The Fresh Market's (TFM) CEO Craig Carlock on Q2 2014 Results - Earnings Call Transcript

Aug.21.14 | About: The Fresh (TFM)

Start Time: 17:07

End Time: 18:14

The Fresh Market Inc. (NASDAQ:TFM)

Q2 2014 Earnings Conference Call

August 21, 2014 05:00 PM ET

Executives

Craig Carlock - President and CEO

Jeff Ackerman - EVP and CFO

Katie Turner - Investor Relations

Analysts

Jason DeRise - UBS

Sean Naughton - Piper Jaffray

Rupesh Parikh - Oppenheimer & Co. Inc.

Vincent Sinisi - Morgan Stanley

Robby Ohmes - Bank of America Merrill Lynch

Kelly Bania - BMO Capital Markets

Ryan Gilligan - Deutsche Bank

Mark Miller - William Blair and Company

Scott Mushkin - Wolfe Research

Kate Wendt - Wells Fargo Securities

Charles Grom - Sterne Agee

Joe Edelstein - Stephens Inc.

Ben Brownlow - Raymond James

Andrew Wolf - BB&T Capital Markets

Operator

Greetings, and welcome to The Fresh Market Second Quarter 2014 Earnings Conference Call. At this time all participants are in a listen only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

I’d now like to turn the conference call over to your host, Katie Turner. Ms. Turner, please go ahead.

Katie Turner

Thank you. Good afternoon and welcome to The Fresh Markets second quarter fiscal 2014 earnings call. On today’s call are The Fresh Market's President and Chief Executive Officer, Craig Carlock; and Executive Vice President and Chief Financial Officer, Jeff Ackerman.

Before we begin, we’d like to remind everyone that any forward-looking statements made by management during today’s call are subject to the Safe Harbor statements found in The Fresh Market’s press release and SEC filings. The Company’s second quarter earnings release and related financial information, including any non-GAAP or adjusted financial reconciliation tables, are available on The Fresh Market’s corporate Web site at the thefreshmarket.com under the Investor Relations section. This call is being recorded and a replay will be available on the Company’s Web site for approximately 30 days.

It’s now my pleasure to introduce Mr. Craig Carlock, President and CEO of The Fresh Market for opening remarks.

Craig Carlock

Thank you, Katie. Good afternoon and thank you for joining us. Today I’d like to provide an overview of our second quarter results, discuss highlights of our unit growth and real estate development and update you on the actions we’re taking to support our long-term growth. Jeff will then discuss our financial performance in more detail and our financial outlook for the remainder of fiscal 2014. After our prepared comments, we will have time to answer your questions.

We are pleased with our results in the second quarter of 2014 as our business continued to perform consistent with our expectations. We achieved a 19% increase in sales and a 12% increase in adjusted earnings per diluted share. Adjusted EPS excludes the impact of store closure activities.

During the quarter, against a backdrop of increasing competitive activity, we achieved a 2.9% increase in comparable store sales and better than expected sales performance in our new stores, which I will talk more about in a moment.

Comp store sales were driven by 2.7% growth in customer traffic as we continue to improve the efficiency and effectiveness of our promotions. Basket size grew more modestly as we limit to the amount of retail inflation that we passed on to consumers and our promotions attracted new customers, who tend to start out with smaller basket sizes.

To put these results in context, I should note that the estimated impact on our comp store sales growth from competitor stores open less than one-year was about 310 basis points in the second quarter compared with about 160 basis points in the same quarter of last year.

As we’ve said in the past, this year we’re experiencing more competitor openings, the impact of individual competitive openings is not materially changing. We believe that our sales results in the current environment speak to the strength of our differentiated market position from our unmatched combination of great tasting Fresh produced meat, upscale, as well as stable groceries, prepared foods and numerous natural and organic options throughout the store as well as are engaging customer service and inviting atmosphere.

We believe that our commitment to quality, taste, and service rather than just competing our natural and organic attributes or price, adds to the sustainability of our margins. For example, we continue to drive greater growth and higher margin value-added items such as prepared foods. Also our grocery and shelf stable items are off to not conventional package goods such as can soup, cereals, or detergents that lend themselves to easy price comparisons.

Consequently, we can achieve and sustain attractive margins in our center of store categories while maintaining some insulation from our competitors. That said, underlying food commodity prices and in some cases availability have been somewhat difficult which impacts our ability to promote certain items. These actions and our positioning contributed to our ability to sustain our merchandise margins in an environment marked by cost inflation and growing competition.

And as we’ve done in the past, we also reduced inventory strength and benefited from lower negotiated logistics costs this quarter. These improvements allowed us to maintain price competitiveness and to continue to absorb some of the cost inflation in proteins and other categories where prices remain high.

Ultimately we did experience a 20 basis point decline in gross margin, but this was due to higher occupancy costs and LIFO expenses as a percentage of sales rather than merchandised margin erosion.

Turning to new store openings, we remain optimistic about our new stores as customers continue to respond enthusiastically to The Fresh Market experience. During the second quarter, we opened four stores, one in Upstate New York, one in Houston, Texas and two in Florida.

To date in the third quarter, we’ve opened two new stores, one in Laguna Hills, California and one in Memphis, Tennessee. Of the 13 stores opened so far this year, 10 of these are in the top third of our historical first day sales. Our first day sales are not necessarily predictive of future success, we’re pleased with the fast start these stores experienced and the success of our efforts to increase interest in these markets during the days leading up to a grand opening.

For fiscal 2014, we currently expect to open 22 new stores, which is down from our previous estimate of 23 to 24 stores. We continue to look for ways to reduce the overall P&L risks associated with our new store pipeline.

The Southeastern United States is a strong region for The Fresh Market. We now operate 104 of our 160 stores in the Southeast, including 38 in Florida. And this group continues to perform better than expected as we build our business through word of mouth, brand equity and strengthen in customer loyalty.

This has led to ever growing strength in sales, better margins, lower occupancy costs and less cannibalization. With that in mind, as we said on our last earnings call, we engage a real estate analytics firm last year to update our white space analysis for the Southeastern United States where we believe there was a much greater potential than what we had been thinking just a few years ago.

