United Natural Foods - Earnings Call - Q3 2025

Executive Summary

• UNFI delivered a solid Q3: net sales rose 7.5% to $8.06B, Adjusted EBITDA grew 20.8% to $157M, and Adjusted EPS increased to $0.44, while GAAP EPS was $(0.12).
• Results beat Street: revenue exceeded consensus ($8.06B vs $7.79B*) and Adjusted EPS beat ($0.44 vs $0.22*); Adjusted EBITDA was above consensus (~$157M vs ~$142M*).
• Guidance: maintained for net sales, Adjusted EBITDA, Adjusted EPS, FCF, and capex; lowered GAAP net income and EPS to reflect exit of Key Food and Northeast network optimization; management otherwise would have raised non-GAAP outlook but paused due to a cyber incident disclosed on June 9.
• Strategic catalysts: continued lean implementation (20 DCs), new business wins, working capital efficiency, deleveraging (net debt/Adj. EBITDA down to 3.3x); near-term watch item is cyber remediation and Allentown DC closure linked to Key Food exit.

Values retrieved from S&P Global (*).

What Went Well and What Went Wrong

What Went Well

• “Seventh consecutive quarter of sequentially improving Adjusted EBITDA” with a higher YoY Adjusted EBITDA margin rate and increased free cash flow; lean daily management now in 20 of 52 DCs driving safety, quality, delivery, and cost benefits.
• Wholesale natural products led growth (+12% YoY); wholesale unit volumes +4%; new business with existing and new customers supported top-line gains. “Our results reflect sales growth above the industry benchmark and adjusted EBITDA growth that was meaningfully higher than our sales growth”.
• Deleveraging ahead of plan: net debt/Adj. EBITDA improved to 3.3x; liquidity ~$1.49B; subsequent $100M voluntary term loan prepayment reduces interest by ~$1M per quarter.

What Went Wrong

• Gross margin rate fell 20–30 bps YoY to 13.4% on lower product margin rates and mix (partly offset by supplier programs and lower shrink).
• Guidance for GAAP net income and EPS reduced due to Key Food contract exit and optimization of Northeast network; expected Q4 recognition of $53M termination fee and $24M impairment recorded in Q3, plus ~$4M severance.
• Cyber incident: unauthorized IT activity discovered June 5; management paused raising non-GAAP outlook pending impact assessment; short-term operational workarounds and potential elevated costs until systems are fully restored.

Transcript

Operator (participant)

Ladies and gentlemen, thank you for standing by. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the UNFI Third Quarter 2025 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during that time, simply press star followed by the number one on your telephone keypad. If you'd like to withdraw that question, again, press star one. Thank you. I would now like to turn the conference over to Steve Bloomquist, Vice President of Investor Relations. Steve, you may begin.

Steve Bloomquist (VP of Investor Relations)

Good morning, everyone, and thank you for joining us on UNFI's Third Quarter Fiscal 2025 Earnings Conference Call. By now, you should have received a copy of the earnings release issued this morning. The press release and earnings presentation, which management will speak to, are available under the investors' section of the company's website at www.unfi.com. We have also included a supplemental disclosure file in Microsoft Excel with key financial information. Joining me for today's call are Sandy Douglas, our Chief Executive Officer, and Matteo Tarditi, our President and Chief Financial Officer. Sandy and Matteo will provide a business update, after which we will take your questions. Before we begin, I would like to remind everyone that comments made by management during today's call may contain forward-looking statements. These forward-looking statements include plans, expectations, estimates, and projections that might involve significant risks and uncertainties.

These risks are discussed in the company's earnings release and SEC filings. Actual results may differ materially from the results discussed in these forward-looking statements. I'd like to point out that during today's call, management will refer to certain non-GAAP financial measures. Definitions and reconciliations to the most comparable GAAP financial measures are included in our press release and the end of our earnings presentation. I now ask you to turn to slide six of our presentation as I turn the call over to Sandy.

Sandy Douglas (CEO)

Thanks, Steven, and thank you, everyone, for joining us this morning. Before discussing our Q3 performance, I'd like to comment on the IT system security update we provided yesterday morning. As we disclosed yesterday, the company became aware of unauthorized activity on certain of our IT systems on June 5th. We promptly activated our incident response plan, implemented containment measures, and are working to assess, mitigate, and remediate the incident with the assistance of third-party cybersecurity professionals. Pursuant to our business continuity plans, we have implemented workarounds for certain operations in order to continue servicing our customers where possible, and we're continuing to safely bring our systems back online and restore broad-based customer service as soon as possible. Our entire company is focused on serving our customers.

Our core values of transparency and doing the right thing serve us well as we manage through this incident and our core principles of our daily operations. We believe we are managing the incident capably with a very strong team of inside and outside professionals, including specialized experts. We'll continue to keep our customers, suppliers, and associates regularly updated on our progress and next steps. Now, let me turn to Q3's results. As you saw in this morning's earnings release, we achieved another solid quarter driven by the strength of our customer base and disciplined execution of our multi-year strategic plan. Our results reflect sales growth above the industry benchmark and adjusted EBITDA growth that was meaningfully higher than our sales growth, leading to our highest adjusted EBITDA margin rate in two years. As part of our strategic plan, we expect to continue driving consistent annual margin expansion.

