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Executives

Kenneth Levy

Craig Carlock - Chief Executive Officer, President and Director

Jeffrey C. Ackerman - Chief Financial Officer and Executive Vice President

Analysts

Renato Basanta - Sterne Agee & Leach Inc., Research Division

Mark R. Miller - William Blair & Company L.L.C., Research Division

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

Jason DeRise - UBS Investment Bank, Research Division

Andrew P. Wolf - BB&T Capital Markets, Research Division

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Benjamin Brownlow - Raymond James & Associates, Inc., Research Division

Karen F. Short - BMO Capital Markets U.S.

Mark Wiltamuth

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Sean P. Naughton - Piper Jaffray Companies, Research Division

Philip Terpolilli - Longbow Research LLC

Scott Andrew Mushkin - Wolfe Research, LLC

Robert F. Ohmes - BofA Merrill Lynch, Research Division

The Fresh Market (TFM) Q2 2013 Earnings Call August 28, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to The Fresh Market, Inc. 2013 Second Quarter Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to the conference over to your host, Ken Levy. Please go ahead, sir.

Kenneth Levy

Thank you, Jamie. I'd like to welcome everyone to The Fresh Market Second Quarter 2013 Earnings Call. Joining me on today's call are The Fresh Market's President and Chief Executive Officer, Craig Carlock; and Executive Vice President and Chief Financial Officer, Jeff Ackerman. Before we begin, I want to remind you that any forward-looking statements that we may make today are subject to the Safe Harbor statements found in our press release and SEC filings. Our second quarter earnings release and related financial information, including any non-GAAP or adjusted financial reconciliation tables are available on our corporate website under the Investor Relations section. After our prepared comments, we will have time to answer your questions. Please note that a replay of this call will be available for 30 days on our website at www.thefreshmarket.com.

With that, let me turn the call over to Craig.

Craig Carlock

Good afternoon, and thank you for joining us today. As you read in our release, The Fresh Market continued to deliver double-digit sales and earnings growth and to extend its brand into new markets. Revenues grew 13% and earnings grew 17% to $0.32 per share. Our comp sales growth rate accelerated from the prior 2 quarters, finishing at 3.4% or 11.4% on a 2-year stack basis. We began to build brand equity with shoppers in new markets and broadened our appeal in legacy markets. We are pleased with how our customer traffic improved this quarter even as broader market trends indicate that consumer behavior was somewhat subdued.

After analyzing past promotions, we saw an opportunity to execute better and drive traffic around the summer holidays. So we leaned into the growing season with great summertime events that feature our signature meat department for Memorial Day and the Fourth of July. Our analysis indicates that our promotional execution drove incremental traffic in a disciplined manner and allowed us to achieve profitable sales with a variety of well-chosen merchandise. We did see a slight mix shift as we ran new promotions and promoted more value-oriented items in certain categories like meat where protein prices have remained stubbornly high. All told, about 22% of our sales this quarter were generated from promotional activity compared to 21% a year earlier. We continue to test new promotional ideas, and we anticipate our promotional cadence will remain at a level similar to Q2 for the remainder of the year.

Turning to margins. We delivered gross margin expansion in Q2 despite a spike in certain wholesale prices, most notably seafood. We made the decision to absorb some of this cost inflation, and we were able to more than offset it with leverage on occupancy and other fixed costs. Real estate site selection and entry into new markets remain a top priority for the company as we execute against our real estate strategy and the most significant resources to new unit expansion. We believe we can achieve 15% annual store unit growth for the foreseeable future, and we are on track for another year of record unit growth.

Through the first half of the year, we opened 7 new stores, including stores in Palo Alto, Houston, the Chicago suburbs and the Pittsburgh area. So far in the third quarter, we have added 3 more locations, including 2 stores in Houston as we fortify our position in this new market. Our new store pipeline remains robust. We now expect to open 21 to 22 new stores this fiscal year. We signed 3 leases during the quarter and had executed 30 leases at quarter end for stores yet to open, seeding our growth through early 2015. As our 2014 pipeline takes shape, we anticipate a more balanced opening schedule than we experienced this year.

We remain excited about our entry into California and Texas, and we believe that each of these markets provides The Fresh Market with significant opportunities to develop new stores and extend its brand, similar to what we've experienced in Florida. Customer feedback in these markets has been good, especially around the fresh offering. It is also clear that our brand is new to these markets, and we will have to earn customer loyalty over time just as we did in Chicago, parts of the Northeast and early on in Atlanta. New store productivity was 79% this quarter and is trending to finish in the 80% to 90% range for the full year, which is consistent with our historical trends.

Jeff will discuss some of the factors impacting this metric as we know this is a closely watched barometer by many of you. In summary, we continue to execute our long-term plan, and I remain excited about our ability to build a national franchise and extend our brand into new markets.

Let me now turn the call over to Jeff for a deeper discussion of the quarter, some of the factors driving our performance and an update on our guidance.

Jeffrey C. Ackerman

Thank you, Craig. First, let me say that I'm very happy to be here with Craig, since I joined The Fresh Market team. I've known The Fresh Market for many years as a shopper, and since my arrival in June, I've gained a much deeper appreciation for the company's product standards, operational discipline and commitment to customer satisfaction.

