Smart & Final Stores' (SFS) CEO David Hirz on Q3 2016 Results - Earnings Call Transcript

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Smart & Final Stores, Inc. (NYSE:SFS)

Q3 2016 Earnings Conference Call

November 16, 2016 5:00 PM ET

Executives

Laura Bainbridge - Investor Relations

David Hirz - President and Chief Executive Officer

Richard Phegley - Senior Vice President and Chief Financial Officer

Scott Drew - Executive Vice President of Operations

Analysts

Bill Kirk - RBC Capital Markets

Karen Short - Barclays Capital

John Heinbockel - Guggenheim Securities

Shane Higgins - Deutsche Bank

Rupesh Parikh - Oppenheimer

Edward Kelly - Credit Suisse

Vincent Sinisi - Morgan Stanley

Sean Naughton - Piper Jaffray

Alvin Concepcion - Citigroup

Operator

Greetings and welcome to the Smart & Final Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode and a question-and-answer session will follow the formal presentation. [Operator Instructions] And as a reminder, this conference is being recorded.

I’d now like to turn the conference over to your host, Ms. Laura Bainbridge, Investor Relations. Thank you, Ms. Bainbridge. You now have the floor.

Laura Bainbridge

Thank you for joining us today as we discuss Smart & Final Stores’ third quarter 2016 financial results, which as a reminder was a 16-week quarter ended October 9.

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 website 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, Smart & Final’s President and Chief Executive Officer.

David Hirz

Thanks, Laura, and good afternoon, everyone. Joining me today is Rick Phegley, our Chief Financial Officer. Scott Drew, our Executive Vice President of Operations will also be available for Q&A.

Today, we’ll review our third quarter. We’ll also share our thoughts about managing growth in this challenging industry environment, where price deflation continues to dominate the conversation around short-term results and provide some additional context around our revised expectations for the year.

So let’s start with a recap of our growth in 2016. Earlier this year, we guided the growth of 33 new stores in the Smart & Final banner, all in the Extra! store format, and for new Cash & Carry banner stores. We’re right on track for this new store growth. This Friday, we’ll open the last of the 33 planned new Smart & Final stores in Oxnard, California. The last of the four new cash and carry stores for 2016 opened a week ago, in a new market and a new state for the banner, Salt Lake City, Utah.

For the full-year 2016, we also planned for the conversion of 12 of our older Smart & Final legacy stores to the Extra! store format with six relocations and six in place conversions. AT the end of the third quarter, we had completed all six of the relocations and the six conversions are on track to be completed by year end.

In the Smart & Final banner, we plan to deliver 15% new unit growth in 2016, an acceleration from our recent history. We’re both on time and on budget in the collective performance of our 2016 class of new stores is in line with our expectations. Our 2016 new store growth has occurred against the backdrop of sustained industry-wide deflation, which in combination with planned higher sales cannibalization from new stores has been a significant challenge to comp store sales and adjusted EBITDA growth.

Notably, we’ve opened over 80 new Smart & Final Extra! store since 2013. About a quarter of those stores have completed some portion of their third-year of operation. And on average, in those stores, we’re slightly exceeding our three-year goal of a 25% cash on cash return.

I’ll speak to deflation and cannibalization in a few minutes. But our simple strategy of shifting the Smart & Final banner portfolio to the Extra! format remains on track. Our Extra! format builds on the unique assortment of our legacy Smart & Final Stores, a large selection of club size items and thousands of unique business items.

In a supplement to that assortment by offering additional household items, including high-quality perishables, natural and organic items, bulk food, fresh meat and seafood, and oven roasted chicken. By year end, we expect almost 70% of Smart & Final banner stores will be in the Extra! Format, which will continue to support or differentiated brand message within the grocery industry.

As part of the shift to the Extra! format stores, in the third quarter, we closed five older legacy stores, which were either marginally EBITDA contributors or face near-term lease expiration. None of these stores have the potential to become an Extra! store through conversion, as they were too small to accommodate the Extra! Assortment.

Now, I’ll address our thoughts regarding deflation and other trends affecting our business. On our second quarter earnings call in late July, we have seen the deflationary impact on total company sales worsen from about negative 0.9% in the first quarter to negative 1.7% in the second quarter. And early in the third quarter, we indicated the deflation trends were intensifying.

The third quarter results confirm this. In a quarter, we experienced total company deflation of approximately 2.4%. Once again, deflation was most pronounced in the categories, where Smart & Final and Cash & Carry sales tend to over index relative to conventional grocery stores; like meat, dairy and cheese, which are also heavily weighted towards private label and business sales.

The early read on the fourth quarter deflation is mixed. While we have seen very modest improvement at the Smart & Final banner, deflation of the Cash & Carry banner has worsen. On our last earnings call, we estimated the full-year rate of deflation for 2016 at approximately 1.7%.

Taking into account the third quarter and early fourth quarter trends, we now expect full-year deflation of approximately 2%. These deflationary pressures, which combined with the operational challenges of significant store growth together put pressure on inventory shrink rates. Despite this, overall net product margin rates in both store banners remain stable year-to-year.

