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Sprouts Farmers Market Inc (NASDAQ:SFM)

Q2 2014 Results Conference Call

August 07, 2014 – 5:00 PM E.T.

Executives

Susannah Livingston – VP of IR

Doug Sanders – President & CEO

Amin Maredia – CFO

Jim Nielsen – COO

Analysts

Kate Wendt – Wells Fargo Securities

Scott Mushkin – Wolfe Research

Joe Edelstein – Stephens Inc

Stephen Grambling – Goldman Sach

Jason DeRise – UBS

Karen Short – Deutsche Bank

John Heinbockel – Guggenheim Securities

Rupesh Parikh – Oppenheimer & Co.

Vincent Sinisi – Morgan Stanley

Edward Kelly – Credit Suisse

Kelly Bania – BMO Capital Markets

Operator

Good day, ladies and gentlemen and welcome to the Sprouts Farmers Market second-quarter 2014 earnings conference call.

[Operator Instructions]

As reminder this call is being recorded. I would now like to introduce your host for today's conference Susannah Livingston, Vice President of Investor Relations. Please go ahead.

Susannah Livingston

Thank you operator, and good afternoon everyone. We are pleased you have taken the time to join Sprouts on our second-quarter 2014 earnings call. Doug Sanders, President, Chief Executive Officer; Amin Maredia, Chief Financial Officer and Jim Nielsen, Chief Operating Officer are also on the call with me today. Sprouts' form 10-Q and the earnings release announcing our second quarter 2014 results and the webcast of this call can be assessed through the Investor Relations section of our website at sprouts.com.

During this call management may make certain forward-looking statements, including statements regarding our future performance and growth, product expansion, new store openings, and 2014 expectations and guidance. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information please refer to the risk factors discussed in our filings with the Securities and Exchange Commission along with the commentary on forward-looking statements at the end of our earnings release filed today.

In addition, our remarks today include reference to non-GAAP measures. For reconciliation of our non-GAAP measures to GAAP figures, please see the schedules in our earnings release. We believe these adjusted results provide a good basis to assess the operating and financial results of the Company year-over-year.

For the second quarter ended June 29, 2014 we reported diluted and adjusted diluted EPS of $0.20. Adjusted diluted earnings per share increased 43% from $0.14 in the same period in 2013. With that, let me hand it over to Doug.

Doug Sanders

Thank you, Susannah. Good afternoon, everyone and thanks for joining us today.

2014 continues to be an exciting year for Sprouts as the broad appeal of our healthy living for less strategy continues to win new customers and create opportunities for growth. With the opening of our first stores east of the Mississippi in Atlanta, Georgia we're now operating stores in ten states from coast to coast. All of this excitement continues to produce strong top line and bottom line growth and we are very pleased report another quarter of strong financial results.

Our net sales grew to $744 million for the quarter, up 20% from 2013, thanks to the strong performance of our new stores and approve comp store sales. The second quarter represents our 29th consecutive quarter of positive comp store sales growth ending with comps of 9.5% and 20.3% on a two-year static basis, as Sprouts continued to outperform the grocery industry.

Before I share some thoughts around the business drivers for the second quarter, let me reiterate what we see clearly distinguishes Sprouts from our competitors. As many of you know, Sprouts attracts the everyday grocery shopper by offering fresh high-quality produce at the best prices in town.

Why produce? It's because produces a healthy product the everyday grocery shopper understands and buys every week. With approximately 25% of our revenue coming from the produce department we continue to benefit the consumers growing interest in improving their diet by making healthier food choices.

In addition, Sprouts promotional approach and our ability to communicate our competitive prices week in and week out through our distributed ad circulars and social networks, continue to drive traffic to our fresh, natural and organic offerings across the store. This differentiated model has created a broad appeal that continues to separate Sprouts from the competition, giving us the ability to take market share from both our conventional supermarket and specialty retail competitors.

The consumer purchasing landscape and food retail continues to evolve as shoppers embrace the need for healthier diet. Studies today show that the most rapidly growing segment of Americans adopting healthier eating habits is primarily middle income consumers.

For years, price and availability have long been viewed key barriers to attracting this middle income shopper, but Sprouts unique combination of health and value offered in a friendly, easy to shop environment has allowed us to break down these barriers and become one of the fastest growing food retailers in the country. It's a strategy unlike any other natural foods retailer and has given us the ability to compete in the broader $600 billion supermarket industry and not just the natural and organic sector.

Bottom line, we believe the growing health movement driven in part by aging baby boomers, millennials, and young families focused on what they're feeding their children is reshaping the food industry as we know it. And Sprouts is change the way people perceive and shop for fresh, natural and organic foods.

Specific to the second quarter business drivers, our comp performance was strong across all departments with great strength in our fresh departments. In addition, the former Sunflower stores continue to perform well, posting second quarter comps above the Company average. Consumer demand for our fresh, healthy product offering continues to be strong which led to a nice balance of a 5% increase in customer traffic and a 4% rise in basket size for the quarter.

In addition, we continue to see significant growth in specialty categories such as organic, raw, gluten-free, and non-GMO verified, with sales growth of more than 20% in each of these categories. Our Sprouts private label program also continues to grow in both variety and sales. We're now up to over 1,500 private label SKUs and comp sales in the second quarter increased by 30% over last year.

On the expansion side, we opened 6 new stores in the second quarter and have opened an additional 5 new stores in the third quarter to-date. Two of the stores are in the Atlanta area, representing our initial entry into the Southeast region. The Atlanta openings have started off well above our expectations with continued momentum past the opening week as we bring affordable healthier food choices to these communities.

