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Executives

John Bourne – General Counsel

Kemper Isely – Chairman and Co-President

Sandra Buffa – Chief Financial Officer

Analysts

Sean P. Naughton – Piper Jaffray, Inc.

Phil D. Terpolilli – Longbow Research LLC

Kate Wendt – Wells Fargo Securities LLC

Joe Edelstein – Stephens, Inc.

David G. Magee – SunTrust Robinson Humphrey

Mitchell B. Pinheiro – Imperial Capital LLC

Mike J. Signore – William Blair & Co. LLC

Scott Van Winkle – Canaccord Genuity, Inc.

Natural Grocers by Vitamin Cottage, Inc. (NGVC) F1Q 2014 Earnings Conference Call January 30, 2014 4:30 PM ET

Operator

Good day, ladies and gentlemen. Welcome to the Natural Grocers First Quarter Fiscal Year 2014 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. As a reminder, today's call is being recorded. I’d now like to turn the conference over to Mr. John Bourne, General Counsel for Natural Grocers. Mr. Bourne, you may begin.

John Bourne

Good afternoon, everyone, and thank you for joining us for the Natural Grocers by Vitamin Cottage first quarter fiscal year 2014 earnings conference call. On the call with me today are Kemper Isely, our Co-President and Sandra Buffa, our Chief Financial Officer.

Before we start, let me remind you that all statements made in this conference call other than statements of historical fact are forward-looking statements. All forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially from those described in the forward-looking statements because of factors such as industry, business strategy, goals and expectations concerning our market position, the economy, future operations, margins, profitability, capital expenditures, liquidity and capital resources, other financial and operating information and other risks detailed in the company’s most recently filed Forms 10-Q and10-K.

The information we present is accurate as of the date of this call. The company undertakes no obligation to update forward-looking statements. The company’s earnings release was issued and made available this afternoon. The discussion that follows assumes you’ve had the opportunity to read the release. The release along with a transcript of a recording of this call and a reconciliation of non-GAAP measures used by us will be available at our website at investors.naturalgrocers.com for a minimum of 30 days. If you have not had the opportunity to read the release, we recommend that you read it in conjunction with or after this call.

Now, I will turn the call over to our Co-President, Kemper Isely.

Kemper Isely

Thank you, John. Good afternoon, everyone. We are pleased to report another quarter of solid financial results and we continue to meet our outlook expectations. We look forward to carrying this positive momentum into the rest of fiscal 2014. During the quarter, net sales increased 25.8% with comparable store sales increasing 10.6%. Mature store sales continued to be strong, increasing 6.9%. Additionally, we experienced positive sales trends across all departments during the quarter. We believe the increase in comparable and mature store sales reflects the commitment we have to our customers, resulting from our continued focus on our founding principles.

In addition to expanding the top line by 25.8%, we are pleased with our continued leverage as indicated by net income increasing 31.6% quarter-over-quarter. Our diluted earnings per share were $0.13 this quarter compared to $0.10 in the prior comparable quarter. During the first quarter, we opened four new stores, expanding our geographic footprint in Idaho, Oklahoma, Oregon and Texas. Our new stores are performing in line with expectations and we remain on track with our new store pipeline.

Now, I will turn the call over to Sandra to highlight our first quarter fiscal 2014 financial results.

Sandra Buffa

Thank you, Kemper, and thank you all for joining us this afternoon. Turning to our financial results, we are pleased to report net sales increased in the first quarter of fiscal 2014 to $120.6 million or 25.8% over the same period in fiscal 2013. Comparable store sales increased 10.6% quarter-over-quarter driven by a 5.1% increase in daily average transaction count and a 5.3% increase in average transaction size. Our mature store phase continues to be strong with daily average mature store sales increasing 6.9% quarter-over-quarter.

Gross profit during the first quarter of fiscal 2014 increased 27.1% to $35.4 million driven by strong comparable store sales and new store growth. Gross margin increased 30 basis points due to increases in product margins across all departments, including productivity improvements at the bulk food repackaging facility. The increases in product margin were partially offset by a shift in sales mix.

Occupancy costs as a percent of sales increased during the first quarter due to increased average lease expenses at new stores. The stores that were accounted for as capital leases rather than being reflected as operating leases, increased gross margin as a percent of sales by approximately 60 and 25 basis points in the first quarter of fiscal 2014 and 2013 respectively.

Store expenses decreased 20 basis points to 20.9% of sales during the quarter. The decrease was driven by a decrease in sovereign related expenses as a percent of sales at comparable stores partially offset by an increase in depreciation expense at new stores. Administrative expenses as a percent of sales decreased 30 basis points quarter-over-quarter as a result of the company’s continued ability to support sales growth without proportionate investments in overhead.