Similarly, in our view, competitive promotional activity over the last two quarters has been in a historically normal range. On the other hand, sales cannibalization from new stores in both Smart & Final and Cash & Carry banners was a factor impacting sales growth in the third quarter.

As noted in our last call, we planned for higher than normal cannibalization in the Smart & Final banner, as a result of the geographic concentration of our 2016 new stores in the Central and Southern California and a tight bunching of store openings in the first two quarters, primarily as a result of the acquisition of the former Haggen store locations. We continue to view the acquisition favorably, as it granted Smart & Final access to high-quality locations in dense urban areas that otherwise would have been very difficult to secure.

So with deflation and cannibalization as a backdrop, I’ll now turn to our third quarter financial results. First, let’s review sales. Consolidated net sales were $1.4 billion, an increase of a 11.9% over the prior year period. On a total company basis, comparable store sales declined by 1.3%, with Smart & Final banner comps decreasing by 1.6% and Cash & Carry banner comps decreasing 5.4%.

Within the Smart & Final banner, the comp store sales decline of 1.6% was driven by a 1.9% decrease in comparable average ticket, which was offset by a 0.3% increase in comparable transaction count. We believe that the deflationary impact on comparable banner sales was approximately 2.1% in the third quarter, approximately 0.5% more deflationary than the prior quarter.

For the Smart & Final banner, we estimate that the impact of sales cannibalization from new stores was approximately 2.3%, which was in line with the second quarter rate, but a little higher than anticipated. We believe the sales cannibalization pressures were less in this quarter, as we cycle by five 2015 fourth quarter openings and even more so to mid-year 2017, as we cycle the 30 2016 first and second quarter new stores.

Of note in the third quarter, approximately 20% of the Smart & Final banner comp store base was impacted by cannibalization. For the remaining 80% of comp stores, the comparable store sales rate was positive 1.9% in the quarter despite the impact of 2.1% deflation.

Looking at this a little differently, if we had a zero inflationary environment in the third quarter, this group of stores would have shown a comparable store sales rate of closer to positive 4%. In the Cash & Carry banner, the comp store sales decline of 0.4% was driven by a 0.6% decrease in average ticket, which was offset by a 0.2% increase in transaction count.

In the third quarter, we estimated that the deflationary pressure negatively impacted Cash & Carry’s comparable store sales by roughly 3.4%, approximately 1.3% more deflationary than the second quarter.

As we’ve increased the growth in new Cash & Carry stores, we’ve experienced a higher rate of sales cannibalization. In the third quarter, we estimated that the cannibalization impact was approximately 1.1% from two new stores opened over the last 12 months. As we continue to open new stores in existing markets, we expect to see continued modest levels of cannibalization in the Cash & Carry banner.

Turning now to the income statement, in the third quarter, GAAP net income was $7 million, or $0.09 per diluted share and adjusted net income was $15 million, or $0.19 per diluted share. Adjusted EBITDA was $57.2 million. We had a couple of unusual items, including the low income tax rate in the quarter and Rick will review these in a few minutes.

Deflation together with cannibalization represented a headwind to total company comparable store sales growth of approximately 4.4% in the third quarter and had a deleveraging effect on EBITDA growth. While we recognize the challenges, we believe both issues are transitory and we remain solidly focused on our long-term strategy.

In the Smart & Final banner, we offer today shoppers high-quality products at great values and in a convenient shopping environment. Communicating to the consumers our core tenants of quality, convenience and value is key to customer attraction and retention. While historically, we’ve leveraged prints and radio as a primary message vehicles. We also recognize that the first point of entry for many new customers with our brand is through our website.

We’re investing in our digital footprint and earlier this month went live with the first phase of our new Smart & Final online platform, which includes a complete redesign of smartandfinal.com. Our new site has also optimized across mobile and tablet devices, as part of a larger roadmap that will improve our ability to interact with our shoppers across the devices that they use most frequently.

As we enter the fourth quarter, we’re increasing our digital, television, radio and print advertising spend around the upcoming holiday season. This year is especially exciting, as our store development plans have taken us to several new markets and communities, where there’s a significant opportunity to drive broader exposure to the Smart & Final story. We’re also supporting customer growth for our delivery platform relationships with Instacart and Google Express, increasing accessibility to better meet the needs of both household and business customers.

In the third quarter, we expanded the Instacart delivery service to our food service business customers at Cash & Carry in select markets. Our robust slate of merchandise initiatives continues to support sales growth and our focus remains on developing product categories with strong potential to build customer visits. As an example, our goodwill offering now available in over 80% of our Smart & Final Extra! stores continues to resonate well, helping to attract new customers and build basket size. We also continue our focus on building a solid pipeline for new store development in both store banners.

In 2017, we expect this Smart & Final banner to have a broader geographic distribution of new stores with approximately half of our projected new stores outside of Southern California and with store opening spread more evenly throughout the year, which we expect will reduce the rate of sales cannibalization to more normalized levels.

In the Cash & Carry banner, we’ve opened four new stores; one in Oregon, two in Northern California, and one in Utah, a new state for the company. Utah is a promising market with favorable demographics, a robust small businesses environment, and location where we can leverage our existing supply chain. It’s very early in the sales majority curve, but we’re pleased with the results of our new Cash & Carry stores, where we’ve integrated new merchandising and marketing initiatives to support faster sales growth.