My first 12 weeks on the job have confirmed for me that The Fresh Market has a collaborative culture with strong leadership, high standards and tremendous prospects for continued growth.

Turning to the quarter's results. The Fresh Market posted earnings of $0.32 per share compared to $0.28 per share a year earlier. Total net sales grew 13.3% and were driven by strong unit growth and solid comps. As Craig noted, while promotional activity rose slightly this quarter, we achieved a continued goal of increasing traffic. As a result, comp sales grew 3.4%, driven by a 180 basis point rise in transaction count and a 160 basis point increase in basket size.

Gross margin expanded 10 basis points to 34.2% this quarter. The largest driver of the gross margin improvement related to short-term leverage on occupancy costs, which more than offset increases in product cost inflation and promotional activity. Occupancy costs as a percent of sales declined about 30 basis points, while inflation and promotional activity accounted for about 30 basis points of gross margin pressure. Finally, we realized about 10 basis points of expense leverage on supplies and other buying costs.

In Q2, selling, general and administrative expenses as a percentage of sales improved 40 basis points from last year to 23.3%. The improvement was primarily attributable to transactions and legal expenses that occurred in the prior year.

As Craig mentioned, our new stores, which are excluded from the concept, have productivity of 79% this quarter. This metric shifts from quarter to quarter and is particularly sensitive to changes in the composition of our new store class and is both sensitive to historic growth into the new store group, as well as from new store group into the concept. In Q2, 23 stores were included in the new store group, and they spanned multiple geographies. Overall, we remain comfortable with the new store productivity and expect it will move back to our target range of 80% to 90% by the end of fiscal 2013.

I know much attention has been paid to this metric in the past, and I'd like to put this measure in context with our long-term financial objectives. Our long-term objectives are to drive 15% unit growth and increase store comp sales by 3% to 5%. This, coupled with modest expense leverage, should allow us to drive meaningful earnings growth. Each quarter, we report out on company-wide ROIC, or return on invested capital, which was 25.1% in Q2. We believe this metric serves as the best barometer for the health of our store network and allows investors to compare our new business to other industry participants. Internally, a portion of management's annual compensation is tied to ROIC, and we are focused on achieving specific ROIC threshold. As we make investments in new stores in various markets, we will work to balance these investments such that returns are stable.

In the recent balance sheet and cash flow statement, this quarter the company generated $23.7 million in cash flow from operations and invested $34.4 million in capital expenditures, approximately 94% or $32.5 million of these capital expenditures related to new and remodeled stores. The company's cash balance as of July 28, 2013, was approximately $16 million. And total outstanding balance on the company's revolving credit facility decreased 29.8% or $12.5 million to $29.5 million from $42 million at January 27, 2013.

Now turning to the outlook. To better help you think about our growth and more accurately model our performance for the balance of the year, I want to provide a bit more detail on how we are thinking about new stores and comp stores performing, gross margin trends and costs related to new store openings. Our confidence in competing successfully in new markets has increased, while projecting individual store performance in new markets is always difficult. While some of our stores have opened at the lower end of our expectations, their performance relative to their opening level has been better than what we have historically experienced. Implications are that sales from some of our new vintage of stores are lighter than we had forecasted at the beginning of the year. However, based on early indications, these stores remained well positioned to narrow this gap as they cycle their first year of operation.

Comp store performance improved during the first half of the year, and we expect to see comp sales accelerate slightly in the back half of the year as comparisons get more favorable. We expect recent gross margin trends to continue as higher wholesale costs persist and we maintain our recent cadence of promotions.

As Craig noted, we expect to open 21 to 22 new stores this year. And as we look into fiscal 2014, our plan now calls for more openings earlier in the first quarter than we had originally projected. These incremental stores will drive approximately $600,000 to $700,000 in additional store-related expenses in the back half of fiscal 2013. The majority of this is timing-related.

We plan to open 10 to 11 stores in the third quarter and another 4 stores in the fourth quarter. These activities will add to occupancy costs, which will run approximately $7 million to $8 million higher in the second half of fiscal 2013 compared to the same period a year earlier. Associated with their acceleration of openings, we will incur an incremental $1.5 million to $2 million of preopening costs in the second half of the year with $800,000 to $1.2 million of that coming in Q3. Recent store expenses serve as a headwind to earnings over the next 6 months and position us well for unit expansion and earnings growth in fiscal 2014.

Before I close, I have a few other housekeeping items to consider as you think about our second half performance. First, as noted in our press release, our Houston stores will now be accounted for as capital leases, not operating leases. This treatment will affect the geography of expenses on the P&L in 2013 but will not have a meaningful impact on EPS. For 2013, we expect that these capital lease obligations will result in a $3.7 million reduction in rent expense, a $1.1 million increase in depreciation and a $2.5 million increase in interest expense. Second, our store renovation plans affirm we will now expect to complete 3 renovations this year. Taking into consideration these renovations and projected spending for our new stores, we are trimming our outlook for capital spending to $120 million to $140 million.