This trajectory reflects our continued focus on creating value for customers and suppliers while also systematically improving processes, implementing technology to enhance customer service, and strengthening operational efficiency. The third quarter was another quarter of year-over-year improvement in free cash flow, which is now well ahead of our original expectations year to date. This has enabled us to reduce net leverage by 1.3 turns compared to last year's third quarter. Based on our third quarter and year-to-date outperformance, we are tracking ahead of the three-year fiscal 2027 financial objectives that we set last year. This gives us even more confidence that we will create long-term sustainable value for our customers, suppliers, associates, and shareholders. This performance demonstrates that our new, more focused and efficient product-centered wholesale structure is helping us better understand and meet both our customers' and suppliers' unique needs in a highly dynamic market.

In some cases, we've supported customers with existing and new market expansions through our well-scaled distribution capabilities. In other instances, we are serving new business in incremental categories for a period as retailers reconfigure their supply network. Our strong top-line performance this quarter reflects the continued success of our winning customers and UNFI's ability to support their strategies across a variety of unique circumstances. We also recognize that both our customers and suppliers are navigating a dynamic macroeconomic environment, and we're focused on helping them plan for different scenarios, find product alternatives where needed, and remain as competitive as possible. At the start of fiscal year 2025, I also shared that we would sharpen our focus on building win-win relationships with suppliers and customers, which has largely driven profitable growth. Importantly, this process includes taking the right steps to adjust or exit relationships that are not mutually beneficial.

Recently, we came to a mutual agreement with Key Food to end our Northeastern distribution agreement and help them transition to another wholesaler that we believe will better fit their needs. This enables UNFI to exit an unprofitable relationship and further optimize our Northeast DC network by ceasing operations at our Allentown facility. Importantly, this will allow us to continue to more efficiently and effectively service our customers and accelerate progress towards achieving our three-year financial objectives. Next, I want to focus on our second strategic objective, which is to become a more efficient and effective company for our customers and suppliers, which in turn is helping us accelerate free cash flow and strengthen our balance sheet. One year ago, during our Q3 fiscal 2024 call, I outlined four foundational initiatives under this objective. One, intensify our network optimization. Second, to focus and reduce annual capital spending.

Third, to optimize our cost structure. Fourth, to increase working capital efficiency. We've made significant progress on all four initiatives, and we see continuing opportunity to enhance our performance going forward. A good example of the progress we're making in improving execution and reducing waste is through the further implementation of Lean Daily Management. With lean processes now being used in 20 of our 52 distribution centers, we are steadily improving safety, quality, delivery, and cost, and we continue to see significant opportunity for further improvement. Additionally, we've made progress to increase working capital efficiency by reducing our inventory days on hand back to pre-COVID levels, while also continuing to improve controllable fill rates. Fiscal year to date, we've reduced days on hand by over three days compared to the prior year, and we've steadily improved fill rates over the last few quarters.

While we're making real progress, we remain focused on continuing to drive fill rate improvements across our network. We said a year ago that we expected to generate up to $100 million in free cash flow during fiscal 2025 and that we would use these funds to reduce debt. One year later, we've surpassed our original target and further improved our balance sheet. As reflected in our guidance, we expect to generate free cash flow over 50% higher than our initial outlook for the full year. By consistently executing these elements of our multi-year strategic plan and continuing to identify more areas for improvement, we see significant opportunity to accelerate achievement of the three-year fiscal 2025 to fiscal 2027 financial objectives that we set at the end of last year.

We believe that our improving execution, adjusted EBITDA, and free cash flow outperformance to date, along with our network optimization proceeds, will lower net leverage to nearly two and a half turns by the end of fiscal 2026, which would be about a year earlier than our previous expectations. After we finalize our fiscal 2026 budgeting process this summer, we plan to update our long-term financial objectives and provide a more in-depth review this fall. In summary, we have work to do to manage the current disruption in our environment, and we are very focused on doing so in a transparent, principled, and customer-focused manner. Above all else, we remain committed to becoming the most efficient, effective, and value-creating partner for our stakeholders, which we expect will help to create sustainable long-term shareholder value.

With that, let me turn over the call to Matteo to discuss our Q3 results and our revised outlook. Matteo?

Matteo Tarditi (President and CFO)

Thank you, Sandy, and good morning, everyone. Thank you again for joining our third quarter earnings call. As Sandy stated, our operating momentum, execution, and performance have continued to accelerate as we completed the third quarter of fiscal 2025. Our confidence has grown with each passing quarter in executing our multi-year strategy and achieving our longer-term financial objectives. Today, I will provide additional insight into our third quarter results, including our sales and adjusted EBITDA growth, free cash flow generation, capital structure, and outlook for this fiscal year. With that, let's review our Q3 results. Turning to slide eight, our third quarter sales grew by 7.5% or about $560 million to nearly $8.1 billion. Our gains in the quarter were led by our wholesale natural products business, where sales increased by 12% compared to last year's third quarter, primarily reflecting higher sales and category penetration with existing customers.

Our wholesale conventional products business was up close to 3%, reflecting new business wins and new categories over the past four quarters. Across our wholesale business, unit volumes were up about 4% compared to last year, which represented another quarter of sequential acceleration and a continuation of the favorable trends we have seen since the end of fiscal 2024. Unified's volume again outperformed the key Nielsen industry benchmarks and reflects solid execution by our broad customer base. This outperformance also reflects our consistent new business wins as retailers continue to recognize the value of working with a well-scaled wholesale partner able to provide the differentiated products and services to help them compete in a highly dynamic marketplace. During the quarter, new business additions of this nature accounted for about half of our volume growth.