We’ve now opened seven new Cash & Carry stores in the past two years, which is helping us better understand the opportunities for this banner. I’m excited about our growth and future prospects, as we continue to develop two strong well-positioned store brands. We’ve executed through a period of significant store growth and we expect to realize additional operational improvements as our new stores mature.

Our new store growth in combination with our merchandising and marketing initiatives have strengthened our competitive differentiation, positioning us well within the competitive landscape, as headwinds to the broader grocery industry subside.

With that, Rick will now review some additional details of the financials and our expectations for the full-year.

Richard Phegley

Thanks, Dave, and good afternoon, everyone. Today, I’ll be discussing the third quarter in more detail, including the impacts from deflationary pressures and cannibalization. I’ll also add some color on our expectations for fiscal 2016.

So let’s begin with sales. As noted in our release, net sales were $1.4 billion, up a 11.9% versus the third quarter of 2015. Net sales growth was driven by the sales contribution of new stores, which opened over the last 12 months, partially offset by the consolidated comparable store sales decline of 1.3%. The comparable store sales rate decline primarily reflects the ongoing impacts of deflation and sales cannibalization that we experienced during the quarter.

As we’ve discussed previously, we plan for sales cannibalization from new stores and believe that over the longer-term, the contributions of new stores are favorable to total sales and EBITDA growth. In the last 12 months, we’ve opened 39 new stores in both store banners, the majority of which is cannibalized sales of existing stores. As a reminder, beyond impacting overall sales in EBITDA, it’s also important to realize that cannibalization is reflected in comparable store transaction growth.

Turning to deflation, our experience has largely married the national CPI food and home statistics. The September CPI rate of negative 2.2% year-over-year marked the 10th straight month of deflation and with a negative trend in the monthly reports during the third quarter. Ongoing deflation continues to impact our income statement, as lower aggregate sales rates delevered fixed costs on a percentage of sales basis.

We expect a very small benefit to comp sales from the closure of five legacy stores, which should transfer some sales to nearby Extra! stores. We don’t often close stores without a concurrent relocation to a new store, but to avoid future capital spending to maintain these stores, it made sense to take the closings in 2016. We are also evaluating three additional legacy stores with similar economics, which could potentially result an additional store closures this year.

On a total company basis, GAAP net income in the third quarter was $7.0 million compared to $12.4 million in the prior year quarter. Our reported third quarter GAAP net income also includes the pre-tax effects of several unusual items, including $3.8 million of preopening and non-cash rent costs associated with the former Haggen stores, a $5.0 million loss on debt extinguishment resulting from the favorable amendment in extension of our First Lien Term Loan Credit Facility and a $1.6 million charge associated with store closures.

Partially offsetting these items, we recorded a debt benefit of approximately $1.4 million from a company-owned life insurance policy. These items are presented as add backs in our adjusted non-GAAP reporting. Favorably impacting GAAP net income was a reversal of $1.9 million tax reserve established in 2007, following a successful resolution of an audit. In combination with the earlier adoption of ASU 2016-09 and other factors, this resulted in a negative income tax rate in the third quarter and a year-to-date tax rate benefit of just over a negative 3%.

Our GAAAP EPS was $0.09 per fully diluted share based on about 77.7 million shares. At the banner level, the effects of deflation and rapid store growth make the comparisons a little more difficult. In the Smart & Final banner, product gross margin was flat year-to-year in the third quarter. Although, the overall gross margin decreased from 15.5% in the 2015 quarter to 14.9% in the current year quarter.

This 0.6% decline is actually an improvement from the year-to-year decline of 0.9% reported in the second quarter and reflects increased occupancy costs from new stores and higher shrink impacted due to deflation. Similarly, although, operating and administrative costs increased from 12.4% of third quarter 2015 sales to 13.0% in the most recent quarter. The 0.6% increase was lower than the 1.3% increase reported in the second quarter and reflects expenses associated with the former Haggen stores, including training and development costs.

In the Cash & Carry banner, overall third quarter gross margin increased by 0.1% on a year-to-year basis, reflecting a small increase in product gross margin, partially offset by higher occupancy costs associated with new stores. The operating and administrative expense rate increased slightly on a year-to-year basis, but was relatively flat with the second quarter.

In both store banners, the income statement has been challenged by the deleveraging from deflation, as fixed costs, including distribution and occupancy do not change as the sales line deflates. We normally plan for the historical average of 2% inflation, and the short-term adjustment to a 2% deflation environment is exceptionally difficult.

We managed the company with a focus on adjusted EBITDA and adjusted net income, as we believe that these measures better reflect the operating performance of our business by excluding certain charges. In the third quarter, adjusted EBITDA was $57.2 million, down slightly compared to $59.8 million in the prior year quarter.

Adjusted net income for the quarter was $15.0 million, or $0.19 per share on a fully diluted basis compared to $16.9 million, or $0.22 per fully diluted share in the prior year quarter.

