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Vitamin Shoppe (NYSE:VSI)

Q3 2013 Earnings Call

November 05, 2013 8:30 am ET

Executives

Daniel Lamadrid - Chief Accounting Officer, Vice President and Controller

Anthony N. Truesdale - Chief Executive Officer and Director

Richard Tannenbaum - Senior Vice President of Supply Chain Management

Brenda M. Galgano - Chief Financial Officer and Executive Vice President

Analysts

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

Simeon Gutman - Crédit Suisse AG, Research Division

Sean P. Naughton - Piper Jaffray Companies, Research Division

Stephen V. Tanal - Goldman Sachs Group Inc., Research Division

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

Karen F. Short - Deutsche Bank AG, Research Division

John Zolidis - The Buckingham Research Group Incorporated

David A. Schick - Stifel, Nicolaus & Co., Inc., Research Division

Denise Chai - BofA Merrill Lynch, Research Division

Justin E. Kleber - Robert W. Baird & Co. Incorporated, Research Division

Jack Mohr

Damian Witkowski - Gabelli & Company, Inc.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Operator

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to The Vitamin Shoppe Third Quarter 2013 Earnings Results Call. [Operator Instructions] I would now like to remind everyone that this conference is being recorded, and I'd now like to turn the call over to Dan Lamadrid. Please go ahead.

Daniel Lamadrid

Thank you, and good morning, everyone. Early this morning, we released financial results for third quarter 2013. A copy of our earnings release and a recording of this call will be available on our website at vitaminshoppe.com in the Investor Relations section. Making presentations today will be Tony Truesdale, Chief Executive Officer; Brenda Galgano, Chief Financial Officer; and Rich Tannenbaum, Senior Vice President of Supply Chain.

Before we begin, I need to remind listeners that remarks made by management during the course of this call may contain forward-looking statements about the company's results and plans. These are subject to risks and uncertainties that could cause the actual results and implementation of the company's plans to vary materially.

The words believe, expect, plan, intend, estimate or anticipate and similar expressions, as well as future or conditional verbs, such as should, would and could, identify forward-looking statements. You should not place undue reliance on these forward-looking statements. And we expressly do not undertake any duty to update forward-looking statements, whether as a result of new information, future events or otherwise, unless required to do so by law.

We refer all of you to our filings with the Securities and Exchange Commission, including our annual report on Form 10-K, as well as our quarterly reports on Form 10-Q, for a more detailed discussion of the risks and uncertainties that may have a direct bearing on our operating results, our performance and our financial condition.

I will now turn over the call to Tony.

Anthony N. Truesdale

Thank you, Dan, and good morning, everyone. Thank you for joining us. During the quarter, total revenues increased 14%. This was driven by a double-digit growth in e-commerce sales, comparable store sales growth of 2.6%, the contribution from Super Supplements, as well as sales from new stores. Margins delevered slightly, primarily due to product mix shifts and channel mix shifts within the business. Brenda will discuss this in more detail during her presentation. EPS was $0.53 in the quarter. There were several key accomplishments in the quarter, notably, the opening of the new Ashland, Virginia DC and the ongoing successful integration of Super Supplements.

Now let me spend some time talking about the quarter. Comps of 2.6% were in line with our expectations and represented the 32nd consecutive quarter of positive comp sales growth. We faced headwinds this year as we lapped last year's strong performance in sports nutrition, accelerated weight management growth and retail inflation, which peaked in the third quarter of 2012. During the quarter, we saw our improving traffic trends. Our in-store execution of the September Bogo was much better than the in-store execution for the April Bogo.

Private label is an important growth opportunity for us, and we continue to improve our product development and speed to market with new products. For example, one of the MyTrition SKUs, which we introduced in the first quarter, is now one of the top-selling products for the company. Given the success we have had with recent private label products, we are also planning a number of new product introductions by year end.

I'll touch on 2 key launches today. The first is the probiotic product line being marketed under PROBIOCARE label. We are launching 2 formulations which target 2 growth trends in probiotics, higher-potency formulas and increasing demand by women. These products are allergen-free and manufactured to be shelf-stable. Both will be positioned as premium products in our probiotic range.

We also see an opportunity in herbs and botanical category for the company. As a result of customer feedback, we've created a line of herbs that include key attributes that our herb and botanical customers identified as most important to them. These will be premium-priced herbal supplements made with all-natural ingredients, which will be marketed under the plant label.

And lastly, on the private label front, we have been phasing in new labeling on The Vitamin Shoppe- and BodyTech-branded products. The new design is more indicative of who we are and what we're all about. By the end of next year, the complete line of The Vitamin Shoppe- and BodyTech-branded products will have these new labels.

Now on to the stores. We opened 10 stores during the quarter and 33 year-to-date. The majority of the third quarter new stores opened in September. Total store count at the end of the quarter, which includes 31 Super Supplements stores and our 2 Canadian stores, was 640. We are on track to open 50 stores this year. The majority of the fourth quarter openings will occur in the last 6 weeks of the year.