Inflation was about 1.5%, largely unchanged sequentially, and about a half percent lower than last year's third quarter. The remainder of our sales increase came from product mix, which added an additional 200 basis points. Total sales in our retail business were up slightly compared to last year. On an ID basis or same-store sales basis, sales were up 1.5%, reflecting sequential improvement across our store base. Moving to slide nine, let's review profitability drivers in the quarter. Overall, our wholesale business continues to be the main source of growth. Wholesale gross profit dollars, net of modestly higher operating cost, were up a combined $33 million, partially the result of higher volumes. However, our consolidated gross margin rate, excluding LIFO, declined 30 basis points compared to the prior year period to 13.4% of net sales.

This was driven by a lower wholesale margin rate as well as a continued mix shift toward wholesale. Retail gross margin rate was flat to last year. In wholesale, our gross margin rate declined about 20 basis points versus last year's third quarter, largely due to a continuing shift in customer and product mix. These impacts were partially offset by innovation and efficiency initiatives, including the value-adding supplier go-to-market programs that we've spoken about in the past and lower shrink expense. More than offsetting this decline in gross margin rate was continued solid operating expense management, which compared to last year declined by approximately 50 basis points as a percentage of net sales. This improvement reflects the leveraging impact from higher sales, our focused efforts on improving processes and removing waste, as well as the operational benefits from the customer and business mix shift affecting our gross margin rate.

As Sandy mentioned, we're now executing lean daily management in 20 of our distribution centers, and we're happy with the progress we're seeing. Across the DCs where lean is beyond the ramp-up stage, we have seen injury rates decline significantly, out-of-stocks improve by about 75%, shrink decrease, and throughput improve. We're really just getting started. In fiscal 2026, we will be focused on value stream mapping to accelerate the systematic identification of waste, improvement opportunities, and additional areas where we can bring value to our customers and suppliers. These actions, along with other strategic initiatives undertaken over the past several quarters, drove adjusted EBITDA growth of 21% compared to the prior year quarter to $157 million. Importantly, our adjusted EBITDA rate increased to 2%, the highest in two years and 25 basis points higher than last year's third quarter.

Our adjusted EBITDA, combined with some benefits on below-the-line items, led to strong adjusted EPS growth, with adjusted EPS in the quarter of $0.44 compared to $0.10 in last year's third quarter. Turning to slide 10, our improved profitability and continued focus on deploying lean principles helped drive $119 million in free cash flow in the quarter, which was approximately $17 million more than last year's third quarter. Year to date, we have generated approximately $150 million of free cash flow, bringing our trailing 12-month free cash flow to about $224 million. We've used this free cash flow to reduce our net debt to under $1.93 billion and lower our net leverage to 3.3 turns, which is about 0.4 turns less than last quarter and 1.3 turns below a year ago.

As Sandy stated, we're now expected to be close to our original three-year leverage target of 2.5 turns or less, about a year earlier than previously planned. Based on our continued confidence in our free cash flow generation and robust liquidity position of nearly $1.5 billion, early in our fiscal fourth quarter, we made a voluntary $100 million prepayment on our term loan that will save us approximately $1 million in interest expense each quarter going forward. Also, subsequent to quarter end, in late May, we closed on the sale of our Billings distribution center and used the net proceeds of approximately $13 million after customary fees and expenses to reduce debt. We're continuing to market facilities in Bismarck and Fort Wayne and have a letter of understanding from a potential buyer for the largest building at the Fort Wayne complex.

Looking at slide 11, we are reiterating most of our outlook metrics with the exception of GAAP net income and GAAP EPS, which have been updated to reflect the costs and charges of our Key Food agreement. We are otherwise maintaining our outlook for net sales, adjusted EBITDA, free cash flow, and capital investments. With one quarter remaining and strong performance to date in fiscal 2025, we would have raised our key non-GAAP financial outlook metrics if not for the unauthorized activity on certain of our IT systems. As we detail in our disclosure on this event, we're still working to assess impact. Otherwise, our underlying business momentum has been accelerating as we have been executing our strategic plan and focus on driving increasing value for our customers and suppliers. As a reminder, fiscal 2024 was a 53-week year with the extra week falling in last year's fourth quarter.

For the balance of the year, which includes only seven more weeks, we expect moderate impacts from tariffs. This is informed by our cross-functional tariff task force, which monitors for potential impacts, works to identify product alternatives, pressure test scenarios, and puts processes in place to maintain connectivity with suppliers and minimize disruptions to our customers. We continue to manage the situation closely. Flicking to slide 12, we had another solid quarter and remain confident in the future trajectory for UNFI. We believe we have the right workstreams in place to add value for our customers and suppliers while making UNFI a more efficient and effective partner to their businesses. Our efficiency initiatives and lean management programs are generating improvements to our business, while our volume trends reflect successful execution by our customers and the differentiated value that UNFI brings to our industry.

We seek to earn the trust that our partners place in us every day. We believe that our operational rigor and customer and supplier value creation focus will serve us well as we finish fiscal 2025 and beyond. With that, Operator, please open the line for questions.

Operator (participant)

Thank you. We will now begin the question and answer session. If you would like to ask a question, please press star one on your telephone keypad to raise your hand and join the queue. If you'd like to withdraw that question, press star one again. We also ask that you limit yourself to one question and one follow-up. Your first question comes from Bill Kirk with ROTH Capital. Please go ahead.

