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Executives

John Mackey - Co-Founder, Co-Chief Executive Officer and Director

A. Gallo - President and Chief Operating Officer

Cindy McCann - Vice President of Investor Relations and Vice President of Construction and Store Development

James Sud - Executive Vice President of Growth and Business Development

Glenda Chamberlain - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Secretary

Walter Robb - Co-Chief Executive Officer and Director

Analysts

John Heinbockel - Guggenheim Securities, LLC

Meredith Adler - Barclays Capital

Scott Mushkin - Jefferies & Company, Inc.

Mark Wiltamuth - Morgan Stanley

Karen Short - BMO Capital Markets U.S.

Robert Ohmes - BofA Merrill Lynch

Stephen Grambling - Goldman Sachs Group Inc.

Edward Aaron - RBC Capital Markets, LLC

Whole Foods Market (WFMI) Q2 2011 Earnings Call May 4, 2011 5:00 PM ET

Operator

Good day, and welcome to the Whole Foods Market Second Quarter Earnings Call. [Operator Instructions] It is now my pleasure to hand the call over to Cindy McCann. Please go ahead.

Cindy McCann

Good afternoon. Thank you for joining us for the Whole Foods Market Second Quarter Earnings Conference Call. On the call today are John Mackey; and Walter Robb, Co-Chief Executive Officers; A.C. Gallo, President and Chief Operating Officer; Glenda Flanagan, Executive Vice President and Chief Financial Officer; and Jim Sud, Executive Vice President of Growth & Development.

As a reminder, all forward-looking statements on this call are subject to risks and uncertainties that could cause the company's actual results to differ materially from the expectations and assumptions discussed today due to a variety of factors that affect the company, including the risks specified in the company's most recently filed Forms 10-Q and 10-K. Please note our press release and scripted remarks are available on our website.

I will now turn the call over to John Mackey.

John Mackey

Thank you, Cindy. Good afternoon, everyone. We assume you've read our press release, so we'll use this time to focus on highlights from the quarter and our updated guidance for the year. We're very proud of our results, with the strongest we have reported in the past five years. We produced average weekly sales per store of $644,000, translating to $888 in sales per square foot, 9.7% store contribution, 6% operating margin, 8.9% EBITDA margin, 29% increase in diluted earnings per share to $0.51, and a 38% net operating profit after tax return on invested capital for all stores.

Our solid execution and capital discipline is generating consistent cash flow. Over the last four quarters, we have produced $645 million in cash flow from operations, and received a $166 million in proceeds from stock option exercises. We've used our cash to invest $279 million in new and existing stores, pay off $700 million in long-term debt, and return $35 million in two quarterly dividends to our shareholders. With our long-term debt now fully repaid, we are considering other uses for our growing cash balance, including increasing the investment in our new and existing stores, raising our dividend and repurchasing stock.

While we're very proud of our results and healthy balance sheet, the biggest news of the quarter is that we were able to successfully comp the comp. Despite a 520 basis point tougher year-ago comparison in Q2 compared to Q1, we are reporting our sixth consecutive quarter of accelerating two-year identical store sales growth. Identical store sales increased 8.3% in the second quarter or 16% on a two-year stacked basis, excluding a negative 50 basis point impact from the Easter shift.

We believe our efforts around value and differentiation continue to gain traction as evidenced by the strong 6% increase in our transaction count and identical stores. We believe the slight decline from the 7% increase we saw in Q1 was due to the much tougher year-ago comparison. On a two-year basis, the increase in transaction count accelerated to 10.9% in Q2 from 9.7% in Q1. We did see some product cost increases in the quarter, which we were able to selectively pass-through at retail. This resulted in a 2% increase in our Q2 basket size, driven by increases in both the average price per item and to a lesser extent, items per basket. We have worked very hard over the last couple of years to successfully improve our price image, remained focused on maintaining our relative price positioning in the marketplace.

Costs have definitely moved up, so we are appropriately cautious about the back half of the year. We are hopeful that we can again strike the right balance between rising product costs, and our retails based on our contracts, distribution and tools to manage value. We believe that it is increasingly important to offer a range of prices in each category to allow people to make choices, and we are focused on continuing to develop new products that are of better value to our customers, particularly in the commodity areas.

While we can't say how our customers may react going forward, our quarterly results underscore signs that consumer confidence continued to improve, even as gas prices rose. Year-over-year, sales continue to shift toward branded and organic products. We also saw a shift in purchases to higher-priced tiers, including shifts in several discretionary categories such as cheese, body care and gift sets.

With 31 weeks now behind us, our identical store sales growth has averaged 8.6% year-to-date. We're proud that we are continuing to gain market share in a much faster rate than most public food retailers, and attribute a lot of our success to the progress we have made in our relative price positioning, and to continuing to raise the bar in areas that matter to our customers. For example, similar to the rating systems we have implemented in other categories such as meat and seafood, we recently announced our new Eco-Scale rating system for household cleaning products. This comprehensive color-coded rating system will allow shoppers to easily identify a product's environmental impact and safety based on a red, orange, yellow, green color scale. We have committed to working with our vendors to evaluate and independently audit every product in our cleaning category, and all products will be required to meet the baseline orange standard by Earth Day 2012.

Turning to new store growth, during the quarter, we opened two new stores in San Francisco, California and Raleigh, North Carolina, and relocated one store in Salt Lake City, Utah. In the third quarter to date, we have relocated our store in Rockville, Maryland, and we expect to open six additional new stores, including two more relocations over the remainder of the quarter.

For additional information about our new Eco-Scale rating system and videos from some of our new stores, please visit the Beyond the Numbers section of our Investor Relations webpage. We will be posting supplemental information there each quarter to highlight our whole story beyond just the financials.

I will now give some additional color on our raised EPS outlook for fiscal year 2011. Please refer to our press release for more detailed information. Based on our Q2 results, we raised our earnings outlook for the year. Our identical store sales growth guidance for the year implies a range of 7% to 9% growth for the second half of the year. We believe these ranges appropriately reflect that our comparisons get marginally tougher from here, while also allowing for the possibility that our 8.6% year-to-date idents could be sustained, especially given the likelihood of some positive impact from higher inflation. We're very proud of our results this quarter, which in many respects, are back to peak levels.

Based on these results and our updated assumptions, we have raised our diluted earnings per share guidance for fiscal 2011 to $1.87 to $1.90. This is a 31% to 33% year-over-year increase in earnings per share on a 12% to 13% increase in total sales, reflecting steady sales growth on tougher comparisons, as well as our commitment to delivering incremental operating margin improvement and earnings growth in excess of sales growth. Our business has been highly successful, producing industry-leading comparable store sales growth, average weekly sales and sales per square foot. We look forward to accelerating our growth in the coming years.

There's plenty of runway left in the United States, and Canada and the United Kingdom hold great promise. In fact, we're happy to report that our Kensington store in London is now producing positive EBITDA. We consider 1,000 stores to be a reasonable indication of our market opportunity. As our brand continues to strengthen, consumer demand for natural and organic products continues to increase, and our flexibility on new store size opens up additional market opportunities.

Our new stores are performing well, and we're positioned to internally fund the acceleration in our new store growth. Since our first quarter earnings release, we have signed nine new leases in Markham, Ontario; Fulham, England; Tampa, Florida; Des Moines, Iowa; Chicago, Illinois; Riverdale, Maryland; Wilmington, North Carolina; Nassau, New Hampshire; and Knoxville, Tennessee. We have now signed 30 new leases over the last 12 months. And for the first time since 2007, our square footage and development has increased year-over-year. For the last several quarters, we have been talking accelerating our new store openings, and this is a very positive sign that we are on the way to seeing that acceleration materialize. We expect to update our new store opening schedule for 2012 and beyond next quarter.

We'll now take your questions, but we'll limit participants to one question at a time, so that everyone has an opportunity to participate. Our call will be ending at 4:45 Central Time. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] It looks like our first question will come from the site of Ed Aaron with RBC Capital Markets.

Edward Aaron - RBC Capital Markets, LLC

There's been obviously a fair amount of debate out there as to just to whether the impact of gas prices have an effect on your business. And certainly, your comps speak for themselves. But just wondering if you've seen any sort of behavioral changes in terms of shopping patterns, or what have you, that might either support or refute that claim?

Walter Robb

Ed, this is Walter. It's clearly the gas thing is real. But I think the news here for us is that our sales have stayed strong, our core customers staying in place. The analysis of maybe it's the in and out customer, it'd be the marginal customer, a little bit under margin. But it looks to me like this is a very different time than 2008, and this is a very different customer. This customer is way more adaptive, has good strategies, and has a stronger commitment to the lifestyle. So we continue to power through this. I mean, there's some effect on the margin. We don't know where it goes from here, but we really like the results given the circumstances.

Edward Aaron - RBC Capital Markets, LLC

Fair enough, and if I could just sneak in one follow-up. You've, for a number of years, have shown five-year ranges on some of your metrics as a way, I guess, of showing that history, the best predictor of the future. And the gross margin seems like -- has things continue for the balance of the year, could come in better than what you've done in any of the last five years. And I'm just wondering if you think that those interesting abilities of that in terms of your ability to kind of perhaps establish a new range there?

A. Gallo

Ed, this is A.C. Well, the gross margin is interesting. A lot of the increase you've seen has been primarily through leveraging our occupancy costs with these strong sales. And as long as sales continue, we think we can continue with our good leverage there. Though we always have to remember that in Q4, we traditionally see our sales--it's our slowest time of year. So that makes it a little more difficult. It's a delicate balance with gross margin for the rest of the year. And in a time like this, where we are seeing some increase in costs, we are able -- we have been able to pass some of them through. There's predictions that we're going to see more inflation in the year, and we're not quite sure how the market place is going to react to that. We want to make sure that we maintain our position in the marketplace, our good value. We've been working really hard at getting what we can on the buy side and through better distribution channels, especially our own internal distribution, becoming more efficient there. So we're cautiously optimistic that we can maintain our margin performance as we go forward. But there is some uncertainty based on not quite understanding how, what kind of inflation we're feeling [ph] in our costs and what we'll be able to pass through.

Operator

It looks like our next question will come from the site of Karen Short with BMO Capital.

Karen Short - BMO Capital Markets U.S.

Just curious, when you guys look at traffic versus basket, can you maybe elaborate a little bit more of this quarter, what you're seeing on the composition of traffic coming from new versus existing customers? And then also, along those lines, discuss the trends in basket, like what percent of the baskets are doing the whole shop, with average tickets kind of in the $40, $50 range?

Walter Robb

I mean -- Karen, this is Walter. And the success for the last couple of years has been driven by a strong, strong growth in the transaction count, 75/25 to item basket. And I think that trend is moderating a little bit as -- and you'd expect it back towards more historical balance, but the traffic kind of still strong nonetheless. And diving into our -- diving into the numbers on a couple of levels, one in the basket, doing the quintile analysis, we've seen that, that customers' holding steady in the $10 basket, $20, $30, $40 basket, and even in the $50 basket, we're seeing actually nice growth year-over-year, suggesting that our core consumer continues to hold and stay with us and grow. And that's being led too by the perishables, which is a very positive sign for us. So I don't know if I have exactly answered your question, but maybe that shed some color on it.

Karen Short - BMO Capital Markets U.S.

Yes. That's helpful. And then I guess just looking at your unit growth in general, from a divisional perspective, how many divisions today do you think can execute kind of on the one store per quarter per division? And I guess what would it take to get to the extent that they -- not all divisions could today, what would it take from an infrastructure perspective to get all divisions able to kind of be at that level to the extent -- forget the pipeline, just from an execution perspective?

John Mackey

Karen, John here. I think all of the regions are capable right now of executing if they have to. A region -- I mean, a store per quarter, I think that's within -- we have the infrastructure to do that. The limiting factor is not capital, and it's not our ability to execute. It's simply finding sites that we think are going to be winners for us. We're very picky in our real estate, and we're accelerating that. You see that the trend line is up there. And we've got 30 stores signed in the last 12 months, and we think we'll continue to sign more stores. But we're not guiding yet for -- I mean, I think we've guided on our stores. I think we promised that we're going to raise that guidance in Q3, or give new guidance in Q3, probably a rise. And so we'll throw some more color on that in Q3. I think we can probably grow as fast as we want to grow. It's really a question of making sure we got quality sites in the pipeline.

Walter Robb

Just adding on there for you, Karen. There's something I think I'm excited about this quarter. Jim may want to add to this too. If you look at the range where these sites are, but our cost to build on a per square foot basis proved again this quarter from 285 to sort of 275, sort of an incremental improvement there. The cost to build the individual store came down under $11 million, as the store size moved from 43 to 40. Again, our confidence in being able to build these stores less expensively, and you saw our return on invested capital jump to 12% this quarter, which is the best in a number of years. So our stewardship of the capital to build these stores will continue. Our confidence continues to grow on that as well. Jim, you want to add any color to -- this pipeline is pretty darn exciting, so...

James Sud

Yes. It's very exciting. We have, as John mentioned, we signed 30 leases over the last four quarters. It's the most since 2006. And we are much more picky in real estate. There's no question about that. But that being said, we are approving a large number of sites and real estate on a quarterly basis. We have a big pipeline of sites that have been approved that are currently in lease negotiations, and I'm quite frankly very optimistic that we'll continue to quickly rebuild the pipeline. Canada, as we've mentioned, we have a goal of having 30 stores there. We have six. United Kingdom, we're just getting started across the United States in the heartland. We're just really just getting started there. So the opportunities in real estate are great for us. The economics are -- continue to be very strong for us, and I'm very bullish on our ability to grow the pipeline and thus, the ability to -- and as that continues, then we'll continue to open more stores.

Operator

And we'll move next to the site of Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Wanted to dig in a little bit more, the stores that you're adding now to the pipeline, are those going in for the fiscal '13, or are there still opportunities to add more to fiscal '12?

John Mackey

There are opportunities to add to fiscal '12.

Mark Wiltamuth - Morgan Stanley

Okay. And that square footage growth number ticks up there for fiscal '12. I know John often talks about the growth paradox, as you expand unit growth, sometimes the margin comes under pressure. Is there some comp number we should be watching for that would keep that margin from coming under pressure, or anyway you can kind of help us through thinking about that as we look in our out years with square footage growth growing again?

John Mackey

Mark, John here. A couple of things. One is, is that we will provide in our Q3 earnings call, we're going to update. We will give you probably definitive numbers towards for 2012 at the time. I think it can pretty much be locked in at that point. So we have to wait another quarter for you to see the results on that one. Regarding the growth paradox, it's still always there, but what's a little different now is that our base of stores is so great that we have to accelerate our growth rate considerably. Remember, five, six, seven years ago, we were growing our square footage growth of a 15% cliff, and now we're at 5%, 6%, even if we get it up to 7% or 8%. That is not going to have as big an impact on us for new stores. It used to have, simply because the percentage of new stores to the overall base of new stores is lessened to how it used to be. So the growth paradox, it's still there, only I don't think we're going to feel it too much even as we accelerate the pipeline, because I don't think we're going to accelerate it so much that we'll see it really kick in.

Mark Wiltamuth - Morgan Stanley

And presumably, the new store pre-open expense won't be as much, because they're slightly smaller boxes than they were back in the heady growth days...

John Mackey

They're smaller boxes, and we're also -- we're spending lots of money on them. So we've got more disciplined on our capital expenditures. And I think as a result, we're hopeful that a lot of the stores are going to be opening up. We're going also achieve better performance sooner than we have in the past. So that would also lessen the impact than these stores might have. So we're a little older and hopefully, a little wiser.

Mark Wiltamuth - Morgan Stanley

Okay. And then now that you've paid off your debt, I know you've got an EVA focus, so that kind of dictates that you need to either return capital to shareholders or plow it back into new stores. And if you look at that EVA calculation now, which one is yielding a better number for you, more stores or return cash to shareholders?

John Mackey

They all are yielding pretty good, sir. I mean, I think we're in this happy situation. We're throwing out so much cash that we can -- we could double our rate of growth right now strictly out of operating cash flow without having to borrow a dime. So we've got huge potential to be able to accelerate our growth. And yes, we do anticipate that we will increase dividend at some point. And I mean, as long as the cost -- as long as these interest rates remain so low, it's accretive almost to do almost anything in terms of share repurchases at almost virtually any price. I'm not saying, therefore, that we'll be repurchasing stock at any price, but all of these will look good. And I suspect Whole Foods will be trying to utilize all three strategies. Also, I might add, we'll probably want to pile up some cash. The company does not want to get into a situation that it had back in 2008 ever again, where we feel like we have to go back to the market, and we sold equity at unfavorable terms. And we don't ever want to do that again. So a fourth use of cash is to hold some more cash than we used to hold. So we're a little more conservative than I think we were a few years ago as a result of the great recession.

Walter Robb

That must be the older and wiser thing in it too, right there.

John Mackey

Yes. We're older and wiser, and a little bit more conservative with cash.

Operator

And we'll move next to the site of Robert Ohmes with Bank of America.

Robert Ohmes - BofA Merrill Lynch

Two quick questions. I was curious if you could comment on sort of the tone on competitors in their attempts to pass pricing through, and sort of how it feels as you look at the pricing going on competitively around you. And then the other question was, is there anything on the merchandising side that you guys are excited about? Or can you comment on that we should be looking to roll out in your stores as you move through the rest of this year?

Walter Robb

This is Walter. As you know, we've been ramping up our comp check efforts over the last year and a half. And we're now checking 12 major markets, thousands of items. And every -- at the compares out there, I don't know about their tone, but you can read the reports, but they're all raising prices. And it looks to me like from 1% to 2% in the last quarter, pretty much across-the-board, and we might be the odd one here too. So I think every retailer realizing there's no way of dodging this, and they're going to have to get out there and raise them in. And they have a greater exposure to commodities than we do as we've discussed in the past. So ours are lagging a bit. But I like our position. I like our ability to pass through. We'll do it in the context of the marketplace. It seems to be pretty rational so far. We may get tested on it at the end of the year. But right now, that's where it is. But things that we're excited about on this end, I mean, again, we saw a nice lift in Easter on our perishable programs. They continued to lead the way for us, and staying very strong. We think the quality of our perishables continues to improve, and as we continue to build differentiated standards, particularly in our meat and our seafood, and we're working on produce. I think we're setting a higher bar. Health Starts Here, all the healthy eating initiatives are just in the first inning as we've talked about, catching on fire. And we are going to continue to pound on value, and it's worked. It's continuing to work. That our Nielsen buzz study that we do every three quarters has shown that our positive notes on value is up 12% last quarter, and the negatives were down 1%. I think that's one of the reasons our customers are staying in place, and continuing to shop with us, because they feel good about the values that we're offering. So I think it's a combination of all those things, but we're pretty excited over here. A.C.'s got some color.

A. Gallo

Yes. I'd like to add to what Walter said is that -- we're really excited about, and Walter's talking about value, is that the -- we've been introducing -- we're in a situation now where certain costs are going up, and certain prices are going up. And we feel like in order to counterbalance that, we need to continue to develop even better selections of value items in each category we have. So in the fall, we came out with this whole new line of wines, it's the Three Wishes Wine, we call it, and it's a control label wine of ours that sells for anywhere from $1.99 in the West Coast to $2.99 in the East Coast, and it's done extremely well. We have just recently come out with a similar line, the "extreme value" line in our cheese area, and we have we have other areas that we're working on right now. So we expect that over the course of the rest of the year and just going forward, that we'll continue to be coming out with selections of products in each category that we have that are really great value for our customers, and we'll continue to contribute -- continue to work on that value proposition for them.

Operator

And we'll move next to the site of Meredith Adler with Barclays Capital.

Meredith Adler - Barclays Capital

I have one sort of housekeeping question. You often mention what the impact was of currency on IDs. I wonder whether it was insignificant, because it just wasn't mentioned this quarter.

Glenda Chamberlain

Meredith, I think it's like 15 basis points. It's pretty small.

Meredith Adler - Barclays Capital

Okay, great. And then just another question, I was looking at the table that shows comps by age of store, as well as returns. And there is a pretty sharp drop off for the stores that have been opened for two to five years. Now obviously, those are not-- stores are not all mature. But I'm wondering if there's anything else you would comment on when looking at that particular group of stores.

Glenda Chamberlain

That category had 13 stores in it, over 60,000 square feet, including Kensington, which is much more than any other age group category. So even though our big stores are doing well, it takes longer, of course, for them to develop the returns compared to the other sizes. Our total company, no-cap for the quarter, was 12.4% versus 10% last year, and our total store level was 38 versus 31. So we're very pleased with the progress that we're making in the ROIC category.

Meredith Adler - Barclays Capital

Absolutely. Is there -- And when you look at those stores two to five years, are there any -- I mean, now it's great that Kensington is now EBITDA positive. Is there anything you look at and say, "This is just not going to get there?"

John Mackey

No, we don't have any stores right now in the company that aren't going to get there. So some of them don't get there quite as fast as we'd like them to. And the funny thing about these categories, of course, is eventually, some of these stores, they're going to drop into the five to eight year category, and they'll maybe slightly lower that category, but then the two-to-five year category will bump up. So I wouldn't read too much into it. We are opening a little bit smaller stores now than we were a few years ago. And unfortunately, we opened a crop of big stores right when the great recession occurred. And we didn't get our comp lift that we've had. Now we're getting it now, but it's like we had a two-year delay on it. So we've got a bigger crop of big stores that are comping pretty well now, but they didn't for a couple of years as a result. That just has an out-weighted effect in the two-to-five year category. So I think it's -- I really think you'll see a year from now, that won't be there, so...

Walter Robb

This is Walter. I really think that's really true, John, because that two to five has those stores hitting that year. And also just reinforce what John said earlier about the stores that we're opening right now, we're opening stronger, sooner and those ones will be jumping into that two-to-five category here in the next year or so. I think that was kind of a one-time thing in there.

John Mackey

Yes, what's interesting if you're looking at the same chart, Meredith, you'll see that -- how strong the comps are for those stores that are two-to-five years. They're almost the same as the stores that are less than two years of age, so that kind of reinforces what I'm trying to say is, we have a crop of large stores. They have a 54,000 square feet that didn't get the normal comp gains that we expected them to get because of the recession. We're getting them now. And that's resulting in very strong comps for the category, but lower NOPAT ROICs. And if they continue to comp well, then we're going to see the ROICs go up, NOPATs go up, and the category is going to look better. So that's the explanation, and I predict you'll see it gradually change over the next few quarters.

Meredith Adler - Barclays Capital

That makes a lot of sense.

Operator

And our next question will come from the site of Adrianne Shapira with Goldman Sachs.

Stephen Grambling - Goldman Sachs Group Inc.

This is actually Stephen Grambling, on for Adrianne. I just had a quick follow-up on the inflation. You referenced that the majority of the 2% increase in basket was related to inflation, I'm just wondering -- or price per item, I'm wondering what the cost input inflation was for the quarter. Was it actually higher than that?

Walter Robb

The inflation for the quarter for us was under 1% on the cost side. That's going up though. It's definitely going to go up in Q3. We feel again we're in really good position for Q3. And like A.C. said, the only question really is the final part of the year, because it's hard to see exactly where this is, where this will keep going to.

Stephen Grambling - Goldman Sachs Group Inc.

Okay. So the LIFO expectation implied something a little bit higher than that?

Glenda Chamberlain

Yes.

Walter Robb

That's correct.

Stephen Grambling - Goldman Sachs Group Inc.

And is there any categories in particular that would be driving that you're concerned about?

Walter Robb

Well, I mean, you guys just issued a report today on commodities, so I'm sure there's a lot of intelligence over there. But I think it's the beef area, the dairy areas, the corn and soy, these are the major areas that people are talking about in terms of experiencing inflation. So all the proteins got to have the corn and soy to feed the animals, and that's one of the major areas that's going up, and some of the major commodities.

Stephen Grambling - Goldman Sachs Group Inc.

Okay. Understood.

Operator

And we'll move next to the site of John Heinbockel with Guggenheim.

John Heinbockel - Guggenheim Securities, LLC

Two related questions. One, how do returns compare in smaller markets, because I think, going forward, there'll probably be more opportunity in smaller markets, given your smaller box size. How do the returns compare to smaller markets versus the big urban markets? That's one. And then secondly, how do you think about capacity in the smaller stores longer-term? And does there come a point, do you think, where you need some by-design cannibalization to deal with capacity, or capacity really isn't an issue long-term in a 35,000 or 40,000 square-foot store?

John Mackey

John, John here. Well, good questions and the first question is, is that we do think there's huge market opportunities for smaller stores. And we've done some experiments, where they were really pleased with the results that we're getting. So I do think we're going to see -- we've announced a number of smaller stores in the last few quarters, and so we are -- we're on that program. And regarding your second question, I mean, we've always, since we've had in our history a lot of small stores, we've dealt with that capacity issue in two ways. One is we've done a lot of relocations to bigger stores, and we continue to do that when a store is just kind of doing great volume, and it sometimes sets up a discussion internally that we just keep that smaller store there that's got tremendous returns on invested capital. In a lot of cases, over 100% a year, or are we better off in order to preempt the competitive industry, to go ahead and relocate it to a bigger store, which gives us more of a competitive barrier. More often than not, we go ahead and relocate it. Because we -- our company tends to think long-term, and most of our decisions are geared in that direction other than just milking something as long as possible. The other strategy we do besides relocation is, in some markets, a good example is, say, maybe in Los Angeles, Western Los Angeles, where we'll group our stores closer together, because it's hard to find big store real estate in that market. So we've got more smaller stores, more densely located--in densely populated areas, more closely located together. So we're doing some of that a little bit, in maybe the D.C. [Washington D.C.] market, San Francisco is another one. Chicago, definitely Chicago, eventually, Manhattan, we'll see that there too. So we're approaching it with both of those -- with both of those strategies.

Walter Robb

I want to add -- and I'm going to add to that and A.C.'s going to weigh in, too. You got us all interested in this question. But I want to add first of all, I want to tell you that to get to our 1,000 store goal, we're going to continue to move in urban areas, as well as suburban, or green field areas as well to get -- and we think there's lots -- we looked at this, we had charted it out. We see potential pretty much across the map besides U.K. and Canada. But you mentioned about profitability and when we go into some of these newer market areas, they're smaller market areas or mid-market areas, the thing is we're kind of -- we're leaving that, and sort of the economics of those areas are very favorable, and you combine that with our ability to build it for less, and our kind of our refinement of the business model in terms of cost, and you have a very nice result. And you have a result that's going to produce well for many years. If you think about our earnings 5 years from now, it's going to come from this crop of stores like Des Moines, Iowa, and sort of the other places that we're talking about today that we've been able to enter in very favorable terms. And I think one other wrinkle on that, as we go into the real estate meeting, we often talk about a market and say, "Is this a one-star market, a two-star market, a three-star market?". We can size the store appropriately. If we think it's ultimately only a one-star market, we can size it up a little bit, right size it to do the business we think it can do. We might put another 3,000 to 5,000 square feet on them, more than we -- just to give a little capacity. If on the other hand, we think it's a two-star market, we may take the first store a little more conservatively, and leave our room to come back and do the second. So that's one of the ways, I think, that we have continued to mature and refine our real estate strategy as we've gotten older and wiser as John said. And so A.C. was going to add on that as well.

A. Gallo

Well, I would just add to that, that a lot of the stores we've opened that are much smaller are usually been in the urban areas like in San Francisco, where in order to get into a neighborhood, that's about -- we might only go 20,000 square feet. But in most of the -- what we're looking at now is smaller stores, a lot of them are in this 35,000 to 40,000 square foot range, which really has been a very well performing, high-performing store with great return over the long term for us throughout our history. And that's -- we're looking a lot in that, and we're still -- we'll open up the 50, 60, even bigger stores in appropriate areas, where it might be relocation of a really successful store or something we think has great capacity. But we're really working all the different sizes, and I think that -- I just think that a lot of what we're doing is putting us in a position to have really good excellent returns for many years.

Walter Robb

Just going to add on that real estate too that the -- in this crop of announcement today, is our first store in Prince George County in the D.C. area, right? So giving a different look on that market as well, so...

John Heinbockel - Guggenheim Securities, LLC

It sounds you guys do think that return on capital in the smaller markets should be similar, maybe even better than the big urban markets, or do you not agree with that?

John Mackey

I think it's highly selective and dependent upon the market and the location, and what we don't know and we won't know for a while is, if we open a big store, it's obviously going to take a little while longer for that to get an optimum return on invested capital. But it also has more competitive barriers. It may produce some longer, higher returns over the long term than a smaller store. Well, smaller stores will produce higher returns, because they'll max out and get very strong returns on invested capital quicker. But they're more competitively vulnerable. And so they may have a shorter lifespan for producing those returns as well. Basically, our strategy has been -- and we're even putting great emphasis on it, is what's the right size store for a particular market? And sometimes, it's a smaller store, and sometimes, it's a medium-sized store and sometimes, it's a really big store. So that's -- when you get into our real estate meeting and we're going over these stores, we're always asking the question, "Is this the right-size store for this particular market?" And a lot of our internal discussions and debates are around that question. "Can we make this store 10,000 square feet bigger? This stores is too big. We need to cut 7,000 square feet out of it". So it's -- we have a -- if we gain more experience, and open more stores, our empirical database is getting more and more better developed, and so we'll be able to make better decisions regarding right-size store for the right market.

Operator

And we'll move next to the site of Scott Mushkin with Jefferies & Company.

Scott Mushkin - Jefferies & Company, Inc.

So well, you kind of talked about a couple of things as we went through the Q&A. One was the cost per square foot coming down, and the other one was generally cost. And I guess I'd maybe brought that out to contribution margins. So I wanted to, I guess, get a feel. Clearly, I know you guys have been working on costs, working on the contribution margin from the stores. Where are we in that process, are we -- you use as the inning, what inning are we in? I guess where are we, I guess, in your mind on that? And then, I guess, on the cost per square foot, it's the same thing. It's been drifting or coming down -- not drifting, that's coming down. Does it have further to go, or we kind of going to round it back up as we ramp up growth?

Walter Robb

Yes, well, I mean, I think what we -- Scott, what we've talked with you about is we're going to make steady incremental progress on the sales earnings growth versus sales, gross margin stability, operating margins, and return on invested capitals. And I think we're delivering on those quarter-after-quarter, continuing to making the incremental progress on those. And I think that's our goal is to continue to make incremental progress on that. And with respect to the cost per square foot, I don't know how much further -- I will say I don't think we're going back. I think the operators have done a fantastic job, doing more with less. And really, our processes have improved. We have leadership here in Austin to help and better information technology and information sharing. So there is further to go, but it's probably more incremental in nature. Probably, I thought, maybe in sort of the 250 range, and maybe a little bit lower, 240 range, and I don't see any reason that needs to go back up. Even if we accelerate the growth, our processes should be improved to where we were able to do that, and still hold costs at a reasonable level.

John Mackey

That assumes -- of course, inflation could force it up. So we're assuming no inflation when Walter gives those numbers.

Scott Mushkin - Jefferies & Company, Inc.

Yes, and hopefully, I don't think that won't be a problem.

John Mackey

I just want to add that hedge in there because we don't know what's going to happen in that.

Scott Mushkin - Jefferies & Company, Inc.

No, that looks like a good hedge right now. So Walter, if I -- I know you guys get a little -- you probably don't want to say too much around the other thing, working on cost and working on performance. And just speaking to people that -- kind of in the channel, they've been so bullish on kind of what you guys are doing with your store operations that I guess I just wanted to get -- forget about the margins. I mean, do you think there's still a lot to go in improving efficiencies? Or any color you might want to add would be wonderful.

A. Gallo

Scott, it's A.C. A lot depends on sales. When we have good solid sales growth, we can deliver a good, consistent leverage on in-store expenses. As long as we continue with a good period of sales here, we think we'll continue to deliver it. We have to balance. We have to continue to balance. It's not about trying to get to some particular number. We have to look at -- we have to balance all the stakeholders, and make sure that the team members are being properly taken care of, and customers are getting the right experience. So I just think that there's more that we'll continue to get as sales increase. But there's no specific number that we're really targeting or can say at this point. Just to continue to see improvement.

Operator

That was our last question. I'd now like to turn the call back over to John Mackey.

John Mackey

Thanks for listening in. Join us in July for our third quarter earnings. A transcript of the scripted portion of this call, along with the recording of the call is available on our website at www.wholefoodsmarket.com. We'll talk to everybody next quarter. Goodbye.

Operator

And this does conclude today's teleconference. Thank you for your participation. You may disconnect at any time, and have a wonderful evening.

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