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Fairway Group Holdings Corporation (NASDAQ:FWM)

Q4 2014 Earnings Conference Call

May 29, 2014 4:30 p.m. ET

Executives

Bill Sanford – Interim Chief Executive Officer

Ed Arditte – Co-President and Chief Financial Officer

Kevin McDonnell – Co-President and Chief Operating Officer

Nico Gutierrez – Manager of Finance and Investor Relations

Analysts

Mark Wiltamuth – Jefferies & Co.

Edward Kelly – Credit Suisse

John Heinbockel – Guggenheim Securities

Kelly Bania – BMO Capital Markets

Rupesh Parikh – Oppenheimer & Co

Scott Mushkin – Wolfe Research

Barry Haimes – Sage Asset Management

Operator

Good day, ladies and gentlemen, and welcome to the Fairway Group Holdings Corp Fourth Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

I'd now like to turn the call over to Mr. Nico Gutierrez, Manager of Finance and Investor Relations. Sir, the floor is yours.

Nicholas Gutierrez

Thank you. Good afternoon, ladies and gentlemen, and welcome to Fairway’s earnings call for the fourth fiscal quarter. With me today are Bill Sanford, our Interim Chief Executive Officer; Kevin McDonnell, Co-President and Chief Operating Officer; Ed Arditte, Co-President and Chief Financial Officer.

By now, everyone should have had access to the fourth quarter earnings release, which went out this afternoon. The release and accompanying slides are available on the Investor Relations section of Fairway's website at www.fairwaymarket.com. This call is being webcasted, and the replay will be available on the company's website as well.

Before we begin, we would like to remind everybody that the prepared remarks contain forward-looking statements and management may make additional forward-looking statements in response to your questions. These statements do not guarantee future performance, and therefore undue reliance should not be placed upon them. We refer all of you to the risk factors contained in Fairway's annual report on Form 10-K filed with the Securities and Exchange Commission earlier today. Fairway assumes no obligation to revise any forward-looking statements that may be made in today's release or call.

And with that, I would like to turn the call over to Bill Sanford.

Bill Sanford

Thanks, Nico. Good afternoon everyone and thank you, all, for joining us today. I’d like to start the call by providing a brief overview of our financial results, followed by a discussion of the larger strategic initiatives we’re working on. I’ll then hand the call over to Kevin McDonnell who will provide you with an update on merchandizing and operations, and Ed Arditte will wrap up with a more detailed financial review and a framework for thinking about the balance of the year.

During the quarter we reported net sales of just over $200 million, an increase of approximately $22 million over last year’s reported number, largely driven by the contribution from the two new stores opened during the year as well as the incremental sales from our Red Hook location which was closed during the first nine weeks of the fourth quarter. Our stores that were open for all of fiscal 2014 generated in excess of $1,700 per selling square foot, while our new stores continue to show positive sales momentum as a result of Fairway’s unique merchandizing mix and value proposition. Our merchandising initiatives at the Chelsea location for example have begun to resonate with our customers as we have seen the average basket size increase nearly 10% compared to the third quarter.

Same-store sales for the quarter were down 1.9%, in part due to a 100 basis point head wind as a result of the timing of the Easter Passover holidays which fell into the fourth quarter of fiscal 2013, but not fiscal 2014. We also had sales transfer of approximately 50 basis points from existing Fairway stores to our new location. Poor weather conditions and heavy snow fall negatively impacted customer count throughout the quarter. Our adjusted EBITDA for the fourth quarter was $12.7 million and our adjusted EBITDA margin was 6.4%, in line with our guidance.

Operationally, we made progress on a number of cost saving initiatives during the quarter, including reducing store expenses, excluding depreciation and amortization, by 70 basis points year over year. We also reduced our central service expense by another 40 basis points on a pro forma basis after adding back our estimate of the lost sales from our Red Hook location during the fourth quarter of fiscal 2013. We will continue to invest in process improvement and talent development to ensure that we have the right platform and personnel for disciplined growth. However, we expect to continue to leverage the central service expense as our store base expands.

We have found that with each new store opening, we learn more about Fairway’s core customer and constantly seek to leverage our experience and integrate lessons learned into both our new and existing stores. The team has spent a great deal of time examining the new store operating core structure and we have designed a more efficient layout at the new Lake Grove store to improve workflow and lower operating expenses without compromising the Fairway customer experience. As an example, we have reduced the distance between service departments and their respective backrooms and have positioned similar departments such as cheese and Deli adjacent to each other and cross trained employees for optimal staffing during peak business hours.

For those of you who are currently Fairway customers, you’ll notice the new look and feel in our Lake Grove store. We have spent the past several months developing a new signage system with new design elements to enhance in-store communications with customers. Fairway has always had a unique and distinct signage. We believe this new approach will more effectively highlight our unique merchandising strategy and value proposition to those less familiar with the Fairway format. Although Lake Grove will be a pilot store for this initiative, we will soon integrate the new design into our existing stores.

Fairway has also begun testing online shopping platform and same day delivery service out of one of our Manhattan locations. Working with Google Express, Fairway’s Omni-channel capabilities now allow customers to shop online or via their smartphones and browse nearly 12,000 SKUs for same day delivery for a flat fee of only $4.99. We expect to incorporate additional Fairway stores into the Google Express network as Google expands its delivery capabilities into areas outside of Manhattan. The new platform will provide our existing customers with an additional level of convenience while simultaneously exposing Fairway to new customers throughout New York City.