The level of consumer anticipation around these openings was far more than we had ever experienced in a new market. That excitement was evident in the 40,000 Atlanta Facebook fans we amassed before even opening our first store the market, and the more than 1,000 customers that signed up for Tuesday night preview event in less than 1 hour. Our impressive early performance in the Southeast clearly demonstrates the strength of the Sprouts brand and our ability to excel in new markets.

Our healthy living for less model continues to generate broad customer appeal, allowing us to successfully operate in natural lifestyle markets as well as markets where healthy living is in its in early phases of adoption. We reinforced our commitment to the local communities and businesses in the Atlanta area by offering more than 170 local products, from Georgia grown peaches, to local handcraft beers and barbecue sauces. You can learn more about these unique local items, as well as the stories and people behind them, in our growing Meet the Brand video series found on the Sprouts Farmers Market YouTube channel.

As with any new market, it was extremely important to build our Southeast team with experienced internal candidates who understand our healthy living for less philosophy and how to on-board new team members who aren't quite as familiar with our brand. We were fortunate to have more than 30 team members, including store managers and department managers relocate to the Southeast to support our expansion. With their help the transition has been very successful and we look forward to developing future leaders as we continue our expansion into the region.

As part of our team member development program, we will be hosting our annual Sprouts Fest this month in Phoenix, Arizona, which will include more than 400 team members from a support office, field operations, and store level teams. Throughout the 3 day event, team members will be treated to industry speakers, product and leadership training sessions and vendor exhibits to help them stay up-to-date on the latest trends in the ever evolving natural and organic industry.

We're on track to open a total of 14 stores during third quarter, putting us at 24 stores the calendar year, or 14% unit growth. Our growth plans currently includes 67 of pre-sites, and 42 signed leases for the coming years. All of our new stores are performing better than we expected, as we continue to serve as the healthy grocery store for our customers.

In addition to investing in new store growth we continue to reinvest back into our business through our remodel program and have completed 13 remodels this year on top of 12 completed last year. To-date approximately 60% of our entire chain is reflective of our newest store prototype, and in a disciplined manner we will continue to remodel those stores with opportunities to improve merchandising and store conditions over time.

Now let me quickly touch on commodities and inflation. During the second quarter, as expected, we experienced higher inflation in certain commodities. Despite this higher inflation, we continue to maintain our pricing strategy by closely monitoring pricing activity within the markets we serve. Our successful promotional strategies during the quarter, coupled with our aggressive produce pricing, continue to deliver strong traffic and comps across the departments as we navigate through these inflationary periods.

Overall, on an average Sprouts basket we saw acceleration in cost inflation during the second quarter of approximately 3% and expect inflation to remain at current levels throughout the end of the year. As we've said before value has been part of the Sprouts DNA since day one. So we're constantly monitoring the competitive environment to ensure we are delivering on our commitment to providing healthy foods at affordable prices every day.

Before closing, I'd like to take time to recognize the tremendous effort of all our team members throughout the Company and especially those involved in our numerous new store openings. Our Southeast expansion involved combined efforts of countless team members from across the Company, and I cannot thank our entire team enough for all their hard work and dedication. Our commitment to healthy foods, affordable prices, and engaging service continues to connect us with new customers everyday and truly differentiates Sprouts from the competition.

With that let me pass the call to Amin to cover our financial results and full-year guidance.

Amin Maredia, Sprouts Farmers Market, Inc. - CFO 4

Thank you, Doug, and good afternoon everyone.

We are very pleased with our strong results for the second quarter. Following Doug's highlights on the business drivers, let me cover our operating results and updated guidance. For the second quarter, gross profit increased to $224 million or 20% over the same period in 2013. Our gross margin rate of 30.1% was consistent with the same period in 2013. Leveraging occupancy, utilities, and buying costs were offset by lower merchandise margins resulting from higher inflation in certain categories including produce, dairy, and certain protein items.

We continue to maintain discipline in our commitment to invest in margins, to drive traffic and sales and bring value prices to our customers. Value has always been the foundation of our model and being competitive and making necessary price investments, even during inflationary times is a core part of our strategy to drive traffic, comp, and revenue growth.

Direct store expenses were $143 million for the quarter. Direct store expense as a percentage of sales was 19.2%, an improvement of 60 basis points compared to 2013. This improvement was driven primarily by leverage in payroll, depreciation, as well as a decrease in insurance expense.

Selling general and administrative expenses were $23 million for the quarter. SG&A as a percentage of sales was 3.1%, representing an leverage of 20 basis points compared to 2013. This benefit was mainly driven by leveraging advertising.

Adjusted EBITDA for the second quarter totaled $69 million, up 31% over the same period in 2013, driven by higher sales and operating leverage leading to EBITDA margin expansion of 80 basis points from a 8.5% to 9.3% during the quarter. Adjusted net income for the second quarter totaled $30.2 million, an improvement of the 68% compared to 2013. This increase was driven by the strong business performance, as well as reduced interest expense as a result of a lower principal balance on our term loan and a lower interest rate from our April 2013 refinancing.

For the 26-week period ended June 29, 2014 net sales increased to $1.5 billion, up 23% compared to 2013, driven by 11.1% increase in comp sales growth and new store openings performing well above expectations. Gross profit increased 24% to $448 million, resulting in a gross margin rate of 30.5%, or an increase of 30 basis points from 2013. Adjusted EBITDA totaled $147 million, up 40% from the same period of 2013, well above our long-term guidance.

We are very excited about our performance year-to-date, above our long-term guidance, which are driven by a number of levers including our ability to continue to drive traffic to our stores with our strong value proposition, strength of our new store productivity, staying relevant to our customers through our advertising and promotional strategies, and disciplined investments and management of direct store expenses, G&A and CapEx.

