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The Fresh Market (NASDAQ:TFM)

Q2 2012 Earnings Conference Call

August 29, 2012 09:00 AM ET

Executives

Lisa Klinger – Executive Vice President and Chief Financial Officer

Craig Carlock - President and Chief Executive Officer

Analysts

Priscilla – JP Morgan

Kate Wendt - Wells Fargo Securities

Mark Wiltamuth - Morgan Stanley

Karen Short - BMO Capital

Chuck Cerankosky - Northcoast Research

Kelly Bania - Bank of America

Sean Naughton - Piper Jaffray

Charles Grom - Deutsche Bank

Jason DeRise – UBS

Mark Miller - William Blair

Tim Moore - Cabot Money Management

Colin Guheen - Cowen and Company

Operator

Good day, ladies and gentleman. Welcome to The Fresh Market Inc. Second Quarter 2012 Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct the question-and-answer session and instructions will be given at that time. (Operator Instruction) As a reminder today’s call is being recorded. I'd now like to turn the conference over to your host Ms. Lisa Klinger. Ma’am you may begin.

Lisa Klinger

Thank you Shannon and good morning everyone. Welcome to our second quarter 2012 earnings conference call. I'm joined by Craig Carlock our President and CEO and we will be your speakers for today's call.

Before we get into our discussion of our results I need to remind you that any forward-looking statements we make today are subject to our Safe Harbor statements found in our press release and SEC filings. Our second quarter earnings release and related financial information are available on our website under the Corporate Information section.

For those who cannot listen to the entire live broadcast a replay will be available for 30 days on our website at www.thefreshmarket.com. After our prepared comments we will be available to take your questions for as long as time permits.

Now, I'll turn the call over to, Craig.

Craig Carlock

Thank you, Lisa, and thank all of you for joining us today. We are pleased to share our second quarter and first half results with you and we look forward to today’s discussion.

Let me begin by saying, I am very pleased to announce another quarter of exceptional growth in both revenue and earnings for The Fresh Market. The company’s second quarter diluted earnings per share increased 26.4% to $0.28 over last year’s second quarter diluted earnings per share of $0.22 and our first half diluted earnings per share increased 35.5% to $0.68 over last year’s first half diluted earnings per share of $0.50.

Our comparable store sales increased 8% in the quarter and our total net sales grew 20.6% to $313 million. Additionally, during the quarter we opened five stores in Wichita, Kansas; Tulsa, Oklahoma; Bedford, New Hampshire; New Orleans, Louisiana and Rogers, Arkansas, adding the states of Kansas, Oklahoma and New Hampshire to our store base. Since the quarter ended, we have opened three additional stores in Bradenton, Florida; West Chester, Ohio and Pinecrest, Florida. We’ve now opened 11 stores this fiscal year and we remain on-track to open 14 to 16 stores in fiscal 2012.

Our gross margin rate increased approximately 140 basis points in the quarter primarily through merchandise margin expansion. Benefits obtained through re-negotiated supply chain and vendor agreement and reduced shrink as the percentage of sales primarily drove the merchandise margin growth. Balancing the strong performance we have achieved so far in fiscal 2012 with the risks and opportunities we see remaining in our next two quarters we’re pleased to increase our fiscal 2012 earnings guidance to $1.33 to $1.38 per share, an increase of 25% to 30% over fiscal 2011 earnings per share of $1.07.

Now, I'll turn the call over to Lisa, who will provide additional details on our financial results.

Lisa Klinger

Thank you, Craig. First, I would like to point out that there were several items that impact the comparability of our quarterly results and those items should be reviewed by investors in order to assess the company’s ongoing operations on a comparable basis. These items were described in detail in our press release and include the transaction expenses related to the equity offering during the second quarter as well as the transaction expenses incurred in the first quarter of fiscal 2011 and the net settlement payments made and received in connection with two resolved legal matters.

For the second quarter, net income increased $2.8 million to $13.3 million from $10.5 million for the second quarter of fiscal 2011. Diluted earnings per share increased 26.4% to $0.28 per share. For the first half, net income increased 35.9% to $32.6 million with diluted earnings per share of $0.68. As Craig highlighted earlier, the company had total net sales growth of 20.6% and comparable store sales growth of 8% for the quarter.