Shifting to the real estate front, we remain actively engaged in lease negotiations with national real estate developers for locations in both New York City and the suburbs, several of which are parts of large development projects. As a reminder, over the next two years we expect to build two stores per year, with the current fiscal year openings being the new store in Lake Grove, New York expected to open in July, and the new store in TriBeCa which is now expected to open in early calendar 2015. The new store in the Hudson Yards redevelopment project is scheduled for a late calendar 2015 or early 2016 opening. However the scope of the project does leave the exact opening dates somewhat beyond Fairway’s control. We are in active discussions with a number of landlords for an additional calendar 2015 opening, which would complete our pipeline through fiscal 2016.

I’d now like to provide you with a brief update on our search for a new Chief Executive Officer. As we communicated on our last earnings call, the search is being overseen by Fairway’s independent Board of Directors. A leading search firm has been retained and we will keep you updated on their progress. Rest assured however, the current management team is extremely focused on day to day execution of Fairway’s long term strategy and positioning the company for the future.

In summary, it remains a busy time for us at Fairway as we continue to innovate and evolve to provide the best experience for our customers. Our unique merchandise mix positions Fairway at the intersection of two of the larger consumer trends we see improve retail; the shift towards healthy living and an increasing focus on value. The combination of fresh perishables and prepared foods, a full selection of natural and organic products, exclusive specialty products and a full conventional grocery offering, provide our customers with one stop shopping destination focused on quality and value. Kevin?

Kevin McDonnell

Thanks, Bill. I’d like to start off by providing a few updates about some of the sales building and merchandising initiatives we’ve been working on. During the quarter we introduced a number of SKUs to the growing offering of Fairway branded products. And on a year over year basis, increased our penetration by approximately 130 basis points. Some of the products to hit our shelves this quarter include organic juices, gluten-free pancakes and an assortment of other items, including popcorn, kettle chips, castile soap and a line of condiments. We are also actively working on expanding our prepared food offerings throughout our stores to reflect the shopping patterns of a younger demographic which have created an increased demand for high quality prepared foods addressing the focus on both convenience and value.

As many of you know, Fairway produces the majority of our prepared food offering in house, allowing us to leverage our high quality standards and proprietary recipes without absorbing third party margins. As Fairway looks to cultivate one of the most diverse generations in American history, we have made it a priority to integrate a more international selection into our prepared food offerings.

We have recently introduced a Latin Table line offering home style tamales and empanadas featured in a recent New York Times article, a new Mediterranean line with Balsamic and Moroccan styled grilled chicken and Indian and Asian inspired noodle bowls among others. The early success of these lines has prompted us to begin working on additional SKUs for added variety. Our fresh food team remains focused on expanding our prepared food platform while providing a complete offering that combines elements of health and international inspired cuisine, as well as indulgences to provide a ready to eat, ready to heat high quality alternative to meal preparation for dining out.

Just this month, we’ve introduced a new mac-and-cheese which integrates our Fairway branded pasta to create four different varieties, classic, lobster, buffalo chicken and bacon cheddar. In addition, our production capacity will be further enhanced as we shift towards our centralized facility later this summer, which provides us with the capability to introduce new product lines into our rapidly growing prepared food offering.

As we approach the Lake Grove opening, we remain excited about the favorable demographic characteristics for the first Fairway in Suffolk County which is among the 25 most populated counties in the country. While boasting strong demographics, we do realize that Lake Grove is our most distant suburban location and we’ll be taking appropriate measures to drive traffic and to cultivate the customer base. To amplify a point Bill made earlier, our renewed focus on enhancing in-store communications will allow us to more effectively highlight fairly differentiated offerings and value prepositions, which becomes increasing important as Fairway extends further out from the city.

It is important to keep in mind that Fairway has always been committed to providing our customers with a strong sense of value, an attribute deeply rooted in our history and inherent in our name. Our pricing strategy has always been to maintain a pricing advantage over natural organic and specialty peers in the market, while pricing competitively with the traditional conventional retailers. This value proposition is reinforced by an outstanding selection of high quality offerings, great customer service and an engaging in-store experience. As the competitive landscape changes, we remain focused on making sure that our commitment to value holds true, our pricing advantages are not compromised and that Fairway remains positioned to grow our market share.

With the $600 billion food and retail market still concentrated in conventional grocery space, our format allows for a seamless transition for the crossover consumer who is becoming increasingly focused on fresh foods and the shift towards a healthier lifestyle. Fairway’s approximate70, 000 SKUs provide an unmatched product selection, including high quality perishables, gourmet and specialty items, together with a full set of natural and organic products without compromising the ability to purchase the national brand grocery items. This differentiated approach continues to resonate with the growing population of health conscious and value oriented consumers.

Before I turn the call over to Ed, I would like to provide an update on a new production facility and the anticipated transition schedule over the next several quarters. As previously communicated, we will begin operations in the new facility over the next few weeks with our produce cross-dock function. The facility contains a substantial refrigerated cross-dock which will help us maximize product freshness and shelf life. Shortly after, we will transition certain bakery functions as well as the operations from current central kitchen to the new facility. Throughout the fall, we will phase in the remaining store kitchen operations. The new temperature controlled facility will contain state of the art bakery and commissary equipment with the automated production lines to maximize labor efficiencies and product output. We expect the complete transition process will be finalized by the end of the calendar year. The consolidation of production operations provides us with labor arbitrage opportunities and enhances our ability to leverage economies of scale. But more importantly, it gives us improved control over product quality and consistency.