Our e-commerce business continues to drive significant growth for us. With the investments we made over the last 2 years, our website is more intuitive and easier to shop. Reflecting these improved experiences, online sales continue to increase at a double-digit rate. During the quarter, e-commerce sales increased 18% over the prior year. And looking ahead, we expect our e-commerce sales to continue to grow faster than our retail sales. We will continue to invest in this channel through growth in product categories, marketing spend, customer service enhancements and additional functionality to drive continued strong performance.

Let me give you an idea of some of the e-commerce and omni-channel investments we're planning to make over the coming year. Our omni-channel initiative is an important focus for the company, one which will enable us to further improve service to our customers. This is a multiyear project. Phase one includes the ability for customers to buy online and pick up in the store. We expect to have this service available by the end of next year. This will be followed with the several additional enhancements as we invest in our omni-channel capabilities over the next several years. All this is designed so that customers can shop however, wherever and whenever they want, and this will set us further apart from pure play e-commerce companies.

We have over 5.6 million active Healthy Awards members in the database. You've heard me speak many times about the amount of information we gather on our customers' shopping patterns and how we've been able to significantly improve our targeted marketing. As good as we've gotten, I believe there is more opportunity. And over the coming year, we will be refining our program and investing in analytics to drive incremental customer insights.

Moving on to the new DC. In September, we commenced shipping of products to the stores from our new 311,000 square-foot distribution facility in Ashland, Virginia. Opening a new DC is a significant undertaking for any company, and I'm very pleased with how the team has successfully executed on them -- this major project, on time and on budget with no disruptions to the business. Rich will talk more about this in his presentation.

So in summary, our business model is solid and our strategies are on target. We are well positioned to increase market share based on our unique combination of broad product selection, knowledgeable health enthusiasts and our total value proposition. With many exciting growth opportunities ahead of us, we will continue to make the investments required to support long-term growth.

I'll now turn the call over to Rich to provide an update on the new DC. Rich?

Richard Tannenbaum

Thank you, Tony, and good morning, everyone. It's a pleasure to participate on this call.

Opening a new distribution center has been a major and exciting undertaking for the company over the past year. And as you just heard Tony say, we are very pleased with the progress we made. We constructed a 311,000 square-foot DC in Ashland, Virginia, which is now operational.

Outbound shipments to the stores began in September. As planned, we started slowly with shipments to 14 stores and have added more stores each week. The new DC is presently shipping to all our Texas, Oklahoma, New Mexico and Louisiana stores: 56 stores in total.

When compared with our DC in North Bergen, New Jersey, there are many new features we added to Virginia to help improve productivity and efficiency. We are happy with the accuracy, speed and service levels coming out of the new DC. Each day, we are checking order accuracy, and auditing the shipments made to stores. We are very pleased with the accuracy levels being achieved at this early stage.

The introduction of the new DC has been seamless to customers. In-stock levels for stores serviced by Virginia remained strong before and after opening the DC. As a result of this good performance, we will begin servicing stores in Florida during the fourth quarter, ending the year with about 120 stores serviced from the Virginia DC.

In anticipation of opening the DC, we added additional safety stock inventory into the supply chain to mitigate any risks or service disruptions related to this large, complex project. Based on the good results, we have begun to release this extra inventory. It will take several months to sell-through this inventory, and we expect a reduction in inventory of approximately $10 million by year end.

In conclusion, we have successfully executed through the most difficult portion of opening a new DC. We have a great team in place that made this happen, and I would like to thank each of them for all the hard work.

With that, I will now turn the call over to Brenda to discuss our financial results and outlook.

Brenda M. Galgano

Thank you, Rich, and good morning, everyone. Thanks for joining us. I will first discuss our third quarter results, and then I'll walk you through our expectations for the fourth quarter and provide our initial outlook for 2014.

During the quarter, we reported total sales growth of 14% with comparable retail store sales growth of 2.6%. Retail revenue increased 13.9% to $244 million with the 31 Super Supplements stores contributing about $17 million. E-commerce continues to drive significant growth, increasing 17.7%, with Super Supplements contributing 6 percentage points to this growth.

The 2.6% comp in the quarter was up against a strong 9.6% comp in the same quarter of the prior year. Last year, as you know, we benefited from above-average inflation and accelerated weight management sales growth. Retail inflation was slightly above 3% in the third quarter of 2012, while this year, we experienced slight deflation in the quarter. And the third quarter of 2012 also had 100-basis-point benefit from a Bogo promotion calendar shift. Even facing these headwinds, our mature stores comped slightly positive in the third quarter of 2013.

Moving down the P&L. Reported third quarter gross profit as a percentage of sales was 34.2% compared to 34.5% in the same quarter of the prior year. This reflects faster growth in lower-margin product categories and higher growth in e-commerce sales.

