The other group of customers also benefited from the shift in holiday time which means that the normalized run rate for this group of customers in the fourth quarter was closer to what we saw in the third quarter.

We continue to optimize the portfolio of chain customers with some wins and some planned excess coming in the first half. The bulk of these excess is coming in Q1 which will add to the decline we saw in Q4 after which we will begin to ramp up to growth to level nearly approaching flat in the back half of the year.

As we discussed in the last call, customers we’re choosing to accept are those with no negative contribution margin which means the impact to EBITDA of these moves is accretive. It does take about 90 days for us to pull out deposits associated with these assets which means a modest in operating expense in the first.

On Page 4, let’s dive a little deeper into the outlook for restaurants. One the left hand side, we are showing Technomic’s updated outlook for the industry which continues to be strong in particular for independent restaurants as shown by the green bars.

In part, this reflects the positive impact of the recently passed tax reform. The right-hand isolates the impact of tax reform but on the entire restaurant sector as per some announces by AHS, a different industry analyst. Our growth with target customers had benefitted from the continued strength in our industry, our market share gains within independent restaurants are fueled bar differentiation strategy.

So now let's turn to Page 5 for an update on those programs that differentiate US Foods and thereby supporting the market share gains that I have just discussed. Let’s start on the left with our innovative products featured in our three times three-year skewed program. These are products that help operators stay on trend or remove labor from the kitchen.

Trial of our new products continues to increase from approximately 20% earlier in the year to- close to 40% in the most recent Scoop. On the middle, you can see e-commerce penetration continues to climb as does the placements of value-added services on the far left. Let's chill down for a couple of pages.

First, Page 6 gives a preview of our next edition of the Scoop, which launches next week. This is our seventh year in our 20th edition of the Scoop and it is entirely dedicated to sustainable products. You may recall that our summer 2016 Scoop was also dedicated to sustainable products, the first such effort in our industry.

And since then, we have launched 280 sustainable products under our Serve Good brand, products that either reduce weights or responsibly source. And the uptake by customers has been very encouraging. On a monthly basis, almost 25% of our independent customers purchase at least one of the products under the Serve Good brand.

Page 7 provides an update on technology. In January, we launched our website. Given our high penetration of sales on e-commerce, our e-commerce platform is where our existing customers tempt to live. Prospects, on the other hand primarily interact with us on our website, which is why we have configured the website to be much more friendly for prospects.

One example is we dramatically invested content on our products and value-added services. Another example is we have given prospects and sellers the opportunity to collaborate so that they can explore and share relevant ideas together. As a result of these changes and these enhancements, average time by visitors to our website is already up 27% which is definitely indicative of greater engagement.

I’m going to finish on Page 8 with an update on our gross profit and operating expense initiatives. By way of a quick reminder, several of these initiatives have been in flight for two plus years and are nearing maturity, while others which were initiated more recently will be discussed in more detail at our upcoming Investor Day.

Let's start on the left hand side with a quick rundown of our gross profit initiatives. Our CookBook pricing optimization has been fully deployed to our sellers and we are very pleased with the impact on gross profit, which you can continue to see. We are continuing with our second touch, targeting those markets with our sellers lower on the adoption scale.

Strategic vendor management is an ongoing opportunity with more upside expected in the future from COP produce as a result of the move to centralize replenishment, which will enable us to better coordinate in down freight and have more looks in opportunity wise.

Speaking of centralized replenishment, completion is expected to be closer to Q2, this is slightly longer than originally anticipated, but it's prompted by our desire to ensure that the hand-off from the local markets is done in a seamless fashion.

And lastly, we see continued benefit from increasing importance of independent customers in our mix as well as the continued growth in our penetration of private brands, which as I mentioned finished the year 100 basis points above where we started.

We are also pleased with our progress in our operating expense initiatives. We've made good progress on the first three, the cost reset, the centralization of indirect procurement and sales force productivity. With respect to the last two initiatives, expanding our shared services and optimizing our supply chain, we are in the early innings and given the size of these two areas and the opportunity, we've identified, we see tremendous upside for years to come another topic that we will explore in greater depth at our upcoming Investor Day.

Lastly, on the M&A front, our pipeline does remain healthy and we are at different stages with a number of potential targets and we will expect to have more news in the next quarter or two.

I will now turn it over to Dirk, who will walk you down on our P&L and balance sheet. Thank you.

[Dirk Locascio, CFO]

Thanks Pietro, and good morning, everyone.

As Pietro commented, we had a strong fourth quarter. Our operating income increased $66 million to $182 million, and our adjusted EBITDA increased 9.4% in spite of a significant continuing inbound freight cost headwind. We also experienced strong independent restaurant growth, solid growth with other customer types and strong cash flow. Let's walk through our results now in a little more detail.