With that, I’ll pass the call to Ed.

Ed Arditte

Thanks Kevin. I’d like to start off by reviewing our financial performance for the fourth quarter and then discuss the current quarter as well as the full year.

During the fourth quarter, we grew our top line by 12% primarily due to the contribution from our new stores, as well as the incremental sales from our Red Hook which was closed for the first nine weeks of the fourth quarter in fiscal 2013. On a pro forma basis to include the estimated lost sales from the Red Hook store, net sales increased approximately 5% in the quarter. Our comparable store customer count was down 4.9%, but the average basket was up 3.1%, which led to an overall decrease in same-store sales of 1.9%. Now as Bill mentioned earlier, this was primarily due to the timing of the Easter Passover holidays, sales transfer from existing to new Fairway locations, and poor weather conditions through the winter.

Our gross profit margin for the quarter declined 120 basis points year over year, in part due to higher occupancy cost as a percentage of sales at our new locations as well as increases in rent at several of our existing locations.

As we discussed on the third quarter earnings call, as a result of the lease amendment at our flagship 74th Street and Broadway location, our rent increased by approximately $300,000 per quarter. Now as a reminder, the 74th Street and Broadway location is our highest performing store and the lease amendment extends certain lease provisions from calendar 2017 to 2029.

Now on the expense side on a year over year basis store expenses, excluding depreciation and amortization, were down 70 basis points and on a quarter sequential basis were down 40 basis points. The decrease in store expenses was primarily driven by increase in store labor efficiencies, in part due to the integration of the new operating structure as well as enhanced cost disciplines. This improvement was achieved despite absorbing higher seasonal utility costs and other weather related expenses.

Our central service expense was $10.7 million in the fourth quarter, down slightly year over year. After adding back the loss to Red Hook sales in last year’s fourth quarter, central services as a percentage of sales declined 40 basis points year over year.

Next, we incurred a $3.3 million severance charge in the fourth quarter in connection with the organizational realignment we announced in our last quarterly call, and the majority of this was noncash and will be paid out over the course of the next two years.

Our adjusted EBITDA for the quarter was $12.7 million, a decrease of approximately $800,000 over last year. On a quarter sequential basis, our adjusted EBITDA was relatively flat compared to the third quarter and our adjusted EBITDA margin improved 20 basis points. Now there’s a very important point I’ll emphasize with regards to our year over year adjusted EBITDA. While the total company adjusted EBITDA was lower by approximately $800, 000, the year over year performance, excluding Red Hook, actually increased by $1.5 million. This increase was more than offset by a $2.3 million decline at Red Hook, which was driven mostly by two factors. The first was the reopening of the Red Hook store following hurricane Sandy which occurred on March 1 of last year. As many of you know, the store reopened to very large volumes for a period of time before settling back into a more traditional sales pattern. We estimate that this reopening dynamic added substantial incremental EBITDA in last year’s fourth quarter. The second issue that impacted Red Hook in the quarter was a competitive opening in Brooklyn. We estimate that this adversely impacted our sales by approximately $200,000 per week which translated into approximately $800,000 of lower store contribution from Red Hook which was relatively in line with our expectation.

Now as we think about the full year impact of that dynamic, we estimate a lower store contribution of approximately $800,000 per quarter until we cycle the competitive opening, perhaps with a lesser impact during the slower summer months.

One final point on Red Hook that I want to emphasize. While our sales in EBITDA were lower in the quarter, this remains an outstanding location for Fairway with average sales well over $1 million per week with attractive EBITDA margins and attractive return on capital. We expect that performance to continue.

Now shifting gears, store opening cost for the fourth quarter were $1.2 million compared to $2.4 million in the fourth quarter of fiscal 2013 while production center startup costs were $1.3 million. Approximately $0.5 million of store opening and production center startup costs combined were noncash due to deferred rent.

Interest expense for the quarter was $4.8 million, a decrease of $1.8 million over the prior year as a result of lower borrowing rate on our senior credit facility. Approximately $1.3 million of our interest expense was noncash.

Turning to the balance sheet, we ended the quarter with approximately $75 million of liquidity comprised of approximately $59 million of cash and $16 million of revolver availability. During the quarter, we generated approximately $12.7 million of cash from operations.

Total CapEx for the quarter was $7.5 million, inclusive of $4.2 million in connection with the new production facility and $1.3 million in connection with the Lake Grove location, with the balance coming from equipment upgrades and important enhancements at existing stores. During fiscal 2014, we spent approximately $7.7 million on the new production facility, which remains very much on budget. As previously mentioned we estimate total capital spending for the production facility to be approximately $20 million, with the remaining spend to be incurred over the next few quarters.

Now before we open the call for Q&A, I’d like to provide a framework for thinking about our unit growth plans over the next several years, as well as our guidance for the first quarter and full year. We remain comfortable with two store openings per year through fiscal 2016, both form an operational and liquidity perspective and don’t see the need to access outside capital given this new store opening schedule. As we move into fiscal 2017, we believe we will have the ability to accelerate our unit growth plans again without the need to raise additional capital.

Today we are in active lease negotiations for a number of locations, which would complete our fiscal 2016 store builds. We are also negotiating leases for a number of potential stores which would likely open in the fiscal 2017 timeframe, but given their nature as large development projects, the timing is clearly subject to change. Some of these negotiations are nearing completion and we will keep you updated as each of these move through the pipeline to full executed leases.