Bill Kirk (Managing Director)

Hey, good morning. Just a clarification real quick. Are you reiterating the guidance on the non-GAAP elements or simply not updating them? I guess there could be a distinction between the two given the beat and given the comment that you would have raised otherwise. Is it a not update the non-GAAP or reiterate the non-GAAP?

Sandy Douglas (CEO)

Yeah. Hi, Bill. It's Sandy Douglas. Before Matteo answers your question, which he's going to do in a second, I want to just reiterate for everybody a little bit of the details on our incident management protocol. Last Thursday, we noticed some unauthorized participants in our network. Pursuant to our incident management protocol, we went into hyper-analysis and awareness mode. By late afternoon on Friday, early evening, late afternoon, we saw enough data to suggest that we needed to shut our network completely down and go into hyper-analysis mode, which we did, bringing in outside experts and again, pursuant to our protocols. Once we got to Monday morning, we let the markets know through filing an 801 to make sure that we were being fully transparent about what was going on.

As we sit here today, we're 100 hours into the management of the situation, and we have two focus points. This is really the whole-of-company focus here. That is to understand the situation and then to safely bring back our network when it's appropriate to do so. Separately, work with our customers and suppliers transparently to do everything that we can possibly do to help them manage through the short-term difficulty that the situation creates. I would further say that to us, the most important enduring matter here is how we take care of our customers and how we show up for them. Our focus has been on that for the last 100 hours, and that continues to be what we're working on with some progress. Matteo, go ahead.

He wants to answer his question, but I just wanted to create that context because that sort of sets the backdrop for how we looked at guidance coming into the call.

Matteo Tarditi (President and CFO)

Thank you, Sandy. Good morning, Bill. We had a strong third quarter, and we have a strong performance year to date. We are up 5.5% in sales year to date. We are up 16.3% in EBITDA and generating more than $150 million of free cash flow. Our plan was to increase the guidance, as we mentioned in the remarks. However, as you heard from Sandy, we are very focused on the restore of the systems and then the focus on the customers. With that in mind, we left the guidance alone for now.

Bill Kirk (Managing Director)

Okay. Thank you. As a follow-up, on Key Food in the Northeast, the initial thesis was with them as an anchor customer, you could build a large facility with some extra capacity to add additional customers around it. I guess what kind of diverged from that plan? Was it Key Food as an anchor was different than you thought it would be, or the ability to add scale around Key Food was maybe different than you thought it would be? What kind of happened there that went against or away from your initial plan?

Sandy Douglas (CEO)

Sure, Bill. This is Sandy again. I think the broader strategic question, which we've been looking at as a part of our three-year plan, is around the country, where are there opportunities to optimize our network based on either market or customer profitability? We have taken actions, as you know, to make adjustments to our DC footprint around the country. That does not just involve closing DCs, but recently, as you know, we moved from York to Manchester and increased our square footage and automation in the new Manchester distribution facility. Specifically to Key Food and to the Allentown market, we simply found that the combination of operational factors, post-COVID impacts, and the details of that agreement were very difficult.

In collaboration with Key Food, we determined with them that the best possible scenario for everyone, given the facts at hand and the likely scenarios that emerge, was to exit the relationship and the market. We did so in an effort to optimize the results for them and for us. It was a clear choice that emerged after careful consideration of all the options. Obviously, we had associates in that market, so we make those decisions very carefully.

Matteo Tarditi (President and CFO)

Maybe to complement your answer, Sandy, we recorded the third quarter, $24 million after the impairment charge and about $4 million in severance expense that have impacted our GAAP results. In the fourth quarter, we expect to record the $53 million contract termination fee that will be paid to Key Food over several months and over achievement of milestones. That will be recorded in the restructuring cost and will impact free cash flow. However, the net cash impact of the payment is materially lower because as we discontinue our operations at Allentown, we're going to get some upside from the working capital release as well as the benefit of the expense reduction. We project the payback period of a year or less.

Operator (participant)

Your next question comes from the line of Scott Mushkin with R5 Capital. Please go ahead.

Scott Mushkin (Founder and CEO)

Hey, guys. Thanks for taking my questions. I'm sorry to hear what you're going through. I guess first off, I want to make sure I understand getting your network back online. Are you actually currently shipping to customers or no?

Sandy Douglas (CEO)

Yes, we are on a limited basis. It depends on the technology platform. Some are further along on the recovery than others. We are partnering with customers across the country and across our formats in various short-term modes to serve their needs as best as we possibly can. It is getting increasingly positive each day, but still work in progress.

Scott Mushkin (Founder and CEO)

Sandy, what do you think is the percentage you normally ship? Is it like 30%, or is it over 50%? How problematic is it? Where are these customers? Is it sheltering and stuff right there, or where is everything?

Sandy Douglas (CEO)

Scott, the entire process is very fluid and ongoing. The way I would describe it is each day is better, and we're working in a very customized way by market and by customer to serve the capability that exists. It's, at this stage, a highly partnering activity. I wouldn't want to give percentages at this time because it's changing every day. It's obviously the top priority of the company to serve our customers as best as we possibly can while we're working to, as rapidly and safely as possible, bring our systems back online.

Scott Mushkin (Founder and CEO)

Are you actively facilitating those customers working with other distributors so their sales are fair? What is your fiscal and what is your monetary responsibility to those customers? Is there contractual issues where they could actually break contracts?