The comp sales increased resulted from a 5.3 percentage point increase in transaction and a 2.5 percentage point increase in average transaction size. The increase in transaction size was primarily driven by increases in average unit retail as a result of passing through cost inflation offset somewhat by the mix effects of lower AUR categories growing faster than a store. We also continue to see the growth of our larger basket transactions outpace the growth of smaller basket transactions as our loyal customers bought more items and spent more per visit.

It is important to note that our second quarter 2011 comparable sales growth of 4.6% was driven by one percentage point increase in transactions and a 3.6 percentage point increase in average transaction size. So, on a two-year stacked basis, our comparable sales have increased to 12.6% driven by a healthy balance of a 6.3 percentage point increase in transactions and a 6.3 percentage point increase in transaction size. In addition to the strong comparable sales growth nearly 21% total sales growth performance was also attributable to a strong new store productivity level of nearly 93% highlighting our ability to continue to grow and enter new markets and states with success. As all five new store performed in line or better with the company’s forecast.

Again to reiterate, as we continue to be somewhat imbalanced in our new store opening timing year-over-year, we need to remain mindful of the potential short term quarterly variations in productivity while still being focused on a first year new store productivity level of 80 to 90%.

For the first half of fiscal 2012, total sales have increased to 21.7% to $637.8 million and comparable sales has increased to 8.1%. During the second quarter total gross margin dollars including occupancy costs increased 25.6% to $106.7 million and the gross margin rate increased 140 basis points to 34.1%. The expansion and gross margin rate was primarily due to increased merchandise margin as well as slight leverage in occupancy cost despite the negative 10 basis point impact of higher occupancy cost related to stores not yet open during the second quarter of fiscal 2012 as compared to the second quarter of fiscal 2011. We continued to leverage our purchasing power and economies upscale with improved vendor and supply chain agreements as well as our inventory management system to reduce our shrink expense as the percentage of sales to increase our merchandise margin.

For the first half of fiscal 2012 total gross margin dollars have increased to 25.7% to $219.4 million and our gross margin rate has increased 110 basis points to 34.4%. Please note that for the quarter and the first half, our year-over-year LIFO accrual did not change materially and was not a material driver of gross margin rate changes. For the second quarter selling, general and administrative expenses increased 25.8% to $74 million versus $58.8 million last year. As a percentage of sales SG&A expenses increased by 100 basis points to 23.7%. Solid expense management was offset by several non-comparable corporate expenses including approximately $500,000 in the transaction expenses incurred in connection with the company’s public offering of common stock approximately $600,000 representing the net amount of settlement payments made and received in connection with the legal matters and nearly $600,000 of incremental expenses primarily attributable to the company’s share based compensation program as a result of its public company status or all together totaling approximately 55 basis points of the percentage of sales. The rate was also adversely impacted by higher incentive compensation accrual given the company’s strong operating performance here today as well as the impact of uninsured inventory losses due to the strong storms and widespread power outages experienced in early July.

For the first half of fiscal 2012, SG&A expenses increased 22.7% to $144.5 million or 22.7% as the percentage of sales compared to 22.5% as a percentage of sales for the first half of fiscal 2011. Depreciation expense for the second quarter of fiscal 2012 totaled $10.8 million compared to $9 million in the corresponding period of fiscal 2011 and depreciation expense for the first half of fiscal 2012 totaled $21.4 million compared to $17.4 million for the first half of fiscal 2011. Operating income for the second quarter increased to 27.8% to $21.7 million while operating margin increased by 40 basis points to 6.9%. The primary driver of the increase in operating margin was the 140 basis point increase in gross margin rate offset by the 100 basis point increase in the SG&A rate.

For the first half of fiscal 2012, operating income has increased to 35% to $52.8 million with an operating margin of 8.3% an increase of 80 basis points compared with the first half of fiscal 2011. The primary drivers of the operating margin expansion were the increase in gross margin rate and favorable cycling on equity offering related transaction expenses offset by higher corporate expenses. Our effective tax rate in the second quarter of fiscal 2012 was 38% versus an effective tax rate of 36.4% for the second quarter of last year. The second quarter rate was adversely impacted by the equity offering related transaction cost of approximately $500,000 which were not tax deductable. Excluding the impact of these expenses the effective tax rate would have been 37.1%.