Lastly, I want to remind you of 2 items that we will cycle in the fourth quarter. One is a reduction that impacted our tax rate in Q4 of last year, which will not recur this year. The other relates to insurance reimbursements for Hurricane Isaac and other storms, which totaled approximately $900,000 of expense in Q4 of last year. In light of these items, we have adjusted our EPS range for the full year and now expect earnings per share in the range of $1.50 to $1.55. I hope this outlook is helpful in allowing you to better model and track our progress.

With that, I would now like to open the call to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from Charles Grom from Sterne Agee.

Renato Basanta - Sterne Agee & Leach Inc., Research Division

This is actually Renato Basanta on the line for Chuck. Thanks for taking my questions. First on the comps, 2Q came in at about the midpoint of your prior full year guidance range, and you raised the low end of your comp view by 50 basis points. I understand that you have easier comparisons in the second half, but is there anything else that kind of caused you to be more optimistic about full year sales? And I guess, related to that, can you just talk a little bit about the cadence of same-store sales throughout the quarter?

Craig Carlock

Sure, this is Craig. For the second quarter, I would say the cadence was pretty even, nothing remarkable in any of the 3 months. And for the year, I'd say we feel real good about the things that we have visibility into. We're excited about our holiday plans. We're excited about our promotion schedule. I'm excited about the store managers we'll have in place as we go through the second half of the year. So we feel real good about those things. So we are cautious a little bit based on the things we see and observe in the macro economy.

Renato Basanta - Sterne Agee & Leach Inc., Research Division

Okay. And then just a question on inventories. You had a 5.5% increase in 1Q on a per-store basis, but on our math it looks like that number is closer to 8% in 2Q. I know you're investing in health and beauty, perhaps grocery expansions and maybe private label, and I know you had talked about previously running 2% cost inflation. But is there anything incremental there to explain the acceleration from 1Q to 2Q?

Craig Carlock

No, nothing to be alarmed about. We're continuing to invest in new products. Some of the grocery products you mentioned, they raised our inventory levels a little bit, but there's no change in the pattern, really.

Operator

The next question comes from Mark Miller from William Blair.

Mark R. Miller - William Blair & Company L.L.C., Research Division

To Craig and Jeff, I'm hoping you can reconcile the 2 pieces, the higher sales, both comps and improved new store productivity, and then also the lower EPS, you kind of touched on this, Jeff. But how much of this is maybe some pressure on gross margin, it sounds like? And how much of it is the nonoperating aspects of timing of store openings, preopenings, et cetera?

Craig Carlock

Yes, this is Craig. So a few points on the guidance. We now think we'll finish at the lower end of the range, and so we wanted to adjust our guidance accordingly, and we want to make 3 points. The first is around sales. Let me just say I have more conviction than ever before about how we'll be successful in California, Texas and our new markets. We know how to identify those stores. We know how to open them, we know how to run them, we know how to staff them. We feel really good. And then once we're interacting with customers in those stores, it's very comfortable for us, it feels like business as usual. Now some of these stores have opened better than the stores we first opened in some of the bigger major metros we've entered in the past. But we've had a few that have opened below our expectations, and we're recognizing that. We're recognizing also and pointing out that those that have opened a little bit lower have had a better trajectory, actually, than some of the stores we've opened in the past. And so that's been a real good thing. But despite that, we don't think we'll make up the gap. So the first point is new store sales have been a little lighter than we thought, though it doesn't change our view on how successful we'll be over time. The second point is we do have cost pressure in key perishable categories, and we look at the cost pressure and the promotions we want to run, and we just think that puts a lid on our margins. I could say it another way and say despite cost pressure and despite a great promotion calendar, we can hold our margins. We just can't really build them. And the third point is related to real estate, and I would say our real estate process is really firing on all cylinders. We're going to be at the high end of the range this year on store openings. Next year looks good in the first quarter, so we're going to have a more balanced schedule, and that's bringing expenses into this year. But we haven't wanted to quantify that one except for the third point, which as I say $600,000 to $700,000 of expenses are being pulled forward. But that's a timing thing. We're pulling forward positive MPV projects, so we feel good about that.

Mark R. Miller - William Blair & Company L.L.C., Research Division

All right, Craig. That's helpful. Maybe you can just expand on the one point there for the stores in Texas and California. You said you need to earn the customer loyalty. I mean, can you, I guess, highlight any specific initiatives you have there to try to build awareness and to increase that loyalty?

Craig Carlock

Well, the initiatives that we undertake to build loyalty and awareness, frankly, is the same one we have used for years and years and years. And that is, we really need to run good stores. We need to source great product, have great managers and have people come in and have a great experience. So that's our bread-and-butter plan is that if somebody comes in and they say, wow, that food was good, that service was good. And they want to come back or they want to tell somebody. Now we recognize there's some unique features about these 2 markets. In Houston, we were able to have more advertising, frankly, and more events, because of the timing of the stores was bunched together. So we opened 4 stores fairly close together, and so that was a good thing and enabled us to be out in the community quite a bit more than usual. So that will be something new and different. And we're considering a couple of things in California that are more event-related than advertising-related, where we can get into the communities more and build awareness with people in bringing groups into the store. So that's the path -- those are the paths we're going down.