Turning now to the balance sheet and cash flow statements. We ended the 2016 third quarter with cash and cash equivalents of $54.0 million, as compared to $59.3 million at the end of 2015. Our working capital management is in line with our internal plans, with investment in inventories of $255.5 million, up $21 million from the year end 2015 level and in line with our expectations, given new store growth.

Our balance sheet debt, net of debt issuance costs was $651.6 million at the end of our third quarter under our term loan and revolving credit facilities. At the end of the third quarter, would utilized only $37 million of our $200 million revolving credit facility.

During the quarter, we amended our first lien term loan credit facility to increase the capacity from $595 million to $625 million and extend the maturity by three years to November 2022. In conjunction with this year’s increase of our revolving credit facility from $150 million to $200 million capacity an extension to July 2021, this year we have significantly increased our financial and operational flexibility.

Over the past year, we’ve repurchased almost 2.0 million shares of our common stock for a total of approximately $28 million. As we’ve noted in prior quarters, one of the objectives of share repurchases is to help offset the effective dilution from new share issuances under our equity compensation plans. But we remain in a very strong liquidity position with an appropriate capital structure to support our future growth plans.

And now let’s turn our thoughts to the balance of fiscal 2016. As a reminder, our 2015 fiscal year was a 53-week year. So the guidance growth is on a 52-week equivalent base. We’re now expecting a deflationary environment of over 2% deflation for the full-year, which is slightly higher than our prior projections, and as previously noted, cannibalization slightly higher than the range of prior expectations.

Combined with the effect of the five legacy Smart & Final stores closed during the third quarter and potential for closure of up to three additional legacy stores, we are revising our 2016 guidance for sales and comp store sales and resulting impacts on measures of income as follows.

First, we now expect total sales growth in the range of 11.5% to 12.0% versus our previous estimate of 12.5% to 13.5%.

Second, we are narrowing our expectation of comparable store sales growth to a range of negative 0.5% to flat versus our previous range of negative 0.5% to positive 0.5%. Adjusted net income is now expected in the range of $45 million to $47 million versus our previous range of $46 million to $48 million.

Adjusted diluted EPS is now expected in the range of $0.57 to $0.59 per share versus our previous range of $0.58 to $0.68 per share. And fully diluted weighted average shares are now expected to be $78.3 million versus our prior guidance of $79.0 million.

And finally, adjusted EBITDA is now expected in the range of $178 million to $183 million versus our previous range of $185 million to $190 million. Guidance includes certain non-GAAP financial measures as more fully detailed in today’s earnings release.

Dave will now have some concluding comments before we open the line for questions.

David Hirz

Thanks, Rick. In closing, I want to thank all of our 12,000 associates for their continued efforts during this challenging environment. Your hard work and dedication to the communities that we serve is what makes both Smart & Final and Cash & Carry stores a great place to work and shop.

The holidays are a time for our customers to gather with family and friends and our associates to come together as a team. We have a great tradition, where twice a year, our corporate and store support groups work alongside our store associates to gain a deeper understanding of in-store activity and help provide our customers with great shopping experiences on two of our busiest sales days of the year.

Next Wednesday, our headquarters team will be working alongside store associates serving customers many of whom will be experiencing Smart & Final banner stores for the first of many holiday seasons together. Thank you all for joining today’s call. We look forward to keeping you updated on our progress and now I open the line for questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this time we will be conducting a question-and-answer session. [Operator Instructions] Now our first question comes from the line of Bill Kirk with RBC Capital Markets. Please go ahead.

Bill Kirk

I think, you said 80% of the stores that weren’t experiencing cannibalization sell comps of plus 1.9% in the quarter. Were those stores experiencing no cannibalization, or were those stores expecting just or experiencing normal levels of cannibalization?

David Hirz

Yes, good question. Those stores we’re experiencing no cannibalization from the newly opened Smart & Final stores, a universe of less than 20% of our stores are what’s being impacted by the 40 some stores that we haven’t cycled yet. So those stores about 80% is not impacted by cannibalization, they’re only impacted by the deflation, obviously.

Bill Kirk

Okay. And going a different route, I think, you’re doing a 145th-year anniversary sweepstakes. How has that gone so far? I know it’s kind of the enrollment phase, but what have – entry rates look like for those who have had purchases that would qualify them?

David Hirz

Right. No, that is – it actually gone really well. We’re pretty excited to celebrate 145th anniversary and give away some cars. We’re about halfway through it. So it’s too soon to tell, but so far, we’re pretty pleased with the way things are going.

Bill Kirk

Okay. Thank you. That’s all from me.

David Hirz

Thanks, Bill.

Operator

Now our next question comes from the line of Karen Short with Barclays. Please go ahead.

Karen Short

Hey, thanks for taking my question. A couple of questions in general. I know, you don’t want to talk too much about 2017, but I’m wondering if you could kind of get preliminary thoughts on cannibalization for 2017, as well as inflation/deflation? And then lastly, just tax rate thoughts, given election noise and I guess, I would ask that question for the fourth quarter, as well. What your guidance implies for taxes or tax rate in the fourth quarter? And then I have a follow-up.