During the quarter, net income increased 31.6% to $2.9 million with diluted earnings per share of $0.13. EBITDA increased 38.1% to $9.4 million or 7.8% of sales in the first quarter. The stores that were accounted for as capital leases rather than being reflected as operating leases, increased EBITDA as a percent of sales by approximately 60 and 40 basis points in the first quarter of fiscal 2014 and 2013 respectively.

Balance sheet and liquidity highlights are as follows. As of December 31, 2013, we had $6.2 million of cash and cash equivalents and $1.2 million in available for sale securities as well as no amounts outstanding on the revolving credit facility. During the quarter, we amended and restated our $15 million credit agreement with improved terms and extended the maturity by three years to January 31, 2017. During the quarter, we generated $5.3 million in cash from operations and invested $7.7 million in property and equipment primarily on new stores.

Now I will turn the call back to Kemper to discuss our new store growth and outlook for fiscal 2014.

Kemper Isely

Thank you, Sandra. As I mentioned at the beginning of the call, we are pleased with the financial strength and solid execution we continue to deliver. During the quarter, we opened four new stores, bringing our total count to 76 stores in 13 states. We have 10 signed leases for the remaining 11 stores planned to open in fiscal 2014 for locations in Colorado, Idaho, Kansas, New Mexico, Oklahoma, Oregon, Utah and Washington. Our new stores are located in a mix of urban and suburban areas as well as new and existing markets. Additionally, we already have good visibility into the fiscal 2015 real estate pipeline. as we discussed on prior calls, during this quarter, we began implementation of the human resource information system. we believe this system will enhance our ability to support our employees at all locations. We expect to start seeing the initial benefits of this implementation during our third fiscal quarter. We are consistently focused on managing and controlling our growth and we see this as a positive step to support our growth going forward.

Moving to our outlook, our first quarter results were in line with expectations and thus we are reaffirming our previously announced fiscal 2014 outlook. During fiscal 2014, we expect to open 13 new stores resulting in a 21% unit growth, remodeled to existing stores, achieved daily average comparable stores sales growth of 8.5% to 9.5%, delivered EBITDA margins of 7.8% to 8%, achieved net income margins of 2.4% to 2.6%, achieved diluted earnings per share of between $0.58 to $0.63 and incurred capital expenditures of between $35 million to $37 million.

We remain true to our five accounting principles and continue to focus on what differentiates us. Our unique national and organic product offerings at affordable prices, we continue to gain trust and loyalty from our customers through our high quality standards and nutrition education. We believe these unique differentiating factors help insulate us from the economic pressure and will continue to support our solid financial results.

We will allocate the remaining time to questions. Please limit your questions appropriately, so that everyone has an opportunity to participate. Thank you.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions) Our first question comes from Sean Naughton with Piper Jaffray.

Sean P. Naughton – Piper Jaffray, Inc.

Hi, good afternoon.

Kemper Isely

Good afternoon, Sean.

Sean P. Naughton – Piper Jaffray, Inc.

Gross margins looked really nice in the quarter. can you talk a little bit maybe about some of the productivity benefits you got in the expanded bulk facility and is this something that has a line item, potentially, to continue leveraging as you continue to gain scale here through the balance of the year?

Kemper Isely

Our bulk facility annualized in the first quarter and it showed significant improvement during the quarter and we expected to continue to improve throughout the year.

Sean P. Naughton – Piper Jaffray, Inc.

Do you think it should be at a similar rate or because that kind of to annualize that now would be a little bit less of a gross margin driver moving forward?

Kemper Isely

No, I think it will be similar rate.

Sean P. Naughton – Piper Jaffray, Inc.

Okay, great. And then on the revenue line item, obviously 25% is a terrific number, but just thought it might have been a little stronger, given the nice comps that you guys had there. Was there anything in terms of number of days in the quarter or when the new stores opened that may have impacted that top line number?

Kemper Isely

Yes, two of our stores opened in mid – one opened in mid-December and one opened towards the end of December to the new stores and so that kind of had an impact definitely on the revenue numbers.

Sean P. Naughton – Piper Jaffray, Inc.

Okay, great and then just quick, lastly on competition…

Kemper Isely

And one of the stores that opened in December, opened in the middle of that nasty ice storm down in Texas, just to let you know, very helpful to it all.

Sean P. Naughton – Piper Jaffray, Inc.