Operator

The next question comes from Stephen Grambling from Goldman Sachs.

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

I guess, you did mention the inflation pressures. Can you just remind us in terms of your guidance what you're thinking about inflation for the back half of the year?

Craig Carlock

Well, we're seeing cost pressure north of 2%, let's say, 2% to 3% on average across our product categories. And as I mentioned, we -- as the category of our category's decision, but in general, we don't think we can pass all of that along. And so that's how we're seeing the landscape.

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

And then, I guess, a follow-up in terms of the new store productivity. As we look at the new stores and some of the disappointment on the top line, and what about the return on invested capital of those stores? Has there been any kind of change there?

Jeffrey C. Ackerman

This is Jeff. What we've -- in the press release, you will see that we did report return on invested capital, and as we mentioned earlier it was 25.1%. And we're comparing to an exceptionally high year even for our leading industry standards, but there's a couple of things that are impacting that, that I'll talk about. One is that our asset base expanded a little bit disproportionately for a couple of reasons. One is that the addition of the Houston capital leases, and the second is that we added some ground leases. So those 2 expanded our asset base. Another item affecting really the returns is really the average age of our stores. And as we accelerate the new store openings, we're seeing the average store age decline, and younger stores have a higher asset base, have less mature sales, have a little bit lower ROIC. But as we said in our prepared comments, as we make investments in new stores in various markets, we're going to be able to balance those off and ensure some stable returns.

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. One last one, if I can squeeze it in there would just be -- and I realized it's still early, but given the incremental cost pressures that you're facing this year, as we look out further, should we be assuming that you're getting outsized benefit going forward? Or as these normalize, maybe this year's a year that's actually a little bit lower than average, but you could have some of that be recouped next year.

Craig Carlock

If you're talking about the new store costs that I mentioned we're pulling in, that's $1 for $1 tradeoff between this year and next year. But we do think it sets us up for some tailwinds, let's call it, for next year.

Operator

The next question comes from Jason DeRise from UBS.

Jason DeRise - UBS Investment Bank, Research Division

It's going to be another one on new store productivity. So could you maybe call out in a little bit more detail which of the new stores or regions have been disappointing? Because I kind of -- I feel like I kind of heard mixed things about what you just said about California and Texas, so I just wanted to make sure I understood. Are those stores the ones that are coming in below expectations, or is it somewhere else?

Craig Carlock

I don't want to go store by store. We're acknowledging that some have been a little lower than we expected, and so that's why the calculation works out to the 79 for the quarter. We have 23 stores in that set, representing, I think, 17 different states and 5 of those states are new states for us. So there's 23 stores, 17 states, 5 -- and so it's a mixture of stores. I wouldn't want you to draw specific conclusions about any one market. I would also point out that this calculation is volatile, and we don't intend to provide current quarter updates on many things. But I can tell you for August, that calculation returned to 85. We're very comfortable that will be between 80% and 90% as we finish the year.

Jason DeRise - UBS Investment Bank, Research Division

Okay. And then, I guess, I wanted to understand the acceleration in the plan for the store openings. I guess, what led to that? Is it just that construction is going fast or you're able to get locations quicker? And is there any regional impact from that?

Craig Carlock

I wouldn't characterize it as a regional impact, but we started the year thinking we could do 19 to 22. Our negotiations have gone well, our construction has gone well. We feel comfortable with the right people, with the right training. So we're ready to go to 21 to 22 for this year. And then as far as next year, we're not thinking that we'll do any more than, say, the ballpark 15% growth, but we're thinking it will be more balanced which puts a few more in the first quarter than we had the last time we provided a forecast. And putting -- opening stores next year in the fourth -- first quarter brings some expenses into this year, the dead rent and the preopening.

Operator

The next question comes from Andrew Wolf from BB&T Capital Markets.

Andrew P. Wolf - BB&T Capital Markets, Research Division

In Houston, I assume you must have experienced kind of a normal attrition that happens when you change the name. And there's a certain amount of people just attached to the old name, independent of anything else. So I assume that happened, and that must have been planned. But the way you're talking about Houston, it sounds like there was some variability there. So was maybe some of that greater than you expected and now with the number going up, you've come up with ways to get some of those folks back? Or was there just greater variability among the 4 stores? And I'm asking, I'm really digging into this one because it's the first sort of acquisition you did, and I would assume -- or I would think it may not be the last.

Craig Carlock

Well, I think -- let's talk about this one. I would characterize it as a 4-store real estate deal. And I wouldn't characterize it as an acquisition. I mean, truly we took and became tenants. And the family that owned rights became landlords, but we didn't take trademarks, people, fixtures, inventory. So we went in there, gutted the stores, built Fresh Market, hired new people and opened our stores. So it's really a 4-store real estate deal. And it was exciting because we were going to get 4 stores in a really great trade area and opened them almost simultaneously, which was great. Again, as we look -- if we compare our forecast now to our forecast that we delivered 90 days ago, we're seeing lighter new store sales. And so -- but I'm not wanting to say that, that's indicative of any kind of forward performing stores or indicative of full returns, but I want to say there's less earnings associated with some of these openings than we saw 90 days ago.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Okay. So I mean, they were running at some point as stores with another banner. But you don't -- so you don't think there's much to my assertion that maybe certain amount of people leave the stores when you change the name even if it's a better store, or different store?