Scott Drew

So let me start with the tax rate. We have normally planned for a tax rate somewhere in the range of 40%. And we don’t see in our guidance, we don’t see in much different tax rate from that. Obviously, in this quarter and in the year-to-date numbers, we’ve had quite a bit of unusual tax items, which have significantly depressed the effective tax rate for 2016. But at this point, we don’t know enough smarter about future tax rates and to assume they look something like today.

Karen Short

Okay.

David Hirz

And the thoughts for next year on cannibalization, we’ll still have pretty intense cannibalization through about the middle of May when we cycle the last of the 33 Haggen acquisition stores. So probably something slightly – something less than 2% in the first part of the year. After that the stores next year should be far less deflationary. in fact, of next year’s new stores. Right now, we estimate about half of those will be outside of Southern California.

So the deflation will return the – cannibalization will return to pretty normalized levels something between 50 or 60 points, I would imagine. On inflation and deflation, it’s really too soon to tell. We’re obviously working on a 2017 plan, but we’re looking every week to see where deflation is going. It actually in the fourth quarter, we’re only a month into it.

But Smart & Final deflation got just a little bit better, but Cash & Carry deflation got a little bit worse. So we’re anxious to see how the next several weeks play out. Our initial thoughts are that we anticipate we’re going to be deflationary next year in quarter one, still deflationary, but a little better in quarter two, and turn inflationary in the back-half of the year. But again, we will be a lot smarter a month from now, as we’re closer to finalizing our plan for 2017.

Karen Short

Okay, great. Thanks. And just looking at your range or in terms of your comp guidance for the full-year, the range for 4Q is pretty wide, kind of, I guess like negative 2.8% to negative 0.5%. So I guess, any color on puts and takes on that? And then is that basically the driver of the range of guidance for EBITDA as well, but is it entirely a function of comp?

Richard Phegley

So the guidelines EBITDA is entirely a function of sales and in the change in guidance, and comp is essentially a derivative of the change in projected total sales. And as you know, there’s a little bit of a range there, and it’s our best estimate at this point, given the uncertainties, particularly around deflation and deflation of the two banners.

Karen Short

Okay. Thanks very much.

David Hirz

Thanks, Karen.

Operator

And our next question comes from the line of John Heinbockel with Guggenheim Securities. Please go ahead, sir.

John Heinbockel

So two things. The legacy stores that you’re closing. When do those leases come up expire, and those stores, are they profitable or not?

Richard Phegley

John, we closed five legacy stores. One of them had a short-term lease expiration and the other four had – two of the other four were actually owned stores and the other two had leases that expire in future years. The sales of them was decent. Although on the lower side, the average store size was fairly small and that’s why Dave’s comment, they didn’t really qualify for future conversion to Extra! and their EBITDA contribution year-to-date was in the aggregate marginal.

David Hirz

Yes, John, we look at every legacy store also see not even many of them are too small, but many of them could be expanded. These actually couldn’t even be expanded either to the left or the right. So there was no expansion potential that we’re in the need of capital and we thought the prudent thing to do is closing.

John Heinbockel

And the three you might close somewhat similar in description?

Richard Phegley

Exactly. Of the three there are three very different geographies. So there’s no clustering issue here. It’s really just about individual store performance, future capital needs and the future expectation of sales in the store.

John Heinbockel

And then secondly, if I think about what you said about deflation and then Smart & Final product margin being flat, it sounds like outside of cost deflation, there wasn’t a whole lot of incremental retail deflation. So,. the question would be is, you’re generally seeing your competition be somewhat rational kind of accept the deflation not try to artificially generate incremental traffic, it sounds like that’s the case?

David Hirz

Yes, the competitive side has been really rational. This entire year we’ve seen really – our pricing gaps for the competition are the same as they have been. Margin at Smart & Final was pretty flat year-to-year. We talked about the higher shrink. Shrink was a little bit higher. Much of that caused by deflation, but that was made up by changes in mix due to some of the new merchandise initiatives, as well as changing as we continue to increase our perishable penetration really help to offset that.

John Heinbockel

All right. Then one last thing. In a deflationary environment, how does learning about club pack product right larger size product versus more standard, is there any change in dynamic or no between the two?

David Hirz

No, there’s really not. In fact, our club sales were positive in the quarter up 2.5% on a comp basis. Very little of those categories were impacted by deflation. Most of the deflation for us is in perishables and most of club over index is in nonperishable. So some of the big deflation in dairy and meat have less impact on club size. Club size itself for the quarter of Smart & Final was up almost 15% and again positive 2.5% on a comp base. Penetration continued to be strong on club about 27% and really has limited exposure to some of the big deflationary categories.

John Heinbockel

Okay. Thank you.

David Hirz

Thanks.

Operator

And our next question comes from the line of Shane Higgins with Deutsche Bank. Your line is live.

Shane Higgins

Yes, thanks for taking the questions. Just a quick one just circling back on John’s question about the impact of the closed stores. Did you say you weren’t seeing any real sales lift from the stores that recently closed?

Richard Phegley

No, we didn’t say that, Shane. What we said was that these were on average a little bit lower sales stores. And so there is a sales loss from the stores in the fourth quarter that is factored into our full-year guidance. And because these sales in the stores have declined over time, as we’ve opened newer Extra! stores and better stores nearby, there is still some potential first sales transfer to other stores. But it’s more limited than you might expect.