With respect to guidance, for our first fiscal quarter ending June 29, we expect sales to be in the $195 million to $197 million range and adjusted EBITDA to be approximately $11 million. The lower sales and adjusted EBITDA on a quarter sequential basis are primarily related to seasonal swings. Historically, sales and margins have trended lower in the first fiscal quarter when compared to the preceding quarter. This is primarily due to lower average weekly volumes as we head into the summer months, particularly true in urban locations as a result of weekend and summer travel. The loss of the higher margin urban sales put some pressure on our margins. In addition, the investments in price remain a headwind. However, we believe this is the right strategic move for the business and leaves us positioned to capture market share.

With respect to the full fiscal year, as a result of the timing shift of the TriBeCa location and the margin investment initiatives that Kevin previously discussed, our guidance is for mid-single digit sales growth with adjusted EBITDA being flat to modestly positive. Longer term, our focus and strategy remains unchanged. We will continue to develop our real estate pipeline, focus on our sales building and merchandising initiatives and more importantly, invest back into the business. We look forward to the transition to the centralized production center which we believe will not only simplify and derisk our production operations, but will also enhance our ability to drive economies of scale and leverage the cost structure over our growing store base.

So with that, let me now turn the call back to the operator who will open the lines for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Mark Wiltamuth with Jefferies. Your line is now open. Please proceed with your question.

Mark Wiltamuth – Jefferies & Co.

Thank you. Can you just give us a little more detail on the lease negotiations that are underway? And also on the timing as we lay out the new stores, what quarters should we expect the new stores to open in fiscal ‘15? And then what kind of timing should we be thinking about for 2016 opens? And it sounds like just to clarify that fiscal ‘6 openings you were previously thinking three. Now it sounds like two, just to clarify. Thank you.

Ed Arditte

Mark, this is Ed. let me speak to the second part of your question first. I think we indicated two for ’15, two for ’16 and then the ability to expand that unit growth rate in ’17. So I want to be clear, that is what our current thinking is. I think that’s consistent. With respect to the cadence of openings, as we indicated in our remarks, we expect late growth to be in July. At this point we expect the opening in TriBeCa to be in our fourth fiscal quarter which is the first calendar quarter of ’15. As we indicated with regards to our comments on Hudson Yards, obviously we’re at the whim of that construction project. And if you’ve driven by or walked by, you know that there’s a lot of activity going on there. We’re at the base of I think a 40 story office tower.

Our current thinking and what we hear from the developer is that it will be in the latter part of our next fiscal year. we are actively working on a number of other locations that we are hopeful would be in fiscal ’16, but at this point in time I don’t have a specific location or date that I can announce to you. But rest assured we’re working on filling in that additional location for fiscal ’16. and then finally as we move to ’17, as we indicated in our remarks, we’re working on a variety of locations that we think have exciting 2017 possibilities and a number of those are in active, very active lease negotiations. We can be a position where we’re announcing at least one of those relatively soon.

Operator

Our next question in the queue comes from the line of Edward Kelly with Credit Suisse. Your line is now open. Please proceed with your question.

Edward Kelly – Credit Suisse

Just to tart with a quick follow-up on the store pipeline. Last quarter you mentioned that you had a letter of intent signed on a New York City location I guess, which would be late calendar 2015, early calendar 2016, and then in advanced negotiations on two suburban locations. So I'm curious if that is still in the realm of possibilities? Or if there’s been some change around those stores? And if there has even, is that because that there may be some change in the way you're looking at locations I guess?

Ed Arditte

I would say that the comments that we made last time continue to be very reflective of where we are today. We are in very, very advanced stages of a New York City location that we would hope to be able to announce to you shortly. But as you know, until we have a signed lease, we can’t be any more specific. But that is clearly something that we're very focused on and feel very, very good about it being an outstanding location. From a timing point of view, that location is probably a calendar 2016 type of activity. It may be -- and likely to be in fiscal ‘17. So there are also the multiple suburban locations that we referenced in our last call that we are -- that I would say today the differing degrees a bit further along in our pipeline. But they are still a ways away from coming out of the pipeline if you will and being signed leases. Does that help?

Edward Kelly – Credit Suisse

Yes. Do you think that second location in fiscal 2016, will that end up being a suburban location you think?

Ed Arditte

It's hard to tell, but I would say at this stage it looks more likely to be a suburban location. But there are also some -- there are also other suburban possibilities as well. But I would say it’s probably better to think of this as a suburban location.

Edward Kelly – Credit Suisse

Okay. And then another question I had for you, I know you're in the process of the CEO search. How does I guess the absence of a CEO at this point impact the way that you're thinking about the business in terms of the way that you're thinking about whether it's leases or implementing new initiatives or really what needs to be done? Is there a chance that you’d go out and you hire somebody and there could be more meaningful changes in strategy at some point?

Bill Sanford

Ed, this is Bill. As you know, I've been working with the senior leadership team there for six years now and Kevin and I and the majority of the people in key positions have been here since the buyout occurred in 2007. And so we have a very robust pipeline of sales op initiatives, merchandising initiatives and things which have been ongoing for the last several years. So the team is very tight and we have a good agenda I believe. Kevin has made some important organizational changes at the Company to focus more on the new markets that we're in as we learn about them. Obviously a new CEO could be something of a catalyst at the Company and we're going to be very careful about this search. But at the end of the day we feel very good about Fairway's business model. We think our model resonates with customers in suburban and urban markets and we don't view this as being a dramatic change to the model situation.