Craig Carlock

I'd say you're correct. Whether we take over a specialty store, which we've done in some cases, we've taken over conventional stores in some cases, by the time that store is closed for months, those shoppers, they have a chance to find other places to shop, and we start -- we feel like we start from ground zero and have to earn our way for sure. So I'll buy into your assertion. I just didn't want to characterize it as an acquisition.

Andrew P. Wolf - BB&T Capital Markets, Research Division

All right. And just on pricing, not really relative pricing, just out there, so there's some inflation. And from what I can tell from pricing studies I do, doesn't look like there's been, a least from Fresh Market, in limited markets. I don't know all your geography, I can't price it all. But you're really, at least -- you haven't passed through price that much in the face of rising inflation, which is what you're saying. And it kind of looks the same from the competitors, so is that kind of what you're seeing out there just a little bit of inflation on the product cost side, but most everybody is kind of sitting on their hands and pricing, hoping the next guy will bring up prices before they do because of the way consumers kind of looks a little soft?

Craig Carlock

I think you -- how you view consumers, as well as the fact that a lot of these categories, especially the perishable ones, you have high absolute costs and prices already. So in categories where prices and costs are a little lower, you can pass it on. But in higher volume categories and the proteins where we are, we don't think it's smart, frankly, to pass it on and risk losing trips, or not to pass all of it on and risk losing trips.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Okay. And just the last question, when you referenced mix shift going against gross margin due to promoting more value items, so I just want -- is that because of your sense or your merchandiser's sense of where the consumer's at? Or is that because the consumer has come in the store and sort of either the basket is different or either just cherry-picking those items, or they're just buying more stuff on special than you would have anticipated? Or what is causing that mix shift?

Craig Carlock

What we're just trying to acknowledge is these promotions did a great job building traffic. We had our best traffic quarter in a while. And we're trying to acknowledge that some of the items we promoted had lower average unit retails. And so we didn't get the basket size growth we might have otherwise seen.

Andrew P. Wolf - BB&T Capital Markets, Research Division

That was a plan to raise -- okay, that was in the plan and you just wanted to call it out that way.

Craig Carlock

Yes. We're just trying to give a faithful view of how our comp trends were through the quarter both on number of people coming into the store and what they're putting in their baskets.

Operator

The next question comes from Kate Wendt from Wells Fargo.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Just one more on the new store performance. I'm wondering if it leads you to rethink, at all, the types of markets that you're looking at or perhaps in addition to building brand awareness, maybe there are changes that you could make to the existing stores to allow them to resonate more in those markets, where there is more prepared foods or more local products or more competitive prices given different competitive sets, or how you're thinking about that, both in terms of new leases you'd be filing and then changes to the existing stores that you've opened?

Craig Carlock

We really come out at the other end of the telescope on this one. I mean, we look at this and say, we are glad to be in Houston, glad to be in California and glad to be in the new markets. Now we've got these stores open, and we say with great conviction that we're going to be successful. And so that's how we come out of it. The sales being a little under our forecast is different than saying -- just because we're a little under our forecast doesn't mean they weren't better than our entry in a lot of our other markets where we have been very successful. And so we are still aggressively expanding in California and in Texas, as well as still expanding on the East Coast. So we're mindful of things, we always want to do things better, but we're not rethinking our strategy in any way.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Okay, got it. And then in terms of gross margin, it would seem up again this quarter against I think your toughest compare of last year. I understand that you were selling more promotional this quarter. Do you ever think about reinvesting, giving back more of these gross margin opportunities than in pricings or promotions to drive even higher sales and traffic? Or how do you think about the balance between those 2 things?

Craig Carlock

Well, I think you've said the right word. We want to achieve a balance of -- in our comp sale of customer traffic and basket size. And we want to achieve a balance in our sales and merchandise margin performance. And so we do think about the things as you suggested, but we plan our promotions very carefully. We rate our promotions very carefully. And our goal is to achieve long-term profitability and long-term customer growth. And balance is the right word.

Operator

The next question comes from Ben Brownlow from Raymond James.

Benjamin Brownlow - Raymond James & Associates, Inc., Research Division

Just to be clear and not to beat the issue to death on the new store productivity, but relative to your initial expectations, was -- do you see the slight shortfall as more of just a lack of consumer awareness in these new markets or maybe not enough advertising? Or is it more of a merchandising and pricing issue?

Craig Carlock

Ben, it is hard to pinpoint something like that. But I would say we feel like we have picked very good real estate, and there is a sense that we have to earn our customers and we're not as well known. So if I had to pick among the choices you gave, I would say the brand equity would be the one that comes to mind that gets easier to build over time, and that we'll see substantial benefits from over time.