Shane Higgins

Okay. So in other words you guys aren’t going to call that out next quarter as an impact on the comp?

Richard Phegley

We don’t expect that it has a material impact on the comp. It does have an impact on the coast sales guidance.

Shane Higgins

Got it. Thanks. And then just looking at your comps in the Smart & Final banner, if I back out the impact of the deflation and cannibalization, it does like your comps have been moderating this year, though, they seem to be leveling off a little bit. Could you guys just give any color, I mean, it doesn’t sound like the competitive environment has gotten worse or has changed much. But just any color as to maybe how your consumers are doing today, and then maybe any color, any differences between he household customers and maybe the food service customers?

David Hirz

Sure, sure. Traffic actually was strong in a quarter. We were pretty pleased with it. In Smart & Final, our traffic in quarter two was up 17%, in quarter three, traffic was up 19%. So we’re happy with the trend. We’re happy with the trend as we enter quarter four. It continues to be similar to that. And what was your other half of the question?

Shane Higgins

Just any differences between the household customers from what you’re seeing from your food service guys.

David Hirz

Not really, we’re not. We’re seeing very similar trends between both. The only difference is from the business customer, they are more impacted by deflation. Some of the biggest categories for us are meat and dairy. Those are huge business categories and are down to give you a feel for. Business for us total company is about 13% of sales in deflation and meat is 7%. So that one category is contributing almost 90 points of deflation. And then dairy, you’ve heard about dairy, I think, from all of our competitors, dairy deflation in the quarter for us was 20%. That’s a huge business category.

For us total company, it’s almost 6% of sales, so about 120 points of deflation just from dairy, and both of those categories over index with business customer. So I will tell you that the trends with traffic and business in household are very similar. The only difference again is businesses more impacted by deflation.

Shane Higgins

Thanks. I appreciate the color.

Operator

[Operator Instructions] And our next question comes from the line of Rupesh Parikh from Oppenheimer. Please go ahead.

Rupesh Parikh

Thanks for taking my question Dave, I wanted to go back to your comments in the prepared script regarding your new store performance. I just want to get a sense of how the Haggen stores are performing versus your expectation so far, and if there are any surprises that you’re seeing with those – with that bunch of stores?

David Hirz

Okay, sure. Good question. No, they’re performing well. We’ve said historically that a new store, it’s Smart & Final’s new store – Smart & Final Extra! in the first year should perform around 80% to 85% of productivity for the first full-year on average. We said that we expect that Haggen stores would perform a little stronger than that, and that’s where they’re at performing a little bit stronger than the average new store.

And again, these stores prior to being Smart & Final Stores for a short period of time they were Haggen. Before that, these were all successful, Albertson’s or Safeway stores. So what we’re seeing in these stores is sales are good. But it’s a higher household penetration. Our business penetration in – on average is lower than what our historical new stores are, but I’ll tell you, they’re moving up pretty quickly.

They’ve all gained traction over the last few months. We’re building business customers and they’re almost to the percent of penetration for business customers are our normal new store, but they’re slightly behind. But the household traffic makes up for that. But overall, they’re performing well.

Rupesh Parikh

And any additional insight in terms of how you guys are thinking about the ramp maybe year two or year three, or is it still too early?

David Hirz

It’s still too early. We think it could be pretty similar to what we normally experience. What we normally budget is in year one to be about 8% same-store sales and year two to be 6%, and by year three, it maybe around 4.5%. Our last group of stores the 2014 and 2015 stores exceeded those expectations.

So we would think once we see deflation moderate and get back to a more normal environment, we believe we’ll see a strong year one and year two comps. But our normal expectation is 8% followed by 6%.

Rupesh Parikh

And then as you look at new store growth next year, the expectation to maintain the same growth for the Smart & Final banner, and what’s the flexibility to alter your growth plans? Should deflation get worse from here, or stay at this 2% level for a bit longer?

David Hirz

Sure, that’s a great question. We’ve had a lot of discussion about it. We normally guide to new store growth for the following year in our quarter four conference call and we’ll do that again this year. But we’re committed to a 10% long-term growth. For 2017, we’re really carefully evaluating and balancing the current deflationary environment, watch and see what happens over as we get through December and enter the first quarter, and we’re balancing that against 2017 growth. And we’re not – at this time not yet prepared to guide to 2017 growth.

Rupesh Parikh

Okay. Thank you.

David Hirz

Thank you.

Operator

Now our next question comes from the line of Edward Kelly with Credit Suisse. Please go ahead.

Edward Kelly

Yes. Hi, guys, how are you?

David Hirz

Hey, Ed, good. Thanks.

Edward Kelly

Hey, Dave, I just want to follow-up on the answer that you’d just gave – you just given to that last question about store growth for next year impact the deflationary environment. Just trying to understand how you’re thinking about this? I mean, obviously, there’s an impact on the business of deflation and how a new store will ramp? But then long-term, if you believe in the business and the strategy and the white space, there’s kind of a different view. Could you just sort of help us understand how you’re weighing one versus the other for store growth?