Moving to balance sheet and liquidity, we continue to build a strong balance sheet and improve our liquidity. For the 26-week period we generated $138 million of cash flows from operations and invested $58 million in capital expenditures, primarily for new stores. We ended the second quarter with a principal balance on our term loan of $350 million and a net debt to adjusted EBITDA leverage ratio, excluding capital and financing leases at 0.6 times. We ended the quarter with cash and cash equivalents of $184 million and $53 million available under our undrawn revolving credit facility.

As we mentioned earlier in the year, and due to the strong cash flow generation year-to-date, during the third quarter we expect to pay down an additional $15 million of principal balance on our term loan. With a strong cash position, robust return on investment, and ample real estate opportunities opening new stores, maintaining superior store conditions, and new sales initiatives continue to be an investment priority.

As we can see, our strong financial performance has continued into the second quarter of 2014. Another solid top line performance and continued leverage in the business gives us a high level of confidence to increase our full-year 2014 guidance as follows. Net sales growth target of 19% to 20%, adjusted EBITDA growth range of 25% to 27%, 45% plus growth in adjusted net income, and adjusted diluted earnings per share range of $0.65 to $0.67, a forecasted growth of 35% to 40% over the prior year. In addition, our guidance range for comp sales growth is a 8.5% to 9.5% for the full year.

Let me review a few additional items regarding our full-year guidance. First, consistent with our view at the beginning of the year, in our guidance we expect comp sales growth to moderate in the back half of the year as we cycle high comps sales from the back half of 2013. We continue to expect the 2year comp sales stack to be in the 19% to 20% range, which still remains amongst the best in retail and well outpaces the grocery sector. Specific to the third quarter of 2014, we are forecasting comp sales growth of 8.5% to 9.5%, which would lead to a two-year stack comp sales growth of 18.5% to 19.5%.

Second, we expect to continue to make price investments as necessary to drive top line sales, a strategy that continues to drive high margin dollars. Third, with the opening of 14 new stores for the third quarter, we expect pre-opening cost to be approximately $2 million higher than the prior year. Further, as you know, in our new store model, our new stores start off with a lower gross margin than our mature stores and we have built in the compression to the gross profit and overall EBITDA margins from the new store openings for remainder of the year in our guidance.

This compression is expected to be higher than normal during the third quarter, as we are opening 14 stores during the third quarter compared to 4 stores in the first quarter of this year and 6 stores in the second quarter of this year. We expect our existing stores to continue to leverage well from the strong comp sales performance. Overall, we are very pleased in our ability to continue to grow top line sales and bottom line profitability well above our long-term goals for now 3 consecutive years.

In conclusion, Sprouts' growth is fueled by the everyday grocery shopper who wants to eat healthier and recognizes it no longer has to be expensive to eat healthy. This broad appeal has led to another strong quarter for Sprouts and gives us continued confidence in the business going forward.

With that we would like to open the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from Kate Wendt from Wells Fargo Securities.

Kate Wendt – Wells Fargo Securities

Yes. Thanks so much. So I would've expected maybe some level of deceleration in your comp trend this quarter, given what we've seen from literally almost every other retailer and given industry weakness in supplements. So I'm wondering if maybe you can talk to what you did differently this quarter, if anything? What – you talked a little bit about what categories maybe performed well – maybe which ones perform better than you expected? And what do you think is driving your continued momentum?

Doug Sanders

Good afternoon, Kate, this is Doug. I think what you're seeing is really reflects the strength of our model and our ability to connect with the everyday shopper. We've always talked about the broad appeal of the Sprouts concept. And as I noted earlier the fastest adoption in healthy eating is coming from that middle-income consumer, who is target customer for Sprouts.

Connecting with that customer goes into everything we do from where we place our stores, to how we market our products. And I think our customers are seeing the value of shopping at Sprouts and really appreciate the effort we put into making sure healthy eating is affordable for them. For a little bit more detail, Jim, you can put more detail in that?

Jim Nielsen

Just add a little color on that. From the fresh side of the business, we obliviously got a very strong benefit in the fresh side, which really speaks to customers' demand for fresh, healthy products.

Kate Wendt – Wells Fargo Securities

Great. Thanks, to both of you. And then in terms of the comps in the converted Sunflower stores, it sounds like they're still out comping and providing a slight tailwind. Originally, you expected that to moderate in the third quarter. Just wanted to check in with what you thinking there? And what is encapsulated in your guidance?

Doug Sanders

Sure. As you've seen, the Sunflower acquisition has proven to be very successful. And for the second quarter, as we talked about and as we expected, the Sunflower comps had started come in line with our Company averages. We cycle a lot of the improvements we made during the rebranding of last year.

During the first quarter, Sunflower benefited. We benefited from the Sunflower comps for about 160 basis points of our total comp, and in the second quarter it's been reduced to about 80 basis points. Again throughout the back half of the year, we continue to expect the Sunflower comps to come closer in line with the Company average.

Kate Wendt – Wells Fargo Securities

Great. That's helpful. One last quick one. New store productivity beat what we had factored in given that some of your stores open later in the quarter. Wondering if you could provide it as you calculated on the weighted basis in the quarter, adjusted for the timing of openings?

Amin Maredia

Yes, Kate. If you do it based on exactly the date the stores opened, we calculate new store productivity for this quarter was very strong it was at 105% of the quarter. Which is fairly consistent between 100% and 110% that we've seen over the past few quarters. Some a very strong openings happen towards the end of the quarter, so we think that will continue to provide us momentum in our new store productivity in the next several quarters.

Kate Wendt – Wells Fargo Securities

Great. Congrats and thanks again.

Doug Sanders

Thanks, Kate.

Operator

Thank you. Our next question comes from Scott Mushkin from Wolfe Research.

Scott Mushkin – Wolfe Research

Hey, guys. Thanks for taking my questions. I wanted to talk about the competitive climate – you talking about investing in price. Other people are talking about investing in price.