Now moving on to the balance sheet; during the quarter, the Company generated $17.3 million in cash flow from operations and invested $24.8 million in capital expenditures. Nearly 94% of this capital spend or $23.3 million was related to new, relocated and remodeled stores as we continue to grow. During the quarter, we opened five new stores and at the end of the quarter we had 121 stores in 24 states.

The Company continues to generate strong free cash flow posting the cash balance at the end of the first quarter of fiscal 2012 of approximately $11.1 million and total debt outstanding for the same period was $46.3 million. Availability under the company’s revolving credit agreement was $117.2 million at quarter end. Average inventory on a FIFO basis per store at the end of the second quarter of fiscal 2012, increased 5.9% compared to the corresponding period in fiscal 2011. However, we did continue to see nice increases in our inventory turns given the strong sales performance.

The increased dollar levels resulted primarily from increased commodity costs in our meat, produce and grocery departments and increased inventory investments in new product assortments and faster growing categories to support our overall sales growth. Given our continued improvement in earnings performance, as well as our disciplined approach to asset utilization our key financial return metrics remain strong. On a trailing four quarter basis, the Company's return on assets was 18.7%, the after tax return on invested capital was 26.7% and return on equity was 37%. As a reminder, our press release includes a schedule depicting how we calculate these return metrics.

That concludes my comments regarding our second quarter and first half financial performance. I'll now turn the call back over to, Craig, so that he can provide you with an update on our outlook for the remainder of fiscal 2012. Craig?

Craig Carlock

Thank you, Lisa. Given our first half results and the current visibility into our business trends, we have increased confidence in our fiscal 2012 performance and are therefore pleased to raise our guidance for the full year. We are still planning to open 14 to 16 new stores with the 11 new stores opened through today, we have planned to open three to five in the remainder of the year.

We also still plan to relocate one store later this year. Our anticipated capital spending range of approximately $95 million to $105 million remains unchanged. We are pleased to raise our comparable store sales guidance. We now expect comparable store sales to increase 5.5% to 6.5% this fiscal year, reflecting the strong first half performance and our current expectations for the remaining two quarters.

We continue to expect our comp sales growth to come from a blend of increasing transactions and increasing transaction size, building on our first half success we are excited about the merchandising and promotional programs we have planned for the second half of the year. Though protein costs remain high, cost pressures and several other departments are stabilizing presenting us with numerous promotional opportunities. These promotions should allow us to promote our products more effectively generating sales, while preserving gross margin dollars.

Furthermore, we are excited about our upcoming seasonal holiday plans. We have exiting new items and promotional events in both the perishable and non-perishable categories that we believe will please and delight our customers. We continue to invest in our private label program and this program continues to grow in popularity, our penetration continues to expand particularly in the non-perishable department.

During the second quarter alone, we introduced over 40 new items in grocery and diary. We anticipate launching nearly 175 new products in 2012 and over 110 those will be rolled out during the third and fourth quarters. Additionally during fiscal 2012, we will redesign over 200 products and we will develop 40 in and out seasonal products.

In addition to growing revenues, we continue to focus on growing our operating margins. We now expect our annual operating margin to improve 30 to 50 basis points over last year’s operating margin of 7.5%. This improvement primarily reflects gross margin expansion as we continue to deploy and refine our order and inventory management tools, enhance our ability to keep our stores better stocked with fresher product and do it in a way that allows us to reduce our merchandise shrinkage.

We’ve also utilized our growth and scale to renegotiate several vendor and supply chain distribution agreement that will provide merchandise margin tailwinds for the remainder of this fiscal year. These gross margin benefits are somewhat offset by operating expense investments related to our growth plan and the incremental corporate expenses related to our public company status. Taking into account our current sales and operating margin forecasts, we now anticipate diluted earnings per share of $1.33 to $1.38 in fiscal 2012, an increase of approximately 25% to 30% over fiscal 2011’s diluted earnings per share of a $1.07.