As you heard from both Tony and Rich, the Ashland DC is now operational and shipping to stores. The higher costs of the new DC are recognized in the P&L as the inventory is sold through. With higher inventories at the end of the third quarter, these costs were not yet recognized, and our overall warehouse and transportation costs were flat as a rate of sales year-over-year. As Rich explained, we plan to reduce inventory levels in the fourth quarter. As a result, we expect to incur higher warehouse costs in the fourth quarter with deleveraging of approximately 70 basis points.

After taking into account the decline in gross margin from category and channel sales mix, deleverage from the new DC and lower Super Supplements margin, we expect that the fourth quarter gross margin rate could be slightly more than 100 basis points lower than last year. Looking at the gross margin as we move into 2014, we expect a first year half -- first half year delevering impact associated with the DC and improvement later in the year as we cycle this year's costs. We expect to experience some leverage on occupancy, which will be primarily offset by both product category mix and channel mix shift, as previously discussed. Overall, we expect the gross margin rate to be essentially flat with the 2013 levels.

SG&A for the quarter was $67 million compared to $58 million in the prior year. The third quarter '13 costs include integration cost of approximately $900,000 related to the Super Supplements acquisition. Excluding integration cost, SG&A as a percentage of sales was 24.3% compared to 24.2% in the same period of the prior year. Aside from the integration cost, the impact to the SG&A rate from Super Supplements with its higher operating cost was approximately 25 basis points in the quarter. This increase was partially offset by leverage in other areas.

Staying on the SG&A topic, let me touch upon next year. As you just heard Tony mention, we plan to make investments as we continue to focus on long-term growth opportunities. For 2014, we are estimating international expenses of approximately $2 million, which includes items such as legal product registration and startup costs for potential new markets and ongoing investments in Canada. We are also investing in customer analytics and in order management system to support our omni-channel initiative, which Tony mentioned. Offsetting these investments will be synergies achieved from Super Supplements and leverage from an expected mid single-digit comp. Overall, on a net basis, we do expect to achieve slight operating leverage for 2014.

Separately, as we've previously discussed, with respect to the integration cost for Super Supplements, there is potential for approximately $3.5 million in additional cost in 2014.

Moving down the P&L. The tax rate was lower than our normalized run rate, which primarily reflects the reversal of charges previously recorded related to uncertain tax position due to the expiration of applicable statutes of limitation. Going forward, we continue to expect a normalized tax rate of approximately 40%.

Reported EPS was $0.53 in the third quarter of '13 compared with $0.54 in the third quarter of '12. This quarter includes $0.02 per share of integration costs related to the Super Supplements acquisition. Results also benefited from a lower effective tax rate in both the third quarter of '13 and the third quarter of '12 up $0.02 and $0.05 per share, respectively. After making these adjustments, EPS was $0.53 in the third quarter of '13 compared to $0.49 in the third quarter of '12.

Moving on to cash flow. We generated $8.3 million of operating cash flow in the quarter. CapEx totaled $8.5 million in the quarter and primarily represents investments for the new DC, buildout of new stores and improvements to existing stores.

Turning to the balance sheet. At quarter end, we held $54.2 million in cash and cash equivalents, had no long-term debt and nothing drawn on our revolver. In order to enhance our financial flexibility, we recently amended our credit facility. Our borrowing capacity was increased to a maximum of $150 million from $70 million. And equally important, given our improved financial performance, our borrowing costs were lowered and some bank restrictions and loan covenants were eased. The new facility will provide us with additional flexibility as we make investments to support future growth.

Now for the outlook. Our expectations for 2013 are unchanged, and the key components are outlined in the earnings release. For 2014, we expect mid single-digit comparable store sales growth for the year. We plan to open approximately 50 new stores. Depreciation is expected to be approximately $31 million. We expect slight EBIT margin improvements, and we are planning capital expenditures of approximately $35 million to $40 million. Investments will be focused on building new stores, remodels and the implementation of a new order management system.

In conclusion, the fundamentals of our business are solid and remain focused on controlling costs as we continue to invest in our business to drive long-term growth.

This ends our prepared remarks. We'd be happy to take your questions now. Operator, please open the line to questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll hear first from Mark Miller with William Blair.

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

The deflation you experienced in the quarter, is that due to changes in your product cost, which you're passing through, or is the Company at retail taking a little bit more aggressive pricing stance?

Anthony N. Truesdale

Mark, it's Tony. There's -- a lot of that was a function of product mix shift in certain categories. One of the things that we saw in weight management was we were selling a lot more units of lower-value items year-over-year, so that created some deflation in the category.

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

And then looking ahead, you're forecasting the category mix shift to be adverse. Is it a continuation of that trend, or can you just elaborate why you see the change continuing?

Anthony N. Truesdale

Yes. I mean, one of the things that we continue to see is when we forecast out for 2014, we're looking at different categories and the rate of growth that we're currently experiencing. We're seeing higher growth rates in lower-margin categories and slower growth rates in the higher-margin categories. That's leading to the mix shift, along with what we believe is going to happen to our online business over the next 12 months. So you take the combination of those 2 things and just -- it's pure mix shift. It's not a pricing phenomenon.