Ed Arditte

Let me add something that I can say that Bill can’t say. In this Company Bill is not the interim CEO. He clearly has that title while we conduct this search, but he's not acting as interim. He’s dropped that in effect from the discussion and from our conversation and this team is operating just as we should be operating, running the Business day to day with a focus on doing the right things for the long-term as well.

Edward Kelly – Credit Suisse

Okay. And then my last question for you is just on Red Hook and the impact of the competitive opening. If you take the $200,000 a week, it seems like that could be in the neighborhood of more like 15% plus impact on the comp in that store and then that’s $0.8 million I guess if you were to try to annualize it, think about it. It's a pretty high margin. So I guess what I'm trying to ask is how has the impact on that store sort of evolved over time since Whole Foods opened? Has it lessened a bit? And then are there things that you're able to do from a cost perspective to maybe right size I guess the cost structure if it's really going to be a couple hundred thousand dollars a week less?

Kevin McDonnell

Hi Ed. This is Kevin. The sales impact has been relatively stable since the opening. We have not declined in any way and we're working to actually grab some back in that store and in a lot of our other stores. We're working on a lot of different I would say efficiencies within the operation to really maximize the profitability aspects. And I would say that's more of really still providing the great customer service that we want to, but looking to streamline the kind of behind the scenes operations to get the redundant cost out of the stores.

Ed Arditte

Ed, as I said in my remarks, remember that even with that impact, this is an outstanding location with very robust sales, very good profitability, very good returns on capital. So I know it’s been an area of focus for people, but I actually think that what remains very strong at Red Hook is our core business. And as Kevin pointed out, there are a variety of things that we’re doing that we believe has the potential to bring some of that back us.

Operator

Our next question in the queue comes from the line of John Heinbockel with Guggenheim Securities. Your line is now open. Please proceed with your question.

John Heinbockel – Guggenheim Securities

So let me ask you I guess two related things. What are you seeing currently with regard to penetrable inflation, in particular meat and produce? And does that complicate the efforts you're making on the price investment side where your cost of goods might be going up? Maybe it's harder for the customer to perceive a change in value. Talk about those two related issues if you would.

Kevin McDonnell

Hi John. It’s Kevin. We are definitely seeing a big inflation in our -- in particular meat and seafood as we’ve gone through the quarter and even prior to that. So yes, that is going to add complication in terms of presenting the customer better reality in the perception of pricing in the marketplace. But we are – we have a very I would say robust pricing comparison survey that we do on a week in and week out basis where we’re looking at every competitor in every one of our markets. We’re probably in the range of over 100,000 price checks per month. So we’re watching very closely in terms of what’s happening from a competitive standpoint. The issue there and what I said in my remarks is Fairway has always had a distinct advantage in pricing, particularly against the natural organic retailers and we’re more competitive against the traditional guys. We want to make sure that we keep the relative pricing index that we think is strong enough to really drive the consumer perception that keeps our sales stimulated. So it’s complicated, but that’s really what we’re doing to watch that.

John Heinbockel – Guggenheim Securities

So when you mention those two, let's say an organic competitor closes the gap versus a conventional competitor widening the gap with you, which one is more problematic for you competitively?

Kevin McDonnell

I would say they’re both. It’s hard to say one is that much stronger than the other. I would say it also does vary store by store. But we have again both ends of the spectrum there and both ends of those are very important. Obviously where we’re seeing the trends in the business is the natural organic and the healthy eating and living consumer is where the growth is and where the population is going. So it’s critical for us to maintain that advantage in pricing in those categories and items for those consumers.

John Heinbockel – Guggenheim Securities

So do you think you're investing more in organic than traditional or you wouldn't agree with that?

Kevin McDonnell

I wouldn’t say that it’s one more than the other. We think we’re in a pretty good position as it relates to where these organics are. But as we are also in our suburban locations and you have a customer, we’re also looking at that -- really that crossover customer who is really shopping at a traditional market now and we are trying to convert them over to more of a Fairway customer. So it’s important for us to also maintain good pricing on the commodity regular items so the customer has a positive experience of that and then transfer them over to the natural healthy and organic products.

John Heinbockel – Guggenheim Securities

All right. And then lastly just for Ed, it looks like the sales guidance that you gave looks to imply that the comp gets worse before it gets better. Is that right?

Ed Arditte

No. I would say John, that our guidance for the quarter from a sales point of view implies a modestly negative same-store sales number for the quarter. My view is it’s slightly better than the quarter we just reported.

Operator

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

Kelly Bania – BMO Capital Markets

Hi, good evening. Thanks for taking my questions. I just wanted to follow-up on the Red Hook commentary. So the numbers you gave do seem to imply maybe a 15% to 20% hit to that store if I'm right. Maybe you could clarify. But just curious how you're thinking about competitive openings in the upcoming fiscal year and should we expect a similar sort of impact in maybe how you're planning in that area and what impact that could have on comps?