I would also like to update you on our growth plan. Our real estate pipeline continues to strengthen and gain momentum. We recently signed leases for new stores in Winter Park, Florida and Charlottesville, Virginia. And we expect to sign several more leases in the coming weeks. We now have 16 leases in our development pipeline for stores that will open in fiscal 2012 or later.

I’m also pleased to say that our California expansion is progressing on track. We plan to open our first store in Roseville, just outside of Sacramento, late third or early fourth quarter. And we believe our stores product offerings and customer proposition and overall store environment will be embraced by California consumers who are already looking for high quality food choices. Also, we have begun construction and development on our Palo Alto and Santa Barbara stores, we have identified our initial field management team and have begun their relocation efforts and we are establishing the necessary new local vendor and distributor relationships. Again, we have been planning and preparing for our west coast expansion for 2.5 years and we cannot wait to get our first store opened and off the ground.

In summary, I want to reiterate how pleased we are with our business and our prospects for the remainder of fiscal 2012 and beyond. We are confident in our new store pipeline, our remodel and relocation opportunities and the momentum we are developing in the real estate marketplace. Our comparable store sales are healthy and our customer count growth remains strong. We continue to push for new items innovation in our perishable and non-perishable departments, and we continue to improve and leverage our sales-oriented investment in store labor. This work combined with disciplined G&A expense control has us very excited about our future.

Thank you. Operator, we will now open the call for questions.

Question-And-Answer Session

Operator

(Operator Instructions) Our first question is from Ken Goldman with JP Morgan, you may begin.

Priscilla Tsai– JP Morgan

Hi Craig, this is actually Priscilla Tsai in for Ken today. So there seems to be a lot of momentum behind gross margin expansion recently. And I’m just wondering how we should think about the level of sustainable expansion going forward and how do you think about reinvesting some different prices, especially given the competitive environment in the industry right now?

Craig Carlock

I think the first point is we do things that we believe are sustainable and good for the long term health of the business, and so we’re getting our margin expansion in good and sustainable ways. We’re talking about lower costs, optimized pricing and promotion, reduced shrink, better distribution arrangements and so all of those things are sustainable. Now we’ve stated the rate of growth that we’ve seen in the first couple of quarters has even surprised that, and we wouldn’t want to forecast or expect the kinds of the jumps we’ve seen going forward. Everything we’re doing is sustainable, we expect to grow margins overtime. I can’t imagine we could maintain the rate of increase that we’ve seen so far this year though.

Priscilla – JP Morgan

Okay and then just as a follow up. How should we look at the margin structure for your new California stores versus your current store base? They will obviously require time to ramp up sales and initial costs relate to moving into that market, but just curious to see if longer term, will there be any structural differences in the margins for these stores due to any differences in prices, is there competition or supply chain structure?

Craig Carlock

No I think we’re going again to this expecting to deliver the same customer proposition that we deliver in the east coast, which is really tasty products, great service, the clean inviting shopping atmosphere and our anticipation is the margin structure should be consistent with what we have now, once we get some stores up, we’ll have better visibility into that. And we do know that there’ll be certain costs that are higher to operate out there but in the big scheme of things we feel like the proposition is pretty similar to what we have in the East Coast.

Priscilla – JP Morgan

Okay, and then my last question is just did the gift card breakage have any impact on the gross margins this quarter?

Lisa Klinger

No actually the impact was around $70,000 for the quarter, so it’s about 1 basis point impact on the gross margin.

Priscilla – JP Morgan

Okay.

Craig Carlock

Thank you.

Operator

Thank you. Our next question is from Kate Wendt with Wells Fargo Securities. You may begin.

Kate Wendt - Wells Fargo Securities

Thanks, good morning and congratulations on a good quarter.

Craig Carlock

Thank you.

Kate Wendt - Wells Fargo Securities

First wanted to ask about your thoughts in terms of the droughts and the potential impact on food prices in terms of whether we might actually see a short term reduction in prices, particularly in meat, is some of the suppliers liquidate herds, and when you think we might start to see that clean back up, as well as, if you think there is going to be any difference in terms of how it impacts fresh market versus traditional grocers.