On Slide 9, fourth quarter net sales were $6 billion, an increase of 5.6% over the prior year. This increase was a result of our 1.9% case growth combined with approximately 3.7% from year-over-year inflation and product mix. Our case growth for the quarter was strong with independent restaurants at 7% or 5.2% organic and healthcare and hospitality volume growth about 2.5%.

Case growth was stronger than we originally anticipated for the fourth quarter, as Pietro mentioned, in part due to the impact of holiday timing which resulted at approximately 50 basis points of incremental cost growth in the quarter. We expect to have an opposite impact in Q1 2018 due to a loss shift day from the New Year's timing and schools returning later in January compared to the prior year.

We saw modestly less year-over-year inflation in the fourth quarter than we did in the third quarter and the inflation was primarily in commodities such as produce, beef, dairy, and pork as well as modest inflation in several grocery categories.

Now the gross profit performance, which you see on Slide 10. We continue to deliver strong gross profit results. For the fourth quarter, gross profit was $1.1 billion which is $ $47 million, a 4.6% increase over the prior year on a GAAP basis and up $40 million or 3.9% on an adjusted basis, this is on a 1.9% case volume increase meaning we continue to increase gross profit per case.

The elements of our strategy, Pietro talked about that are focused on gross profit rate expansion continue to make good progress with gross profit per case up double digit cents per case again this quarter in spite of the continuing freight headwind.

As a percentage of sales gross profit on both a GAAP and adjusted basis was 17.9%. This is 20 basis points lower than the prior year period on a GAAP basis and 30 basis points lower on an adjusted basis with the decrease primarily driven by higher freight costs.

Gross profit as a percent of sales was negatively impacted by year-over-year inflation and higher inbound freight cost as I just mentioned due to the continued tight inbound freight capacity. The trucking industry capacity has continued to tighten since mid-2017 which has been widely reported out in the press.

A recent Wall Street Journal article cited there were 10 loads waiting for every available truck one week this January compared to just three loads a year ago for the same week, meaning demand is far outpacing supply.

As a result, we’ve seen spot market freight cost increase significantly over the prior year. We’re taking steps to re optimize our freight lanes and are working with our vendors to mitigate the impact from higher third party freight costs.

Industry capacity is expected to continue to be a headwind at least through the first half of 2018. For the full year gross profit increased 4.1% in dollars over the prior year from volume growth and the benefits of our margin expansion initiatives partly offset by an increase in our LIFO charge and on an adjusted basis gross profit increased $199 million or 4.9% and adjusted gross profit as a percentage of sales decreased 10 basis points from the prior year to 17.5%.

Moving now to operating expenses on Slide 11. Operating expenses decreased 2.1% or $19 million for the quarter from the prior year to $892 million, primarily resulting from a reduction in our depreciation and amortization expense due to the full amortization of a customer intangible asset at the end of the second quarter, lower restructuring and productivity gains. These gains more than offset the additional expenses related to higher case volume.

Adjusted operating expenses increased $16 million or 2.1% for the quarter and adjusted operating expenses as a percentage of sales was 13.1%, which is a decrease of 40 basis points from the prior year. The increase in adjusted OpEx dollars was primarily due to higher case volume.

For the full year, operating expense dollars were essentially flat to the prior year period. As a percent of sales, operating expenses decreased 80 basis points to 15.1%. Adjusted operating expenses increased 3.7% year-to-date for the year, were 30 basis points ahead of the prior year as a percent of sales.

From an adjusted OpEx perspective, our focus has been and continues to be on a controlling OpEx growth so that it increases significantly less on a rate per case than gross profit in order to continue to drive our operating leverage.

As you can see on Slide 12, our adjusted gross profit per case expansion has been significant this year and we're very pleased with those results since we're making more gross profit dollars per case than a year ago.

In fact, the fourth quarter again in operating leverage per case was our best quarter in 2017 being the difference between gross profit rate per case growth and OpEx per case growth was its largest.

We've significantly improved our operating leverage by growing gross profit per case meaningfully faster than we increased the OpEx per case in every quarter of both fiscal 2016 and 2017, resulting in 60 basis point higher adjusted EBITDA margins in fiscal year 2017 compared to fiscal year 2015.

I'm moving now to Slide 13. We made solid improvements in our key profitability metrics. Adjusted EBITDA was $290 million in the quarter, up 9.4% over the prior year and $1,058 million for the fiscal year up 8.8% from the fiscal 2016. As a percent of sales, adjusted EBITDA increased 10 basis points to 4.8% for the fourth quarter and 20 basis points to 4.4% for the fiscal year.

As I mentioned earlier we've increased the EBITDA margin to 60 basis points for fiscal year 2015 through fiscal year 2017. Operating income this quarter increased $66 million to $182 million and year-to-date increased $160 million to $574 million.