So I guess where does this go? How does it end? I think the fear in the market is that everyone is doing the exact same thing and while you guys are clearly the cream of the crop here, that you will not be immune to what's going on in the marketplace. And so maybe take us through how you think you don't suffer, if everyone starts pushing on that price dynamic?

Doug Sanders

Sure. Hi, Scott, this is Doug. We look at competition in a couple different ways. Really looking at it from standpoint of access to natural foods and then pricing, kind of in a different bucket, if you will.

From the access side, obviously you can find natural foods in far more places today, and retailers have been increasing their offering of natural and organic foods probably 5 plus years. That's really nothing new. But it is obliviously creating greater access to natural foods on that side.

And then on the price side, we've spent a lot of time and a lot of resources doing a lot of competitive price checks, making sure we're up to speed on what all the competition is doing. And we really haven't seen a very material shift on the competitive pricing side of natural foods. So again, a couple different ways to look at it. Both from greater access to natural foods and then from a pricing perspective. And I'll let Jim give a little bit more color on the pricing side.

Jim Nielsen

Scott, how you doing? This is Jim. For the non-produce side of the business when you look at Q2 – Q1 versus Q2, we can see material shift. We hear a lot of talk about we haven't seen a material shift in the market.

What we have seen is a low but more investment in the protein and produce side of the business from our conventional players. We're obviously very aware of it. As you know, we continue to stay true to our pricing strategies and pricing disciplines. And good news is that we're getting good continuous unit lift off of our investments.

Doug Sanders

I think the only thing I would add, Scott, to that would be, again as more traditional retailers and other format continue to add natural and organic offerings, at Sprouts again focus on a broader breadth of offerings. From specialty to gluten-free to organic. So very wide breadth of offerings. And also that product knowledge and authentic offering that we have at Sprouts. Again, our consumer being that middle-income consumer, where the growth is, is in natural and organic. Coming into the stores wanted to learn more about natural foods, so expecting to see a broader offering. And then also having that engaging customer service to teach them how to eat healthier and what the benefits of natural and organic products would be.

Scott Mushkin – Wolfe Research

If I could paraphrase, it sounds like it's more of an offensive strategy where you are trying to drive value, kind of accentuated to your core customers or your potential customers, what you guys stand for, rather than of reactionary strategy. Is that fair?

Amin Maredia

Hey, Scott, this is Amin. I would say we remain focused. We've always remain focused on our core strategy of value. And in an inflationary period like what we're seeing today, we've been passing on inflation in certain areas and invested in certain of the departments, our products, where competition remains highly promotional.

We've always also invested in other areas where we don't want to go past a certain price points to preserve the value to our customers. The method that we have is, with a tailwind in our sector and the growth of the natural and organic sector, Doug talked about the full product set of natural and organic, clearly puts us in that offensive position to stay sharp in pricing to the marketplace but also be able to keep driving that value equation and leverage in other lines of the P&L. I think part of that offense strategy is really inherent in our business model.

Jim Nielsen

One last thing to add, is the customer themselves is transitioning as well. We're getting a benefit from that. Not just buying add products, and coming in as an add vehicle, but also shopping our regular retail, shopping our TPRs, and we're getting a better full basket of not just add items.

Scott Mushkin – Wolfe Research

That's perfect. I actually have one more, but it's been a long question. So I appreciate your answers. Thanks, guys.

Doug Sanders

Thanks.

Operator

And next question comes from Joe Edelstein from Stephens Inc.

Joe Edelstein – Stephens Inc.

Hi, good afternoon. We heard you talked in the past about ramping up the advertising, particularly as you get closer to those Atlanta store openings. It really does seem like you are benefiting from being aggressive with that marketing campaign. Is the spending something that you'll need to continue at these elevated levels, particularly as you consider that one of your larger natural and organic competitors is thinking about this brand campaign this fall?

Amin Maredia

Joe, I'll say two things, as far as getting into the market is really our new store marketing strategy, so really new markets is where we get into the market early, through not only our Facebook promotions, but also the grassroots and customer engagement activities. So, what I would say is as we go to new markets and large new markets you'll see a rotation of spend from – it might Atlanta today and some other market next quarter or early next year.

So I think that would remain consistent, as we go from market to market. The nice thing we've also seen is, including this quarter last quarter is, in our existing markets where we're continuing to see good comp growth, we are able to leverage on our advertising costs because we are not really expanding the advertising zip codes any further. So you get a nice leverage in that area as well.

Jim Nielsen

We're also seeing a level of, as Doug mentioned in the call, is a level of anticipation in markets that we've never seen before. As you mentioned, 30,000 Facebook fans before we open just Dunwoody, specifically – excuse me, Snellville. So just the anticipation of coming to that market is much different than we'd seen a year or year and a half ago.

Joe Edelstein – Stephens Inc.

That's great to hear. If I could maybe come back to the new store productivity metrics that you spoke about earlier. Is it too early to say that these strong levels are sustainable?

And then kind of a follow-up to that, is the implications for your same store sales growth, with the store starting out at such high levels. Is it getting to a point that you actually need to rethink the economic store model in any way, and kind of how that would flow into your longer-term growth rate an the targets that you set, perhaps that's moving up?

Amin Maredia

Yes. That's a good question. I think again couple of things there is we started this more robust a program improve merchandising assortment and new store marketing strategy at the beginning of 2013. And those stores are starting to get into the comp base to as they come in with 61 weeks.

I think what we're seeing is – one thing we are seeing – it is a little bit early to tell, but the one thing we are seeing is that the stores are settling in at higher volumes, so irregardless of the impact to comp sales of that particular store in future years, the early signs is that the sales level are higher, the gross profit dollar levels are higher, and the profitability of the stores are ramping faster than 3 or 4 years, depending on how mature the market is. And so as we expand unit growth we'll continue to see – to the extent that we continue to see that benefit accelerate in, I think that just bodes well for overall profitability and overall EPS for the business.