David Hirz

Sure. Yes, we’re still again having a lot of internal discussion. We’re obviously still incredibly committed to the banner, the format, and 10% growth going forward. But it’s been a crazy year in the industry with – if I look back five years, or even ten years, our inflation rate on average has been over 2%, but call it 2%, and now here we are in a 2% negative deflationary environment, it’s 400 points upside down.

In 2000, as you can see from, where we’re at in 2016 and our industry is kind of the last year, we think and we’re feeling like deflation is going to turnaround. In 2017, we’ll certainly be inflationary, by the end of the year, but we don’t know that. A year ago, I had a forecast that 2016 would be 1% positive inflation. And you can see how close I came there where we’re now projecting it to be 2% deflation. So we’re really monitoring closely how we’re finishing up here in Q4 and what the outlook is for 2017. But it’s pretty uncertain right now. So we’re just taking our time and making good informed decisions.

Richard Phegley

And Ed, we’re also looking at this from a cash generation standpoint and balancing that against total capital spend.

Edward Kelly

Okay. As you think about California long-term in density and what you’re learning from the acquired stores, where do you stand today? So I think, part part of that acquisition was to sort of help you understand if you could have greater density than maybe you initially thought. Just curious around what your thoughts are around that at this point?

David Hirz

Yes, on density, we still think, the cannibalization is painful this year. It’s in line with what we expected. And again, when we build a new store pro forma, we want a year three cash on cash return of 25%. And we fully burdened that pro forma for any cannibalization from sister stores, both sales and EBITDA. So it’s already burdened in their pro forma.

So we like the trade off. We like the market density that we’ve acquired here over the last year-and-a-half or so. San Diego is a good example, I probably used before. We thought that San Diego was a 20-store market for us. Today, we have 27 stores in that market and Scott and the real estate team think there’s a couple more opportunities, we could end up closer to 29 or 30.

So our model appears to allow us to be much more dense than we initially thought with a little bit of cannibalization. Again, this year is really extreme. We think though that by next year, once we cycle these in May, we’ll be back to a more normalized kind of historical 60 point kind of cannibalization impact. But we – I think we’ve learned a lot from the acquisition. We’ve learned a lot about cannibalization and market density and proper spacing. And so we still think there is over 100 opportunities still in California for the Smart & Final Extra! banner.

Edward Kelly

Great. And just one last one for you. Any update on all that and what you’re seeing there, as they open stores when the impact, if any on your business?

Scott Drew

Sure. This is Scott. I would just tell you that, there are 45 known locations, the first 31 are now open. Our stores compete within a three-mile radius of 22 of those stores and really they’ve had very little impact on our competitive landscape there impacting Smart & Final. And the total store sales loss is roughly about $1,000 to $2,000 on a weekly average per store. So really no overall impact to our total company.

Edward Kelly

Okay. Thank you.

David Hirz

Thank you.

Operator

Now our next question comes from the line of Vincent Sinisi with Morgan Stanley. Your line is live, sir.

Vincent Sinisi

Hey, great. Thank you very much for taking my question. Hi, guys.

David Hirz

Hey, Vinny.

Vincent Sinisi

Just wanted to – hey there. Just wanted to ask you guys a little bit further on cannibalization. I’m just wondering if or how much that factored into some of the recent or future Smart & Final closures? And then also, I know you mentioned, I think kind of for the coming year going forward about half the stores will be outside of Southern California. Just wondering if, how much cannibalization might be factoring to that as well?

Richard Phegley

So cannibalization as it relates to historic closures was not completely unanticipated, as we develop new stores in the areas where the store closures occurred. In four of those five cases, we were fully aware that the legacy stores could be cannibalized, and in fact, or and sales had declined a little bit in those stores. The first store, as I said earlier, was – the factors were both cannibalization and a – and near-term lease expiration.

So we, as Dave said earlier, we do anticipate cannibalization in a number of cases when we open new stores. And it’s not a bad thing, the new store can be successful and we can carefully evaluate the portfolio and occasionally proven, which is in the case of these five what we did.

On a go-forward basis, it’s very situational and we look at every opportunity. And where new stores make sense, net of cannibalization from existing stores will continue to do them and increase density as a result.

Vincent Sinisi

Okay, great. Thanks, Rick. And maybe just sticking on cannibalization just on the other side of the business, I know, you mentioned, I think, within Cash & Carry, I think two stores juts had kind of had some impact. So just you have any further elaboration there? Was that also kind of in line with your expectations and maybe just kind of any updated thoughts on as you’re wrapping that part of the business up going forward, how you’re thinking about it?

David Hirz

Sure. The cannibalization in a quarter for Cash & Carry is 1.1% and that really came from two stores that heavily cannibalized sister stores in areas. We expected heavy cannibalization and that’s what we realized. The two stores that cannibalized are running really well against pro forma. We have factored that increase sales into the pro forma, so they are running well against that.

If you look at our last three stores we opened in the last five weeks, Concord in Northern California, San Lorenzo in Northern California, Salt Lake City, all three of those are new markets with no cannibalization, very little cannibalization at Concord. We’re literally close to no cannibalization from those three stores. So we think going forward, if I look at next year’s pipeline, again, we’re still evaluating it, but we have a pipeline of Cash & Carry for 2017, 50% of those stores for next year are also in new markets. So 50% would have some level of cannibalization.