Sandy Douglas (CEO)

Yeah. I think the focus right now, and I think the through line across the network, is to help customers meet their needs in whatever way it can be done. That, in some cases, involves help from other wholesalers. In other cases, it's a lot of very innovative work that our teams have done to help respond as best as our capabilities will allow. I think the strategic point in the middle of it is how we work together with customers in a crisis. In some ways, it's a defining opportunity for us. Any way that we can help them meet their needs, we're doing. Nothing would be offered.

Scott Mushkin (Founder and CEO)

How about their ability to break contracts?

Sandy Douglas (CEO)

Yeah. I don't.

Is this a breach,

From my perspective, first of all, our contracts with our customers are highly varied. As you know, they're confidential and specific. Our focus right now is less about that and more about meeting their needs today. I wouldn't be able to factually answer that question even if I was inclined to disclose it. The focus is making sure we serve the customers and have them be able to do whatever they need to do the best they can in this environment. In parallel, our focus is, as quickly as possible, to address the issues, ensure the systems are safe, and bring them back up online. As you know, how companies manage situations like this are defining in terms of their relationships. We view it as that kind of moment.

We have been completely transparent and completely focused on our customers' outcomes from the start.

Scott Mushkin (Founder and CEO)

My final one is, I know Marks and Spencer's over in the U.K. has still got issues. I mean, this could be a multi-month process. Is that how we should look at it? A follow-up to my follow-ups is that if you look at the equity trading, it very much appears either someone knew this was going to happen. Is the SEC involved in that? I guess also, why did it take you guys so long to report it to the market?

Sandy Douglas (CEO)

Scott, let me, first of all, decline to speculate at all regarding regulatory authorities and the first part of your question. Let me remind you the timeline. The company became aware of an unauthorized entrant in our technology on Thursday. Pursuant to our incident management routine, we began hyper-analysis and awareness of diagnosing just how broad that situation was. Because, of course, in many cases, when you initially see it, you may be inclined to think it's isolated. By late Friday afternoon, we made the decision to lock our systems down. We filed an 8K on Monday morning before the market opened. There is no way that we could have communicated any faster. There was no trading that I—well, I don't know. There was no open markets between the time we locked our systems down and the time we.

Scott Mushkin (Founder and CEO)

I'm actually talking about before the attack. I mean, if you look at the equity, it was dropping.

Sandy Douglas (CEO)

Yeah.

Scott Mushkin (Founder and CEO)

Your attorneys have notified the SEC. I would.

Sandy Douglas (CEO)

I'm confident that we are engaged with all the authorities, including relative to the cyber event, reporting all that we know to the FBI. Those are all part of our protocols that we follow strictly.

Scott Mushkin (Founder and CEO)

Okay. I've taken about.

Operator (participant)

Your next question comes from the line of Mark Carden with UBS. Please go ahead.

Mark Carden (Equity Research Analyst)

Hey, thanks so much for taking the questions, guys. To start, I'm going to go with a little bit of a follow-up on Bill's question. For Key Food, it was originally expected to be a $1 billion annualized business. Is this essentially where it landed? I know you guys were pretty excited about landing the contract originally. Was this situation unique to Key Food, or does it make you rethink at all how you approach larger contracts?

Sandy Douglas (CEO)

Thanks. Mark, what I would say relative to the individual customer is that we do not really comment specifically. Obviously, we did today because of the size and scope and the history of the announcement and the connection to Allentown. The broader question about our approach to overall contract underwriting and analysis, I would say that today we have a very rigorous process that looks at all the factors that go into it because we pursue win-win agreements. Our customers deserve that. All our customers deserve that we do not have agreements where we are losing money because that hurts everybody. The rigor that Matteo and his team working with our commercial leaders have put into that process is significant, and I have got a lot of confidence in it.

I would also say that a whole lot, particularly in the transportation side of the New York area, changed in the COVID period. We made the decisions we made based on a very factual analysis of the current situation and at the end of the exploration of all options that we might have been able to pursue to turn that agreement into a positive one. Following all that, we chose to exit because it was the best decision for our shareholders. I believe that Key Food made the same decision for the same reason for theirs.

Mark Carden (Equity Research Analyst)

Got it. That makes sense. As my follow-up, just on the cyber attack, how has the customer response been so far? Does it impact how you approach resources devoted to both customer retention and new business acquisition in the near to intermediate term? Essentially, does new business go more to the back burner temporarily, or is it still going to be pretty balanced?

Sandy Douglas (CEO)

Yeah, that's a great question. What I would say is, and again, this is anecdotal in the midst of a crisis response with 30,000 customer rooftops. I have daily personal conversations with about 15 - 20 CEOs of our customers. The conversations have been extremely constructive and collaborative. Our teams are working very hard for them to make sure that we help them get everything that we can to manage through. My own view is that until we reach a point of functional equilibrium and when our systems are safe and operating as they should, we have to focus on existing customers and meeting their needs with every ounce of our energy. That's what we're doing. I would also caution everyone not to make assumptions about the length of the issue. I mean that on both sides.

One of the things that I have learned is to focus on the facts in front of you and generally not to speculate, to serve the needs of the process and making sure that we are safe, we're diligent, we're thorough, and at the same time, in parallel, work very hard to solve the operational opportunities in a given DC with given customers in the coming day. We're doing the same on the back end with our suppliers. I believe over time how companies and their customers work together in crises have the opportunity at least to strengthen relationships. We will be talking about that after it's over.

Mark Carden (Equity Research Analyst)

Got it. Thanks so much. Good luck, guys.

Sandy Douglas (CEO)

Thanks.

Thanks, Mark.