The research confirmed our belief that the addressable market in the Southeast is much greater than we originally thought and prior studies indicated. As a result, we’re raising our store growth potential in the Southeastern United States to double our current store base in this region, which coincidently is also double with the study in 2010 indicated. This estimate takes into consideration competitive openings, site availability, and excess cannibalization.

Our unique market position in the Southeast doesn’t change how we view the number or nature of future unit growth opportunities in other markets. We continue to work through our analysis on the rest of the country and expect to provide updates in the coming quarters.

We are still targeting square footage growth going forward in the range of 12% to 15% annually and we’re pleased that more of these stores can be in the Southeast. Another objective of this work was to develop and enhance robust sales forecast tools to provide us with better capabilities in assessing future site sales potential.

We believe our analysis in these tools will help us with our goal to not only grow, but also to increase our returns on invested capital and improve the predictability of those returns. In addition to our new store growth, we plan to leverage the consumer and employer research that we commissioned to develop initiatives that will drive long-term comp sales and improve profitability. We want to build on our success as well as identify initiatives to get people to shop with us more frequently.

In summary, we are encouraged by our first half results and the earnings momentum we expect for the second half of the year. Despite the competitive headwinds, our comparable store sales are stable, our new store sales on average are better than expected and we continue our efforts to improve operational efficiencies.

We believe that our strong results are a testament to The Fresh Market’s distinct shopping experience and our commitment to offering outstanding food quality and selection and a well trained, engaged staff. We believe we are in a position to retrieve our strategic and financial objectives for the year as we continue to expand our store base, build our brand equity, and enhance our customer offerings.

With that, let me turn the call over to Jeff, to provide more color on the financials.

Jeff Ackerman

Thank you, Craig. As Craig indicated, we are pleased with our performance in the second quarter, particularly, with our ability to maintain our sales momentum and hold margins relatively flat in light of the competitive retail and inflationary environments.

In the second quarter The Fresh Market’s GAAP-EPS was $0.24 per diluted share, a net sales growth of 19%. Excluding store closure costs related to previously announced store closings in California and Texas, adjusted earnings per share were $0.36.

Sales continue to be driven by strong unit growth as well as a 2.9% increase in comparable store sales. Transaction volume increased 2.7% and average transaction size increased 0.2% for the quarter. We are encouraged by the improvement in traffic this quarter, which resulted from solid execution of our promotion and merchandising programs.

We are pleased with our ability to continue to promote rationally and in a way that drives traffic and allows us to achieve profitable sales. During the quarter, we continue to absorb some cost inflation in certain categories, such as seafood, meat and diary, were costs and prices have remained high.

About 22% of our sales this quarter were generated from promotional activity, which was in line with the prior year. Given our expectation that protein prices were remain inflated, in the current competitive environment will persist, we expect our promotional cadence on balance will remain at a level similar to Q2 for the remainder of the year.

Gross margin contracted 20 basis points this quarter to 34%. Increases in occupancy and LIFO costs as a percent of sales were partially offset by a 10 basis point improvement the merchandise margin. Given the continuation of product cost inflation, we were pleased to realize an increase in merchandised margins through the commitment to quality, differentiated merchandise and service that Craig mentioned, and better management of inventory shrink.

As in recent quarters, cost per unit inflation remained elevated in proteins mostly seafood, meat, and dairy as well as some produced while at moderated in most other categories.

Selling, general & administrative expenses as a percentage of sales increased 20 basis points from last year to 23.5%, mainly due to an increase in store labor associated with new stores and benefit costs. This was partially offset by modest leverage in corporate G&A due to eliminating some corporate redundancies.

We opened four new stores during the quarter, compared to five new stores in the second quarter last year. Pre-opening expenses were in line with our expectations and down about 20 basis points from the prior year.

For the quarter fully diluted earnings per share were $0.24 and adjusted earnings per share were $0.36. Adjusted EPS excludes pre-tax store closure and exit costs of $9.8 million or approximately $0.13 per diluted share related to the four stores that were closed in California and Texas earlier this year. Adjusted EBITDA increased 14.5% to $46.2 million.

Looking at our capital spending, our CapEx totaled $15.9 million for the second quarter, of which $14.5 million related to new stores and remodels. We generated cash flow from operations in the first half of 2014 of $68.2 million compared to $69.7 million in the prior year, reflecting a decline in net income and the timing of certain working capital items.

Our cash balance at quarter end was approximately $17.2 million and the total outstanding balance on our revolving credit facility was $3 million, a decline of 88% from $24.7 million at the end of fiscal 2013.

Now I’ll spend a moment on our guidance for the balance of the year. As Craig mentioned, we are encouraged by our stable comparable store sales and the sales trends in our new stores. We remain confident in our outlook and prospects for growth in 2014.

As we look to the second half of the year, we will continue to face increasing headwinds from new competition. We anticipate that the impact on comp store growth from competitive new store openings will increase in the third quarter and moderate slightly in the fourth quarter. As a result, in Q3, we anticipate that comp store sales will be at the low to mid point of our 1.5% to 3.5% for fiscal year range.

In Q3, we will also incur an approximately $1.5 million increase in incentive compensation expense compared to the third quarter of fiscal 2013 when we reversed some of our accrued compensation expense based on our performance at that time.

We plan to open 6 stores during the third quarter, and 5 in the fourth quarter compared to 10 and 5 in the third and fourth quarters respectively last year. Based on our performance thus far and our current assessment of business conditions for the remainder of the fiscal year, we’re reaffirming our previously issued fiscal 2014 comparable store sales and adjusted earnings guidance.

We continue to expect adjusted EPS of a $1.56 to a $1.66, excluding anticipated store closure costs of approximately $60 million or $0.21 per diluted share. On an adjusted basis, EPS is expected to grow 11% to 19% for the fiscal year.

Sales will be driven by 22 new store openings and 4 to 5 store remodels. We are trimming our CapEx to $100 million to $150 million. Comp sales growth is expected to be in the range of 1.5% to 3.5% including the impact of competition.