Joe Edelstein – Stephens Inc.

Thanks for taking my questions.

Doug Sanders

Thank you.

Operator

Our next question comes from Stephen Grambling from Goldman Sachs.

Stephen Grambling – Goldman Sachs

Hey, good afternoon. Thanks for taking my questions. I guess, keeping of the new stores in the Southeast – I mean what has surprised you and we how are you adjusting the approach, if at all, as you continue to ramp up in the area? And have you seen any competitive reaction at this point?

Doug Sanders

Hi, Stephen, this is Doug. Our approach to Atlanta was fairly consistent with our approach to new markets that we've entered in the past. We get into the market early. We start to establish our brand early before the first stores open.

We had a few more pieces to the offering, if you will, because obviously really leveraged social media. We really leveraged the grassroots, getting in the market, getting kind of well-established with the brand with the potential consumers in the area.

So I think really what you saw with Atlanta was just a really harder push up front through social and grassroots to get our brand in there. And obliviously you've seen the reaction from it. From a Facebook perspective we had north of 40,000 Facebook fans before we even opened our first store. So obviously being able to connect with that consumer via social media and then having our on the ground grassroots marketing team out there for 2or 3 months before the stores open, really connecting with the consumer at the grassroots level was very, very beneficial. What was the second half of your question?

Stephen Grambling – Goldman Sachs

Just if you've seen any competitive reaction at this point.

Doug Sanders

At this point we haven't seen a lot of competitive changes. And again, it's been – the competitive response is been very similar to the competitive response we've had a new markets over the past 12 years and we've entered new markets in Texas, in Colorado, and parts of California. Nothing really new from a competitive standpoint.

Again, I think from our research we did – the couple of years of research we did in the Southeast before going into the market, we were well prepared for what we were walking into both from a customer standpoint and from a competitive standpoint. I think the research we and the investment we made in really understanding the customer in that region and the way we went and attacked the customer and attacked the right products – I mentioned the local products that we brought in – really, really gained us a lot credibility with that Atlanta customer. And again you're seeing the benefit of that in the initial numbers coming out of the store.

Stephen Grambling – Goldman Sachs

I was going have a follow-up for Amin, which was just as you continue to grow the business and grow cash, what is the appropriate capital structure in your mind?

Amin Maredia

I think we're obviously – as I mentioned, the investment priorities are one, new stores; two, sales initiatives, which have been returning very well; and make sure that we keep a superior store conditions and continue our remodel programs on a disciplined basis. So outside of the capital structure – sorry, outside of the CapEx plan we are looking to, at this point continue to pay down some debt at a time. And we will revisit capital structure towards the end of the year and probably guide a little bit more to it on our year-end call for 2015 and beyond.

Stephen Grambling – Goldman Sachs

Thanks for taking the questions.

Operator

Thank you. Our next question comes from Jason DeRise from UBS.

Jason DeRise – UBS

Thanks for taking the questions. Can you talk about some of the new classes of stores and maybe compared to the older classes of stores, how the trade up process is going? If you are still finding as customers become familiar with Sprouts and they lead with the produce at the attractive prices, if you're finding you're still trading up throughout the store, including the vitamin section?

Jim Nielsen

This is Jim. Overall, what we're seeing is a better basket size in the new stores, which is really been driven by the improved assortment and all the sales initiatives that we had put together in the past.

From a maturity standpoint, it's fractionally better. It's really too early to tell how much improvement we're going to get. We're really pleased with the overall basket size.

Amin Maredia

One thing I would just add is, is we're continuing to see, Jason, good momentum in sales of specialty categories in our store, non-GMO, gluten-free, raw foods, vegan. We're definitely seeing customers expand to more and more sections, going from the traditional produce, bulk, meat, seafood – is kind of where people start and they continue to work around the store, and so we're continuing to see the specialty categories grow. As of the last few quarters, we've also seen organic produce continue to grow quite nicely, and we'll continue to expand assortment in organic produce to more number of stores, and all of our new stores, of course.

Jim Nielsen

Consumers a giving us more credit than just being a produce store. They're giving us credit for being a value oriented grocery store.

Jason DeRise – UBS

Great. And also asked bigger picture, now that you are over 180 stores. Where do you think the biggest opportunity is for scale benefits, going forward?

Amin Maredia

I think overall from a scale benefit perspective, our focus is on continuing to be really disciplined and focused around the customer. We do continuous planning around the customer, and say what is the customer want from a product standpoint, from a service standpoint, from an education standpoint? So we think our big opportunities are really in that area and continuing to get better and better.

We think we are good today, but continue to get better by listening to our customers, and we're spending a lot of time and effort right now in going through the process of saying: what are the next things that we want to achieve over the next several years to be even better? With a focus on two things, health and value.

Doug Sanders

Jim, I don't know if you want to add anything to that?

Jim Nielsen

No, I think that's it.

Jason DeRise – UBS

Thank you.

Operator

Our next question comes from Karen Short with Deutsche Bank.

Karen Short – Deutsche Bank

Hi there. A couple questions. First starting with the gross margin. I'm just wondering, can you quantify the impact of inflation on the gross margin? And was it an issue where it was a lag on passing on inflation, which should abate? Or was that a conscious decision not to pass on inflation to gain share maybe? Just a little color there?

Jim Nielsen

A little color is, as far as inflation and the passing of inflation, we were able to do it mostly on regular retails. But when it came to promotions, most specifically on the protein and produce side of the business, we did take a little bit of margin compression. It was about 10 basis points. But obviously, it was conscious effort. We have strict pricing strategies and we adhere to them.