Not good for getting to a store. And then just lastly on the competition, a lot of conversation about a lot of competitors coming into this market, I know Trader Joes is coming to Colorado in February, and I know you compete with them in other markets, but maybe, could you just talk about how you do against them in other markets and maybe just generally address the competitive dynamics that you’re seeing the marketplace today?

Kemper Isely

Well, specifically about Trader Joes I would say that, they are a food retailer; the number of items that we stock that they stock is very limited. and so there impact on our sales usually, when they open near one of our stores is very limited. I would actually say that we are probably more synergistic than super competitive, I mean that they would be more synergistic to our sales in the long run than super competitive towards, I mean damaging to our sales in the long run.

Sean P. Naughton – Piper Jaffray, Inc.

Okay. and then just anything on competition that you’re seeing out there outside of just more players in the space as you go to new markets or is it relatively unchanged at this point in time from your perspective?

Kemper Isely

From my perspective, it’s relatively unchanged, I mean we have Denver as perhaps one of the most competitive natural foods market in the country and we’ve been dealing with it for a long time.

Sean P. Naughton – Piper Jaffray, Inc.

Okay, great. thank you and best of luck in Q2.

Kemper Isely

Thanks.

Operator

Our next question comes from Phil Terpolilli at Longbow Research

Phil D. Terpolilli – Longbow Research LLC

Yes, good afternoon. just a couple of quick questions, I was just wondering if you could talk a little bit more about maybe by categories, supplements versus grocery, if you maybe noticed a little bit more of a shifts than in the past, there has been some kind of discussion out there maybe supplements have been a little bit slower lately, but curious what you are seeing in your markets?

Kemper Isely

Supplement sales, we still have positive growth and supplement sales during the quarter; they’re just not growing as fast as our grocery sales have been growing. I wouldn’t say that we had a deacceleration in sales of supplements.

Phil D. Terpolilli – Longbow Research LLC

Okay. that’s helpful. And then just on the comp, the 10.6%, very good numbers here. just kind of curious you are not changing your guidance for the year, is that maybe you being a little bit conservative or is it just kind of the expectation that maybe comparisons get a little bit tougher in the back half of the year and you're factoring that in.

Kemper Isely

We want to make sure that our number is achievable. and so we have a – what we think is an achievable number out there, as far as – it’s hard to continue to do double-digit increases year-in and year-out. That’s what I’d have to say about that.

Phil D. Terpolilli – Longbow Research LLC

Okay. thank you. Congratulations.

Kemper Isely

Thanks.

Operator

The next question comes from Kate Wendt at Wells Fargo Securities

Kate Wendt – Wells Fargo Securities LLC

Yes, thank you. Congrats on a great quarter amidst what has been a pretty awful period for most other retailers. Just wanted to ask you, actually, about some other things in terms of the supply chain – whether you think the earlier season freeze and now current drought in California, as well as storms in other parts of the country, could impact supply and lead to either inflation or impact margins here as we move throughout the year?

Kemper Isely

I think that the drought in California is somewhat concerning in regards to nut supplies, that’s for sure and the pricing on that. as far as the freezes and so forth, I mean mainly that would affect produce and you expect that at this time of year.

Kate Wendt – Wells Fargo Securities LLC

Okay, great. So it sounds like not too big of an impact. And then just following up on Sean's question on gross margin, you guys have, last quarter, had margin improvements in all categories and mix that have been hurting you and your overall gross margin was still down. Would you say then that the improvement this quarter is mostly the bulk production facility that's starting to kick in or maybe less shrink on better sales or maybe supplements performing better than they did last quarter? Any other color there would be helpful.

Kemper Isely

The distribution center helped, but we had margin improvement in almost all of our – all categories over the last quarter just from – I mean, like in diary, we decided to emphasize cheese a little bit more and that has a better margin than milk. And so that improved our margin in diary substantially. Our produce margin was stronger, because we had less shrink in the produce department during the quarter. Supplements, we did lose a little bit of ground, as has been the trend, but we have a little bit of improvement in the margin there also.

Kate Wendt – Wells Fargo Securities LLC

Okay, that’s great. Thanks so much.

Operator

The next question comes from Joe Edelstein at Stephens, Inc.

Joe Edelstein – Stephens, Inc.

Hi, good afternoon. Thanks for taking the questions.

Kemper Isely

Thanks, Joe, for asking them.

Joe Edelstein – Stephens, Inc.

First, to start then, you did mention that you're looking forward to carrying this solid momentum here into the rest of the year. Could you just update us as to where you're tracking so far through January?

Kemper Isely

You mean as far as our sales go?

Joe Edelstein – Stephens, Inc.

Comps, yes.

Kemper Isely

We really don’t discuss sales outside of the end of the quarter.