In closing, we’re encouraged by our first half results and believe we’re well positioned to achieve our strategic and financial objectives for the year as we further expand our store base and enhance our customer offerings. Our team is committed to the continued improvement of our operating results to deliver a greater overall profitability long-term.

With that, we’d now be happy to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you. At this time, we will be conducting a question-and-answer session. (Operator Instructions) Our first question comes from the line of Jason DeRise from UBS.

Jason DeRise - UBS

Hi. It’s Jason DeRise. I guess, I wanted to get a bit more understanding of how you’re thinking about the unit growth long-term. I see that the number for this year has come down as you trying to reduce the risk in the P&L. Does it make sense to just go slower long-term and maybe let some of that excess cash come back to shareholders?

Craig Carlock

Hey Jason, this is Craig. So the unit growth goals we have are 12% to 15%. Last year it was 17%. So in effect we’re signaling a little bit slower growth. I think if we were to be north of 15%, it will be something particularly opportunistic and that will likely lead to as you said, cash generation and at that point we will begin to consider what we should do with that.

Jason DeRise - UBS

Okay. And maybe just a quick housekeeping, sorry if I missed it in the prepared remarks, but could you share how you calculate your new -- the new store productivity for the quarter?

Jeff Ackerman

Hey Jason, it’s Jeff. So the way we’re calculating new store productivity is we look at the number -- each individual store that’s in -- not in the comp set and what those sales are as a percentage of the average stores, so all the comp store sales for that and we’re doing that on a month-by-month basis and store-by-store basis and then accumulating that number to come up with the number for the quarter.

Jason DeRise - UBS

Sorry, what was the number? I think I just missed it.

Jeff Ackerman

For the quarter it was 83%.

Jason DeRise - UBS

Okay. And what -- again, I just got one last one in because these are maybe shorter answers, and still not taking up time for other questions. You touched on the idea of more merchandising efforts around being a specialty store and less about being an organic or natural store. What kind of units do you have in the plan for the next three or four quarters to really emphasize that and maybe some categories that could get deemphasized within the store? I mean, I’ve seen vitamins in the store, I don’t know if that fits in with that way you are thinking about it now?

Craig Carlock

Well as we mentioned on the last call, for us we’ve undertaken an unprecedented amount of customer research and I’d like to share with you what we’re finding. The first thing we’re finding is that customers are shopping at multiple grocery stores. So there is no need to be a one-stop shop as people don’t expect that necessarily from grocery stores. The second thing we’re finding is that we’re really resonating with aspirational shoppers, people who respond to the experience, folks who want to eat better, and at our very best people who find our shopping experience special. The opportunity we’re finding is that we’re serving more customers than we had realized, but with less frequency than we had realized. So our business is not as concentrated as we thought it was. And so, we’re putting together initiatives and plans now to increase the frequency with which people shop with us. It’s premature to identify specific categories, but we will be working on projects that should drive frequency.

Jason DeRise - UBS

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Sean Naughton from Piper Jaffray.

Sean Naughton - Piper Jaffray

Hi. Thanks for taking the questions. So on the competitive environment, you talked about some increased pressure in Q3, kind of give us the number for the impact in Q2, going to be a little less in Q4. But can you talk about how your -- what your response is to the competitive environments when new people come in? And then maybe a little longer-term outlook into 2015, how that competitive impact looks like as we get into next year?

Craig Carlock

Well our response when we see competitors coming is to -- first and primary response is make sure we’re executing as well as we possibly can. And so, in each store we take a -- we did this all the time, but we do it especially rigorously when a competitor is coming to make sure that we’re operating as well as we can, we have the right people, we have the right training, we have the right equipment, we have the right store condition so that the customers we have, we have the greatest probability of hanging onto. And from time-to-time we develop incentives that are short-term in nature to make sure we retain as many people as we can in each store, so that our competitors don’t hire away our own people. So that’s our approach, is to run our stores as well as we possibly can. We don’t dramatically change our margins, we don’t reduce our prices, we don’t change our profit structure in order to respond to a competitor or in anticipation of the competitor.

Sean Naughton - Piper Jaffray

And then, anything longer term as we get past Q4, does the competitor environment start to heat up again in 2015 or is it kind of similar to the 2014 kind of cadence?

Jeff Ackerman

Yes, Sean, it’s Jeff. So we have just kind of limited visibility as to kind of beyond probably six months in terms of what competitors are going to be doing. We may know that they’re going to open in a particular market that we may not know exactly where it is and where that is in relation to our stores and we definitely don’t know the timing, so that we don’t have great visibility beyond that, so beyond about six months.

Sean Naughton - Piper Jaffray

Okay. That's helpful. One last question is on the gross margin. Clearly the logistics and shrink sound like they are continuing to come along. How much more runway do we have on those? We consistently hear about those, just curious are those -- what sort of runway are left on those two particular line items? Thank you.

Craig Carlock

This is Craig. I’m very optimistic that over time we can continue to find ways to supply our stores with lower unit cost items, because there are so many places that we can benefit from the scale. So we’re very optimistic about that. The shrink is something we’ve made a lot of progress on in recent years. We continue to make progress and we’re really on version 2.0 of our tools and so those continue to yield its -- I don’t see an end of those two that you’ve mentioned. I think the scale from logistics and supply probably exceeds the Shrink opportunity.

Sean Naughton - Piper Jaffray

Okay, Craig. Thank you.

Operator

Thank you. Our next question comes from Rupesh Parikh from Oppenheimer.

Rupesh Parikh - Oppenheimer & Co. Inc.

Thanks for taking my question. Also I want to delve a little more into the merchandize margins. So, how could we think -- how are you guys thinking about gross margins for the full year?

Jeff Ackerman

Yes, so Rupesh, it’s Jeff. As we talked about the gross margins are -- we’re not looking for a huge change kind of year-on-year, looking for them to be fairly consistent. And so what we saw in the quarter was we’re able to do that and that was based on really merchandize margins being up about 10 basis points. The occupancy cost for the balance of the year looked like they’re probably going to come down a little -- its not going to be as big of a drag as we had originally talked about. We had originally talked about that being about a 30 basis point drag on margins, 30 basis points of de-leverage and we think that’s more like kind of 10 to 20 now, just based on the numbers of stores that we’re opening.