Bill Sanford

Hey, it’s Bill. You’re right. We said on the last call I believe that the impact on revenue at Red Hook was in the 12% to 15% range. And obviously we’ve had a lot of competitive openings in Manhattan over the last seven or eight years. 10 years ago Fairway was one of the only full line stores to offer all the different categories we offer. And we have had numerous openings within blocks of our existing stores and it’s always somewhat different, but we have a plan. We had a plan for Red Hook. We have a plan for the openings we see over the next 12 months. And part of that is just reemphasizing what differentiates Fairway, which is you can do one stop shopping. We believe one stop shopping is important in the city especially. And when customers know they can get their conventional groceries, they can get organics at a discount to the pure organics and natural customers, plus they can get that full range of specialty and gourmet food at Fairway that they can’t really find elsewhere. And so we continue to focus on those. We have a plan for the Upper East Side underway, but we are going to have competitors everywhere we are. We have competitors in the suburbs different than they are in the city, but we feel that our business model and our value prepositions still resonates with customers.

Ed Arditte

Hi, Kelly. I think what I would add to that and you may want to follow up, but what I would add to that is that as we open this year our Lake Grove location, as we open TriBeCa, we are opening all those in areas that have competitive stores and we would expect to take in very sizable chunk of the sales available in those markets. So it is part of the world we live in. It is part of the business as the business exists today. From a comp point of view, if you do the math on Red Hook on an annualized basis, $200,000 a week is $10 million a year on that type of a basis ballpark. And to put that in perspective, that’s over a point of comp sales probably approaching something in the neighborhood of 1.3% or something like that. Just to calibrate a little bit for you.

Kelly Bania – BMO Capital Markets

That's very helpful. And then just curious if you could also talk a little bit more about this new pilot and more specifically some of the changes that you're making to the Lake Grove store? And you mentioned some moving around of departments and adjacencies, but any more specifics on how that maybe changes the model for the urban layout and what exactly at this point is being planned for TriBeCa?

Bill Sanford

There are really two objectives in our reengineering and it’s again the overall goal is to allow us to operate in less dense population centers, smaller cities and still provide the unique Fairway experience. So there are two components to what we are working on and I’m going to let Kevin add in here. First of all, lower cost of building the store. And a big part of what we are doing is trying to figure out how to not have as much heavy equipment in a store. Some of this will be taken care of by the production center, but some of it is just redesigning how we build the store.

And the second part of that is ergonomics in the store, what you are doing where, where you are unloading, where you are parking up, cross training employees in different departments to -- when a truck comes in for one department, the same people get it as it does for another department. And our goal is to reduce the number of fulltime employees required to open a store without changing the Fairway customer experience. Kevin?

Kevin McDonnell

The only thing I really can add to that or more I guess emphasize on it, there’s nothing significant that we are doing that we are changing the model as it relates to Lake Grove from a customer experience standpoint. What we are doing is as we are putting together the store footprint is maximizing the efficiencies where if the back rooms are attached to each one of the individual department areas. We are comingling our cheese department by our Deli department. So we can leverage the workforce there. So it would be nearly invisible from a consumer standpoint as you would see that store. We will have some visual differences there basically on some of the signage and the aesthetics of the store, but the efficiencies are really again more back of the house.

Bill Sanford

And another version of this really -- Bill again, is in TriBeCa and in some respects in Chelsea where we’ve moved into neighborhoods in the city that have different demographics. The Chelsea neighborhood has 35% of the population under 35 years old. TriBeCa has five times the number of people in the daytime that it does at nighttime. And so we are modifying those stores to emphasize -- in the case Chelsea more grab-and-go food, more prepared food, more ready to eat, ready to eat food because that’s what a lot of the people who live in the area that’s the way a lot of them shop. In TriBeCa we want to get the daytime crowd. So we are going to have a whole lot more food that’s prepared, ready to eat, ready to take back to your office for lunch. A big organic selection of lunchtime food, breakfast food, coffee bar and things like that, which is going to be much robust than an uptown store in a residential area would have for example.

Kelly Bania – BMO Capital Markets

Great. And then just also a follow-up on the sales transfer, I think you mentioned that was running about 50 basis points. Just curious how that compares to your expectations and how we should think about that next year or into fiscal 2015?

Ed Arditte

I think it’s very much a function of which stores we open and their proximity to existing stores as well as traffic patterns. In this particular case our newest store obviously is Nanuet. Nanuet is not a long, long, long, long way from Paramus. I think it’s case specific relative to which store we open, I would say relative to our expectations. I think it’s very, very much in keeping with that. When we think about market share and we think about those two moves, clearly that sales transfer is a negative for our comps. But at the same time in Nanuet we are picking up a very significant amount of new customers to Fairway by significantly growing our market share in that area and adding $700,000 a week of sales to the system.

Bill Sanford

And when the customers that leave Paramus to go to Nanuet, it’s more convenient for them to shop at Nanuet. We are probably going to get more of their overall grocery spend because we are closer to them. So it’s a win-win for us we think in the long term.

Operator

Thank you. Our next question in the cue comes from the line of Rupesh Parikh with Oppenheimer. Your line is now open. Please proceed with your question.

Rupesh Parikh – Oppenheimer & Co

I wanted to delve a little bit further into gross margins. The gross margins came in a little lighter than we expected in the quarter; as we look out this year, how can we think about some of the positive and negative drivers for this upcoming year? And then do you guys still feel that there's another 100 basis point of improvement in margins over the next few years?

Ed Arditte

So the biggest margin issue, gross margin issue for us is really the increase in occupancy and that would include obviously the ramp that we talked about as well as the utilities. And the winter period obviously with the weather that we had was a bit of a drag. Our overall merchandising margins were solid and I think pretty much spot on with our thinking. What was the second part of your question?