Benjamin Brownlow - Raymond James & Associates, Inc., Research Division

And did you change the advertising -- your advertising stance in August that drove that increase in productivity?

Craig Carlock

We really don't advertise. I mean, we use word of mouth, we use social media a little bit, we use email a little bit. But no, I would again say that, that measure can also like based on what stores are in the measurement and what stores are not.

Benjamin Brownlow - Raymond James & Associates, Inc., Research Division

Because there wasn't anything specific in August you could point to that drove that improvement?

Craig Carlock

No, we didn't turn on a campaign or anything like that. We didn't change our pricing. We didn't add labor. We didn't do anything to drive that statistic up. It's just a function of the stores that opened in July and August and how they did.

Benjamin Brownlow - Raymond James & Associates, Inc., Research Division

Okay. And on the real estate pipeline, I know you don't want to name exact lease locations, but can you give us an idea of how many of the locations are a rough ballpark of the signed leases or include those new states, California and Texas, et cetera?

Craig Carlock

I have the California list in front of me. They're all on the website, though. But this year, we're going to open 2 more in Sacramento, 1 in Santa Barbara and then after this year, we've got deals in Laguna Hills and Yorba Linda that we can disclose.

Operator

The next question comes from Karen Short from Deutsche Bank.

Karen F. Short - BMO Capital Markets U.S.

A couple of questions just on your sales and promotion, that 22% that you gave. Just curious, what would that number be kind of in your newer markets versus your existing? Or could you give some directional comments on that?

Craig Carlock

Well, we run this virtually the same promotions. And so I wouldn't expect a big difference. I don't think I have the statistic right in front of me, but I would be surprised if it was very different. I mean, the similarity among our customers for market to market, state to state is remarkable. They enjoy good food, they enjoy our promotions, they enjoy our service, but we don't see dramatic changes from market to market.

Karen F. Short - BMO Capital Markets U.S.

Okay. And then I guess, maybe the ones that you didn't -- again, back to the new store productivity. The stores that you didn't think opened quite as strongly as you would have expected, so you think you fixed that, and can you -- sorry, can you elaborate on what you think the fix was?

Craig Carlock

No, I would go a different way. I'm not sure I'd say that's a problem. I would just say in any time you're opening 21 or 22 stores in the year, you're going to have some that exceeds your expectations a little bit, and some that fall below your expectations a little bit. There's just uncertainty around new store sales forecasting. But no, we didn't change anything. We didn't fix anything.

Karen F. Short - BMO Capital Markets U.S.

Okay. That's helpful. And then, I guess, just to see, if I'm paraphrasing this properly. So this year, your earnings growth ranges 10% to 14%. I know you called out the items that are coming in higher than expected in this current fiscal year. Is it fair to say this year is kind of an anomaly and then you should revert to your higher teen kind of 20% earnings growth going forward?

Craig Carlock

We haven't guided for any future years, but our thesis is that over time, we ought to have 3% to 5% comps. We ought to be able to get to 15% unit growth. We ought to get some expense leverage, and then we ought to have meaningful growth in earnings. This year is a little better than our own unit growth, but a little worse than our earnings because the timing of these new stores. The second half openings have all of the costs, but not that much of the sales and profit associated with them.

Karen F. Short - BMO Capital Markets U.S.

Okay. That's helpful. And then just last question. I know the weather in the southeast was generally really wet this year or this quarter for you guys. Do you think that played any role in your quarter in any way?

Craig Carlock

I feel like there are times when weather explains the comp trend, but a little more rain in one geography isn't really an explanation for anything particularly good or bad for us.

Operator

The next question comes from Mark Wiltamuth from Jefferies.

Mark Wiltamuth

Craig, thanks for all those comments on the preopening and the rest of the year because it's kind of difficult for the analyst to model. First, now that you've operated these West Coast and Texas stores for a while, how is the distribution and logistics coming in versus your expectations? And is the margin structure on those still viewed as similar to the rest of the chain?

Jeffrey C. Ackerman

Yes, it's coming in the way we planned it. We still use boroughs as our primary distribution points out of Atlanta. We're sourcing locally on the most perishable items just like we thought we would, seafood and chicken, things like that. And some items are actually sourced from Texas or from California. And so those items probably have a little bit lower cost. And then that works to offset some items that might have a little higher cost because of the higher gasoline. We're also actively working backhauls to make sure those trucks pull both directions because that's maybe the most important determiner of the whole thing.

Unknown Analyst

Okay. And on that comment about 22% of the sales coming from promotional items, what does that look like versus year ago? Does that mean you're going to be more promotional for the rest of the year?

Craig Carlock

A year ago was 21, Mark. So we -- the popularity of the items picked up a little bit. We found better price points. It's not a dramatic change. We just want to highlight that it's the reason for some comp growth, and it's the reason why our margin guidance was cautious.

Unknown Analyst

Okay. And on the quarter, we did see interest expense pop up a little bit. Is that the Houston capital leases and also the new ground leases?

Jeffrey C. Ackerman

This is Jeff. It is. As we said, we're looking at about $2.5 million of incremental interest expense in the back half of the year.