Rupesh Parikh - Oppenheimer & Co. Inc.

And then just touching a little -- diving a little more into the competitive environment. Outside of what you’re seeing from just competitor openings in your market, are you guys seeing any other significant changes from what you saw maybe earlier this year in the competitive environment?

Jeff Ackerman

For the competitive environment -- are you asking, Rupesh you’re asking from a kind of pricing standpoint or …

Rupesh Parikh - Oppenheimer & Co. Inc.

Yes, just -- I guess just from price or any other changes you’re seeing from maybe what you saw in Q1. And I know another publicly traded retail recently entered one of your markets, so I just wondered if you’re seeing any impact there?

Craig Carlock

Let’s take it Atlanta head on, this is Craig. I would say the impact we’ve seen is what we were expecting. No better, no worse.

Rupesh Parikh - Oppenheimer & Co. Inc.

Okay.

Jeff Ackerman

And then more broadly on the margins, I’d just say that we continued to monitor competition in the prices and how we index relative to those and over probably the last four or five months we’ve not really seen a change in that relative pricing.

Rupesh Parikh - Oppenheimer & Co. Inc.

Okay. Thank you.

Jeff Ackerman

You are welcome.

Operator

Thank you. Our next question comes from Vincent Sinisi from Morgan Stanley.

Vincent Sinisi - Morgan Stanley

Hi, thanks very much for taking my question, good afternoon everybody. I wanted to -- I’m sorry to beat a little bit of a dead horse here, but just wanted to see, I appreciate the color on the 310 basis point impact from competitor openings. Jeff, maybe if you could just compare that a little bit more to what you saw last quarter specifically, I believe you said 41 stores during the first quarter were impacted by a couple of 100 basis points. And maybe if you can compare those two quarters and maybe also how those 41 in the first quarter are doing at this point?

Jeff Ackerman

Yes. So, what we said was that 41 in the first quarter, and I think as we put it, it was in excess of 200 basis points was the competitive impact. And kind of the similar number if you will for the 41 for Q2 was 43. And really what ends up being the biggest driver on competitive impact in the proximity of those new stores relative to ours, we’re not really seeing a change in the amount of impact that we see from any one competitor, that has not really changed.

Vincent Sinisi - Morgan Stanley

Okay, thank you. And then just a follow-up on the real-estate study, as you mentioned you’ve in the south east identified an opportunity to basically double the number that you have right now. Can you just give us a little sense for as we go through the remainder of the year and you look to some other geographies within that third-party study? Any further color on kind of timeframes or geographies?

Craig Carlock

No, we commissioned the study to study the south east. We knew we were doing very well in the south east relative to our 2010 study. We wanted to update it, so we updated that. We’re not yet updating the rest of the country but as we go through time we will anticipate doing that and we’ll be prepared to update you.

Vincent Sinisi - Morgan Stanley

Okay, Craig. Thank you very much. Good luck.

Operator

Thank you. Our next question comes from Robby Ohmes from Bank of America Merrill Lynch.

Robby Ohmes - Bank of America Merrill Lynch

Thanks. Hi, Craig a couple of quick follow-ups. On the competition you talked a lot about the impact from competitor store openings, but the other concern for you guys and others is about what the conventionals are doing and is there anything that in any regions that any of the conventional people are doing in terms of all the noise about them increasing natural organic product and raising the bar on their specialty product as well. Are you seeing any impact in your view on your comps related to that? And then I have a follow-up question.

Craig Carlock

Well, I think they’re doing a good job. And from time to time a significant remodel of one of their stores its in pretty close proximity to one of our stores can impact us. But in general people are coming to us for the experience, the ambiance, the quality differences and so, a bigger variety of organic food or a bigger variety of packaged organic and natural items has a pretty limited impact on us.

Robby Ohmes - Bank of America Merrill Lynch

Got you. And the other question, the study you did on your white space, did the -- is the study sort of confirm that not only should you -- you can do a lot more in the south east but should we expect a lot less store openings in Texas and California going forward. So is this really a focus to concentrate over the next half decade really in the south east?

Craig Carlock

I hesitate to use the word concentrate but I would say we’re still saying 500 is an appropriate target and we think more of those 500 can be in the south east. We have a 104 in the south east today and we’re saying we can double that. So the pace of expansion outside the south east maybe a little slower than what we would have thought a year ago or two years ago.

Robby Ohmes - Bank of America Merrill Lynch

Got it. Thanks very much.

Operator

Thank you. Our next question comes from Kelly Bania from BMO Capital.

Kelly Bania - BMO Capital Markets

Hi, good evening. Thanks for taking my question. Just another one on the white space analysis, I guess as you look at doubling that potential in the south east, what are you finding about that study? Are you able to put your stores much closer together? I know you’ve talked about less cannibalization, but how close can you put your stores together and how much of that doubling is new markets versus existing markets.

Craig Carlock

So, I think -- let me describe the nature of the potential opportunities that we found and few anecdotes to illustrate. In 2010 we did the study and there was not a site identified for Lynchburg, Virginia and we opened one and did very well there. There was not a site identified for Athens, Georgia. We took over a former bookstore, have done well there. There was one site identified for Mobile, Alabama. We’ve now got two stores in that area doing well. So, the white space is identifying smaller markets that in general are less expensive, that in general won't attract as much competition, and so we can go into those markets and be one of the few if not the only specialty provider and get a good return. And additionally the study identified that we could go into metropolitan areas and that’s what you’re talking about, and let’s take the metropolitan areas of Florida as a good example. We’re able to put more stores in the metropolitan areas of Florida because we’re experiencing less cannibalization than we thought, I don’t know that I want to put the number of miles on it actually in a metropolitan area, we think of it more minutes and drive times and miles. But if I had to something like five miles, might be an appropriate number today and we would have been hesitant four or five years ago to put stores five miles apart. So, the good news is white space in smaller towns, less competition. Good news, more white space in larger metropolitan areas where we can put stores closer together.