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

All right. And, Tony, can you elaborate on what actually is changing with the dotcom offering and the enhancements? I mean, what specifically will the consumer see in it? It sounds like -- are you expecting acceleration from the current dotcom rate or just continuation?

Anthony N. Truesdale

Yes. I think we'll continue to perform well in that business. We introduced PayPal this quarter, which we haven't had for years. We're one of the -- probably the largest websites to not have PayPal. We now have PayPal. We've made some changes to how we handle abandoned carts for people that leave the site. So a lot of subtle things that we've done that we think will improve the business over the next 12 months.

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

Two other quick ones. Brenda, you referenced -- I think you said potential for another $3.5 million of costs with Super Supplements, if I heard that right. Can you clarify what you're referring to?

Brenda M. Galgano

Yes, that's correct. When we first announced the acquisition, we had talked about total integration costs of approximately $70 million -- or, rather, $7 million, about half of that expected to be incurred in '13 and the other half to be incurred in '14. And we did note that most of the '14 cost is primarily related to charges associated with store closures. That is still under review. Just want to note that there is still that potential for that charge.

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

All right. And then a final, can you just give us the square foot -- square footage figures for the third quarter of '13 versus '12, or at least the growth rate? Because I think this creates a computation of lower new store productivity, given the stores have been trending smaller.

Brenda M. Galgano

Yes. We do not provide square footage for the total company. What I can say about square footage is on the stores that we've opened this year are averaging approximately 3,000 square feet. We did close 3 stores this year, which -- our averaged core portfolio has a square footage size of about 3,700. So based on that, you can probably do some pretty high-level math to get to the figures you're looking for.

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

Okay. It would be help if we could get that detail in the future. But I appreciate the responses.

Brenda M. Galgano

Yes. Just another thing to consider as you're modeling that out, as Tony mentioned, we did open the stores this quarter later in the quarter. So that's an important factor as you're looking at the performance of new stores.

Operator

[Operator Instructions] We'll take our next question from Simeon Gutman with Credit Suisse.

Simeon Gutman - Crédit Suisse AG, Research Division

First, I guess, a high-level question on some of the investments. If you compare 2014 to 2013, I think 2013 was coined a more of a investment or transitional year. 2014, it sounds like there a couple of other elements there. But by and large, should it be a slightly lower year from an investment standpoint, or how do the 2 stack up?

Brenda M. Galgano

Yes. So overall, it will be -- I mean, the level of investment will certainly be lower than what we have this year. As I did note, we do expect to have some EBIT margin accretion this year. With these investments, we did not see that. So next year, we'll begin what we believe that improvement in the operating margin over the longer term.

Simeon Gutman - Crédit Suisse AG, Research Division

And then if the EBIT margin expands more next year, besides sales being better, is it -- is there some wiggle room in some of the costs of these projects? Like you said, there might be a little bit of margin pressure earlier in the year from the DC. Could some of those items be a little bit less impactful than you're forecasting? And so besides better sales growth, could the EBIT margin expansion be better because the cost come at -- come a little lower than you think?

Anthony N. Truesdale

Yes. It's a little bit early to talk to -- whether the -- where the costs are going to come in. We've got some high-level estimates on the omni-channel, what's going to cost us to do that, and you're going to cycle through the DC costs for the first half of the year. So the real big thing is you're going to -- you got your fix costs associated with your new DC rollout for the first 6 months of the year. And in the back half of the year, it gets much stronger.

Simeon Gutman - Crédit Suisse AG, Research Division

Okay. And to clarify again, the gross margin component, there's no price impact that's being built into what's happening in margin, it's purely mix in both the channel and the product?

Anthony N. Truesdale

Yes, both of these are mix related.

Operator

We'll take our next question from Sean Naughton with Piper Jaffray.

Sean P. Naughton - Piper Jaffray Companies, Research Division

Tony, you talked a little bit about the private label business. Can you remind us of how big this business is today? And it sounds like it's going to be an increasingly important area of focus for the company. You have a long-term goal in mind for this business and then maybe just what the -- kind of margin structure is between private label and national-branded product?

Anthony N. Truesdale

Yes. We've typically said that we're making investments in product development. We think it's important for the business model long term, but we haven't set any long-term goals for penetration. We typically have been running in the 20% to 22% of sales. But when we do things like add categories, so I talked earlier about adding categories to the web that we don't currently sell, if we did that, that would depress private label penetration. We added aromatherapy and natural bath and beauty and expanded that business last year. That would depress it in totality. So it's tough to look at it in totality, but we are making progress in the categories where we're investing in and building the SKUs. I mean -- and that's why I called out the MyTrition. That's an item that didn't exist and is now in our top-selling SKUs of the company.

Sean P. Naughton - Piper Jaffray Companies, Research Division

And is it fair to say that those are margin accretive to the overall business?

Anthony N. Truesdale

Pardon, I didn't hear it, the question.