Rupesh Parikh – Oppenheimer & Co

And then I know previously you guided to that, you still think there's another 100 basis points of gross margin improvement over the next two to three years. Do you still feel that’s the case?

Ed Arditte

I feel as we talk about three specific initiatives and let me just repeat those three. The production center and you heard from us that we are going to start operations there over the next several week and we will ramp it up over the next few quarters. And we think there is a very meaningful opportunity there for us to get more efficient, but more importantly enhance the quality and the consistency of our product. So that’s initiative number one. Initiative number two, you heard Kevin talk about a number of our new products in the private label category. We picked up again our penetration of private label and that’s an important area of focus. And the third obviously is working with our vendor base to get the best terms and conditions, not just the best price, but the best terms and conditions that we can given our growing size.

All three of those are important. All three of those have the attention of many, many Fairway employees throughout the company. And those are things that we will continue to focus on for a long period of time. We think there is the potential that we talked about there. At this stage though given where we are, I believe all of that will happen to the tune of 100 basis points plus. But at this stage I’m not yet -- I’m not in a position to say what the timing of that will be.

Rupesh Parikh – Oppenheimer & Co

Okay. And then just from your guidance perspective, I know you guys gave us guidance for Q1 and the full year. How can we think about maybe the cadence of revenue and EBITDA growth throughout the year? Should we expect there to be stronger growth later in the second half of the year?

Ed Arditte

At this stage I think if you look at the store openings that we have planned, obviously Lake Grove being the next one, I think other than that and the -- clearly the partial period for Nanuet that we have, we’ll have it in this year obviously for a full period, partial. Chelsea, we’ll have that for the full period this year. As you model those two existing store and Lake Grove and then obviously later in the year TriBeCa, I think those are the biggest drivers of revenue in your model.

Rupesh Parikh – Oppenheimer & Co

Okay. And if I can sneak in one more question, just from a competitive standpoint, you guys gave great color in terms of the Red Hook impact. Did you see any other -- in terms of other markets, have you guys seen any changes in the competitive environment this quarter versus maybe the past few months?

Kevin McDonnell

It’s Kevin. The only thing again I’m seeing I would say in both the meat and the sea food areas with the increases and dramatic increases in cost. Again we are looking very closely and we are not seeing everybody passing on those increased costs through to retail. And so people are being aggressive I think promotionally in the marketplace and I would say that’s more on the traditional retailer standpoint. So that is putting a little pressure on us in terms of those commodities but I would expect that that would also continue. We are starting to see the sea food market lighten up a little bit. So that should help, but meat is still an issue.

Ed Arditte

And again I’d come back to the comments that we made about Red Hook and importantly the rest of the company was ahead, ex Red Hook was ahead from EBITDA point of view. But obviously the dynamic of that big opening that we had at Red Hook last year and the competitive opening which we talked about here obviously offset it.

Operator

Thank you. And our next question comes from the line of Scott Mushkin with Wolfe Research. Your line is now open. Please proceed with your question.

Scott Mushkin – Wolfe Research

Hey guys, how are you doing? Okay. So I’m just kind of trying to understand the mechanics of the Google service that you're doing. Can you go into a little detail? They're charging about $4.99. Are they taking out of your store? How does it work, and do you guys subsidize that at all or is that -- can you give us little details?

Bill Sanford

This is Bill. Obviously this has just been going on for a couple of weeks right now. The model that Google has is they provide the shopping. They provide the picking the order in the store, in a cart just like a normal consumer does and then they deliver it to the customer. And so it’s -- for that fee it’s a pretty good deal for us. And what we are seeing is pretty quick adaptation in the market we’re in. It’s better than we thought it was going to be. But it’s not going to move a needle in revenue until it rolls out into the rest of the system. But they come in, they already have the credit card, they choose the items and they deal with any substitution it has to occur. I will say that we are exceeding their threshold for fill rates in the store. And so they’ve got a pretty high service level commitment to their customers and Fairway is exceeding that service level commitment.

Kevin McDonnell

The only thing I would add to that is currently it’s just on a non-perishable basis. So it’s not perishable products, which really is our sweet spot. But we are seeing pretty good adoption of the program in a couple of weeks.

Ed Arditte

And what I would add to that, just a couple of things; one is it’s currently non-perishables. But I don’t think -- while I can’t speak for Google, I don’t think they start off with a strategy that says we only want to do non-perishables. I think they are actively thinking about how to make a move big time into the perishable space. The other thing and I think there’s plenty of information online on this, they have been doing this business in the San Francisco Bay area and I define that as probably within maybe 75 miles to 100 miles of the center of the city of San Francisco and they’ve been doing this for a while and have ramped up a very, very successful program from a number of transaction point of view. So New York as I understand it is their second big market and they are very serious about this.

Scott Mushkin – Wolfe Research

And do you guys pay them or no?

Bill Sanford

No. And the competition is going to keep this very competitive, the way we think about it. There entities out in the market trying to do this and they want to keep the delivery charges low for the consumer. And to the extent they are agnostic the way Google is with their suppliers, they want to keep their relationships with us strong.

Ed Arditte

I think again not to speak for them, but I think their strategy is they come to a market and they come to New York is they welcome the opportunity to have Fairway on prominent display on their website.