And finally on the far right, fourth quarter net income increased to $256 million compared to $77 million in the prior year period. Our pretax income increased $62 million year-over-year as a result of strong business results, lower intangible asset, amortization and lower restructuring.

Our fourth quarter net income improvement also reflects $180 million income tax benefit in the current year compared to essentially no impact in the prior year with the credit resulting from an adjustment to our deferred tax liabilities to reflect the new corporate tax rate. Fourth quarter adjusted net income decreased $22 million from the prior year due to $66 million adjusted tax increase partially offset by stronger business results.

For the full year, our net income improved $234 million to $444 million as pretax income increased $273 million to offset by a lesser income tax benefit in the current year period than the prior year. Adjusted net income also decreased $9 million to $312 million as a result of improved results offset by a $197 million higher adjusted income tax expense.

Turning now to cash flow in depth debt. Operating cash flow in fiscal 2017 was strong at $748 million compared to $556 million in the prior year, from for $192 million increase or 35%. Net debt at the end of the year was $3.6 billion a decrease of $13 million from fiscal 2016.

As Pietro mentioned, just as another reminder, we completed a $280 million share repurchase during the quarter and absent that repurchase, our net debt would have decreased nearly $300 million from the prior-year end. Our net debt leverage remained at 3.4 times at the end of the year even with the repurchase, which is consistent with the end of the third quarter and down from 3.8 times at the end of fiscal 2016.

Moving to Slide 15, beginning with our mid-term outlook, we're updating and raising our mid-term outlook from 7% to 10% to 8% to 10%, which we'll discuss further at our upcoming Investor Day in March

We're also providing guidance today for fiscal 2018. We expect adjusted EBITDA growth for fiscal 2018 to be in the 6% to 8% range, and we expect the first quarter growth to be approximately 100 basis points below the low end of this range, primarily as a result of broad based for a weather conditions across multiple regions so far in Q1, holiday timing as well as some temporary transition costs related to the plan customer exits that occurred in late Q4 and in Q1. We expect year-on-year adjusted EBITDA growth rate to accelerate sequentially throughout the year.

I'll now walk through face case volume and net sales guidance. Weather and holiday timing will impact our Q1 growth rates across almost all of our customer types. For full year 2018, we remain bullish, as Pietro noted, on our outlook for independent restaurant volume growth and expect to be at or above the growth levels we achieved in 2017. We expect full year 2018 total case volume to increase 1% to 2% from the prior year period and we also expect net sales to increase 3% to 4% in fiscal 2008.

In 2018, we expect gross profit per case to continue to increase significantly faster than OpEx per case even as we make some necessary investments in supply chain. Interest expense is expected to be $175 million to $180 million and depreciation and amortization between $340 million and $350 million. We expect cash CapEx of between $250 million and $260 million.

And finally, we expect a significant increase in our adjusted diluted EPS to $2 to $2.10 per share and expect our 2018 adjusted effective tax rate to be 25% to 26%. Our business performed well in Q4 and fiscal 2017 and we're pleased with the results.

And with that, thanks for joining us today, and now we can go to Q&A.

[Operator]

[Operator Instructions] Your first question comes from the line of Karen Short with Barclays. Your line is now open.

[Karen Short, Barclays]

Just a clarification and then I guess the bigger picture question, there is an extra week in fiscal 2020 isn't there. So I just want to clarify that that 8% to 10% EBITDA growth includes or does not include an extra week if there is one?

[Dirk Locascio, CFO]

You kind of - what you’re referring to?

[Karen Short, Barclays]

In fiscal 2020, isn’t there an extra week and so I guess I'm just wondering on your 8% to 10% three-year new target does that - if there is an extra week does that include or exclude the extra week?

[Dirk Locascio, CFO]

This will be on a normalized basis when comparing to 52-week to 52-week periods.

[Karen Short, Barclays]

So just wondering if you could dive into that a little bit in terms of what will drive that increase is it kind of better top line, better margins, and if it’s kind of margins, I'm assuming it's more gross margin than OpEx, so maybe you could just give a little color on what the drivers of that would be?

[Pietro Satriano, President and CEO]

The drivers really come across the whole P&L you saw how our growth with independent restaurant is accelerating. We expect that to continue to continue. We'll talk about it at our Investor Day, you’ll see how gross profit for cases continue to increase and we expect to continue to do that.

And as per my - the last part of my comments to the opportunity and shared services in particular are in supply chain is given that those are two biggest cost lines in the operating expense for the P&L, and that's where we see the biggest opportunity. That's also a big contributor to the guidance in our outlook for the mid-term.

[Operator]

Your next question comes from the line of John Heinbockel with Guggenheim Securities. Your line is now open.