Operator (participant)

As a reminder, if you would like to ask a question, please press star one on your telephone keypad. Your next question comes from John Heinbockel with Guggenheim. Please go ahead.

John Heinbockel (Senior Managing Director and Equity Research Analyst)

For both of you guys, I know you've been speeding up the rollout of Lean Six Sigma, right? You did 11 this quarter. How does the breach impact that, right? Do you basically, whatever you've done in the fourth quarter, that's it, and it slows down temporarily? Also, if you think about shrink, does shrink potentially go up in the short term because volume is down, a product is going bad, or too early to tell if that happens?

Matteo Tarditi (President and CFO)

Good morning. Thanks for the question. Let me give a quick recap of where we are in the early lean journey. We are focusing on three areas. The first one is decentralization for higher accountability. These are some of the comments and references that Sandy made on how the new wholesale product-oriented organization is performing, or for instance, how the decentralized procurement organization is performing on reducing days on hand while supporting a 7.5% growth rate. The second area is on lean daily management. I will get there in a second on your question on the breach. That is where we now have 20 distribution centers out of roughly 50 applying daily management. We see benefits across the safety quality delivery cost sequence.

The last piece is waste management, which is where we have been able, through a set of actions, to take another 50 basis points of operating expenses out of sales. Specifically on your question, throughput has been improving over the last several quarters. It's up 5% in the third quarter. There could be a few days of disruptions, as Sandy said, focusing on restoring our systems and meeting our customers' needs as much and in more curative ways as we can. The underlying momentum is strong. We are getting a lot of engagement from the DCs on applying lean daily management. Sandy and I and the leadership team were visiting Manchester last week, and we saw real-time examples of how these things are working. We are encouraged by the progress, speed bump related to these cyber incidents, but the underlying momentum is strong and will continue.

Relative to shrink, obviously, as part of the 100 hours reaction plan and process, we've been using widely every single one of these 100 hours. We look at the prioritization of receipts and procurements and inventory and fresh because the shrink dynamic was very high up on the list. We are responding as quickly as we can in the more creative ways that we can. Again, without speculating, we are not putting days of recovery to our statements, but we are moving methodically and swiftly.

John Heinbockel (Senior Managing Director and Equity Research Analyst)

Maybe following up on that, just where do you, when you look longer term and the sort of the recurring benefit of Lean Six Sigma, how does that sort of play out, do you think? You get it in every DC in year one, you refine it. What do you think is the most important longer-term contributor there? You think about labor productivity, and I may have asked this to you before, do you think you can sustain, say, 3-5% labor productivity gains over many, many years as this gets refined, or is that optimistic?

Matteo Tarditi (President and CFO)

I think we can sustain it. What we see the benefit is clearly in continuing to improve the throughput as part of the lean daily management, continuing to expand the reach into our distribution centers with the sequence of SQDC. We are excited about the fourth leg that we are going to add to our lean journey, which is value stream mapping. Value stream mapping is a way to complement our CapEx investment, as a way to complement the problem-solving and making solutions more sustainable. We expect to, again, methodically deploy VSM and start seeing sustainable benefits there.

John Heinbockel (Senior Managing Director and Equity Research Analyst)

Thank you.

Matteo Tarditi (President and CFO)

Thanks, John.

Operator (participant)

Your next question comes from Leah Jordan with Goldman Sachs. Please go ahead.

Leah Jordan (Equity Research Analyst)

Thank you. Good morning. Just given the termination of your relationship with Key Food, I wanted to see if you could just comment on how you're thinking about the conventional segment longer term. I understand you've been focused on kind of streamlining your contracts to drive profitable growth. As I see it, driving more volume through your network should create some leverage benefits over the long term. How do you balance this kind of streamlining to drive near-term profitable improvement versus making sure you don't cut too much to sustain growth longer term?

Sandy Douglas (CEO)

Leah, this is Sandy. That's an excellent question. Let me start at the sort of strategic segmentation that we did a year ago because I think sometimes labels constrain your thinking. We've identified a $90 billion addressable market that includes natural, organic, specialty, ethnic, really all retailers that are predominantly focused on a differentiation strategy. We're designing UNFI's product services and programs for that customer base. We view that customer base, having done a lot of very disciplined and deep analysis, to be a growth segment of the food industry going forward. With that design and that sort of target, we've assessed our business on a DC-by-DC basis to evaluate where we are going to see growth, where the profit opportunities exist from a service and program perspective. Ultimately, as that then goes down and works with individual customers, we look for ways to create win-wins.

We have had a lot of success on that. As you know, we had provided a year ago a three-year sales guide of flat. This year, year to date, we are way ahead of that because of the success of the segmentation thinking and the work we have done with customers. In the case of Key Food in Allentown, it is a unique situation or largely unique situation where a customer and a DC are inextricably linked. In that case, there was no way that we could see, based on all the work we have done, that we could turn that situation into a profitable growth opportunity. We made the hard decision to close the DC, and we and Key Food mutually decided to end the relationship. Ultimately, the value gets driven by driving throughput and creating excellent returns against our capital, which tend to be DC-driven.

We see opportunities to grow profitably against the $90 billion addressable segment. We are in the process of making sure that we align and shape the customer efforts that we are putting into that target market and to the ability to drive profitable growth and significant amounts of free cash flow to deleverage our debt and drive economics for our shareholders.