Craig Carlock

So the first point, we actually had the same question, would the cost of paid and maintaining cattle on (inaudible) drive increased number of cows to slaughter, and therefore I’ve a short term blip. But we really haven’t seen that and if we have it, it’s already come, we’re still seeing very high protein costs and not expecting them to decline. And your second part of your question was is there any different from fresh markets than everybody else. I would guess no, we buy on the spot market, I think most retailers, food retailers on the spot market and so I think we’re all in the same boat.

Kate Wendt - Wells Fargo Securities

Okay, great. And then for Lisa, on SG&A, expenses were still little higher than we had modeled even excluding some of the sort of one timers, and I’m just wondering if you could provide what the basis point impact was of higher incentive comp, as well as pre-opening costs, just as, we’re trying to figure out if we should expect you to continue to de-lever SG&A excluding these sort what time items you have this quarter going forward.

Lisa Klinger

Yes, certainly we have the unusual items, which were the 15 basis point impact on the equity offering transaction cost and the 20 bps on the net legal settlement payments. So within that while we had some other items that weren't necessarily unusual or distinct onetime items, they were a little bit off the norm and those were the uninsured inventory losses that we had in July related to the thunderstorms that kind of swept through the Mid Atlantic region, and we lost a lot of power in our stores. You mentioned the increased incentive compensation accruals and then we also did have higher legal expenses that were involved with those noted legal settlements, obviously once you are ramping up to settle those litigations your actual legal expenses were higher. So again we’ll not distinct one item. They were a little bit outside of the norm and those items when all taken together were about 64 basis points of an impact on the SG&A rate, so, kind of getting back to your question on whether that will continue for the second half. You know the one aspect of what I just outlined that we probably would continue to see, put some slight pressure on the SG&A rate would be the increased incentive compensation expense versus last year as well as the share-based compensation expense that we are now incurring each quarter as we start to layer on the multiple years underneath our annual long term incentive programs, so those would be the two things that I would say are a little bit more ongoing but it will be a slight impact, it won't be nearly the impact that we saw this year in the second quarter.

Kate Wendt - Wells Fargo Securities

Okay great, thanks for the color. Thanks again.

Operator

Thank you. Our next question is from Mark Wiltamuth with Morgan Stanley. You may begin.

Mark Wiltamuth - Morgan Stanley

Hi, good morning. I wanted to focus on the comp, I mean, with the first half comp running at 8.1% you’ve clearly broken out of that 4% to 5% comp trend we've seen last couple of years, what's really going on differently in the stores to really drive that?

Craig Carlock

I think pinpointing changes in comp is difficult but I think we feel great about our execution. I think we feel great about the promotional programs we’ve run. I think we feel like, you know there’s been somewhat of an economic tailwind and until recently perfect weather. And so a lot of good things have come together. I would also say that we focused so heavily on just delivering a great experience day-in and day-out that we've done a good job in the field of not being distracted by anything else and so that feels really good to us.

Mark Wiltamuth - Morgan Stanley

So as you look ahead, we've got the class of 2011 that will be maturing as it rolls through 2013 to 2015. Do you still think the maturing of those stores can add to the comp base given that the comp is now structurally higher?

Lisa Klinger

Yeah I think that they will be somewhat additive, I mean the one thing that we do have to keep in mind is that we did start to see the comp trend pick up in the second half of last year, so our current guidance really implies that consistent kind of 12% to your stack basis for the remainder of the year. So, right now we don't see anything dramatic one way or the other to push us off of that current consistent 12% trend to the good or to the bad, so, again at this point we think this is the best and most balanced outlook from a comp perspective.

Mark Wiltamuth - Morgan Stanley

Okay and just one more question on the gross margin drag from stores that are not in the comp base yet, like you had mentioned 10 basis points in the quarter?

Craig Carlock

And we’ve stores those aren’t opened yet.

Mark Wiltamuth - Morgan Stanley

Right, so stores that are not opened yet, that's the drag on the rent expense. So, is that going to be a little bigger in the next quarter because you've got more still pending in the pipeline or how do we stand for the rest of the year on that?

Lisa Klinger

No the fourth quarter should be fairly consistent. We opened quite a few stores in the back half of the fourth quarter so for a lot of the fourth quarter, we were expanding rent for stores that weren't opened. I remember, I think we opened 5 or 6 stores in the fourth quarter of last year but three of them were in the last couple of weeks and then we opened another store in February, so, it should be similar in the fourth quarter.

Mark Wiltamuth - Morgan Stanley

Okay, well thank you very much and congratulations.

Lisa Klinger

Thank you.

Operator

Thank you, our next question is from Karen Short with BMO Capital. You may begin.

Karen Short - BMO Capital

Hi there.

Lisa Klinger

Hi Karen.

Karen Short - BMO Capital

Just a couple of questions, Craig, in your prepared remarks, you know you said balancing. You said something about balancing opportunities with risks in the back half and that’s how you kind of came to our guidance, I guess I wanted to explore a little bit what the risks you see are in the second half?

Craig Carlock

Well we were referring somewhat generally to -- hey you’ve got an election state and then kind of loaded political environment, we’ve got a lot of global economic news and there’s questions about U.S. economic conditions and so, when you take a look at all that, it just feels like when we guide we should be careful about guiding to what have been two great quarters but we are not going to kind of jack up the yearly forecast based on two quarters.

Karen Short - BMO Capital

Okay that’s helpful. And then in terms of operating expenses and your expectations in the back half, are they actually higher than you originally expected them to be or they are, you’re just continuing to kind of point to those?

Lisa Klinger

No. They are consistent with what our original plans were and again, which is one of the reasons why we continue to be able to increase our overall EPS guidance for the year.

Karen Short - BMO Capital

Okay. And then in terms of shrink, could you just give me an update on where you are in terms of how many categories the shrink tours in now, I guess, in what inning you are in? And then how much longer you think you may have some benefit on that?

Craig Carlock

They are fair questions. So I think back in the past I said middle innings and so you have a good memory. I think 7th inning, I mean, if we are going innings, we are not done. We continue to modify and improve and learn. But this happened successfully, this have been a source of margin expansion. They are sustainable, but we are getting toward the end of their ability to be new. So we are getting from new to refinements.

Karen Short - BMO Capital

Got it. Okay. And then last question, any update on the transition to the second DC?

Craig Carlock

Yes. So we opened that warehouse, we are sort of operating out of it on August 13 and we have no significant problems.

Karen Short - BMO Capital

Great. Thanks very much.

Operator

Thank you. Our next question is from Chuck Cerankosky with Northcoast Research, you may begin.

Chuck Cerankosky - Northcoast Research

Good morning everyone, great quarter. I would like to ask about as you see your most loyal customers, I think you said, Craig, is differentiated from the people buying smaller baskets, but how those most loyal customers build basket size, which categories are they going after? Are they ending up raising their price per item as they build the basket, but some of the dynamics behind that please?

Lisa Klinger

It’s really broad to be honest with you. I mean, what we are seeing is individuals continue to shop the entire store and to shop for an entire meal. So that’s really been the overall driver. It’s not necessarily been an overall trading out as a broadening of the baskets.

Chuck Cerankosky - Northcoast Research

So, they might start out with the meat department but then they graduate to shopping the entire store?

Lisa Klinger

Well, I wouldn’t know individual specific shopping patterns. But what we are seeing in the transactions of that size, that’s what we are seeing, is a broadening of the baskets across categories.

Craig Carlock

One of the things that we believe is that you can have all of your food needs met at The Fresh Market. As customers learn that and discover that they are able to shop all the departments and really have all their food needs met. So, it’s not surprising to me that over time people learn that and adopt their behaviors. Because what we offer is good and tasty and then we make it easy to find.

Chuck Cerankosky - Northcoast Research

Alright. Thanks you. What was inflation during the quarter?

Lisa Klinger

Come again. It wasn’t a material difference for the quarter, for the half. For our full year we have an implied estimate of just under 2% for the year.

Chuck Cerankosky - Northcoast Research

Lisa, can you give me a number for inflation in the first half of the year?

Lisa Klinger

I mean, again, we have accrued something that’s consistent about slightly under 2% number.

Chuck Cerankosky - Northcoast Research

Alright. Thank you.

Operator

Thank you. Our next question is from Robert Ohmes of Bank of America, you may begin.

Kelly Bania - Bank of America

Hi, good morning. This is Kelly Bania in for Roby. Craig and Lisa, I was wondering if you could talk about the inventory investments that you mentioned in some new product assortments and maybe what those faster growing categories are and how maybe private label and organics fit into that.