Kelly Bania - BMO Capital Markets

Great, that’s very helpful. And then just a follow-up on your guidance, I guess with comps maybe towards the lower end of or towards the lower end to mid point of the range and maybe one to two less stores opening. Just maybe the offset in order to maintain that EPS range, I guess you talked about a little bit better in occupancy cost but would that be the only factor or anything else to note there?

Craig Carlock

Yes, there is occupancy cost and then maybe a little bit of pre-opening expenses or some other things that are -- that we’re seeing.

Kelly Bania - BMO Capital Markets

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Karen Short from Deutsche Bank.

Ryan Gilligan - Deutsche Bank

Hi. This is actually Ryan Gilligan on for Karen, just a few quick questions. First, what was the percentage of products sold on promotion in the quarter?

Jeff Ackerman

This is Jeff, it was about 22%.

Ryan Gilligan - Deutsche Bank

Great. Can you remind us what your private label penetration is in non-perishables?

Jeff Ackerman

Non-perishables, it’s right about 16%.

Ryan Gilligan - Deutsche Bank

Okay, great. And then lastly maybe could you just talk about the cadence of sales throughout the quarter and maybe give some color on the comp excluding competitive openings or excluding the impact from competitive openings into the third quarter?

Craig Carlock

The cadence was just a little slower at the end of the quarter than it was at the beginning of the quarter, and I think that’s consistent with now what you’ve seen in the news from others. On the competitive openings I think the comp you could just add that 310 to our reported number and that would give you kind of what we’re seeing in the absence of competitive openings.

Jeff Ackerman

If might I just add one other thing else, if we looked at things on a year-on-year basis maybe July might have been a little bit slower, but that was probably -- we were cycling on probably the best event we had all year last year kind of July, 4th. So it was probably the most difficult comp we had. But on a two year basis things will still look pretty good.

Ryan Gilligan - Deutsche Bank

Got it. Thanks.

Operator

Our next question comes from Mark Miller from William Blair.

Mark Miller - William Blair and Company

Hi, good afternoon. A question on employee engagement; Craig, I wanted to get your impression of where that stands today and, in our research we find it’s not quite as strong as customer satisfaction. So, I mean what are your main initiatives to improve that and you’ve seen a little bit of increase in wage and benefits. Is that specifically targeted to that or is that coming up for other reasons?

Craig Carlock

So, at the same time that we entered into the unprecedented level of customer research we also worked for the first time with a research firm to help us do some employer research and opinion surveys. The firm looked at our results and compared those results to other retailers and other companies, and we scored very high on the level of commitment that our employees have and the admiration for their co-workers. So most companies scored high, they told us, we scored particularly high. Our goal and what we kind of found out is we need to tap into that commitment to make sure that our employees are feeling as valued as possible and as much engagement as possible. So, we’re putting together some initiatives for employees that relate to employee engagement.

Mark Miller - William Blair and Company

And then, how should we think about that manifesting itself across the business broadly. I mean would you anticipate investing some in in-store labor or just understand a little bit that increase you’re highlighting at benefits what -- is that related to this or is that apart from that?

Craig Carlock

My own view is that, that’s really apart from it. The employee benefits changes -- Jeff can talk more about them are related more to the national landscape and having more employees participate in our plans than we did a year ago.

Jeff Ackerman

Mark, Jeff here. The other thing just on the labor that we were referencing, that’s really more driven by our store mix. So, we had a higher percentage of our total store base, were non-comp stores. So, the store is not in the comp set and no stores traditionally run higher labor expenses. It was more of a store mix issue than having anything to do with the employee engagement work that we’re doing.

Mark Miller - William Blair and Company

Okay, great. And then, I mean given all the work you’ve done around customer research as well. I wanted to come back at that and see if there are any perception gaps that you would highlight for us including customer perception of pricing versus actual pricing or anything else that looks like something you can tap into further? Thanks.

Jeff Ackerman

So we outlined -- I outlined earlier where we resonate and what we’re doing as far as frequency being an opportunity. As far as perception, they certainly were viewed as an upscale grocery store and some of the folks we surveyed certainly identified price as an opportunity or in some cases a barrier to shopping. I don’t conclude from that research though that, that means we should lower our prices across the board. I think what we’ve got to do is deliver on the expectations that people have when they walk into the store. They expect great tasting food. They expect high levels of service. They expect clean store, short lines and we need to make sure we deliver an experience and then the prices will, I think be satisfactory. That doesn’t mean we won't promote. That doesn’t mean as we reduce supply cost over time we might not reinvest in promotions or prices but we don’t walk away from the research saying we have got to reduce our prices.

Mark Miller - William Blair and Company

Great. Thanks, Craig, Jeff.

Operator

Our next question comes from Scott Mushkin from Wolfe Research.

Scott Mushkin - Wolfe Research

Hi, guys thanks for taking my questions. So I had two basic ones, the first one back to the south east discussion. And just wondering, did the stores in the south east perform markedly better than other places? Is the comp stronger, I mean is the sales per store better or I mean if there any thoughts you can give us around that?

Craig Carlock

Yes, over time and this was not always the case. But over time the stores in the south east had begun to open up at higher levels and generally have higher than average sales levels. Over time and again this also wasn’t always the case. Our success in the south east has enabled us to get better and better real estate deals. So, we have this very powerful and positive dynamics of increasing sales levels and better occupancy cost that create real good returns, so that’s fantastic. But that’s a function of the fact that we’ve added slowly and steadily to our store base in the south east for 32 years. As far as comps, I would not characterize the comp growth rate better in fact it might be slower. It tends to be that the stores that open better comp a little more slowly, and stores that open a little lower comp a little more positively.