Sean P. Naughton - Piper Jaffray Companies, Research Division

Is private label -- is that accretive to the overall gross margin for the business?

Anthony N. Truesdale

Yes, yes, absolutely.

Sean P. Naughton - Piper Jaffray Companies, Research Division

Okay. And then just lastly, on the -- as follow-up here is on the guidance for same-store sales trends for Q4. Pretty wide range of outcomes based on the guidance that you have. Is there any way to give us a little bit more color on where you expect things to come in? Should it be relatively similar to Q3? Or since you saw an improved kind of traffic throughout the quarter, have an easier comparison, should we be thinking about being mid single-digit range area for the comp in Q4?

Anthony N. Truesdale

What I said earlier in the year after the first quarter is I said the second and third quarter would be our toughest quarters, and we'd see improving trends in the fourth quarter.

Operator

Our next question from Matt Fassler from Goldman Sachs.

Stephen V. Tanal - Goldman Sachs Group Inc., Research Division

This is Steve Tanal in for Matt. Just one quick one, like a follow-up on the 4Q comp trends, some of the moving pieces that we're thinking about. In terms of inflation and thinking about last year and where inflation was, how is the compare there and how do you think that inflation unfolding in 4Q? And also, just comment on Sandy and what you think that might do for the comp, if you will.

Brenda M. Galgano

Okay. I'll take that one. In terms of inflation, I think we've said before that the third quarter was the peak of inflation, where it was over a 3% into the -- going into the fourth quarter. It did come down. It was still over 2%, but it wasn't over that 3% rate. And then the impact from Sandy last year, we had estimated, that that had a 1.6% impact on the comp. And so we'll be cycling through that in the fourth quarter.

Stephen V. Tanal - Goldman Sachs Group Inc., Research Division

Got it. That's helpful. And then just on the gross margin line for next year. As you think about Super Supplements, clearly, the chain is running at sort of a lower gross margin than Vitamin Shoppe, is there opportunity there in terms of purchasing scale that perhaps bring that up a bit?

Anthony N. Truesdale

Yes. I think there's some opportunity, but we haven't quantified what the -- what we think the opportunity is.

Brenda M. Galgano

And we factored that in, in the initial guidance that we provided. So when we talk about the product margin being -- that decline being primarily offset by occupancy, we did factor in some improvement for Super Supplements.

Operator

We'll hear next from Kate Wendt from Wells Fargo Securities.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

I wondered if you could talk about what you're seeing from the new stores you've opened recently. I know you talked about changing the mix of kind of marketing with in-store versus outside of store and if that gives you enough confidence to reaccelerate store growth next year from 50 to 60 stores.

Anthony N. Truesdale

Yes. I mean, Kate, I think what I said in the last call was we were really struggling with the landlords, trying to get the stores -- the dates that they have given us or giving us and handing over the stores to us in place. So what we've done is we're trying to add to the pipeline so that we have some buffer along the way on the new storefront. And that's why you've seen, all year long, we've opened late in the quarter, and I just said we're going to do that again in the fourth quarter. So people that have modeled midweek, we typically get about 24 weeks to 25 weeks a year out of each new store for sales, and we're getting about 20 this year, so a significant change. As far as -- we just hired, in the second quarter, a new store marketing individual that's responsible solely for new stores. I think this gentleman is doing a great job for us. We've done some unique and different things, and I think that will continue to go forward. So we feel comfortable we can get 60 stores opened next year.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Okay, great. And then you mentioned refining your loyalty program. Would this be a broader relaunch that would maybe take time to test and then roll-out, or are they more add-on enhancements? And if that's the case, can you give us an example of what you might be thinking of along these lines?

Anthony N. Truesdale

Yes. I think what we would do is test some different things and tap into something. I don't think we'd do anything that would be broad-based and rolled out nationally. We would want to test into some things to make sure they work, but we have some theories about some things that would be accretive to what we're doing today.

Operator

We'll take our next question from Charles Grom with Sterne Agee.

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

Just to follow up on that last question, Tony. With regards to the loyalty cards, is there any thought towards tweaking that program to try to attract the customers that have not shopped with you guys in the past 12 months? Because my understanding is that the loyalty card members are given -- are for customers that have shopped with you in the past year.

Anthony N. Truesdale

Yes. I mean, we -- we're always marketing to those customers that have fallen off, that we call them lapse customers. So when they fall off, we will market to them on a regular basis. So we do that. It's just the real question is are we doing it effectively enough and should we tweak the program.

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

Okay. And then just to follow up on the omni. As you continue to sort of integrate the channels, can you talk about your online pricing strategy versus your in-store pricing strategy and any changes that may need to occur to align those prices across channels?

Anthony N. Truesdale

Yes. I think over time, we've aligned them more. I think we have about 500 items that are priced differently between the 2 channels. We've talked about that publicly. While that -- we also -- we have the Super Supplements website that allows us more flexibility and how we go after the online business from a price perspective versus the Vitamin Shoppe, which is the national business. So I think the benefit that we get from Super Supplements website hasn't been realized yet.