Joe Edelstein – Stephens, Inc.

Okay, that’s fair. You also mentioned that you're getting that visibility on the 2015 store openings. Is that really a pickup in developer activity? Are you still finding available existing sites?

Kemper Isely

Well, right now, there is a lot of available existing sites coming available, and really good existing sites coming available due to some consolidation in the office supply business.

Joe Edelstein – Stephens, Inc.

And has there been any pick-up in terms of the level competition for those existing sites?

Kemper Isely

All good sites have a lot of competition and it’s always been that way. I mean, at the very bottom of this downturn, good sites had competition for them. I mean, it’s tough to get good sites. You have to be aggressive and you have to have your eyes and ears to the ground.

Joe Edelstein – Stephens, Inc.

Sure. Maybe one more question for me then. The leverage, just at the administrative level, continued progress there, and if you were to assume that business continues at a similar pace that what we've seen, maybe even the high end of the guidance range, would there be any sort of catch-up, bonus accruals or anything else that we should consider?

Kemper Isely

We accrue our incentive compensation by quarter, so there is no catch up.

Joe Edelstein – Stephens, Inc.

Okay, great. Thanks for taking the questions today.

Operator

The next question comes from David Magee at SunTrust Robinson Humphrey.

David G. Magee – SunTrust Robinson Humphrey

Yes, hi guys. A good quarter.

Kemper Isely

Thanks, David.

David G. Magee – SunTrust Robinson Humphrey

Just a couple of questions, one is you referenced a new HR system and I'm just curious if you could give some more color around that and is that something that's sort of primarily beneficial to the employees or does it help you with the cost side or both?

Kemper Isely

It will help us with both areas, I mean, it will give us a better way to communicate to everybody that works here and it will help us to train people better, it will help us to just be more efficient on the human resources side of the equation.

David G. Magee – SunTrust Robinson Humphrey

Okay. With regard to the drought in California, if it gets worse from here and say it doesn't rain that much this spring, what would be your course of action? Would you source from Mexico or is there things you've done in the past to sort of offset that that you could go to?

Kemper Isely

Well, I think that a lot of the agriculture out in California is using wells, and so, even if the drought got worse, I think that the well situation, they're going to drill a bunch more wells that are deeper.

David G. Magee – SunTrust Robinson Humphrey

Okay.

Kemper Isely

I mean that’s what I’ve gotten from talking with various farmers out there. That seems to be the course of action right now.

David G. Magee – SunTrust Robinson Humphrey

I see, and then lastly, as you've gone to new markets like Oregon, are you finding interesting trends with regard to mix of business or the cost of business that might be new to you or that surprise you in any way?

Kemper Isely

I think every state has its own surprises, except for Wyoming is the best state of all to – as far as cost of business goes.

David G. Magee – SunTrust Robinson Humphrey

Okay.

Kemper Isely

And they don’t have an income tax and they don’t have a business franchise tax and they don’t do – they don’t regulate you to death, and they are really nice at Wyoming.

David G. Magee – SunTrust Robinson Humphrey

Great. Thank you and good luck here.

Kemper Isely

Thanks.

Operator

The next question comes from Mitchell Pinheiro at Imperial Capital.

Mitchell B. Pinheiro – Imperial Capital LLC

Yes. Hey, good afternoon. Just two questions; one, on the supplement side, did you notice any impact on your supplement sales as a result of that flawed study or the flawed conclusions on the – on that vitamin study published a couple months ago?

Kemper Isely

Fortunately, our customers are very well-educated and it really didn’t have much of an impact?

Mitchell B. Pinheiro – Imperial Capital LLC

Okay. And then second, as it comes – as it relates to the new store, did you talk about how many, your new stores, for the second quarter and, perhaps, how they're going to be spaced out within the quarter?

Kemper Isely

We will open four stores this quarter; two of them are opening in February and two are opening in March.

Mitchell B. Pinheiro – Imperial Capital LLC

Okay. Thank you very much.

Kemper Isely

Okay.

Operator

The next question comes from Mike Signore at William Blair.

Mike J. Signore – William Blair & Co. LLC

Hi, everyone. Thanks for squeezing me in here at the end. I just had a question on if sales were different at all across geographies and I guess the reason I ask is because the Nielsen data seemed to show that sales of natural and organic grocery products may have slowed during the fourth quarter and obviously you didn't see that, so were there any particular markets it’s outside of the growth or maybe even some markets it's a slower growth?

Kemper Isely

No, I won’t say that there was any market that was, in particularly, better than another market. Texas has been particularly strong for us, but that's because those stores are younger.