Scott Mushkin - Wolfe Research

All right, that’s great. And then, my second question is just trying to understand the guidance as we move to the back half of the year and a little bit better. It seems that the street in the third quarter might be just a little bit too high given the fact I think you called out a $1.5 million incremental expense plus the comps being at the low to mid end -- low mid range there. So, that seems -- and then I also think Jeff you maybe said that, year-over-year we should think of gross margins kind of similar in the third and fourth quarter, and so that kind of gets me to a place where I guess I’m having a hard time how we get to kind of the guidance that you got out there, because it seems like you need a lot higher gross margins in the fourth quarter to get into the kind of 156 to 166 range, am I missing something?

Jeff Ackerman

Scott, so let me just kind of walk through that. So, yes in the third quarter we don’t give quarterly guidance but as we’ve tried to always do is if there is anything that’s a bit of an anomaly that’s happening in a quarter we would like to call that out. And so just, that was really the point of just calling out the $1.5 million on incentive compensation, so just cycling on the reversal of some accruals last year. But overall our guidance is not changing for comp sales for the year nor for EPS. But I recognize that maybe some people are struggling a bit with the fourth quarter and there is I think it’s helpful to just remember that what we’re cycling on in the fourth quarter is several California and Texas stores that were the least profitable and those have now been closed and are no longer there. The remaining California and Texas stores that we have, their performance has improved significantly from where they were in the fourth quarter last year. So when we take those into account it really shows that we’re probably going to see a $0.05 improvement year-on-year in the fourth quarter just associated with California and Texas. And then the second thing that I would point out is, as I mentioned earlier that occupancy costs are now coming down a little bit as we’ve moved -- as we have reduced the number of stores that we’re opening and so we had originally talked about seeing a 30 basis point drag on -- or de-leveraging I should say on occupancy cost and that’s now more like for the full year we’ll be more like 10 to 20 basis points. So those are and most of that coming in the fourth quarter. So those are the things that I think are, maybe not everyone has an appreciation for as it relates to the fourth quarter.

Operator

Thank you. Our next question comes from Kate Wendt from Wells Fargo Securities.

Kate Wendt - Wells Fargo Securities

Yes, thanks. Jeff, just following up on the gross margin, first of all this quarter was better than we -- especially and I think you had forecasted. I was just curious given the factors you mentioned what came in better than you expected whether that was on the Shrink side or maybe some just relative moderation and some of the cost inputs versus what you had previously thought or maybe passing on just to touch more than you had thought you previously would.

Jeff Ackerman

Yes. So we ended up with our merchandize margins coming in pretty close to in line with the prior quarter and that was really we saw really effective promotions where we weren’t necessarily as aggressive in some areas. And that ended up helping us out and then we were really successful with our -- with managing the inventory Shrinks. So those were the things that helped us out the most. And ultimately we ended up with 20 basis points of de-leverage.

Kate Wendt - Wells Fargo Securities

Okay, that’s helpful. And then I guess just a clarification on some of the last couple of questions. For gross margin outlook, I think the prior question I thought it implied you meant gross margins being flat for the year or as just in the last one it sounded like it was for the back half. So, if you could just kind of clarify that it seems reasonable that you can get some pick up in the fourth quarter just on the year-over-year comparison basis.

Jeff Ackerman

So, what I was saying was for the full year it will be fairly close to the prior year is what we expect. And then for the balance of the year we’re looking at a potential, as you said a little bit of an opportunity for a pick up in the fourth quarter. But again remember that’s part of what I was saying about California and Texas, that was the big -- that was really a big drag on our margins last year and so that’s what I was saying about that year-on-year we would expect for the California and Texas markets to show a $0.05 improvement for the quarter.

Kate Wendt - Wells Fargo Securities

Okay, that’s helpful. And then just also following up on the prior question about private label, you guys haven’t talked about that in a while. And when I have visited stores recently, I have actually noticed some new introductions in more kind of I guess what I would call pantry essentials that you didn’t have before that might kind of improve the value offerings in some of those areas, canned beans or steel cut oats or chia seed or whatever it might be. Just kind of if you could update us on your philosophy as it pertains to private label and where you see that penetration going over time.

Craig Carlock

Well we continue to reap positive benefits from private label it’s a source of sales, certain items, certain categories it’s a source of margin improvement, so we’re very optimistic and feel really good about our private label program and the investments that we’re making there and how customers are seeing them. I would say some of the items yet tend to be shelf stable groceries that are pantry style items. Others tend to be really neat items that you just can't get anywhere else and we hope will drive a dedicated trip the Fresh Market and drive customer in it might have otherwise gone some other place. So yes, you’ll see everything from oatmeal to yogurt to [ph] [Greek] yogurt, I mean you’ve seen the list and it’s -- we keep adding and it keeps honestly working.

Kate Wendt - Wells Fargo Securities

Okay, great. And then Craig just a final one for you, just following up on, you mentioned those surveys regarding customer perceptions. Are you targeting those towards current customers or also trying to include some past customers or non-shoppers in those as well?

Craig Carlock

It was a very large survey, 1000’s or people and it included current customer and non-customers. The majority were non-customers.

Kate Wendt - Wells Fargo Securities

Okay, interesting. Thanks so much.

Operator

Our next question comes from Charles Grom from Sterne Agee.

Charles Grom - Sterne Agee

Thanks. Good afternoon. Just to follow-up on Scotts question with regards to your guidance, if I square your comp, your store growth maybe a net improvement in in-store productivity and merchandize margins kind of flattish for the year. Could you just elaborate what you expect just SG&A dollar growth to be? It looks like its going to come in a lot, in other words going to be a lot lower year-over-year than it was in the front half which looks like it was up over 20%, just am asking whether, is my math right? And is that mainly a function of those stores that you closed last year or is there something else going on in the P&L?

Jeff Ackerman

Yes, the biggest area is going to be really on the store labor Charles. And as I mentioned we saw in Q2, we saw really high mix of non-GAAP stores and that was -- I’m sorry, non-comp stores. And that was in comparison to the mix that we had in the prior year. And in the fourth quarter it trues up to be pretty consistent year-on-year, it’ll actually be -- in the third it’ll be pretty much in line with what it was the prior year. So we would have less of that unfavorable mix impact on our expenses.