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

Okay. And then congrats on opening up the new DC. Is the goal to eventually close the New Jersey facility and ship everything out of Ashland, or is it to have both DCs up and running over the next couple of years?

Anthony N. Truesdale

As we stand today, the goal wouldn't be to close the facility here. We're going to continue to grow the business. We're going to continue to do distribution study every couple of years to make sure that we're doing the right thing. But as of now, we would -- we believe that with some of the plans we have for growth, we can easily suck up the capacity we have in Virginia.

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

Okay, great. And then just one question for Brenda, just on the 2.6% comp. One, how do the trend to -- can you give us the traffic and ticket components, and then any color on October to date?

Brenda M. Galgano

It was all driven by traffic with respect to the comps. And with respect to October trends, we don't -- typically, do not supply color on the current quarter.

Charles X. Grom - Sterne Agee & Leach Inc., Research Division

okay. And then the sequential trend, it sounded like September was the best month of the period with the Bogo, is that correct?

Brenda M. Galgano

That is correct. That is what Tony said. We saw improving traffic performance throughout the quarter.

Operator

We'll take our next question from Karen Short with Deutsche Bank.

Karen F. Short - Deutsche Bank AG, Research Division

Just a couple of questions, again, on the fourth quarter comps. You gave a gross margin deterioration expectation in the fourth quarter, but that obviously will vary depending on where your comp checks out. So any color there?

Brenda M. Galgano

So the guidance that I provided was based on the low to mid single-digit comp for the year. And I'd also add in what Tony said earlier, which is that we expected the fourth quarter to be improving over the second and third quarter.

Karen F. Short - Deutsche Bank AG, Research Division

Okay. And then can we -- can you just provide an update on what the comp waterfall is looking like on the new units? We haven't talked about that for a while.

Brenda M. Galgano

Sure, yes. So as we look at the pool of stores that have now cycled through their second year and we look at the growth there, we're continuing to see an increase year-over-year in that second year in the high 20s. And historically, I'd say we're closer to the mid-20s. So we're seeing it in the high 20s. And then that second year it's in the mid single digits; third-year, the high single digits; and then going to the mid single digits and then basically entering into the mature store pool beyond that.

Karen F. Short - Deutsche Bank AG, Research Division

Sorry. The third year was what? It went from -- it goes from the high 20s to what?

Brenda M. Galgano

So first year comp or second year open, it's high 20s. And then it goes into the mid-teens and then high single digits and then mid single digits.

Karen F. Short - Deutsche Bank AG, Research Division

Got it, okay. And then I guess -- just to confirm. So next year, for the unit growth, the store size we should be using is 3,000 square feet.

Anthony N. Truesdale

Yes. That's a good size.

Karen F. Short - Deutsche Bank AG, Research Division

Okay. And then just looking at your CapEx spend for next year, it was a little lower than what I was looking for, but obviously, it means that your free cash flow will be better. Any thoughts on your priority...

Brenda M. Galgano

That's correct.

Karen F. Short - Deutsche Bank AG, Research Division

For cash flow?

Brenda M. Galgano

Yes.

Karen F. Short - Deutsche Bank AG, Research Division

Do you have any thoughts on your priorities for free cash flow?

Brenda M. Galgano

I'm sorry. Ask that question again, Karen?

Karen F. Short - Deutsche Bank AG, Research Division

Any thoughts on your priority for free cash flow for next year? Your CapEx guidance came in a little bit lighter than what I was looking for. So your free cash flow is going to be looking a little bit stronger. So any thoughts on your priority?

Brenda M. Galgano

Yes. So of course, our first priority will be continuing to invest in the growth of the business. And as we have said before, we'll continue to have discussions with the board and evaluate at what time is appropriate to either buy back shares or issue a dividend. And we'll continue to consider that as we move forward.

Operator

We'll take our next question from John Zolidis with Buckingham Research.

John Zolidis - The Buckingham Research Group Incorporated

As a follow-up question to that last one, I was wondering if you could discuss your philosophy on acquisitions, maybe give us a little bit more color around what kind of deals you would consider doing and the size of those deals. And then I have a second question which is on your inflation expectation, which is embedded in the 2014 comp guidance.

Anthony N. Truesdale

John, a couple of things -- this is Tony. Typically, we look at opportunities when they come by, but we haven't given any color about specific acquisitions or anything that we would do. It's really based on how we think that opportunity would sit with our current business model and strategy. The second piece is inflation. We typically, historically said run that kind of 1% to 2% range on a yearly basis, and we probably expect in 2014, it'll be at the low end of that expectation.

Operator

We'll take our next question from David Schick with Stifel.

David A. Schick - Stifel, Nicolaus & Co., Inc., Research Division

First question, you've had a healthy mix of different customer types over the years, whether it's the bodybuilders like myself or the -- or maybe the older consumers. Maybe a little early for that joke. So the question is, is there anything changing that you're seeing over time in that mix of the different customer sets? That's my first question.