[John Heinbockel, Guggenheim Securities]

So a couple of things. Let me start off, is there or was there a tangible tax benefit reinvestment contemplated in the 2018 guidance of 6% to 8% growth. If there was, how much roughly and in what areas might you be reinvesting?

[Dirk Locascio, CFO]

So, it's there's not an explicit investment we believe we've been making and continue to make the investments that we need in the business in order to drive the results that we have and expect to continue to where we are seeing some reinvestment of a portion of savings is that you can see we have a little bit of higher CapEx spend, as we increase some of our facility CapEx as well as the modest increases in IT costs.

I think, in those areas where we continue to be disciplined to make sure we do the right projects, but that's where you're going to see a little more of the reinvestment coming back through.

[John Heinbockel, Guggenheim Securities]

And then secondly, I know it's only 1% at the low end of the range, but when you think about the new medium-term guidance, what is that specifically coming from sort of in your thought process, is that share gains accelerating primarily?

[Pietro Satriano, President and CEO]

As your question, John, with respect to when you say where’s that coming from you talking about the Q1 guidance Dirk gave or same guidance?

[John Heinbockel, Guggenheim Securities]

No, when I think about the 8 to 10 versus the 7 to 1, right, so the low end is up 1%. The high end always had some M&A, right. So, the low end I assume that's organic. Is that more organic share gains accelerating from the prior plan, as opposed to margin improvement?

[Pietro Satriano, President and CEO]

My answer is very similar to what I gave to Karen, we've always said, we think we can perform better with independent restaurants, that’s at the high-end of the spectrum from a margin perspective.

We're starting to see that as a relative to the work Jay is doing, you’ll hear from Jay at Investor Day on talent and routines to drive better performance. And the outlook, the other piece that is a little bit new and the outlook continues to be very favorable for independent.

Gross profit I would say just a continuation of the trend we’ve been on, and lastly just the opportunity that we see supply chain, supply chain is as we we've often said, 55% of our cost, that's where we're in our very early innings and again at Investor Day we’ll hear Ty Gent painting a picture of the roadmap by which we can reap the benefits of some of those initiatives.

And as Dirk said, we are having to invest a little bit this year to make sure that we drive the productivity agenda that we expect to drive inventory guidance.

[Operator]

Your next question comes from the line of Edward Kelly with Wells Fargo. Your line is now open.

[Edward Kelly, Wells Fargo]

Can we just start on the EBITDA growth target of 8% to 10%, you did 9% in 2017, 11% in 2016, these are numbers that you've been hitting. As we think about 2018, 6% to 8%, if we were to adjust for freight, the transition drag, are you essentially in that range in 2018 as well?

[Dirk Locascio, CFO]

Yes, we're relatively close to that range. It’s the industry headwinds around freight, weather et cetera as you called out. So and especially as you think about Q1 just a meaningful impact those things have on the quarter, otherwise the core part of the business continues to form strong with all the levers that Pietro talked about.

[Edward Kelly, Wells Fargo]

And then just as we think about freight, could you provide a little bit more color on how this impacts the business, is it only the non-contract business, how does it impact the contract side, what's the lag like in passing this through, just some color there I think would be helpful?

[Pietro Satriano, President and CEO]

I'll take it just because my merchandising days is something that we touched. So I'll do a little bit of a freight great primer if I can. So we talk about in-bound freight, either that happens one of the two ways, the vendor delivers or we pick up. When the vendor delivers freight built into the cost of goods and that gets - so any risk is absorbed by the vendor and that gets passed on to us to the degree that they choose to increase cost of goods.

And as you just, I think we're intimating with the contract, that it's being passed on relatively quickly. In small contract, there's potential lag. But when we look at our margins, non-contract margins excluding freight, they've been continuing to rise. So that has gone well.

The issue is when we pick up and there are two, there's two flavors when we pick up and we do it on our own trucks, minimal impact. The primary costs, which is drivers is governed primarily by collective bargaining agreements and so there's lots of visibility into how those costs might change. Where the compression has happened is when we pick up and we outsource to a third party and that's where the staff that Dirk gave really come into play, right.

When capacity shrinks, as we've seen it partly as a result of some new regulations with electronic laws, when demand is up, spot prices go up I think the article that Dirk referred to has spot rates going up 20% year-on-year.

And so that's where the compression happens because our costs from those third parties go up immediately. But the revenue I guess, or the spread between the costs and the allowance, we negotiate with the vendor when we're picking up, that has to be renegotiated. And so that's what we're focused on.

So when Dirk in his comments says, self-help plan is around we optimizing the freight lanes and renegotiating those rates, those allowances to vendors. Regardless of what happens with respect to those headwinds, we will have mitigated them by the back half of the year to those two initiatives. Does that help?