Charles Grom - Sterne Agee

Okay. So, dollar growth you’re expecting somewhere in the mid high single-digit range for the back half in 3Q and 4Q for SG&A dollar growth?

Jeff Ackerman

Well, I mean we expect it to be as far as probably see a little bit of leverage -- we’ll see a little bit of leverage on our SG&A in the back half.

Charles Grom - Sterne Agee

Okay, great. And then Craig, can you just flush out the commentary about the supply chain improvements. Is that the Burris relationship and is that helping you guys offset some of the other pressures you could be seeing in merchandize margins, because obviously they’re a little bit better this quarter which is good to see, Shrink was a component but you talked about the longer term being the supply chain, is there something going on with contract negotiations that’s helping you guys out or is that still to come?

Craig Carlock

Well the current contract expires in February of 2016. So, what I’m referring to as far as current quarter is just, most of our deals with most of our growers, producers, vendors as well as with Burris provide for declining unit costs as we grow volume. So we benefit from that call it day-in and day-out. The longer term we’re optimistic, we’re excited about the chance to renegotiate the contract that expires in February of 2016, it’s premature to know what's going to happen. But we know what happened last time, that we’ve grown a lot in that periods since the prior contract and so we’re able to strike a deal, it was good for them and good for us and we’re optimistic that this time when the competitive process we could see some leverage. And then there are other distributors we don’t talk about as much because they’re not of the size that Burris is, but we have the same kind of competitive dynamic as far as buying for our business.

Charles Grom - Sterne Agee

Okay, great. And then in light of the increased competition, just bigger picture Craig. Can you just speak to the relationship between overall merchandize margins and traffic and I guess are you willing to accept a lower traffic rate to protect margins? Are you willing to invest more margins to drive higher traffic, not just this quarter but just over the next couple of years?

Craig Carlock

Well, I think you’ve said it properly. I think we want to make investments that get very positive returns. And so, if reducing our margins could be tested and we could drive higher traffic and that traffic generate a profitable sales or paid for the investment I think that would make good sense and we’re very open minded about that. Where I’m cautious is thinking that a slight reduction in the price level of lets say 10,000 items is really going to drive traffic. I think we’ve had much more success with events like Jeff mentioned the 4th of July last year or you’ve seen our $2.99 Tuesdays or our Little Big Meal Campaign on Thursday. More event and promotion and short duration tends to resonate with more people and be more profitable than just kind of price changes. The other place we could drive cost down and potentially prices down is if the supply chain savings over multi-year period where to come to us that could be reinvested in prices. I don’t know that supply chain savings would need to all go straight into margin that might not make sense.

Jeff Ackerman

Charles, I just want to add one other thing there is, in the comment Craig referenced it earlier that what we’re -- we continue to see as outsized growth in what we call our value-added items and so whether that’s prepared foods or other value-added items elsewhere in the store. That’s where the outsized growth is and that also -- those are also higher margin items. So that’s a source for us to continue to allow us or create a funding pool, if you will, to be more competitive on things that are more directly price comparable and make price investments in those areas.

Charles Grom - Sterne Agee

Okay, great. And then, if I could sneak one more and just on the third quarter comp guide, is that because the pace quarter to date has slowed a little bit or is it your expectation that what was about a 310 basis point headwind from competition is going to augment in the third quarter? Just trying to square that up.

Jeff Ackerman

Its -- so first off, let me just say it’s not really different from what we’ve been expecting, but secondly it is being driven by the number of new store openings by competitors.

Charles Grom - Sterne Agee

Okay. So that roughly 2% comp guide for 3Q is more a function of increased competition, not because of like a slowdown in the business that you saw in July?

Jeff Ackerman

That’s correct.

Charles Grom - Sterne Agee

Okay. Okay, thanks very much.

Jeff Ackerman

You bet.

Operator

Thank you. Our next question comes from Joe Edelstein from Stephens.

Joe Edelstein - Stephens Inc.

Hi, thanks for taking my questions.

Jeff Ackerman

Hi, Joe.

Joe Edelstein - Stephens Inc.

Good afternoon. And based on the transaction count and the basket size trends, it kind of indicated initially that the consumers were just shopping the deal, but then you did talk about inflation and I am curious at this point with all the consumer research that you're doing, do you have a sense for when we might see the baskets start growing again? I’m just trying to get a sense also for your willingness to push through some of that inflation?

Craig Carlock

Well, a few questions in there. I think that we’re excited to bring new people into the stores and excited that transaction count was almost 3% this quarter. That’s a good number for us. And the fact that the folks who are new tend to buy less on average as they join the franchise is a okay. I mean those folks will grow into great customers over time and so that’s great. We don’t have a sense and we measure this very carefully that people are cherry picking us. Yes, there is a handful, but by and large the folks who come in for some of our promotions by other items and then we can lawfully look at transaction data and some of the information people give us and determine they’re coming back. So we feel pretty good about that. As far as passing on the inflation, that’s a category by category decision, but very difficult in categories for retail prices are already high. It’s very tough in meat and seafood to pass on much more inflation than we’re currently seeing. So other categories like diary, people are going to buy a gallon of milk and you can pass it on there, we’re able to do it, other folks were able to do it. But you get into the more expensive categories and it’s tougher and we’re very cautious about it.

Joe Edelstein - Stephens Inc.

That’s very helpful. Earlier you were talking about some of the opportunity you’ve in some of the smaller towns.

Craig Carlock

Yes.

Joe Edelstein - Stephens Inc.

You’ve also in the past talked about some willingness to trade off the lower productivity rates as you opened stores perhaps in some smaller markets.

Craig Carlock

Yes.

Joe Edelstein - Stephens Inc.

Are you now starting to adjust the way to think about new store productivity rates or does the 80% kind of threshold number is still hold today or just maybe some clarity from a modeling perspective how we should think about it going forward?

Craig Carlock

Well, the primary determinant of real estate decision for us is the return on capital. I mean that is what we focus on when we make a decision. And so we’re very, very willing to do a deal that might have less than 80% productivity if the occupancy and cost structure, capital structure is right and we can get a nice rate of return. And so, we personally know that historically we’ve been around 80%, but we don’t go in with that as the target, that 80% is an average of some 70s and some 90s and that kind of thing. I don’t know that it change your modeling at this point.