Anthony N. Truesdale

No. We've actually been pretty consistent when we look back over the last several years. So it's been pretty consistent. I think what I've said in previous calls is that, that low-spender occasional customer is the one in the second and third quarter that we saw not come back. It's often lower price points, lower units per basket type of customer. But our core business has been very strong.

David A. Schick - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then second and last. The online numbers continue to be robust. Is it filtering into your thought process, either on the ultimate number of stores or the characteristics of those stores that you plan to open over the long term, again?

Anthony N. Truesdale

Yes. Nothing has changed at this point. We continue to monitor the migration based on the database of customers to different channels and look at that on a regular basis. And we feel very comfortable that opening 60 stores is the right thing to do next year.

Operator

We'll take our next question from Denise from Bank of America.

Denise Chai - BofA Merrill Lynch, Research Division

Great. I just wanted to go back to your new store openings for next year. I'm wondering how many of the 60 leases are actually secured, where the growth is going to be focused, whether it'll be in new or existing markets and just kind of how do you see the real estate market shaping up compared to how you saw it at the beginning of the year.

Anthony N. Truesdale

Yes, a couple of things. The largest proportion of the stores are in the hopper, so to speak, for next year or so. We've been working hard with that. We hired another real estate professional earlier this year, and so we've had incremental resources working against the sites. So we feel pretty good about where we are there. The stores are positioned across the country. It's about 85% in existing markets, about 15% in new markets, and that's consistent with what we've historically done, probably with a little bit more bias to the East Coast, given we have a new DC there and we're trying to throw volume through that DC.

Denise Chai - BofA Merrill Lynch, Research Division

Great. How many will be in Canada? And also I think you mentioned potential new markets. Can you elaborate on that? And just lastly on the new stores, how many of them will be the 2,500-square-foot stores? And actually, how many do you have of those right now?

Anthony N. Truesdale

Yes. We have 5 existing small market prototypes that we're running right now. We will probably add a couple of those next year. And then we have one store in Canada that was going to open -- it's been pushed to the first quarter of next year.

Denise Chai - BofA Merrill Lynch, Research Division

Okay, great. And if I could just slip in one more. So just going back to your comp guidance for the fourth quarter, I mean,, it's a pretty wide range. I'm just wondering what are the main variables or unknowns that we did -- gave such a wide range of guidance.

Brenda M. Galgano

So, Denise, I think some of the key things we talked about that you should factor in is we talked a little bit about the inflation factor being less of an issue in the fourth quarter, and the other big thing is really cycling of Sandy, which, last year, was 160 basis points. So I think those are probably -- as I think about the fourth quarter and look at changes in trends, those would be 2 of the bigger drivers.

Operator

We'll take our next question from Peter Benedict with Robert Baird.

Justin E. Kleber - Robert W. Baird & Co. Incorporated, Research Division

It's actually Justin Kleber on for Pete. Brenda, just a point of clarification on the guidance, the initial guidance for next year. Do you guys expect the operating margin expansion? Is that inclusive of those $3.5 million in integration costs or would that exclude those potential expenses?

Brenda M. Galgano

That would exclude those potential expenses.

Justin E. Kleber - Robert W. Baird & Co. Incorporated, Research Division

Okay. And then just turning to the gross margin again. I think, historically, you guys have talked about mid single-digit comp environment generating about 30 basis points of occupancy leverage. Is that still the right level we should be thinking about next year?

Brenda M. Galgano

That's correct. It's about -- they're typically around 30 basis points. And as I noted, we do expect some decline on the product margin side. And so I said on an overall basis, we expect our gross margins would be about flat, with warehouse and transportation also being about flat for the year.

Justin E. Kleber - Robert W. Baird & Co. Incorporated, Research Division

Okay, that's helpful. And then, Tony, just a question for you. I'm curious on the MyTrition product. I think you mentioned that one of the SKUs is now the top seller in the company. We've noticed a Bogo promotion you've ran specifically on MyTrition in early October. So just curious as to the drivers behind that promotion.

Anthony N. Truesdale

I think it'd be just part of the normal cadence that we would normally do on any product line during the course of the year.

Operator

We'll take our next question from Meredith Adler with Barclays.

Jack Mohr

This is Jack Mohr calling on behalf of Meredith. And just wanted to dive a little deeper into your e-commerce platform, looking at the mobile initiatives specifically. Last quarter, you've spoken of an in-house mobile website and how you're managing that and seeing a dramatic change in both traffic and conversion. Are you continuing to see that trend? Is that something that will be a driver going forward? And how does that kind of play into your strategy?

Anthony N. Truesdale

Yes, this is Tony. I think that -- look, we're seeing -- there's a reason we brought the mobile website in-house. We're seeing the tremendous movement of customers and growth in the tablet business and our phone business. So we're going to continue to invest in those 2 devices, to make sure that they experience -- it continues to meet what the customer expects from The Vitamin Shoppe.