[Edward Kelly, Wells Fargo]

And if I could just squeeze one more in. As we think about the growth strategies of the companies here, there does seem to be a little bit of divergence. I mean, you are clearly intensely focused on driving the right growth, the higher margin growth, some of your peers seem to have a little bit of a broader strategy now. I think the market is a little concerned that may be within all this, there is an acceleration in price competition for some of these counts. Is that the case or is this just simply differences in strategies between these companies at this point?

[Pietro Satriano, President and CEO]

I think it's difference. It’s the latter, it’s differences in strategies and focus and some of it is due to we bring a different set of assets, right. We are singularly focused on broad line and so we're always looking to do is optimize the mix of customers across those three customer contract that I talked about. And we have not seen, again the three largest players account for about a third of the industry.

And so even though we all are talking more about pursuing independence, we have not seen the impact on pricing or margins, it's a pretty competitive industry to start with as and when we look at gross profit for Case, one of that, I think it's been going up and I think that's as good an indication as any that price competition has been steady, no change there.

[Operator]

Your next question comes from the line of Karen Holthouse with Goldman Sachs. Your line is now open.

[Karen Holthouse, Goldman Sachs]

There has been some commentary from some of your competitors about the health of the independent restaurant industry recently. So just curious what your thoughts there are in terms of sort of share shifts between chain businesses and independent, how is the same - how healthy same-store sales are at independent? And do you have any concerns that price competition among some of the, the largest chains is going to be driving market share towards what are in a lot of ways cell phone distribution models? Thanks.

[Pietro Satriano, President and CEO]

Right. So as per my answer to Karen, we haven't seen it. We look at the industry data that we all have access to and I referred to Technomic most recent update which is more positive than some of your previous update. When we look at IHS which granted as the entire sector does attribute some benefit of tax reform.

The outlook continues to be positive if not more positive. In terms of some of the comments you referred to, the other thing we look at internally is where the growth is coming from. We call it new existing in churn and I can tell you as, as we look at that data for the last six months we’ve seen no change in the pattern of growth as it comes from new, new customers, existing customers or, or lost customers.

So we haven’t seen a change in outlook, that has gone better. Our conversations with our leaders in the field are very bullish and our own internal metrics are fairly consistent.

[Operator]

Your next question comes from the line of Kelly Bania with BMO Capital Markets. Your line is now open.

[Kelly Bania, BMO Capital Markets]

Just another one on gross margins, it's helpful to hear you walk through the freight. But just curious with gross margin has been up year-over-year, if it weren’t for the elevated freight costs, I guess, I would have thought that the mix between your customers would have been more supportive of gross margin.

So just any more color on that and if you can also just what percent of your inbound freight is coming in via third party and what’s the exposure there and the steps that you can use to mitigate that as you go into the back half?

[Dirk Locascio, CFO]

So our gross margin on a basis points would have been closer to flat year-over-year excluding the freight headwind and I think that’s still because of a lot of the commodity inflation year-over-year that we’ve talked about in a number of our prior calls. So I think though if you look back at our rate per case improvement on gross profit, you see it continue to be significant even with the freight headwinds.

So we - one of the things the levers really that we’re working on the two things that Pietro talked about is really making sure we’re re-optimizing our internal freight lane management as well as working with our vendors in order to be able to pass that through as we proceed through the year.

So we haven’t talked about the individual percentages, but the piece that we use third party for is pretty meaningful and really for the quarter, just to give you a rough estimate, our EBITDA growth was negatively impacted about 300 basis points as a result of the freight compression year-over-year. So you can see it pretty meaningful and even in spite of that we’re able to grow the business 9.4%. Hope that helps.

[Kelly Bania, BMO Capital Markets]

And just with the independence, I think I heard the word market share gains a couple of times. I know it’s hard to pinpoint down to an exact number, but do you feel the acceleration and the confidence you have with that channel in the future is because of the strength of the independents themselves or the market share gains that you're also getting with them or maybe a little bit of both, just any thoughts on how you're thinking about that and the analysis you do to get to that point?

[Pietro Satriano, President and CEO]

And it's a little bit of both, Kelly. And it comes from when we look at the external data on growth independents which continues to be around 2%. We're going income year 4% to 5%. So we've often set our target as 2x and that's what we seem to be achieving, which equates to market share gains.

And the things we are working on as I think I’ve mentioned in terms of building - we still see variability across markets that is not related to the particular economic circumstances of those markets that relates to just continuing to strengthen the routines and extend the best practices and driving the talent agenda to make sure we have the right leadership and also the right sellers.

I think I've mentioned in the past how - when you look at the performance of our top quartile salespeople compared to our bottom quartile salespeople, the top quartile salespeople tend to grow better and churn less, which I mean has been a big of the motivation to continue to optimize the number of sellers we have in place.

[Operator]

Your next question comes from the line of Ajay Jain with Pivotal Research Group. Your line is now open.

[Ajay Jain, Pivotal Research Group]

I first just wanted to get some clarification on the independent case growth figure of 7% in Q4.

Can you confirm how much of that was organic? And then I also wanted to ask if you have any color on what you're assuming for independent case growth in your fiscal 2018 guidance?

[Dirk Locascio, CFO]

So organic for the quarter, we have in the materials, it’s 5.2% and as Pietro commented, that was helped a little bit by some of the holiday timing, so as we normalize, it's about 4.7%, which is still the strongest growth we’ve had in roughly two years, so very, very strong independent restaurant growth quarter.

And we haven't put a specific number out there for 2018, but we do expect 2018 organic growth to perform at or better than what we saw in 2017, so remain very bullish on our ability to grow that at 2x the market or faster as we continue throughout 2018.

[Ajay Jain, Pivotal Research Group]

And as a follow-up on the fiscal 2018 guidance, I know you've already gotten some questions along these lines, but what's the main driver for the slower growth rate of 6% to 8% EBITDA, it looks like based on the data that you cited from Technomic growth from independents is supposed to moderate a little bit this year.

And then you mentioned in your prepared comments that expense leverage between gross profit dollars and expenses should be solid. So I'm just wondering, is expected slowdown in earnings growth partly a customer mix issue based on the outlook for independence or would you say it's much more expense driven from some of the recent industry headwinds for the freight costs?

[Pietro Satriano, President and CEO]

It really is more on the three or four factors that I talked about before, the freight headwinds that we expect at this point to continue to release the first half of the year as well as the early in the year weather and holiday timing, which are fairly meaningful drag on Q1 combined with some impacts from transition cost as we exit some of these unprofitable national accounts or chain accounts.

And then as we talk about with the core elements of the business continued to be performing well and things around in restaurant growth, margin levers, private label, et cetera and we expect those to continue to perform as well or better than they have in the past. So that's why we remain so bullish on the outlook for the midterm.

[Ajay Jain, Pivotal Research Group]

And I just had one final question, maybe I'll address it to you, Dirk. So I know you can't necessarily forecast all of the non-GAAP adjustments on the P&L. There is a lot of variability there. But for business transformation specifically, I assume a lot of those costs are contemplated ahead of time. So, do you have any sense for when those costs eventually roll off or are that something we should expect to see for the foreseeable future?

[Dirk Locascio, CFO]

We have you right we haven't quantified specifically. But what I can tell you is, we do expect transformation cost to meaningfully decline over the course for 2018. And we would expect them to be, minimal as we get to 2019. Really the only thing there's a couple of things around supply chain transformation and like it may span a little bit into 2019.

But 2018 ramps down 2019 largely goes away. But we're really in the last elements of the big transformation parts of our business. And that’s you see our add-backs has declined and continued to decline as we are driving GAAP results even faster than we're driving our adjusted results.

[Operator]

Your next question comes from the line of John Ivankoe with JPMorgan. Your line is now open.

[John Ivankoe, JPMorgan]

At first the clarification and then a question. On the clarification, do you know what drove the increase in overall restaurant sales in 2019 over 2018? That’s kind of interesting- to see that your external people are expecting an acceleration in 2019 for growth over the growth that we’ll see in 2018.

[Pietro Satriano, President and CEO]

There were a number of factors when I looked at it, John, and one of the contributing factors was the impact of tax reform. There were several factors which we’re happy to share - which we’re happy to share.

[John Ivankoe, JPMorgan]

Can you share them?

[Pietro Satriano, President and CEO]

Actually I don’t have it right in front of me, but I don’t want to do misquote the latest report.

[John Ivankoe, JPMorgan]

But that is interesting that they expect the impact of taxes to be more of a positive in 2019 than the positive seen in 2018. So that lag I guess surprised me a little bit, yes, I certainly look forward to some clarification there.

And then secondly in terms of your sales staff, I mean, some of your competition is talking about actually adding to their marketing associates or territory managers whatever vernacular is in terms of pursuing new accounts and new business. So you can you talk about what you’ve been doing with your territory managers year-over-year. What that number is, if you’re still quoting that? And if you think that’s the right type of strategy for you to consider in 2018 and 2019 specifically to get some of that new independent business?

[Pietro Satriano, President and CEO]

So just to go back to a couple of the statistics quoted earlier and you’ll hear more from Jay at our Investor Day who’s really been driving this. The learning for us a few years ago when we started on this path is the better sellers actually grow the business more and they grow it more through all three levers, they grow it by better finding new accounts, better sourcing existing accounts, insuring their accounts.

So there’s a - I guess, the above mixed benefit from moving accounts from TMs that are underperforming to TMs that are over performing and that really is why driving the slow reduction in the sales force.

Having said that, we do continue to hire new salespeople as we do want to grow. And we're hiring salespeople who better fit the profile of what we offer. Sales people who you know aren't necessarily interested in being order takers, who represent the brand well, who are consultative in their approach and who can leverage all the assets and tools we have to help our customers. So the profile of the seller of the future is also changing in conjunction with how our customers are changing.

[John Ivankoe, JPMorgan]

Certainly understood that. Yes, thank you for repeating some of that language, but as we get to the end of 2018 and end of 2019 do you anticipate having seen more or less territory managers in the company?

[Pietro Satriano, President and CEO]

That we want to disclose that for obvious reasons, John. I think hopefully what you take away from the conversation is the thoughtfulness of the approach, the database approach gives you the confidence that we're being very smart about this. And the way the industry works today is very different than its going to work in five years and we're going to be ahead of the game perhaps compared to others.

[Operator]

Your next question comes from the line of Marisa Sullivan with Bank of America/Merrill Lynch. Your line is now open.

[Marisa Sullivan, Bank of America/Merrill Lynch]

Just wanted to quickly follow-up on the 6% to 8% EBITDA growth. Does that include acquisitions and if so how much of an impact those have?

[Dirk Locascio, CFO]

That would be our all in expected growth as Pietro said since we haven't had any new acquisitions at this point and would provide some later in the year new acquisitions at this point and it would provide some later in the year, the new acquisitions would be as we go further. So that is our all-in expectation for the year.

And so the M&A impacts would be relatively small at this point based on transactions completed in the last year. We would update it to the extent that we have new information as Pietro said in the next quarter or two.

[Marisa Sullivan, Bank of America/Merrill Lynch]

So to confirm, it includes existing M&A, but not any new M&A in the pipeline?

[Dirk Locascio, CFO]

That's right.

[Marisa Sullivan, Bank of America/Merrill Lynch]

And then just on the case growth in 1% to 2% being a little bit below the 2% to 4% mid-term target, you talked a little bit about the outlook for independents in 2018, but can you just comment a little bit more about the 10 customer types, I think you mentioned that you had some wins and then also on the healthcare and hospitality, how should we think about the cadence of case growth in those channels as well as in 2018?

[Dirk Locascio, CFO]

So I think within the all other as Pietro mentioned, so we had some of the assets that continued in Q4, we have some additional ones in Q1. So really, we would expect the Q1 negative to be more significant than we had in - even Q3 - which Q3 is never holiday nor the Q4 did.

And then from Q1, we would expect us to continue to improve the balance of the year, getting closer to flattish, all other by the end of the year as the assets begin to cycle on as well as we bring some new expected wins on board as well.

That's for healthcare and hospitality, so healthcare and hospitality will be a little bit softer in Q1 as weather holiday and full ramp of large big deal customer that Pietro mentioned and we would really expect healthcare and hospitality to return more to market level growths in the back half of the year as the customer pipeline remains solid there.

[Operator]

Your next question comes from the line of Shane Higgins with Deutsche Bank. Your line is now open.

[Shane Higgins, Deutsche Bank]

You guys finished the year with leverage around 3.4 times and I know you guys have a mid-term target of around three times. Free cash flow remains pretty strong and by my math I think you guys are going to get another incremental $70 million or so from the lower cash taxes this year. Can you just talk about priorities for free cash flow and whether or not share buybacks are factored into your EPS guidance for the year? Thanks.

[Dirk Locascio, CFO]

So we'll talk more about this at the Investor Day, we’ll actually share just more broadly our updated thoughts on capital allocation. At this point historically that the information we put out there is absolute. We remain focused on reinvesting in the business and it’s been to reduce debt and we'll share at that point further thoughts on how we may use some of that incremental cash flow going forward on net debt versus other options.

[Shane Higgins, Deutsche Bank]

And then I just had a bigger kind of a bigger picture question. You guys talked about optimizing the portfolio of your business. How much more opportunity do you guys have had in terms of just overall portfolio optimization, as you look out over the next say two years to three years, do you think the portfolio looks a lot different than it does today and I guess I'm just trying to understand where your national chain business might be. Does it really start to stabilize maybe in 2019 as a percent of your total book and then how should we think about the margin implications of that mix? Thanks.

[Pietro Satriano, President and CEO]

I presume you're talking about the portfolio of chain customers what is - which is what the all other largely consist of. So as I said in by the back of 2018 as Dirk reiterated by the back of 2018 and as Dirk re-iterated you expect that to approach flat.

As we look out two years to three years beyond that, obviously is result of the good work we have done, there's fewer and fewer customers I mean I should say deals there's fewer and fewer deals that are lower negative profit. And the reason I think deals is because exit as we’ve said is always the last resort. Well we prefer to do is to find something that's a win-win proposition, that works for the customer and works for us.