Karen Short – Deutsche Bank

Okay. And then turning to direct store expenses, those came in obviously a little bit better than expected. Is that the new – was there anything unusual there that isn't sustainable going forward? Or any color you could point to there? I did drop off for second, because I got cut off so apologies if you covered that.

Amin Maredia

No, Karen. On direct store expenses this quarter we saw a couple of things, of course with the 9.5% comp for the quarter that gives quite a bit of leverage. And the 3 areas of really leveraging DSE is – the big ones are in all of our insurance, workman's comp, GO, claims et cetera. R&M expenses and depreciation, and those are sort of the big leverage points and, as you know, once you get past 4%, 4.5% in comps, some of these areas which tend to be a little bit more fixed nature, provide good depreciation – sorry, leverage in the business.

What we are seeing is, as we are getting bigger and all the work we've done around training and working with our stores on the claim side, is we're starting to see – not only getting improve rates – not only getting improve rates from our insurance companies but also getting benefit of lesser claims for the self-insurance portion. So we're starting to leverage well on the GL workman's comp side of the house.

Karen Short – Deutsche Bank

Any way to quantify that – the insurance and the workers comp component of the benefit in direct store expenses?

Amin Maredia

It's fairly even – the 50 basis points this quarter between the 3, insurance is slightly higher, but it's fairly even across the 3 of insurance, R&M, and depreciation. And we just got – we just finished negotiating our policies for the rest of this year and next year, and we're really, really pleased at what we're seeing on that front. We're really focused on, again, being disciplined about driving improvements in all lines because as you know, every 5 or 10 basis points matters.

Karen Short – Deutsche Bank

Okay. And then just a last question. Obviously, you've been very vocal about cycling the Sunflower benefit to your comp, but I think – and when that ends. And obviously, you just talked to that of the call. But you also have started seeing very significant strength in several markets.

I think you previously called out Texas, California, Nevada in previous calls, and I think you started calling – goes out as being outsized in terms of strength. I think was on third quarter call last year – might have been the second quarter. Can you give a little color on when you started seeing that? And whether there is any cycling to think about?

Amin Maredia

I think a couple of years ago, if we kind of look back on what we've seen cycle wise is, a couple of years ago we saw a really good strength in Colorado and Texas and going into 2014 – late 2013 and 2014, we continued to see strong strength in California. We saw – in Nevada, as well as in Arizona, we're continuing to see very strong comps.

What I would say right now is no region is really lagging too far behind. I think all of our areas are performing pretty well, so we feel pretty good about where we are.

Of course where our brand's getting recognition as leading Arizona is fantastic, California's very good, Texas is continuing to come along. The brand is continuing to get established in Houston. So we're looking forward to keep building there, going forward.

Karen Short – Deutsche Bank

Great. Thanks very much.

Doug Sanders

Thanks.

Operator

Our next question comes from John Heinbockel from Guggenheim Securities.

John Heinbockel – Guggenheim Securities

Thanks. So two things. Let me start with real estate. I know you guys have thought that there was a big opportunity, as hard lines retail got recycled here. Particularly in some sub-sectors.

Do you have any more concrete thoughts on that? As that whole process has progressed. And what was your thought on how much you would be willing to flex up in any one year, in new openings or unit growth, to take advantage of those opportunities that come along?

Doug Sanders

Hi, John, it's Doug. So we're still seeing and hoping for some opportunity in some of those industries that are in transition. We talked about books and electronics and office supplies.

It's been a little slow going, but obviously we're still working with some of the developers and some of the other companies that are in transition. Not a whole lot new to report on that front. Again, we're still working in close contact with those entities.

John Heinbockel – Guggenheim Securities

You would flex up – if you had an opportunity to do a certain number of units, you we temporally go above 13 or 14% unit growth. Is that fair?

Doug Sanders

That's fair. Obviously, we are very committed to that 14%, obviously being from a consistent growth plan. But given the opportunity, yes, absolutely. We would flex up to take advantage of an opportunity that came our way.

Amin Maredia

No different than in 2009 – 2008, 2009, when the economy started softening, and we started to see opportunities in places and markets which are hard to get into, like Los Angeles or parts of Southern California. We took the opportunity at that time to flex up and get into those leases. And again, this comes back to the discipline.

We're seeing very aggressive rates in certain parts of the country, certain parts of California, and that's where we just have to be patient and not get outside – get too aggressive in rate, and just be patient because cycles to come in and out. There plenty of saw opportunities in our ten states currently, so to the extent that we have to be patient in one market, we will do that and stay extremely disciplined about our business model and growth.

Jim Nielsen

John, I think we'd be remiss to not bring up the new store opening teams that we have, have really perfected what they do and are able to open those stores very seamlessly, and in the operations team has been able to transfer the culture and improve the operations of the new store openings.

John Heinbockel – Guggenheim Securities

And let me ask you conceptually, when you think about sale out at the older stores that you have, or somewhat older stores – what do you think – how much incremental volume could some of those stores, or a lot of them, handle without service deteriorations? So I sort of wonder, could you do 40%, 50%, 60% more volume before you kind of tap out in terms of capacity? Have you ever thought about what the opportunity is there?

Amin Maredia

Sure, John. If you look at the average volume of a Sprouts store today, we have stores which do almost 2X that volume, certainly 70%, 80% higher. Those stores are tight on peak days like a Saturday or a Wednesday, but we'll continue to add registers and do all the things to can to drive.

In addition to that, we also look to bring density into that market, potentially looking for new sites. And what we've experienced here in Arizona, as an example, is when we put another site 4 or 5 miles away, you make some cannibalization, but those core stores, over 1, 2, 2.5 years have built right back up to their original volumes. And then we've done it all over again. There's several stores here in Arizona we could look to, where we've done it a couple of times. In short, we have stores which are 70%, 80% above our 300 volume.