Jack Mohr

And then -- that's helpful. From, also, data analytics perspective, it's obviously kind of a very -- kind of more unique kind of new way to aggregate data and analyze data from the mobile and from the tablets to the customer. How can -- how are you looking to kind of use those investments to not just aggregate that data but actually analyze it in effective ways, since it's less traditional than kind of the previous avenues that you used in the past?

Anthony N. Truesdale

Yes, this is Tony. We wouldn't talk publicly about how we use the data, to aggregate the data and look at how we're appealing to customers. But I can tell you that the tablet experience is different than the phone experience, and we're adapting our experiences based on how the customer uses those devices when they shop at The Vitamin Shoppe.

Operator

We'll take a follow-up question from Simeon Gutman with Credit Suisse.

Simeon Gutman - Crédit Suisse AG, Research Division

Just 2 quick ones. Tony, first, the product strategy, it was encouraging to hear the focus on some of the private brands. Is there, I guess, a concerted effort to step this up next year, or is this part of your ongoing effort to try to boost the penetration?

Anthony N. Truesdale

I think it's really about creating our assortment differentiation in the marketplace long term. So owning some brands like plants, MyTrition, PROBIOCARE, really, we're the only place you can buy those products. So it's important to us, from an assortment strategy, to maintain our assortment advantage, the 8,000 SKUs that we have. we think this is the right way to go. I mean, certainly, both True Athlete and MyTrition have been solid brands for us and we expect PROBIOCARE and plant to be as well. And we're -- we'll continue to take advantage of opportunities as they show up on the product development. But the new label for BodyTech and The Vitamin Shoppe brand is pretty sharp. It looks quite nice in the store.

Simeon Gutman - Crédit Suisse AG, Research Division

Yes, we agree. And then second, on Internet or on e-commerce competitive landscape. I think a year ago, it was -- year ago, on the fourth quarter, it was mentioned that there was more intense competition. They may have ebbed and flowed as the year went on. Can you just describe or characterize the environment in e-commerce today?

Anthony N. Truesdale

Yes. I mean, I think it's been similar to the way it has been for the last several quarters. So I haven't seen any dramatic change from anybody, either softening or a more aggressive stance from anybody in the last 3 quarters.

Operator

[Operator Instructions] We'll hear next from Damian Witkowski from Gabelli & Company.

Damian Witkowski - Gabelli & Company, Inc.

Tony, I think you mentioned it but I missed it. What do you say the marginal -- the low spender, that consumer in the third quarter? I know they weren't shopping as often in the first half. Is the trend -- has the trend continued?

Anthony N. Truesdale

It's very similar to the second quarter. I mean, that's kind of why we gave the guidance at the end of the first quarter, the second and third quarter would be similar. When we looked at the database, we figured we'd have some softness for 2 quarters in those customers. And then it was really driven by the Dr. Oz effect and some of the TV stuff. We're well beyond that in the fourth quarter.

Damian Witkowski - Gabelli & Company, Inc.

Okay. And then just sort of micro competitive landscape question. There's in White -- in Port Chester, there's one of your stores. And now, there's a Whole Foods that opened up right next door, frankly, and it's in the same strip mall sort of shopping center. So the good news, the traffic has probably -- they've gone up fivefold. But I'm just curious, from your perspective, how do you think it's going to play out? Is it going to be -- is the traffic actually going to be a benefit to you, or is the fact that someone like Whole Foods, who does sell supplements or vitamins, will then offset and what do you think is going to play out?

Anthony N. Truesdale

Well, typically, we wouldn't talk on a -- about an individual store on a call. But I would say, in general, we think that Whole Foods is a good competitor. We like being near Whole Foods, and we have other locations in the country that have a Whole Foods near it as well. So just kind of normal course of business.

Operator

We'll take our next question from Matt Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Just wanted to follow up on the mature store comps that you guys touched on quickly. Was the trend there improving relative to the second quarter? How do you think about underlying demand in the mature stores at this point?

Brenda M. Galgano

It was pretty similar to the second quarter. I believe in the second quarter we also said that the comp is slightly positive. I would say also this quarter, it was slightly positive maybe a tick better, but not anything that's noteworthy. It's about the same.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it, understood. And then just on Canada. We have been thinking you'd be running about $1 million of losses there for the year. I think that was sort of your guidance. How is that developing relative to the initial plan? And is it lumpy? Would you say it's pretty even by quarter here?

Anthony N. Truesdale

I mean, it's very similar to the plan that we laid out for the business. So I would say there's not much difference there.

Brenda M. Galgano

In terms of your question on lumpiness, there is -- as we continue to make some investments in that business and we're adding a bit to the overhead to support the growth of that business, we do see a little bit of lumpiness. And that is all factored into the approximately $2 million of international investments next year. That includes not only new international markets, but also what we expect for Canada.

Operator

[Operator Instructions]

Anthony N. Truesdale

Well, thank you for joining us this morning, and we look forward to updating you on the next quarter.

Operator

This does conclude today's conference. We thank you for your participation. You may now disconnect.

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