Joe Edelstein - Stephens Inc.

Okay. And last question for me is, as you’ve gone through these consumer studies, have you come to any conclusion that might require you to increase any amount of capital that you would be putting into these stores?

Craig Carlock

No, I don’t think the implications relate to capital. They relate to delivering on the experience that people expect to have when they come in. We need to make people feel special, we want to make The Fresh Market their favorite store and as more to do with having food solutions that has more to do with having well trained people who are friendly, that has more to do with conditions in the store than capital in the store.

Joe Edelstein - Stephens Inc.

Sounds great. Thank you.

Craig Carlock

Okay.

Operator

Our next question comes from Ben Brownlow from Raymond James.

Ben Brownlow - Raymond James

Thanks for taking all the questions today. Can you give any updates on the performance of California and Texas, either in terms of store productivity or returns?

Craig Carlock

Yes. I think we mentioned on the last call that the store in Houston, Baybrook, was off to a good start. It’s going to be a nice returning store. Laguna Hills opened just a few weeks ago and it appears to be a nice returning store. Again, returns are function of sales and costs and the costs in those two stores are much more in line with what we’ve done historically and they’re -- frankly they’re very different than the cost structure of the stores we opened in California and Texas last year. So feel real good about it.

Ben Brownlow - Raymond James

Great. And just to follow-up on earlier question, on the competitive openings, just to be clear, the same store sales deceleration in the third quarter that you expect that’s a function of a greater number of competitive openings than originally expected? Because I thought the last quarter there was the expectation that there was more of an even cadence of store openings, competitive openings expected for the second half?

Jeff Ackerman

Hey Ben, it’s Jeff. Maybe there is just a misunderstanding, but what we’ve said is that competitive openings, the number of them that would increase throughout the year. So definitely more back-end loaded than what we were experiencing in the first half of the year and so yes, for the third quarter it’s just -- it’s an increase in the share number comp stores being impacted by new competitor openings.

Ben Brownlow - Raymond James

Great, thanks. And congratulations on the quarter.

Jeff Ackerman

Thanks, Ben.

Operator

Thank you. Due to time restraints we have time for one last question. Our last question comes from the line of Andrew Wolf from BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

Thanks. Good afternoon and congratulations on the improvement in the business trends. That last question, I would like to follow-up on the California and Texas stores now doing better, and expenses I know the rent was out of line. But is there other aspects of operations whether it’s labor management or just better training. And also I wanted to ask about local merchandising, if that’s gotten better and any other factors that are causing those stores to perform better?

Craig Carlock

Again, inherently the cost structure is different. So the returns we think will be much better than what we saw last year. There certainly was pre-opening marketing based on the things we learned last year that we did in both the Houston area and in the Laguna Hill store and those provided somewhat of a burst at the opening and we’re tracking that to see how much of that additional customer base we were able to -- we are able to sustain. The store design of Laguna Hills was took into account what we learned in the other California stores, so there is more prepared foods, and less of the meat and seafood. Certainly a great offering, but a little bit less there, a little more emphasis on prepared foods. There is less emphasis on candy. We move the candy and Laguna Hill stores, so we’ve taken into account a number of things we learned last year to try to be as relevant as we possibly can. And then we’ve got just for the record no more stores open this year in California. We got two that will open in the Dallas area. No more in Houston, well two in Dallas that are late in the year.

Andrew Wolf - BB&T Capital Markets

Okay. And Jeff you said there was -- the fourth quarter I believe could have a nickel swing in just in California and I got to think that’s mainly on the cost side, and other stores are doing well, but if you just sort of normalize what three stores could do for the P&L in one quarter? It sounds like it’s almost all on the cost side.

Jeff Ackerman

Yes, and its California and Texas. So the two states, all the stores that were and I’m comparing the store that will have opening in those two states in the fourth quarter of this year compared to what we had last year and so there should be a nickel improvement there. And yes, it’s really cost driven.

Andrew Wolf - BB&T Capital Markets

Okay.

Jeff Ackerman

As Craig was talking about that everybody -- that the people in the stores are doing -- they gain experience and they just continue to do a better job of managing kind of labor hours as well as shrink and just doing a better job serving the customers.

Andrew Wolf - BB&T Capital Markets

And the stores that are operating there, so would they be profitable at this point or are they still just heading there? All the stores in (multiple speakers) point?

Craig Carlock

We want to go store by store on profitability, but just to say we’re pleased with the trajectory.

Andrew Wolf - BB&T Capital Markets

Okay. Is it normal with what you get in other new markets outside the Southeast? Let’s say like when you went to Chicago or whatever?

Craig Carlock

The trajectory is normal. It’s a good trajectory, we’ve been pretty candid that the cost structure was pretty challenging in some of those stores, looking back.

Andrew Wolf - BB&T Capital Markets

Sure. I’m talking about the stores as operating now. And one thing I wanted to revisit was your 83% new store productivity and the way you defined it sort of sounds like a trailing 12 months weighted thing. But maybe just do a simple model, you can see that at least my model looks like the new stores this year really are improved; is that accurate? I mean would this quarter’s new store productivity in isolation or the first half be above that number?

Craig Carlock

Yes, let me clarify. It’s not a trailing 12 months, okay. So its -- again, what we do is we take all the stores that are in the non-comp set and we add up the sales for each month and that they are there and then we -- and divide that by the number of stores to come up with the average new stores doing in terms of revenue and then we compare that number to the average revenue of a comp store. And we do that for each month and aggregate them up. So if a store was entered the comp set at some point during -- after one months in the quarter, then we only count it as non-comp for one months and two months as a comp store.

Operator

Thank you. That’s all the time we have for questions. I will turn the call back over to our speakers for closing comments.

Craig Carlock

Thank you for joining us today. We look forward to speaking with you again at the end of the third quarter. Have a good night everybody.

Operator

Thank you. This does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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