Vincent Sinisi

Awesome. Great. Thank you, Dave.

David Hirz

Thanks, Vinny.

Operator

And our next question comes from the line of Sean Naughton with Piper Jaffray. Please go ahead, sir.

Sean Naughton

Good afternoon, guys. Quick question for you and I apologize if I missed this. But any update on all the – your hard discounters kind of in the Southern California market how that may have impacted your business in the quarter and what you’re seeing from those guys?

Scott Drew

Yes, just to reiterate, we’ve really seen very little impact with all the – grocery outlet has had a new market entry in several of our marketplaces. Again, when we go head-to-head with them, we’ve seen very little impact of late and in through the quarter. So I would tell you some of the discount operators that we’ve come up against were comfortable with our model and the impact has been really roughly between $1,000 and $2,000 per week per store.

David Hirz

When [indiscernible] team analyses, of course, we look at it every Monday morning the prior week sales. And she measures cannibalization, I’m sorry, she measures competitive impact of Smart & Final Stores to all the – where they’re within a one-mile radius and one within a two-mile, one within a three-mile to see if there’s any difference. And as Scott said, on average, we’re seeing about a $1,000 to $2,000 a week per store in these 22 stores that are near all the stores. And again, almost doesn’t matter, if it’s within one-mile, or two miles, or three miles, there’s very little impact.

Sean Naughton

That’s kind of consistent with where you guys said in the last quarter, right?

David Hirz

Yes, it is.

Sean Naughton

What you’ve seen pretty consistent, okay. And then anything on the just on the merchandising side, I know you’ve been trying a bunch of different stuff on the sushi and bakery, and then any update on kind of the organic and natural food kind of better for you offering inside of the store, is that fully penetrated now throughout the Smart & Final Extra! Banners?

David Hirz

Yes, good question. No, it’s not fully penetrated, but we’re getting there. The merchandise initiatives are right on schedule. We have multiple traffic driver initiatives. And again, the mix change has been – had been really helpful. Really what they’re doing is position us for a really strong 2017. If you look at rotisserie chicken, the number of stores this year were increasing with rotisserie chicken, is increasing by almost 70% same with bulk foods, natural and organic.

But as far as being out of stores by the end of the year, our rotisserie chicken will be in about 75% of the Extra! Stores, bulk foods will be in about 70%. So there’s still some more work to do on those initiatives. Natural and organic is doing really well.

By the end of the year, we’ll have that in 80 stores, and it continues to do well. It’s growing exponentially of a small base, but performance is really strong. It continues to be a great basket driver. Natural and organic products somehow seem to really drive a deep basket and again, continues to perform really well.

Sean Naughton

Okay, great. That’s all. Thank you.

David Hirz

Okay. Thank you.

Operator

Our next question comes from the line of Alvin Concepcion from Citi. Please go ahead.

Alvin Concepcion

Thank you. Thanks for taking my questions. I was wondering about your store expansion potential outside of California and also while we’re talking about that, how has the store performance been outside of California?

Scott Drew

Speaking to outside of California namely Arizona and Nevada, we’re really optimistic about these stores and they’re doing well. We see some real benefits and long-term opportunity. And today, 50% of those stores are Extra! versus the legacy format. So we continue to look for real estate opportunities and we’ll evaluate that marketplace. And in our existence market in California, we’ve been extremely pleased with the results of the new stores meeting pro forma objectives and very optimistic.

As Dave cited earlier, we still think there’s over 100 opportunities in California alone. So we continue to evaluate it with a real estate team and developing a pipeline for continued growth.

Alvin Concepcion

Great. And then I think there were a lot of questions about already. But I’m wondering what you’re seeing from Walmart and price investments from them?

David Hirz

Again, we price check every competitor weekly for commodity items and for perishables, meat and produce and we are checking them every month on a wall-to-wall basis. I would tell you, the competitive sets in California, Arizona and Nevada has been very stable for the last year. We have a price gap that we work to maintain below our competitors, that gap has been very consistent all year long with really no substantial investment to keep it there. We haven’t seen from a real estate standpoint, Walmart has slowed quite a bit. There are very few Walmart’s opening in the marketplaces. From a pricing standpoint, we haven’t seen any movement in the price checks in the markets that we’re offering.

Alvin Concepcion

Again, and last one for me, in the longer-term beyond 2017, and as you lap, deflation, cannibalization pressures, how should we think about the normalized comp growth and earnings growth?

David Hirz

Yes, we – from a comp growth, we – again, we – looking at our sales today, we’re pretty pleased. We’re pretty pleased with 19% customer count growth. And if we look at our sales net of deflation and net of cannibalization, we’re pleased with where our sales are. We think once we cycle the deflation and we get into a more normal cannibalization rate that we’ll be back in that 4% same-stores sales rate and 13% long-term EBITDA growth.

Alvin Concepcion

Great. Thank you very much.

David Hirz

Thank you.

There are no further questions at this time. And with that, we’d like to close up the program. We thank you for your time and participation today and have a wonderful rest of the day.

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