John Heinbockel – Guggenheim Securities

Okay. Thank you.

Operator

Our next question comes from the Rupesh Parikh from Oppenheimer.

Rupesh Parikh – Oppenheimer & Co.

Thanks for taking my question. The area I wanted to delve into further, is online. In the past week or two, we've heard from some of your competitors that they're making more investments online. So I just want understand how you guys are thinking about, whether it's home delivery, or investing in your website going forward?

Doug Sanders

Hi, this is Doug. We obviously keep that under review. Couple things to remember is, 50% of our revenue comes out of fresh produce and from our dialogue with our consumers, it's an area that they obviously choose to really want to be able to pick themselves and so that's something we take into consideration. And keeping in mind that we do have a really robust dialogue with our consumers through social and through a lot of the consumer insight that we do.

Our goal really is to find a solution that best fits our customer, which is the everyday grocery shopper middle income consumer. So the goal is to find a solution that best fits our customer and that best represents our brand, as well, so we keep those things under review. We really haven't found a solution yet that we feel like best fits our customer and best represents our brand. But again, those are things we're keeping under review.

Amin Maredia

And I was just going to add in. We've talked to nearly all of the companies that do online and home delivery included and we understand what the value proposition is and we look to see how that can be best tied. We do have some urban stores, but most of our stores are in the suburbs and the customer preferences there still haven't shifted as much as if you were in San Francisco – in the middle of San Francisco or the middle of New York City.

For us, where can we get our greatest – again the discipline, where can we get the greatest bang for the buck by investing resources. And we think for our customer base and what they're telling us today, it's not an investment priority. That doesn't mean that we won't do tests to see how these models work, and if they add significant benefit to the business, then we would expand on that.

Doug Sanders

I guess the only thing I would add to that is, again customer engagement is a big piece of our business, because remember that our customer is that middle-income consumer. Where the growth in natural and organic is today, but many of those customer are starting to embrace the need for healthier diet and need a lot of education and a lot of direction and a lot of understanding of how to shop for the products that we sell.

Again, we keep the opportunities under review. We've met with a lot them, but just haven't quite found the right one that fits our customer and represents our brand as well we want it to.

Rupesh Parikh – Oppenheimer & Co.

Great. If I can just touch on just the commentary about the Q3 guidance. There's going to be an elevated level of store openings. So you think about the operating margins in Q3, do you think they can still expand in Q3?

Amin Maredia

Yes, I think what I would say is our existing stores – our core stores are pre-2013 vintages will continue – we would expect 8.5% to 9.5% comp sales continue to expand margin in those core stores. You do – when you and 14 stores, and particularly we have significant contraction in the first quarter or first couple of quarters of opening new stores, and this share of 14 stores that we're adding this year in the quarter is going to bring in quite a bit of compression.

So our current expectation is that we would see compression in margin in the third quarter. And part of it also depends on the competition in the marketplace and how the core stores behave, in terms of planning, but overall we would expect a slight compression in the quarter over last year. But from a dollars perspective, we expect very solid numbers, from a growth perspective.

Rupesh Parikh – Oppenheimer & Co.

Thank you.

Doug Sanders

Thank you.

Operator

Our next question comes from Vincent Sinisi from Morgan Stanley.

Vincent Sinisi – Morgan Stanley

Very good afternoon. Thanks very much for taking my questions. Wanted to ask a bit about the store remodels. I know that you guys had said that in some of the new stores you're seeing that better basket size because of the enhanced assortment.

Can you talk a little bit more detail about what specifically you are doing with the assortments or anything else with remodels? What type of maybe directional lift that you are getting? And if we could be – I know 13 are done so far this year – maybe would be above that 10, 15 annual rate going forward?

Jim Nielsen

This is Jim. As far as the remodels, we've seen a range of anywhere from 2% to 5%. On the 2% side, it's areas that have some of the sales initiatives that we've launched. And the 5% side, it's adding all the new elements, so it's a more dated store. Some of the things that we do in a remodel is our bringing on Boarshead, expanded refrigeration and deli, soup juice bars, expanded frozen and our meat selection, expanded offering in the organics.

We raised the gondola heights in our grocery departments, which gives us ability to bring on about 1,200 extras SKUs. So a wide variety, but every store is a little bit different. Some have those elements, that's why you see the range of 2% to 5%.

Amin Maredia

And when thing I would comment is, the way we started to look at those is, stores that need remodeling because they don't meet our goal of superior store conditions, those are the stores that we would remodel and – however, we still have sales initiatives for other stores to continuing to add on some of the things that Jim talked about. So our approach is really twofold, if the store does look tired or needs a remodel then we would go fully remodel it, but if it doesn't then we'd still look to expand on the sales initiatives.

Jim Nielsen

Another driver of some of our remodel selections, if we are going to experience a potential competitive intrusions.

Vincent Sinisi – Morgan Stanley

Right. That makes sense. Just for this current year, current expectations for number of remodels?

Amin Maredia

We've pretty much completed our remodel program for the year. So we did 12 last year and 13 this year, and we're done for the rest of the year. We have 2more that are almost of that are in progress to round it out, but most of our effort this quarter is really focused on our new store openings.

Vincent Sinisi – Morgan Stanley

Okay. That make sense. And if I could slide one more quick question in there. On private label, I know you said over 1,500 SKUs now. Has there been any notable change in terms of percent of sales, or maybe new categories that you've started or have thought about entering from a private label standpoint?

Jim Nielsen

Doug mentioned it earlier, as we're obviously for us, we're seeing a 30% comp growth – in raw growth of roughly 40%, just excess of 40%, so obviously pleased with the performance. It's a good balance of grocery, as well as from the fresh departments that we've launched. We've seen some nice growth there.