Operator

The next question comes from Ken Goldman from JPMorgan.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Craig, I just wanted to confirm, you talked about -- you mentioned at some point the lower end of the guidance range. I assume that was referring to your previous guidance range, not the current one.

Craig Carlock

You're correct.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

And then I'll beat the dead horse again, I'm just maybe asking Karen Short's question a slightly different way. I guess, what have you learned? What's the key takeaway from you if anything, from the new stores opening, I guess, slightly lower than what you might have expected. I'm just thinking about internally what you're maybe doing to sort of benefit from what you're seeing? And I guess, try and make productivity a bit higher off the bat over the next few quarters or maybe the answer is it's just an anomaly and there's nothing you can really do.

Craig Carlock

Well, I think a couple of things. We think the statistic is prone to some ups and downs. We have guided toward 80% to 90%, and we were north of 90%. We said, "Hey, don't get too excited about that." And then this quarter, we're below 80%, and we don't want people to get excited the other way about it. But we do want to be open-minded, and we want to learn. I think the #1 area we want to explore is how we can get more people into the stores in new markets with marketing ideas rather than pricing ideas or gimmicks. And so we're thinking about ways to be more involved in the communities with our store managers or with central people making trips to get more people into the store sooner because once they go, and they a great experience, and they want to come back.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

That's helpful. And then...

Craig Carlock

I'll just point out one more time that while these stores were a little below our forecast, our entry into new markets, I can tell you, is far better than our entry into some of our newer markets in the past. So there's missing in the forecast a little bit and then there's being low in the absolute. Those are 2 distinct things.

Kenneth Goldman - JP Morgan Chase & Co, Research Division

Okay. And then speaking of learning and taking away from experiences, if fourth quarter last year was one of the more difficult quarters in your history. And part of the reason I think you cited for that was kind of consumer fear of higher taxes, fiscal cliff, and so forth. We're kind of heading into another period, maybe not quite as bad, but the average American maybe being a little bit concerned about the debt ceiling and so forth and the way the economy is going. So I guess I'm curious, if we do it in a period like that and the customer gets a little skittish, what lessons did you take away from last time that maybe you could apply? And I know you talked last quarter about, hey, it's hard to prepare for a macroeconomic surprise, but if it's the same surprise, maybe there's some lessons you learned that you can kind of apply to the next time it happens, if it does.

Craig Carlock

Well, I appreciate the point. And that's one of the reasons we're cautious on our comp outlook even as we cycle on favorable numbers. I think the primary thing we learned is with respect to running the stores is we've got -- we'll have to be as careful and conscientious as possible about all of the expenses if, in fact, sales volumes aren't quite what we want them to be. That would be #1 as far as getting dollars to the bottom line. We're being very cautious about store level expenses because there -- it's really hard to put the brakes on, there's a lot of momentum in the fourth quarter. There won't be as much in the third quarter. And so if, in fact, what you describe happens, I'm hoping it's earlier than -- rather than later.

Operator

The next question comes from Sean Naughton from Piper Jaffray.

Sean P. Naughton - Piper Jaffray Companies, Research Division

You talked a little bit about the promotional cadence and inflation, in fact, impacting the merchandise margins. But in the past, you've been benefiting from improvements in shrink and also some improvements in volume increases based on the renegotiated contract that you had with Burris. Are most of those benefits gone now? Or are there any additional things you can still do with shrink at this point in time?

Craig Carlock

2 things. So we have cycled through some nice contract improvements that we saw with Burris and with our specialty grocery distributor. So what you say is true that we sort of enjoyed those benefits from a P&L point of view for a year, and then there were -- they tend to flatten out from there. We saw about 10 basis points of improvement in our shrink. We continue to look for ways to reduce shrink, so there are certainly things we can do. We did benefit from it this quarter, and I would say all of our apartments are keenly focused on that.

Sean P. Naughton - Piper Jaffray Companies, Research Division

Okay. And then just secondly, on the merchandise in the store, we talked about adding some additional categories. This has been a little bit of a test. I know it's in a number of stores with the expanded assortment. Maybe could you talk about the performance of those, how you're getting the attached rate in the basket to the customer that was already coming in there? And is this something we can be expecting to be rolled out across the chain over time?

Craig Carlock

We think that our customers appreciate health and beauty product offering. Most of our competitors already have one, frankly, and so we intend to expand our health and beauty offering where the stores are big enough to accommodate it and where the opportunity cost of putting it in isn't too great. So we want to put it in, we're expanding it, but it's not going to be a huge source of margin or earnings pressure or earnings growth. I mean it's just -- there's not that much sales there for us. There are other retailers, I know it's upwards of 10% of their sales. That's not what we're set up to experience. We don't have the labor, we don't know the number of SKUs, we don't have the square footage to get that kind of sales improvement from it.

Operator

The next question comes from Phil Terpolilli from Longbow Research.

Philip Terpolilli - Longbow Research LLC

Just want to go back to cost inflation one last time, the decision to not fully cover higher cost. Sounds like you're still expecting approximately 2% cost inflation overall for the year. And I think that's what we talked about before. So it's really a function of maybe the competitive environment. Maybe that you're just nervous about taking pricing in certain categories like me to think it's too risky. I'm just trying to understand what's changed here because it seems like the cost inflation hasn't really changed in the last quarter or 2.