Scott Mushkin – Wolfe Research

Okay, interesting. So just moving on if we could, two more questions. The central production facility coming online in a couple weeks, talk to us about the risks maybe associated with that? I mean obviously over a multi-year period it's easy to understand what the benefits are going to be. But it seems to me when you make these transitions that there are some double costs. There's maybe stock-out issues depending on how things go, so talk us through a little bit how you view the risks and how we should be thinking of it from our seats?

Kevin McDonnell

It’s Kevin. The risks there as we see them, currently we have kitchens in most of our existing stores and there’s a pretty big step there. Obviously one of the benefits of doing this is that we can leverage and not have as many total employees and get better consistent quality and execution. The risk during the transition will be as we migrate from basically closing the kitchens and the stores and we won’t totally close them there’ll be a much more limited it will be like a finished kitchen, but there’ll be much more reduced staff and then you basically are converting the staff where appropriate over to the centralized production facility.

So it’s really in managing I think the employees through that transition and what our position is going to be is we will really err on the side of having over exposure on the employee base as we go through the transition. So we are not going to wipe out the kitchens and the stores at the same time that we are getting the production facility up. So we’ll have some kind of double staff there for a while until we are comfortable that we’ve transitioned correctly into the centralized facility.

Ed Arditte

Scott, what I would add to that is I think the most important thing for us is that this facility come online from over a period of time as we ramp it up in as efficient a way as possible and in a way that is as serving the customer as possible. And so to Kevin’s point, there will be certain redundant costs. We do have some of that built -- we have something built into our forecast for that, like clearly the extent to which we drive towards those number. We’ll have to see how that plays out. But we have a very, very professional team that we’ve brought into the company over the last year plus that have significant experience doing this activity. They are very integrated into what we are doing. They are leading the planning. They are leading the startup of all of this. They are leading the systems implementation and so on. So we feel pretty good. But as you know and everybody else on the phone knows, this is a significant strategic move for us. Anytime you move to a central production capability, there’s the risk of a speed bump, but if we do have one I expect it to be a small one.

Scott Mushkin – Wolfe Research

Okay, that's good. And then I -- last one, sorry, I’ve got three here, but I guess a lot of people have done that. Nanuet, I think you guys said $700,000 a week is where that is running, I remember Whole Foods opening Princeton, New Jersey back gosh in 2006, 2007, whenever it was, 2005, but they ran about $700,000 in a big store in the suburbs and I think they lost a lot of money. Not that $700,000 isn't a great sales generation for a suburban location, it's just when you have high amounts of prepared foods and other things, those stores really need to do better than that, not to make that happen. Can you give us a little more color on Nanuet?

Kevin McDonnell

Yes. It’s Kevin, again. Nanuet, it’s a good store for us. The sales are around that $700,000. There are still some openings in the occupancy, in the outdoor mall that’s there, which my understanding at this point is that they will not be filled until probably the fall. There is construction going on in an out parcel for a bank. So we are expecting as the weather gets better and as we get filled in with some of these last tenants that the store will do better. So from a sales perspective we feel okay. We are going to strive to do better and we think as we get the fill in we will. There are still other operational benefits we can get out of the store similar as we talked to the things that we are doing in Lake Grove and some of the other stores that can increase the profitability of that store.

Ed Arditte

What I would to that Scott, is that part of the work that Kevin referred to earlier and Bill referred to relative to the reengineering of the store model, particularly the suburban store model to operate our stores in a more efficient way, again the production center being a big part of that, gives us the ability to feel very good about being able to make money and make good money and make a good return at $700, 000 a week. So I think the fundamental premise that $700,000 a week as we all know is a good number. We think Nanuet has the ability to do better than that as Kevin just mentioned, but importantly for us is to design these locations in the suburbs and make good money and make a good return for us at $700, 000 a week.

Operator, I think we have time for one last question.

Operator

Our next question and last question comes from the line of Barry Haimes with Sage Asset Management. Your line is now open. Please proceed with your question.

Barry Haimes – Sage Asset Management

Thanks very much. Just two quick questions. One is moving from two openings per year to three; is the major constraint on that finding the real estate, or is it funding, or is it personnel? Just give a little feel for what the constraint there is. And then secondly, on the new production facility, how many stores will it support once you get it up and running? And then how many stores ultimately could it support? So what will be the capacity? Thank you.

Ed Arditte

Let’s go to the production center first. Our thinking is that it can comfortably accommodate our requirements out to 30 stores. I think there’s probably a sense that we have as we get into it and we figure out ways to get even more efficient and maybe it’s got some ability to go beyond 30. But for now I think it’s appropriate to think in terms of taking care of our needs at the 30 stores, which think in terms of the next five, six, seven years depending on our build rate. So that would be the production center side of it. With regards to the new stores per year, I would say at this stage given the real estate pipeline, it’s more about the right real estate than it is about the capital and I think with the right -- I think we see 2017 developing in a way that we see both opportunities there. We see the possibility of some very good locations and clearly we’ll be a bigger company at that point, generating that much more free cash flow.

Barry Haimes – Sage Asset Management

Terrific. Thank you. Appreciate it.

Ed Arditte

Ladies and gentlemen, thanks for joining our call today'. We look forward to any follow up sessions with any of that you feel you need. And again, we look forward to our next earnings call to discuss our first quarter results. We’ll also be in touch with you as we get closer to the grand opening of Lake Grove. So for those you that would like to attend, you can be sure to join us. Thanks for joining us today.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Have a good day everyone.

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Source: Fairway Group's (FWM) CEO Bill Sanford Q4 2014 Results - Earnings Call Transcript

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