Mike J. Signore – William Blair & Co. LLC

Okay.

Kemper Isely

So you have more growth potential down there. And I think part of the issue with sales data is that Thanksgiving came a week later in the quarter than it normally does. And so that kind of had an impact on December sales a little bit, because there was only four – there was one week between Thanksgiving and Christmas this year.

Mike J. Signore – William Blair & Co. LLC

Okay. Yes, that makes sense and then just – you kind of already answered it, but on the expectation you have for inflation. I guess before on the last call, you kind of said maybe moderate. Some of the CPI data we show kind of shows that decelerating. I mean, is your expectation for inflation in 2014 changed at all or is it relatively the same?

Kemper Isely

It’s relatively the same. so far, we have not seen a lot of price inflation.

Mike J. Signore – William Blair & Co. LLC

Okay. and I just have one question on the P&L here. So pre-opening expense of $900,000 in the quarter, that seemed to be a bit lower than where we were and I guess you had relatively the same amount of stores as last quarter. Is that just because there were later store openings and some of that cost gets pushed into Q2 or is $900,000 kind of the run rate here for the rest of the year?

Kemper Isely

Sandra, can you answer that question?

Sandra Buffa

Yes, I think some of the difference that was moving along had to do with just the timing of when the stores were opening and when we were getting billed and paying for specific costs. There’s also some change that you see in that line is that store, if the store is a capitalized store or if it’s an operating store.

Mike J. Signore – William Blair & Co. LLC

Okay, great. Thanks

Kemper Isely

Thank you.

Operator

Our next question comes from Mark Sigal at Canaccord.

Scott Van Winkle – Canaccord Genuity, Inc.

It’s Scott Van Winkle here. Thanks. Most of the questions have been asked, but the mature comp was, looks like, quite a nice little acceleration at 6.9%, while the comps, overall, have been relatively consistent. Any color you can kind of throw out on why the mature comp accelerated?

Kemper Isely

It was – really compared to last year, it was a little bit less, but our mature stores just do pretty well as far as keeping on comping. and as we – the mature comp more come on board that are younger every year. so that kind of helps also. If that make sense to you.

Sandra Buffa

Stores that are six years old, five years old, start to move in there.

Scott Van Winkle – Canaccord Genuity, Inc.

Yes. Are we at a point where maybe that scenario is accelerating, where – I mean are we six years removed from a significant acceleration in unit growth?

Kemper Isely

No, I think that it will be little be about two more years before we really have that significant unit growth that starts going into the mature comp.

Scott Van Winkle – Canaccord Genuity, Inc.

Got you. And then…

Kemper Isely

I think it is more than it used to be, because at that point, I think there was like, six stores that probably came on at that point in time.

Scott Van Winkle – Canaccord Genuity, Inc.

Right, but that point, the point where you accelerated to kind of this 20% or so unit growth, that might have been four years ago?

Kemper Isely

Yes, That’s about right, yes.

Scott Van Winkle – Canaccord Genuity, Inc.

Excellent, and then on the gross margin, the commentary about kind of improvements throughout the store, everything from shrink to mix within categories like dairy, etc., is that something that you drive with your store leadership, something that they’re measured against? Is this a new emphasis?

Kemper Isely

No we’ve always had our high shrink categories as part of incentive comp judgments at our store level and – but we’ve really put a lot of emphasis on those categories in the last couple of quarters. and so that helped to change mix in the diary categories I said and then also to lower shrink in the produce category.

Scott Van Winkle – Canaccord Genuity, Inc.

Great. And then one more, if I could. Everyone’s kind of focused on some of these hot categories on your stores and the space in general, like gluten-free or the non-GMO project label that’s out there. Any new kind of emerging trends, hot categories, that maybe you’re putting a concerted effort to adding shelf space to?

Kemper Isely

We really have emphasized the Paleolithic diet in our stores lately. and so items that would be food items that would be synergistic with that are having a really good acceleration of sales right now. And then the other thing that we are in the process of doing is really increasing our standards on particular categories. So that there is even a higher standard to be in our store and people really like that and having the higher quality products.

Scott Van Winkle – Canaccord Genuity, Inc.

Is there a new signage or something you’re doing to call that out?

Kemper Isely

We’ll be having a pretty major change in a couple of our product category standards entering the next couple – next month or so.

Scott Van Winkle – Canaccord Genuity, Inc.

Great. Thank you very much. Congratulations.

Kemper Isely

Thanks.

Operator

At this time, there are no further questions. I would like to turn the conference back over to management for closing remarks.

Kemper Isely

I appreciate everybody being on the call today and have a good afternoon. Thanks, bye.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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