Leah Jordan (Equity Research Analyst)

That makes a lot of sense. Thank you. Just for my follow-up, I wanted to dig into some of the drivers in the quarter a little bit. Putting the recent cyber incident aside, I mean, you still had a nice acceleration in your overall business with volume growth. I mean, and this is within a backdrop of macro uncertainty, low consumer sentiment. I guess, what are you seeing on consumer behavior? Have there been any big shifts in which categories they're shopping and in channels? How much do you think just the shift toward more food at home has been a benefit for you this last quarter?

Sandy Douglas (CEO)

Sure. I'll take a shot at this and invite Matteo to comment as well. I think the first distinction I draw is that the wholesale market is not exactly a mirror image of the retail market. We're in the B2B products and services business, and our growth is driven by the fact that retailers view us as being helpful to them in a various range of circumstances. We work hard to be the provider that they look to to help them grow their business, help them shift their strategy, help them move into new markets, a range of different situations. Our growth reflects that. Some of it's short term, some of it's long term. Our sales and merchants are busy helping customers regardless of the situation. We've seen really strong sales results as a part of that.

Within the consumer, clearly, what you hear from retailers across the market is there is certainly stress at the bottom end and increasing sort of wariness across the customer base. We are seeing really strong performance in the natural, organic, and specialty area. We are also seeing good performance in differentiated ethnic and some other really powerful and good retailers who are doing an excellent job. It is going to continue to be, we use the term dynamic in the script. We think it is. We are seeing lots of innovation. Finally, I would remind you that we credited most of our growth to the quality of our customer base, which is really the truth. It is the biggest driver. We have great customers who are doing incredible things in the market. Matteo, any additions, subtractions there relative to the market?

Matteo Tarditi (President and CFO)

Thanks, Sandy. Yeah, I've read a couple of insights on the business trends. As you unpack the 7.5% growth, 400 basis points came from volume, which is the highest growth that we have seen since the volumes turned positive at the end of 2024. Inflation is stable at 1.5%. We picked up about 200 basis points from positive category mix with higher dollars per case. When you think about natural and conventional dynamics, obviously, natural is growing at a faster pace at 12%. Conventional was up 3% and had slightly positive volumes. The last comment is building on some of the iterations that we had in the last call. Even within natural, when you exclude the new business and the largest customer, the underlying performance has grown from 2% in one Q, 3% in two Q, 4% in the third quarter.

We see momentum in the natural business at large.

Leah Jordan (Equity Research Analyst)

Very helpful. Thank you.

Operator (participant)

Your next question comes from Edward Kelly with Wells Fargo. Please go ahead.

Edward Kelly (Managing Director and Equity Research Analyst)

Hi. Good morning, guys.

Sandy Douglas (CEO)

Good morning, Samed.

Edward Kelly (Managing Director and Equity Research Analyst)

Just a follow-up on the IT issue. Just curious, do you think there's anything about UNFI that made it more susceptible to this problem? Bigger picture, sort of taking a step back, do you think it impacts at all how you're thinking about spending, CapEx, technology, that type of stuff moving forward?

Sandy Douglas (CEO)

Yeah. The instinctive answer is no... but let me answer the question more thoughtfully than that. We have, like a lot of companies, a significant investment in process around the cyber area. It is highly dynamic and rapidly growing. The threat actors out there are always looking for ways to innovate and find new ways to penetrate systems. Whether it is our management routines, our board oversight, risk management that tracks all the way up into our governance structure, we rigorously review and invest in this hyper-infrastructure and capability in the company. We use multiple different external benchmarks to assess ourselves and really hold nothing back in this area. Having said that, we just got penetrated.

We will be continuing to look at every aspect of our defense, every aspect of how our tools are working, and what may be necessary to bolster it going forward because it is clearly an area that requires a tremendous amount of focus from companies today and will continue. How that affects CapEx going forward? Ultimately, CapEx is a choice. We have and will continue to prioritize cyber investment. I do not think it changes the ultimate big picture for UNFI on capital. I think a company needs to be both high capability and humble when it relates to cybersecurity. This event is just a demonstrated example of why.

Edward Kelly (Managing Director and Equity Research Analyst)

Okay. Just a follow-up. As we think about the mitigation efforts that you are taking at the moment, obviously, there's a case volume impact associated with that. What about from a cost perspective in terms of trying to run the business with some capacity at this point? Is there an added cost associated with doing that? Just curious. I mean, I know you do not have great visibility, but we are all thinking about how we should at least be modeling what has happened so far. I am curious as to any impact it might be having on the cost side.

Sandy Douglas (CEO)

Sure. What I would say on this one is we're 100 hours in. At this stage, we are taking action with one, well, really two tracks of focus. The first is to address the cyber incident to make sure we understand it, that we've taken actions to repair, improve, and then get our systems safely online as fast as possible. That is one track of work. We're putting the resources that are necessary, all of them, to bring that to effect as soon and safely as possible. On the other side, we're using our resources and our tremendous team of sales and supply chain and procurement to work with suppliers and customers to make their situation as good as we possibly can. Will there be elevated costs as a result of both of those tracks? Yes. Of course, there will be.

How much that will be, we do not know at this stage. We believe we will be able to manage it. At this point, we are focused on those two tracks, and it is too early to try to quantify that.

Edward Kelly (Managing Director and Equity Research Analyst)

Okay. Thanks, guys.

Sandy Douglas (CEO)

Thanks, Sam.

Operator (participant)

Your next question comes from the line of Ben Wood with BMO Capital Markets. Please go ahead.