And the reason we don't have more visibility for 2019 and 2020 is if you take the back half of this year as the baseline which whereas Dirk said approach is flat, there is potentially upside on top of that as we are able to change deals as opposed to exit customers. So I would say what we’re calling for in the back half of this year is a good starting point to work up from.

[Operator]

Your next question comes from the line of Vincent Sinisi with Morgan Stanley. Your line is now open.

[Vincent Sinisi, Morgan Stanley]

Just wanted to ask so if we think of just kind of the sequential cadence of this year, right, two of the larger factors are going to be of course kind of normalizing trends in freight in the second half and then also as you get kind of past some of the first-half customer exits and associated expenses kind of working themselves through, right. So, I guess on those two lines kind of what are you thinking first from a freight perspective like how much of that is the costs kind of get worse before they get better or how much is your ability to kind of maybe switch from third parties, how much maneuverability is there?

And then just more of I guess kind of a big picture question on the chain exits. Kind of when you exits on those businesses where do those customers typically go and then if you look at the rest of the landscape there obviously you’re having nice independent growth, but is there more opportunity that would be worth it for you to look at on some of those higher volume customers or just not, any color would be great?

[Dirk Locascio, CFO]

I’ll start on the great outlook. Good morning. As you said, we expect to see sequential improvement in our EBITDA growth as the year goes on, a lot of that as you noticed because in the second half we get past some of these “temporary” first half headwinds. So the freight is a big component. It helps in the second half and really it’s three things.

One is you are lapping sort of a higher cost period a year ago, but then within the improvement of the self-help type of things, that's the combination that Pietro may reference to earlier. It really is a mix of re-optimizing our lanes where it’s managing the mix of what we all making sure we have - can we expand our carrier base there better deal for us, et cetera as well as working with the vendors to get them to increase. So not specific quantification, but it really is one of those things as we go to the back half of the year.

[Pietro Satriano, President and CEO]

And on the chain customers, Vinnie, as I said, we definitely do look for opportunities to strike an agreement or a deal that's better for both of us whether it is large or small and of course if they’re larger the more important to us and there is a number of levers from assortment and routing those can really drive the contribution margin one way or the other and that's always where we start the conversation as always we start the conversation with existing customers.

[Operator]

[Operator Instructions] Your next question comes from the line of Andrew Wolf with Loop Capital Markets. Your line is now open.

[Andrew Wolf, Loop Capital Markets]

Pietro you were talking about the enhancements to your sites and how that driving increased usage and time spent. I thought I heard you say that's also the sellers and prospective customers are engaging they're just trying to make sure I heard that right?

[Pietro Satriano, President and CEO]

Yes.

[Andrew Wolf, Loop Capital Markets]

And so can you elaborate a little bit about that process and maybe even provide an example of the flow of how that would occur?

[Pietro Satriano, President and CEO]

Again we'll talk more about this at our Investor Day. But if you think about it existing customers view less of a need to navigate website where they mostly interact is on our e-commerce platform when they're placing orders. And so we've done a lot of work over the years to provide opportunities to cross-sell.

When they are on our e-commerce platform but to do so in a way which doesn't remove the utility of that site will slow them down because they want to get stuff done. Prospects obviously don't have access to the e-commerce platform the way they interact with us is through our website.

And so what we have done is configure in a way that is more prospect friendly. There's information there now and content there now is probably a less interest to existing customers and more of a prospects.

What I was referring to is by the opportunity to exchange favorite that can now go two ways if there is a business manager attached to a prospect that they can together create some identify some opportunity identify some opportunities that they get and talk about when they're continuing the courtship process. And that’s going to continue to evolve over time.

[Andrew Wolf, Loop Capital Markets]

I'll look forward to your conference as well. And just a follow-up, Dirk, on the drag 50 basis points, it’s not to help in the quarter but now the drag in this quarter to taste growth from the holiday swing, will that mostly to do with independents. And if so, could we bump up the independents benefits and drag to about 75 basis points based on your mix?

[Dirk Locascio, CFO]

It impacted a lot of different customer types. And what happens is the way Christmas goes from a weekend to the middle of the week and then the timing of shifts Christmas break. So it had a pretty meaningful impact across a lot of our different customer types. So I think the 50 is a good proxy for independent restaurants as it is for the overall number.

[Andrew Wolf, Loop Capital Markets]

Okay. Thank you.

[Pietro Satriano, President and CEO]

Okay. So we're at the hour. Thanks everyone for joining us. I want to - as I always like to do, thank you. As always, I thank all our employees for their commitment to our customers, and the great results they continue to generate coming - in spite of some of the headwinds we see. And we look forward to seeing many of you on our upcoming Investor Day in about a month. Thanks again.

[Operator]

This concludes today's conference call. You may now disconnect.