And in terms of overall penetration, it is slightly up, but we're really looking forward to the back half of the year. The first half of the year we launched just around 50 items, back half we are looking at 170 items. Even more exciting, we've got 20 unique quality items coming in this year that will be new to us.

Just continuing expansion and improve sourcing, so we can continue to grow the brand, and it's really obviously resonating with our customer. Just the quality and value they can trust.

Vincent Sinisi – Morgan Stanley

Great. Thanks very much and good luck.

Doug Sanders

Thank you.

Operator

Our next question comes from Edward Kelly from Credit Suisse.

Edward Kelly – Credit Suisse

Hi guys. Nice quarter. I have a bigger picture question for you. When you think about the stores and the merchandising in the stores, the product, the spacing, the look and feel – where are the stores today relative to where you think they can ultimately be? And I guess, I ask this question because obviously you're doing a great job at driving traffic, you've seen increase in the basket. But it seems like with all the traffic, the basket is the big opportunity, long term, especially related to that middle income consumer. I'm just curious as to where you think you are versus what you think the concept really can be at some point?

Amin Maredia

Yes. I think if you look at the overall customer bases, we've got a broad range of customer base. We've got a customer who is – a portion of our customer is very educated in terms of product knowledge and knows exactly what they want.

We have customers who have – they have certain conditions or diets that they're trying to follow, whether it's celiac or they're following a vegan diet. And then we've got a lot of customers who are, as Doug talked about earlier, are looking to eat healthy and they have a lot of questions and opportunities. Those are the customers that tend to over time convert into more departments in the store.

So what we've seen is twofold, is an opportunity to continue to educate that customer and move them to more departments through trial and other promotions that we do. But then for the customers who are already very knowledgeable about the products, it's really bringing them more variety and a deeper variety than anyone else, to continue to drive their interest in buying new products, trying new products, and I'll give it to Jim to see if he wants to add anything else. But we have customers in multiple stages of sort of shopping lifecycles at Sprouts.

Jim Nielsen

Yes we define those as kind of the want to be healthys and at some of the new stores, I think as people go in our store they view us as a full shop. And some of our older stores, while they have maturated into the vitamin side, there's still part of that discovery that we need to help them and help them educate them from moving just to produce into the other departments.

So this definitely upside. It's going to take efforts on our part to be engaged with the customers, and help them and educate them on the other products we sell within the store.

Edward Kelly – Credit Suisse

And just from a merchandising perspective, I know you guys have done some things like shelf heights and adding some share foods, Boarshead, Borshe and that type of stuff. Is there more to be done there? I guess what inning do you think you're in, in terms of – from a merchandising perspective on where you want the store base to be?

Jim Nielsen

What inning are we in, is that what you said?

Edward Kelly – Credit Suisse

Correct.

Jim Nielsen

I would say we're in the 7th inning. We are kind of confined to a 25,000 square-foot box. What we're continuing to be focused on, in certain areas of the building improving our ingredient dex and our offerings, mostly on the deli side and the bakery side. Where we've already seen fantastic results.

But major launches, we've obviously started juice bars and started testing in some of the stores and we've had a great response to that. But we're going to stay true to that 28,000 square feet.

Doug Sanders

And we're going to continue to innovate. Obviously, the natural and organic industry is still in it's probably second inning, or maybe even third inning, so there's a lot of innovation out there in front of us. And we're going to continue to make sure we stay ahead of the game, staying up on the upcoming trends, and making sure we're staying relevant with the customer. So it's a combination of innovation, sticking to our core base of value and health, and really growing and continuing to reach that middle income consumer, where the growth is and continues to be.

Edward Kelly – Credit Suisse

Great. Thank you.

Operator

Our last question comes from Kelly Bania from BMO Capital Markets.

Kelly Bania – BMO Capital Markets

Hi. Thanks for taking my question and squeezing me in. Just a question on customer analytics. Just curious where you stand with customer analytics and any data on your customer?

I think I'd read you guys were looking to get a little bit deeper into that. So I was just curious if that's true and what the potential opportunity may be there? Thanks.

Amin Maredia

Yes. We obviously – Kelly, we do a lot of basket analysis today. And what customers are buying and looking at opportunities from a cross-selling perspective and merchandising perspective, and where we have the greatest opportunities in the store. In terms of, as you know, we don't have customer level data in terms of what they're buying today versus what they're buying next week, et cetera.

But overall, I think we get a pretty good feel and are able to bifurcate and analyze the different type of customers and kind of the buying behavior from just the basket analysis. That actually drives a lot of what we do in our review cycle. We have – every department goes through a department reviews – and Jim can talk a little bit more about that, and what's trending and what's coming up as a trend, what the customer is buying more of, what they're not buying. And so we're continuing to use that process to really innovate and try to stay ahead of the cycle of purchasing pattern or product patterns.

Jim Nielsen

Yes, we utilize third-party data, spends data, to make sure we have the right items. As Amin mentioned, we go through a very strict category review schedule. And one benefit we have, obliviously, being centralized, our execution level at store level to get those products out there and be first to market, I'd say is one of the best in the industry.

We've got promotional planning tools that will be rolled out here towards the tail end and the first part of next year which will help us put together ads a little bit better using technology. And one of the things we do is we always do third-party consumer research. So really talks about what our strengths are as we continue to capitalize on those, and what are some of the needs of the customers that may not be completely met, so we can continue to focus on those.

Operator

That concludes the Q&A session for today's call. I would now like to turn the call back to Doug Sanders for any further remarks.

Doug Sanders

Okay. Well thank you for your time, everybody, and your interest in Sprouts. And look forward to speaking with you in the coming months. Have a great evening.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect. Everyone have a great day.

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Source: Sprouts Farmers' (SFM) CEO Doug Sanders on Q2 2014 Results - Earnings Call Transcript

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