Ben Wood (VP and Equity Research Analyst)

Hi. This is Ben on behalf of Kelly Bania. Thanks for taking our questions. Not to belabor the breach anymore, but just a question going into it. Where were you guys on the consolidation and updating of your IT systems? I know a lot of the last cycle of inflation, you commented that you had a lot of systems that impacted your visibility into the business. So where were you in that process?

Matteo Tarditi (President and CFO)

Hey, Ben. Good morning. It's Matteo. Over the past couple of years, we have been focused on improving our systems and processes. As you think about our $300 million CapEx, guys, we always allocate about a third to safety and overall DC modernization, about a third to technology improvements, and about a third to automation. Within that envelope, we have invested in updating our systems and processes and with that, increasing capabilities. We continue to modernize our networks. Think about the recent release of the warehouse management systems. Think about some of the inventory management applications that we released. We continue to look at opportunities to methodically and with discipline consider an ERP.

We want to make sure that it's clear that the fact that we have closed some kind of technology deficit in the last couple of years with a lot of system and process improvement is separate from what happened in the cyber attack.

Ben Wood (VP and Equity Research Analyst)

Right. Understood. No, that's helpful. I just want to transition to talking a little bit about service levels. You guys have provided some good updates. I'm curious, for the DCs that are on your lean daily management compared to the DCs that are not, how are service levels, customer retentions, new business wins tracking? On a related note to that, what about the DCs in the surrounding areas of some of the DCs that you've closed? How is customer retention and service levels there going?

Matteo Tarditi (President and CFO)

Ben, great question. Thank you. We see service levels improving and being able to benefit from immediate problem-solving at the 20 distribution centers where we have deployed Lean Daily Management. With that said, it does not mean that the other 30 or so do not focus on fill rates and service levels and delivery qualities. The methodology of having teams huddling every morning around the safety, quality, delivery, cost dashboard, seeing the green or the red, and being able to jump straight away to the red and act in problem-solving is very, very powerful. With that in mind, we have seen shrink benefits, service level benefits, delivery quality benefits. That is why we are encouraged about expanding the program to more and more distribution centers. To your point, the adjacent distribution centers that do not have lean daily management in place can also learn from the best practices of the others.

There is a formal method of rolling out the LDM, but there are also daily interactions and practice sharing that helps the overall network. Relative to the customer retention, when we issued a guidance about a year ago, the outlook, the three-year guidance about a year ago, and talk about flight revenues, we had just started the network optimization plans. To date, we have closed four distribution centers if you include the move of York into Manchester. Obviously, we announced Allentown this morning. We could say that our ability to work with customer and find win-win path forward has been stronger than we were expecting at the inception of this program. We are happy with that because, as Sandy mentioned, our first goal when we see low-performing distribution centers is to be able to find win-win solutions with our customers.

If not, we need to take different actions.

Operator (participant)

Your final question comes from William Ruder with Bank of America. Please go ahead.

William Ruder (Analyst)

Hi. I have two quick ones. The first, in terms of the termination fee with Key Food, did I hear correctly that that was $53.53?

Matteo Tarditi (President and CFO)

That is correct.

William Ruder (Analyst)

Okay. In terms of capital allocation, you've now sped up your expectation of when you're going to get to two and a half times leverage now by the end of fiscal year 2026. How are you thinking about capital allocation when you get to that target? Do you think that you'll change towards more shareholder-friendly, either share repurchases, larger dividend? Alternatively, do you think you might kind of reduce your leverage target going forward from that point?

Matteo Tarditi (President and CFO)

That's a great question. Our focus is 100% on converting free cash flow into that reduction for now. Within that framework, we talked about investing $300 million in CapEx every year, about 1% of our top line. The envelope is split a third into safety and DC maintenance, a third into technology, and a third into automation. Every dollar goes to that reduction. That is the focus and the mantra through the point of achieving 2.5 turns or less. I think at that point, we'll have a different conversation on where do we see the best shareholder returns. To your point, the full portfolio of more targeted investments organically in certain areas, thinking about a different buyback policy, is all going to be on the table. For now, the one and only focus is to deleverage. There is no mistake within the company.

William Ruder (Analyst)

Got it. All right. Helpful commentary. All right. Thanks a lot.

Operator (participant)

That concludes our question and answer session. I will now turn the conference back over to Sandy Douglas for closing comments.

Sandy Douglas (CEO)

Thank you, Operator. As you heard on today's call, we are focused on diligently managing through the cyber incident we announced yesterday morning to rapidly and safely restore our capabilities while helping our customers with short-term solutions wherever possible. While this may be a short-term incident in the longer picture of our business, we see a defining character moment to show up for our customers in a way that reflects the challenges of the time and the character of the company that we want to be. Bigger picture, we continue to make solid progress towards implementing our multi-year strategy and delivering on our financial commitments, both in fiscal 2025 and beyond. We again delivered strong sales, adjusted EBITDA, and free cash flow growth compared to last year's third quarter.

We continue to gather insights and develop plans for how we can deliver even more value for our customers and suppliers, knowing that the learnings from our past will be the drivers of success in our future. We're committed to getting better every day and have embraced lean management as a disciplined approach to becoming more efficient and effective. For our customers and suppliers, especially now, we thank you for your continued partnership and the business we do together. For the UNFI associates listening today, our thanks to each of you for everything that you do for our business, our customers, our communities, and each other. For our shareholders, we thank you for the trust you continue to place in us. Thanks again for joining us this morning. I look forward to updating you this fall on our year-end call.

Operator (participant)

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect.