Smart & Final Stores, Inc. (NYSE:SFS)
Q2 2016 Results Earnings Conference Call
July 28, 2016 5:00 p.m. ET
Laura Bainbridge - IR
Dave Hirz - President and Chief Executive Officer
Rick Phegley - Chief Financial Officer
Scott Drew - Executive Vice President of Operations
Vincent Sinisi - Morgan Stanley
Rupesh Parikh - Oppenheimer
Sean Naughton - Piper Jaffray
John Heinbockel - Guggenheim Securities
Edward Kelly - Credit Suisse
Karen Short - Barclays
Alvin Concepcion - Citi
Shane Higgins - Deutsche Bank
Greetings and welcome to Smart & Final Stores Incorporated Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Ms. Laura Bainbridge of Investor Relations. Thank you. Ms. Bainbridge, please go ahead.
Thank you and thank you for joining us today as we discuss Smart & Final Stores' second quarter 2016 financial results. Before we begin, we want to remind you that comments made during the course of this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ in a material manner from those expressed in such forward-looking statements for any reason, including those listed in the Company's SEC filings. The Company assumes no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results.
During this conference call, the Company will refer to certain non-GAAP financial measures, including adjusted net income, adjusted net income per diluted share and adjusted EBITDA. The Company uses these as measures of operating performance, not as measures of liquidity. These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with Generally Accepted Accounting Principles. In addition, these measures may not be comparable to similar measures used by other companies. Please refer to the Company's earnings release made available on its investor relations Web site for definitions and reconciliations of these measures to the most directly comparable GAAP measures.
With that, I will turn the call over to Dave Hirz, the Company's President and Chief Executive Officer.
Good afternoon, everyone and thank you for participating in today’s call. Joining me is Rick Phegley, our Chief Financial Officer. Scott Drew, our Executive Vice President of Operations will also be available for the Q&A portion of today's call.
To start, I will provide some context for our second quarter results. While the industry environment was certainly challenging in the quarter, we are pleased with our operational progress and momentum in 2016. We executed our store growth plans and delivered solid product gross margins. In the second quarter we completed the conversion of 33 stores formerly operated under the Haggen banner. Some of the acquired stores replace existing Smart & Final legacy stores and as a result we have achieved 30 of our planned 37 new stores for 2016.
Collective new store sales and EBITDA performance are right on plan. As anticipated, our 2016 new Extra! Stores are generating sales at levels above our new store model. Our increased store density in key central and southern California markets has enabled us to efficiently invest in our differentiated brand message to both new households and business customers. As expected, these new stores and new stores from 2015, have cannibalized sales and EBITDA contribution from existing stores. The cannibalization impact is in the range of our expectations and we expect those cannibalization pressures will begin to moderate as we move through the balance of 2016.
In contrast, deflation in the first half of 2016 has been higher and persisted longer than our range of expectation and it widespread effects have been felt throughout our industry. The current rates of deflation are amongst the highest levels seen in recent years. Deflation has been both an impediment to overall sales growth and has a deleveraging effect on the income statement. Mainly the product categories where deflation has persisted have a more pronounced impact on Smart & Final because of our product and customer mix than you might see in a conventional grocery retailer.
Thus far in the first four weeks of our third quarter, we have not seen any improvement in deflationary trends. For the year, we are now forecasting a deflationary environment of approximately 1.7%, a 2.7% swing from our prior estimate of about 1% inflation. As a result, we are revising our sales expectations for the full year in the approximate amount of the deflation change and Rick will expand further in his comments.
It's important to note that our total sales in the quarter grew by almost 15% on a year to year basis despite the significant impacts from cannibalization and deflation. Further highlighting the effective deflation in the Smart & Final banner, total sales increased in the quarter by 18% yet unit sales were up over 22%. These short-term pressures aside, we are focused on executing against our well defined growth plan and advancing our merchandising and marketing efforts. We look forward to many exciting growth prospects leading into 2017.
Earlier I said, that we are proud of our accomplishments in the first half of 2016 and key to our performance have been our over 12,000 terrific employee associates, including 3500 associates hired just this year. During this unprecedented period of staff growth, our team has been focused on the training and development necessary to preserve our unique culture and maintain the level of customer service and high store standards in which we take great pride.
Now I will turn briefly to our second quarter results. Consolidated net sales were $1.04 billion, an increase of 14.7% over the prior year period. Adjusted net income was $15.5 million and adjusted EBITDA was $50.7 million for the second quarter. Fully diluted adjusted EPS was $0.20 per share. On a total company basis, comparable store sales declined by 0.3%, including the effects of deflation and cannibalization with Smart & Final banner comps decreasing by 0.6% and Cash & Carry banner comps increasing by 0.4%.
Within the Smart & Final banner, the comp store sales decline of 0.6% was comprised of 0.4% increase in comparable transaction count and a 1% decrease in comparable average ticket. We believe that the deflationary impact on comparable banner sales were roughly 1.5% in the second quarter, a year to year negative swing of about 1.4%. We also estimate that the impact of sales cannibalization from new stores was about 2.3%. So our estimate is that the headwinds to comparable store sales growth in the second quarter, cannibalization and deflation were between 3.5% and 4%.
While it's early in our third quarter, which is a 16 week quarter ending October 9, the current deflation rates in the Smart & Final banner are slightly worse than the second quarter rate. This backdrop of a challenging industry environment shouldn’t shift focus away from our strong growth in the Smart & Final banner. Total customer transactions have grown by around 17% year to year, led by continued success in our merchandising initiatives. Our efforts to grow the number of stores with organic produce, natural and organic center store SKUs, bulk foods, rotisserie style chicken, and newer products like in-store bakery, cup fruit and sushi in selected stores, are providing an environment for new customer growth and increased shopping frequency with our existing customers.
Our natural and organic private label brands, Sun Harvest, continues to be a driver of overall basket size and a contributor to overall growth within the natural and organic category. Likewise, we are seeing strong demand within our Good and Well offering, the 1400 natural and organic items that we have been rolling out over the past couple of years. Good and Well now covers 29 categories throughout the store, including center store, frozen and perishables.
We grew the number of stores offering Good and Well by 40% in the first half of 2016 to end the quarter at 110 stores. And we have added over 50 new items to the categories. Turning to the Cash & Carry banner, our comp store sales growth of 0.4% was comprised of 0.3% increase in average ticket and 0.1% increase in transaction count. In the second quarter, we estimate that the deflationary pressure negatively impacted Cash & Carry's comparable store sales by roughly 2.1%, which was also a higher rate than the first quarter estimated deflation rate of approximately 1.3%.
So we believe that the sales performance was solid given the impact of deflation. Cash & Carry also had a small amount of cannibalization from 2015 new stores opened in the second half of last year. Since late 2014, we have opened three new Cash & Carry stores and the collective performance is tracking ahead of our expectations for both sales and EBITDA. The Cash & Carry banner continues to resonate with customers focusing primarily on food service. We price well below national food service delivery operators with no membership fees or minimum order size and we operate an incredibly efficient store model with our average Cash & Carry generating approximately $17 million in annual sales with about a dozen store level employees.
We are excited to continue expanding this unique format in the second half of the year. So, overall, the sales growth environment in the second quarter was more challenging than expected, largely the result of factors impacting our industry. We strongly believe in our overall plan for continued store growth in both the Smart & Final and the Cash & Carry store banners.
In the second half of 2016, we plan to complete this year's development goals with the opening of three new Smart & Final Extra! stores plus the relocation of two Smart & Final legacy stores to new Extra! format locations and the conversion of six legacy stores into Extra! At year-end we expect to have approximately 70% of our Smart & Final banner stores in the Extra! format. We also plan to open four new Cash & Carry stores in the second half of this year. We are excited that in addition to expanding within existing markets, our store development plans take us to a new state, Utah, in the fourth quarter of 2016.
Based on the success of the three Cash & Carry stores recently opened, we plan to increase new store growth to 10% of the banner next year with six new stores. In the Smart & Final Extra! format, we expect the pace of new store development to return to a 10% unit growth rate, which would be a target of 25 new stores in 2017 along with continued relocations and conversions of legacy stores. As we move through the balance of 2016, we expect that sales cannibalization from new stores will begin to moderate, as the 2015 new stores cycle their opening dates, enroll into the comparable store sales base.
Here's how it works. By the end of the third quarter, nine of last year's 20 new stores will be contributing to Smart & Final banner comp sales and by the end of the fourth quarter, this number will increase to 15 stores. In 2017, we expect further moderation based on a new store mix that is more geographically diverse than in 2016. And we continue to expect moderation and deflation as we move beyond 2016, although our current view based on our year-to-date experience and including recently reported CPI data, is for deflation to remain a challenge throughout the second half of this year.
Our stores are successful because we have a unique product offering with pricing that offers great value to both our household and small business customers in convenient easy to shop locations. The unique look and feel of the Smart & Final stores with warehouse style of racking and low frills, continues to reinforce the message to our customers that we remain focused on delivering value every day. We have a long history of sustaining growth in comparable store sales based on our core merchandising and marketing strengths, including high quality private label offerings with natural and organic products, over 2500 warehouse club pack items, more than 2000 unique business customer SKUs and a core strength in high quality fresh produce.
Approximately 40% of SKUs offered today in our Extra! Stores are unique to Smart & Final. Our competitive positioning in our markets is strong, based on our unique merchandise offering and broad customer appeal. In our southern California market we have had a new competitor enter in the first half of 2016, as we have had many new competitors throughout our 145 year history. And thus far the sales impact from new competition has been minimal. We also continue to build a solid foundation with the local communities that we serve. Our communities represent a broad range of customer demographics and our marketing and brand awareness efforts are designed to connect with a diversity of customers and shopping needs.
Looking forward, we will continue to benefit from increased market density, including marketing and brand awareness. With our higher store density in central and southern California, we have focused our communication efforts in video, radio and digital media to tell our differentiated story to new customers. We invite you to see one of our branding video messages recently posted to our investor relations Web site, which does a great job of explaining what differentiates Smart & Final in today's marketplace.
With that, Rick will now review some additional details of financials and our expectations for the remaining part of the year.
Thank you, Dave and good afternoon everyone. Building on Dave's comments regarding second quarter store development activity, deflationary pressures and cannibalization, today I will add some additional color on the second quarter performance and discuss our thoughts regarding the second half of 2016. So let's begin with sales.
As noted in our release, net sales were $1.04 billion, up 14.7% versus the second quarter of 2015. Net sales growth was driven by the sales contribution of stores which opened over the last 12 months, partially offset by the consolidated comparable store sales decline of 0.3%. The comparable store sales rate decline reflects the impact from sales cannibalization and deflation and I will review these topics in more detail.
In the last 12 months, we have opened 43 new stores. The majority of these stores have cannibalized sales of existing stores. As Dave noted, we estimate that stores opened over the prior 12-month period cannibalized our Smart & Final banner comp by approximately 2.3% in the quarter. We plan for sales cannibalization from new stores and believe that over the longer term, the benefit of new stores are favorable to total sales and EBITDA growth.
As we have previously noted but it's worthy of repeating. In the short-term this represents a little more of a challenge as typically the cannibalized sales are from a mature, profitable store and transferred to a new store with a lower current EBITDA rate. With the Smart & Final banner, we believe that the second quarter should mark the high point of cannibalization in 2016.
Our policy on reporting comparable store sales is for a new store to enter the comp base in the 61st week after opening. So most of the 2015 new stores will not contribute to the 2016 comp rate until the latter half of this year and a 2016 new store openings to track from 2016 comp sales rates. Accordingly, as we look forward, we expect that the third quarter cannibalization rate will be approximately 2.1% and that the fourth quarter cannibalization rate will be approximately 1.6%.
Sales cannibalization from new stores in the Cash & Carry banner was estimated at approximately 0.7% in the second quarter and with four additional new stores in the second half of 2016, including three in existing market, we expect that Cash & Carry cannibalization will increase. In addition to the overall sales and EBITDA effects, it's important to realize that cannibalization is reflected in comparable store transaction growth.
Turning now to deflation. On a total company basis, we estimate that the overall deflation impact was about 170 basis points, up from 90 basis points in the 2016 first quarter. For reference, in the 2015 second quarter we experienced an estimated 60 basis points of deflation on a total company basis. Notably, we experienced deflation in several key categories. Just looking at the raw deflation impacts of 2016 prices compared to 2015 prices, in the second quarter we saw a deflation of almost 8% in proteins, over 11% in dairy and eggs, 1% in center store grocery items, and 3.5% points in cheese which is on top of last year's second quarter deflation rate of almost 16% in cheese. Produce was 2.8% inflationary in the second quarter but the category had been over 7% inflationary in the first quarter.
In both store banners, deflation has been especially pronounced in categories with strong exposure to our business customers. The income statement challenge from deflation is simple. Most of the system cost of selling a case of product, like warehousing and transportation, stocking and front-end store costs, these don’t go down when deflation reduces the selling price of the case. And the lower aggregate sales rates delever fixed cost in the income statement on a percentage of sales basis.
So far in the third quarter, overall deflationary pressures had persisted in both store banners and as a result we are planning for deflation to continue at approximately negative 2% for the balance of 2016. On a total company basis, GAAP net income in the second quarter was $7.8 million, a $3.2 million decrease compared to the prior year quarter. On a percentage of sales rate basis, our gross margin rate declined modestly, impacted by the deleveraging effects just mentioned and an increase in operating and administrative expenses including training and development costs for the former Haggen stores.
Looking at the GAAP segment reporting tables, most of the effect is within the Smart & Final stores segment. It is important to point out that the second quarter GAAP income reporting includes the effect of $6.5 million of onetime pre-opening and non-cash rent cost associated with the former Haggen stores, which are presented as add-backs in our adjusted non-GAAP reporting. Our GAAP EPS was $0.10 per fully diluted share based on about 78.9 million shares. The effective tax rate in this year's second quarter was approximately 31%. Although our standard tax rate expectation is approximately 40% of domestic income, in the second quarter we adopted ASU 2016-09, the new accounting standard for share-based payments, which had a favorable impact on tax rate in the quarter.
We manage the company with a focus on adjusted EBITDA and adjusted net income as we believe that these measure better reflect the operating performance of our business by excluding certain onetime and non-cash charges. As a metric, adjusted EBITDA adjusts for some of the elements of growth and public company costs, including by adding back share-based compensation expense, store pre-opening cost and non-cash rent. In the second quarter, adjusted EBITDA was $50.7 million, roughly flat with the prior year quarter and reflecting the impacts of deflation and cannibalization which we have discussed.
Adjusted EPS on a fully diluted basis was $0.20 per share and includes the higher share count which results from the adoption of ASU 2016-09. Turning now to the balance sheet and cash flow statements. We ended the 2016 second quarter with cash and cash equivalents of $67.4 million as compared to $63.1 million at the end of the first quarter. Our working capital management continues to be solid with investment in inventories of $245.9 million, inclusive of the new stores that we have opened in 2016. So this is a fairly modest increase from the $234 million of inventory at the end of 2015.
Our balance sheet debt, net of debt issuance costs, was $617 million at the end of our second quarter under our term-loan and revolving credit facilities. At the end of the second quarter, we had utilized only $30 million of our revolving credit facility to fund store development. As a reminder, our term-loan facility has no required amortization payments through its November 2019 maturity.
Subsequent to the end of the second quarter, we amended our revolving credit asset based facility to further enhance our financial and operational flexibility. Under the new ABL, the facility size has increased from $150 million to $200 million and the maturity of the facility was extended to July 2021. During 2016, we have repurchased approximately 327,000 shares of our common stock for a total of $5.1 million. As we noted in prior quarters, one of the objectives of share repurchases is to help offset the effective dilution from new share issuances.
We remain in a strong liquidity position with an appropriate capital structure to continue our growth. And now let's turn to our thoughts for the balance of fiscal 2016. We are now expecting deflation of approximately 1.7% for the full year, a 2.7% swing from our prior estimate of inflation of about 1%. Based on these deflationary challenges to sales growth and the resulting impact on EBITDA, we are revising our 2016 guidance for sales, comparable store sales and the net income and EBITDA measures.
So for the full year 2016, we currently expect total sales growth in the range of 12.5% to 13.5%. As a reminder, our 2015 fiscal year was a 53-week year, so the guidance growth is on a 52-week equivalent base. Comparable store sales growth in the range of negative 0.5% to positive 0.5% year-over-year, this is also expressed on a 52-week basis. Adjusted net income in the range of $46 million to $48 million. Adjusted diluted EPS in the range of $0.58 to $0.60 per share, based on fully diluted weighted average shares of 79 million. And adjusted EBITDA in the range of $185 million to $190 million.
The guidance includes certain non-GAAP financial measures as more fully detailed in today's earnings press release. As Dave noted, through the first half of 2016, we have been very focused on managing the operational and strategic aspects of our business in the context of the difficult external environment. We have successfully achieved an 11% increase in new stores and an even larger increase in square footage. Our efforts remain focused on the continued successful expansion of our store-base in both banners and achieving a level of sales, margin and operating expenses that will provide a solid return to capital spending.
And now, Dave will have some concluding remarks before we open up the line for questions.
Thanks, Rick. I would like to thank all of our associates for a strong quarter in a challenging environment. I am extremely proud of our team's commitment and passion in delivering our growth plan while creating great shopping experiences for our new and existing customers. We have established deep roots in the neighborhoods we serve, driven by our dedication to a culture of teamwork. The first half of this year was no exception as we welcomed 3500 new associates who are quickly becoming part of Smart & Final family.
Together, we are excited about the future of Smart & Final stores. We have a strong growth plan in place and our merchandising and marketing efforts are resonating with today's customers. Thank you all for joining today's call. We look forward to keeping you updated on our progress. We will now open the line up for questions.
[Operator Instructions] And our first question comes from the line of Mr. Vincent Sinisi from Morgan Stanley. Please proceed with your question.
I wanted to just make sure I heard a couple of things correctly here. In terms of kind of reconciling the top line headwinds and more so as we are into the third quarter here. Am I right that the cannibalization you said was about 2.3%. I think if I remember you guys had said it would be around 2.5% or so. So relatively in line with expectations. But the, Dave, you had said that kind of quarter to date, slightly worse. So is that really kind of moderating cannibalization and more just so from the deflation. I just want to make sure I heard those numbers properly.
Yes, Vin. I think you heard it right. We had estimated for the year that we are going to be 1.6% cannibalization. We still think that number is fairly close in the quarter. It was pretty close to where we thought it would be, ended up at 2.3%, and as Rick mentioned in his comments, it will moderate throughout the rest of the year. We are looking at something closer to 2%, 2.1% in this quarter, and then the fourth quarter, 1.5%. So moderation and cannibalization in the back half of the year but on the other side of the coin, on deflation, we are thinking now it's going to get just a little bit worse in the back half of the year.
Okay. All right. Thanks, Dave. And then just as a follow up, we get asked all the time as you do, I am sure as well, about your newer competitor out there in California. I know you mentioned kind of minimal effects but can you compare and contrast all these entrees to maybe some other folks in the areas already and now that there has been at least a couple of months since it's entered the market. Just kind of any basic thoughts or effects that you may be seeing?
Sure, Vin. Scott Drew here. Let me take that question. Really all these, the competitor I am sure you are referencing, come into the marketplace. One of the things that keeps Smart & Final in the front and center is the unique itemization that we carry as you know, Vin, catering to that business customer. And we believe that all these does not carry the club pack items which represent 30% of our sales. It's early but the impact has been less than 1% per store on a weekly basis and we don’t believe there is going to be any long-term impact or anything significant. It's difficult to probably compare them to Fresh & Easy as another new market entry. I might liken it to Wal-Mart neighborhood stores and the impact that they had really is, long-term impact will be really not that significant for Smart & Final.
And our next question comes from the line of Rupesh Parikh from Oppenheimer. Please proceed with your question.
So I just wanted to go back to your guidance reduction. Just to make sure, I think, we are on the same page. The guidance reduction that we are seeing, that’s all deflation related and nothing else is, I guess, different than your expectations, maybe last quarter.
Yes. The revised guidance, I think as I said in the comments, we initially thought that same store sales -- I am sorry, the deflation this year would be in the 1% range. We now think for the full year that it will be about 1.7% deflation for the year. So 270 point swing. So the revision in sales guidance is entirely attributable to the revised outlook for deflation. And the biggest change is in the back half of the year, we expect in the back half of the year that we would begin seeing inflation and now we are anticipating about 2% deflation in the back half of the year.
If you look at EBITDA guidance reduction, really a lot of deflation there too. If you think about sales, last year, our sales base going into this year sales, last year we were close to $4 billion and now in our guidance we have 270 point impact from deflation, almost to $4 billion. So we get over $100 million in deflationary impact. You obviously have the sales, the EBITDA flow through of that sales implication as well as Rick talked about in this comments, the deleveraging impact in our distribution centers and labor and shrink and fixed expenses.
So, again, we believe that we will continue to see strong traffic in the back half of the year and strong performance from new stores but certainly a deflation headwind.
Okay. Great. And then the deflation pressure that you expect in the back half of the year. Are you expecting it to reign consistently at the, down 2% level, or you expecting to improve, I guess the rate of deflation, do you expect that to improve as we get towards the back half of the year.
Sure. For the back half of the year we are looking for about 2% I would say that we think the third quarter will be around that 2% in the fourth quarter. We are not seeing talking to some of our key suppliers, looking at curves, we are not seeing a big difference but we are currently about 1.9% in the fourth quarter.
Okay. My final question, I will quickly sneak in. Clearly we have seen a number of grocers have challenges, especially [this period] [ph]. Just curious, if you look at the promotional backdrop with number of grocers already reporting negative comps, are you seeing anything out there that would suggest that they are starting to become more competitive to try and drive, or more promotional to drive their top line in this deflationary environment.
Great question. We really haven't seen much change versus the prior quarter. The marketplace continues to be very competitive in the conventional markets. As you look at the natural and organic operators, they are really not as aggressive in their promotions and there really hasn’t been much change since Q1. So no significant changes in market strategy overall.
And our next question comes from the line of Mr. Sean Naughton from Piper Jaffray. Please proceed.
So just putting maybe deflation aside and then some of the cannibalization. If you look at some of the Smart & Final or Smart & Final Extra! doors, let's say in Arizona or northern California, what did the transaction trends look like. Were they relatively similar to what you kind of did in Q1, so you think you are running high 2s in Q1 and if I just add back the cannibalization, in Q3 it looks like you are still on that area. Is that the right way to think about it?
Yes, I think it is. The big impact on traffic was the 2.3% impact of deflation. And that impact on deflation was all in southern California. Again, the Haggen acquisitions were all from Santa Barbara South. Those are the stores that saw the big change in cannibalization. In the first quarter we had 10% of our stores impacted by cannibalization. In the second quarter we had over 20% of our stores impacted by cannibalization Smart & Final stores. And again, those are predominantly, all the cannibalization is southern California.
Okay. So traffic trends relatively stable in areas not impacted by cannibalization at this point?
Okay. And then any differences, I know you have a little bit different customer than some people, any difference you are seeing in the spending trends for the business customer? Maybe compared to the household customer. I know it can be tough to separate the two but I think you guys do have a way of doing it. Any behavior changes that you are seeing within the Smart & Final Extra! Banner for those customers?
Good question. We do have a way to separate those transactions and not a lot of difference. You know the business penetration in the quarter was strong again, almost 30% business penetration. We talked before business penetration in our legacy stores runs about 36%, in our Extra! Stores it runs about 26.5%. In business dollars, the Extra! Stores actually do m ore dollars but heavily diluted by the additional household customers. So over time as we reach by the end of this year, almost 70% of the Extra! Stores, of the Smart & Final stores will be Extra! We expect to see some dilution. So almost 30% in the first quarter. Really happy with that. The biggest impact is some of the really big business categories. Beef, dairy, eggs, cheese are really heavily influenced by deflation and that’s why we are seeing higher deflation percent in Cash & Carry than we are seeing in Smart & Finals because of that, even over-indexing in that customer.
I will give you one example of deflation that at Cash & Carry, and this is for them it's all business customers. So 150 count egg, in the most recent period their egg sales were down 34% but their units were up 42%. It kind of gives you a feel for one of their huge dairy items in Cash & Carry that’s been impacted by deflation and there's dozens and dozens of stories similar to that.
I can imagine that’s difficult to manage through. Last question for you on San Diego. I think there has been a little bit of boycotting stepped up this week, down in that market. And I think you have got some of your stores very close to some of these other locations that are being boycotted. Are you potentially -- are you seeing any lift benefit in those stores in San Diego at this point.
We are really not. And it's not just San Diego, we have had similar activity up here in Los Angeles in some of the conventional supermarkets that -- we have been monitoring it obviously to make sure that our stores are in good shape and that if we wouldn’t experience some volume increase we would be ready for it. But we have really seen no increase in the -- it's been a pretty limited spread activity over the last couple of days but we have seen no impact at this point.
And our next question comes from the line of Mr. John Heinbockel from Guggenheim Securities. Please proceed with your question.
So based on your updated sales forecast. It does look like new store productivity jumps up quite a bit in the back half of the year. So how are the Haggens doing versus your expectations? It looks like they might be even doing a little bit better than you thought they might do at the outset of the year.
Yes. John, I probably wouldn’t say that. I would tell you they are performing fine. We expected that they would open better than the past new stores, they may even open like a year or two type productivity. And they are operating, both from a sales and EBITDA standpoint, better than our, call it 2013, 14, 15 fleet of new stores. We knew they would. But they are really in line with our expectations both from a sales and EBITDA standpoint.
So if you look at your historical model, right, those new stores pick up 500 basis points of margin between years one and three. Do you think these stores perform the same way even though they are opening up a little higher?
We don’t know what to expect in years two and three both from a sales and an EBITDA standpoint. We know that, you are right on, where they go up to about $800,000 average in EBITDA in your three in our typical new stores. We don’t have enough information to probably project these Haggen stores will be in the third year of operation. But we are really pleased with where they came out of the gate.
John, if you remember, the economics that we gave at the time of the acquisition, we said that we were buying these stores at a price that was very comparable all-in cash cost, that was comparable to an average new store model. So we just need them to be average at the third year in terms of EBITDA contribution to achieve a good cash on cash return.
Okay. And then just lastly, so we are losing $20 million of EBITDA this year, so it sounds like the incremental margin is say, 15% to 20%. If we kind of look at '17 as kind of a flat inflation year, we don’t get back what we lost this year, I guess, until there is a return to a decent level of inflation. Is that fair?
We need a little bit of inflation to leverage the cost structure. So obviously, if we can get to flatter inflation in 2017 or even a small amount of positive inflation, there is good incremental leverage that is according with that. And so we want to see, is we want to see an absence of deflation at worst and inflation at best.
And our next question comes from the line of Mr. Joe Edelstein from Stephens. Please proceed with your question.
This is actually John on for Joe. Good evening. So I wanted to ask about the conversions that you guys do. We heard in the past you targeted 4% same store sales, obviously big part of that is inflation and then you have this part, the conversions. Have you guys seen the conversion rate that you get go down because of the lower inflation.
Yes. Our historic model of 4% comps, so that’s actually 2% inflation. And if we go back and look at our 10-year history, that’s about where we running. We run about 2%. In that there, what we have said on conversions is at an average year conversions contribute 60 points or so to comp sales. I would say that this year so far we have done no conversions. The first half of the year was really focused on given the Haggen stores converted and getting 30 some new stores open. So all six conversions will take place in the back half for the year at Smart & Final.
Yes. I guess I should ask it in a different way. Will you see the same 30% or so lift that you guys will see?
Sure. We expect to see the same 30% lift because, again, the legacy store as it operates is being impacted by deflation. We still, as we convert it to an Extra! store, we add the additional 5000 items predominantly in perishables, we expect to see the same 30% lift.
Great. Thanks. And then I wanted to ask on your pricing versus competitors. I think you said it's 12% to 15% lower than competitors, the bottom line with Wal-Mart or so. But given the deflationary environment, have you guys still seen that same price gap and then what's the willingness behind kind of pulling the line and letting your cost go down but you are holding the price and taking a little bit more margin.
We would love to do that. We see deflation as costs go down, we see retails going down really quickly in the conventional world, in the mass world. A little slower in food service. We see it move down just a little bit slower and in some cases keeping a little bit over but not much. And the product margin at Cash & Carry was really strong in the second quarter and some of that was that slower pass-through or deflation. But in the conventional world, in the mass world the deflation gets passed through pretty quickly and we always react to that. We don’t want to be -- we want to keep the same gap. So today our gap 8% to 14%, we have talked about. We have a Wal-Mart near us where we are within 2%. We match them on a key couple of thousand items. Our price gap today, to all of our competitors is very similar to what it was in the last year and the year before. So we have maintained that gap.
[Operator Instructions] Our next question comes from the line of Mr. Edward Kelly from Credit Suisse. Please proceed with your question.
So I wanted to ask you just a follow up on the guidance reduction. It's clear deflation is lasting longer than expected. I guess what caught us off guard is that it's leading to a 10% reduction in EBITDA. So I really kind of have two questions related to that. One is that we do hear from peers claiming that deflation is not that big of a deal and I guess the argument is elasticity, some elasticity benefit as well as that gross profit dollars don’t get impacted very much.
So first question here is, why is the math different. And then you mentioned, you compared marks about overall your mix hurting you more from a both inflationary standpoint than what it might hurt others. So could you elaborate on that as well?
Sure. So let's take the second question first and talk about sales mix. With our exposure to business customers we think that or exposure vis-à-vis Smart & Final as compared to a conventional grocer, our exposure in some high deflation categories, meat is one of them, particularly beef. Cheese is another. Eggs is the third. All of these have been very high deflation rate categories and our sales mix in these categories is differentially high relative to a conventional grocer. And so I think when we look at this and try to analogize our situation to others, we see that the sales mix is a piece of that overall deflation rate. Frankly on the second part of this question, second part of the second question, and that is if there is a elasticity benefit in demand that makes it up.
We just historically have not seen that in our view of the industry. We think that unalloyed inflation is good, deflation is bad and that’s it's hard to adjusted as fast as deflation is effecting the top line and effecting the flow through to EBITDA. Turning back to the first part of your question, which is why a flow through rate of 15% to 20% and EBITDA from a sales impact from deflation. We have our standard flow-through that accounts for most of the deflation impact in EBITDA. But the other part of it is that there is real deleverage in the business and the deleverage in the business is around fixed costs and the easiest way to see that would be not on EBITDA itself but going from EBITDA to net income and obviously interest expense being a big component of that D&A. Those don’t change as you go from an EBITDA change to a net income change.
Likewise, when you are deleveraging things above EBITDA, there is a lot of fixed costs in store operations, distribution and occupancy that delever quite rapidly as sales drop.
And a couple of things on deflation there. What's really changed over the last several months is we are seeing deflation on a lot more categories. It's no longer those chicken and beef and cheese, it's eggs and rice and beans and corn oil. In fact, inflation we are seeing in very few categories, maybe butter, coffee and sugar. But if you look at the impact on food service for instance, I don’t want to give away the whole mix but Cash & Carry's meat department is 23% of their sales. And deflation in meat at Cash & Carry was almost 9%. So you have got one category in deflation impacting same store sales by more than 2%. I mean this is big. We over-indexed in food service customers, in cheese, probably more than double what a conventional percent of sales would be in cheese, dairy is big.
So I think what we are seeing is some of the big deflationary categories are really over-indexing in food service.
Okay. Thank you. And just second question here on Cash & Carry. You have been looking at ways to ramp sales at new stores faster, just to develop a faster payback period for your model. Can you just provide an update on those efforts and how it's impacting your overall growth plan for the model.
Absolutely. We talked about a couple of years ago when we opened these last few stores, starting with the first one in Burlington, Washington. We tried to, with John Matthews up at Cash & Carry along with Eleanor Hong here at Smart & Final put together plans to accelerate customer acquisition through mailers, through digital, through cable. We actually took, if you go back and look at their stores that were opened years ago, we actually took the new store budget, marketing budget, up four times because we wanted to test customer acquisition and it's working. We are pleased with both sale and EBITDA in the new stores. They are ahead of expectations and that’s why next year we have announced a 10% sales growth, unit store growth and the Cash & Carry banner will open six new stores next year. Pretty pleased with what we are seeing.
Our next question comes from the line of Ms. Karen Short from Barclays. Please proceed with your question.
I was just curious, so obviously you have had a bit of a perfect storm in terms of turbulent environment with the effect of inflation and deflation and that’s, obviously, also been coupled with significant changes to your store base. So I guess what I am wondering is, with some many more weeks into your belt from the acquired stores, anyway you could kind of bridge the gap year or year on what you think the drag would be for new stores in '16 versus what, the ramp or an acceleration will be in '17. And I know you don’t want to give '17 guidance, it just would help because they are so many moving parts.
Sure. You are talking mostly the impacts of cannibalization?
No, no, EBITDA, sorry.
EBITDA. Well, let me have Rick speak to that, but the big change next year in 2017 will be much lower cannibalization. Obviously the cannibalization that we expect this year at 1.6% is the higher watermark and really take advantage of a great opportunity to acquire these stores. But Rick, can you speak to EBITDA?
So I think there is two things, Karen, that you want to think about from a modeling standpoint. One is that the new stores in 2016 were more numerous. We did roughly 15% unit growth rate in the Smart & Final banner and accelerated those openings into the first half of 2016. So they will be contributing to a comp, their internal sales and cost structure will be maturing and we will see a benefit from those in the first half of 2017 as they reach the one year point.
And then secondly, the unit growth expectations as Dave outlined earlier, we will go back to something that’s closer to 10% unit growth in the Smart & Final banner and have those spread over the course of the year in 2017. So all of those things you would expect to accrue to improving EBITDA, the maturing of new stores and the slowing of the impact of new store growth in any individual quarter and kind of an evening out. So we expect that there will be some inflation and that that will be good, the lapping of new stores from 2016 to 2017 will be good and the maturing of the cost structure will be good. And that should all be positive things to 2017 EBITDA generation.
You are correct in saying that we don’t want to be giving guidance for 2017 at this point and part of the reason for not giving guidance at this point is to see how we shake out in the deflation world.
Okay. That’s fair. And then just in terms of ALDI. I know you have given in terms of like sales impact from your directly competing stores. But I guess what I struggle with is, you said this on the last quarter and then again on this quarter. It seems like the impact was a little greater last quarter than it was this quarter. And I know it's in a fairly small number of stores. But it doesn’t seem like the sales impact is actually that insignificant. I mean 1% to a comp is not insignificant, if that’s what you are trying to say. And I think on last earnings call, you kind of gave a weekly sales impact from the stores that were impacted and I backed into 1.5% comp impact on, again, those impacted stores. So maybe can you just help me, let me know if that math is right on those directly impacted stores and maybe a little more color there.
Karen, I think one way to look at it is these stores open up as in any grand opening, there is a lot of fanfare and ad activity and folks that want to just check out something that’s net new in their marketplace. So when we saw those store open in our marketplace, sure you had folks taking a quick look at it. But quickly they returned to Smart & Final and we really don’t see a lasting effect that is anything of significance at this point in time, in the areas that we compete with these stores.
We have 21 stores today operating in proximity to an ALDI store. In the average stores down, when Scott says less than 1%, it's far less than 1%. It's not 1%. It's really been a minimal impact once the grand opening was gone.
Okay. And just curious in terms of how you change your positioning initially when they opened versus where you sit today. I mean if you don’t want to discuss that, I understand that too but you know there is a lot of fear over this and it seems like it's overdone.
We went out before ALDI opened in the three stores where they were the closest and we lowered prices. We put in a new price region to test against ALDI. After a couple of months of opening, we looked at the impact in those three stores versus the impact in the other 18 stores and there was no difference at all. So we have reversed the pricing policy and we have all the stores around ALDI that are on the same pricing policy as the rest of the Smart & Final stores because, again, there is a couple of things. Number one, we are priced really well and competitively continue to take share, but also the mix of product is so differentiated. Scott talked about from 30% club size to almost 30% business customers and ALDI has nothing there looking for. There is a lot of competitors in the market but long-term ALDI is not one that I believe will have a measurable impact on Smart & Final.
And our next question comes from the line of Mr. Alvin Concepcion from Citi. Please proceed with your question.
I am wondering you are in a unique position of having insights into the food at home market as well as food away from home. I am just wondering what you are seeing in terms of general consumer demand in each segment and more specifically, are you seeing any significant shift in eating at home versus eating out.
We are really not seeing much shifts at all. I mean we are reading a lot here. Rick was talking today about the restaurant industry and weak sales there. We are actually seeing our business customer in the Pacific northwest, our food service customers feel a little better. It looks like, you see our average transaction size was up in Cash & Carry in the first quarter even with really heavy deflation, over 2%. And we think that’s because our food service customer is feeling a little better. They are buying more per trip. They are stocking up on promotional product where they weren't a year two ago when they didn’t have the confidence in economy. So in that market it looks like they are feeling pretty good.
Down here, it looks very similar to the household consumer market. Both of them are behaving very similarly.
Got it. Thank you. Just wanted to clear something up as well, make sure I heard it right. Are you seeing the competitors, retail prices are coming down as much as the rate of deflation.
We are seeing our competitors, as costs drop, we are seeing them drop retail fairly quickly and in about the same ratio. So we are seeing deflation can pass through pretty quickly in the retail grocery, conventional trade and in the mass trade.
Thank you. Last one from me on the topic of labor. Do you expect any sort of impact from the overtime legislation that affects your salaried employees?
No, we really don’t. And in our Smart & Final banner stores, everyone except the store manager in a California store is a hourly employee. So we don’t expect to see the impact that competitors might.
And our final question comes from the line of Mr. Shane Higgins from Deutsche Bank. Please proceed.
Just real quick on, I just wanted to know if you guys could make adjustments on any variable expenses, just to mitigate some of the deleverage that you are seeing.
Sure. As an example, we established store labor that’s related sales and we try to constrain the use of labor throughout the enterprise where we can. We look to achieve purchasing efficiencies in a number of other categories. Anything that we can do to offset the impact of deflation, we are pursuing. But the reality is that it's very difficult in a low margin environment to constrain costs as fast as the deflation impact.
Got it. That’s helpful. And then I just want to know if you guys could provide a little color on the results of your company-wide marketing campaign that you kicked off, I believe around Memorial Day. How is that going and what are your plans in terms of marketing as we go into the fall?
Okay. Sure. Great question. Yes, obviously we are pretty excited to launch new marketing programs, especially since we introduced our new branding program. So as you said, we launched a video radio, a digital display marketing, primarily through memorial day, from memorial day through July 4. And we are pretty pleased with it. The investment in social marketing in digital media is really yielding promising results and we think we are being helped by that mix shift getting away from a few years ago. 80% of our market was in print and today it's down to about 50%. But the holiday traffic has been strong, it always is. Summer holidays are good at Smart & Final. It's a place to shop and if you are planning any type of a party or an outdoor event or even just a dinner. Our Memorial sales were good, they were strong. In fact the week leading into the Fourth of July, we had record weekly sales at both Smart & Final and Cash & Carry.
There are no further questions at this time. Ladies and gentlemen, this does conclude today's teleconference. We thank you for time and participation. You may disconnect your lines at this time and have a great rest of the day.
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