Craig Carlock

Well, I think you said it correctly that when you see inflation in categories where prices are already somewhat high or there's higher average unit retail, you need to be more careful. So inflation in seafood or meat is different than inflation in dairy. So inflation on salmon is different than inflation on a gallon of milk. That's just from -- you made the same percentage, but you're talking about a lot more dollars, and so we're more careful. And the second point is you're correct that the competitive environment, especially among specialty, grocery retailers as such the price is a focal point, and we're very mindful of what our competitors are doing.

Operator

The next question comes from Scott Mushkin from Wolfe Research.

Scott Andrew Mushkin - Wolfe Research, LLC

I just wanted to go back and make sure I understand the root cause of the lower guidance, if I could. But it sounds like I want to paraphrase it, lower new store sales, higher occupancy cost year-over-year, more price investments or less pass-through of inflation, and the pull forward of expenses. Is that really the root cause here of the reduction of the guidance?

Craig Carlock

I think that's a fair summary. But I would just add to that, I want to make sure that you hear our conviction about the success we're having in new markets.

Scott Andrew Mushkin - Wolfe Research, LLC

Okay. That's perfect. Then the second thing is, Craig, I think you said something -- I'm not sure I caught it right -- that you hope the sales slowdown would happen if more of the economy got bad, later, or sooner, that -- there's something with the store expenses between the third and fourth quarter. I just wanted to clarify that.

Craig Carlock

Well, I think the question that came to me was a, what did you learn or what did you observe about changes in consumer sentiment that you think you experienced last year in the fourth quarter. And I just said if we're going to experience another change in consumer sentiment, I'd rather it come sooner and not around the holidays and not around our big volume times than later.

Scott Andrew Mushkin - Wolfe Research, LLC

Got it. Okay, that's a great clarification. The third clarification, sorry to do this kind of trying to understand some things. But there was a comment about the CapEx being down because of the remodels, but you're also speeding up the stores like, I guess, I'm a little confused on why we're dropping CapEx, yet we're speeding up our stores and trying to square that one for me.

Craig Carlock

Well, you're correct that directionally one's a help and one's a hurt. But when you net it together, it's a reduction in CapEx.

Scott Andrew Mushkin - Wolfe Research, LLC

Okay, that's good. And then as I take these things off, as we look at the higher expense levels -- a little bit higher rent and the store expansion plans, I mean, is that -- how much of this is onetime and how much is as we look at next year, we're going to still see some really fairly robust growth in some of these expense items as we ramp up store growth?

Craig Carlock

We think that what we're experiencing this year, late year openings juxtapose next year to earlier openings, sets us up for a real good year next year. But we really don't want to provide specific guidance for next year until we get to a point in time where we can take you A to Z through the whole thing. But our view is some of that headaches we're having this year from a profitability point of view will be very helpful to profitability next year.

Scott Andrew Mushkin - Wolfe Research, LLC

And is it -- am I assuming this is the second or third or fourth quarter next year because it sounds like the first quarter, you're going to have some meaningfully more younger stores and whatnot. Is that the way to look at it? It's really going to be a back half of next year event when that happens?

Craig Carlock

I don't know that I'd think about it like that. We really don't want to go quarter-to-quarter. But we're going to open 15 stores in the next 6 months, but it will all be open day one of the first quarter of next year so...

Scott Andrew Mushkin - Wolfe Research, LLC

Okay. And then my final one is, with the comp rates in the 3-ish percent and a lot of new stores flowing in. I always get the question, are there older stores that are 5 years plus? Are they actually comping positive?

Craig Carlock

Affirmatively, yes. But it is true the newer stores comp better, but we look at the age of our stores on a comp trend, and I can affirm they're positive.

Operator

The next question comes from Robert Ohmes from Bank of America Merrill Lynch.

Robert F. Ohmes - BofA Merrill Lynch, Research Division

I don't want to keep honing on this new store productivity thing, but I was hoping you could reach into your history and maybe remind us of any examples going back where you went into new markets. And maybe for the first 3 months or whatever, the store productivity might have been less than what you were expecting and maybe let us know what happened after that. Did those stores generally get in line with chain averages in terms of bottom line and -- or did they comp -- did they have a different comp curve over the following few years? Any sort of anecdotal picture you could paint for us would be great.

Craig Carlock

The anecdotal picture would be we certainly have had stores opened with a range of opening sales levels. And our pattern as the stores that opened, call it middle to lower end, tend to start lower but comp better. Stores that open at the higher end tend to start higher and comp lower. What we're trying to point out with the Houston and Texas stores is some of them opened lower but they are -- well, they're not comp store comping, they are exhibiting better sales than you would have thought, looking at the first couple of weeks or first couple of months of sales depending on which store you're talking about. So their trajectory has been better, and we've got different views on why that might be, but we're still thinking through why that might be.

Thank you very much for participating in the call today. We look forward to speaking with everyone in November on our third quarter earnings call. Have a good evening.

Operator

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.

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