Craig Carlock

Well, I think what tends to happen in food retail environment is as you are introducing new products and as categories grow and as your business grows your dollar value of inventory tends to rise and in some cases your days of inventory tends to rise. So that’s what we are referring to. We have had great success launching a lot of new grocery items, including many private label items. So those are new items that becomes stored and stocked in the store.

Kelly Bania - Bank of America

Great. Just another follow-up. The success you are having with private label, is that what’s impacting the lower AUR? I think Lisa mentioned some lower AUR categories going faster. Is that just driven from private label?

Lisa Klinger

No, not specifically private label. Because again, our private label strategy isn’t necessarily a price point. We are looking for a very nice type quality products. So, it’s more of the mix effect of the fact that we do have and have continued to see items within grocery, items within dairy, be very popular. So we are seeing those categories grow faster than maybe some of the other protein categories which typically have a higher AUR. So, some of that is a mix from our perspective, more of a category shift than specifically something like private label.

Kelly Bania - Bank of America

Great. That’s helpful. And then, one last question, you mentioned the uninsured inventory loss impacting the SG&A and I was curious if there is anything we should be thinking, keeping in mind for third quarter as kind of hurricane passes your largest market down in Florida, anything we should think about that typically having an impact on that?

Craig Carlock

First point on the hurricane is that we were very conscious, none of our employees that we know of are hurt and so that’s great news so far. We do have some stores that are closed so we convey that information. But I would say that uninsured inventory, it’s unusual, but it does happen during the tropical storm season or in tornado season. So there is a deductible associated with these things and so we go through the process of insuring what we can and paying for what we can’t.

Kelly Bania - Bank of America

Great, thank you.

Operator

Thank you. Our next question is from Sean Naughton with Piper Jaffray, you may begin.

Sean Naughton - Piper Jaffray

Hi, thanks for taking the question and congrats on the strong second quarter. Looking at the guidance on the same-store sales trend, it looks like you have brought up the lower-end of the range, but it seems to be implying a little bit of a slowdown in the second half. Are there any dynamics in the second half that we should be thinking about? And then, maybe just anything from a modeling perspective between Q3 and Q4 that were a little bit different?

Craig Carlock

No, I don’t feel like there is any underlying dynamics that are peculiar. So we had a great last couple of quarters last year. We began to cycle on those. So, we are targeting 12% kind of 2 years stack, but there is no fundamentals that are changing.

Lisa Klinger

Yes, and Sean, if you recall last year in the third quarter we posted a 5.5 comp, so really kind of that first quarter that we broke above that 5% range. In the fourth quarter we had a 7 comp. So, again, just trying to keep consistent with this, fairly tight pattern that we are seeing of the 12% 2-year stack for the last three quarters feels appropriate.

Sean Naughton - Piper Jaffray

Okay, that’s fair. And then I guess on the – it looks like the average capital per store is coming down a little bit year-to-date. Is there anything that you are getting some better deals from the landlords that are out there?

Craig Carlock

No. I caution everyone on that one. I would say that that number is highly dependent on the number of as is deals compared to the number of build to suit deals. So that number moves depending on the mixture or the mix of as is deals with build to suit. To the extent the number has fallen a little bit, which means we have been able to get in some new constructions, which is really great from a capital perspective.

Lisa Klinger

And in the first quarter, Sean, the numbers that we posted were influenced by our Fort Lauderdale store that we opened, in which we had also purchased the land. So, there were some additional development cost that were associated with that. So as we continue to open more stores that are more normalized capital level, it dilutes Fort Lauderdale a bit.

Sean Naughton - Piper Jaffray

Got it. And then just lastly, I know a couple of people have asked about the inflation, is there anything that you are hearing from your suppliers on potential price increases, maybe outside of the perishable side?

Craig Carlock

Well, so there is a kind of national inflation of commodities that you all follow and understand. And in there is the cost inflation for items that we purchase, and so, our view point is, regardless of national trends we are buying more and more items from the people who sell to us and we expect that we are reducing their unit cost of production and we expect them to pass on some of that unit cost savings to us. We don’t blinders on, but on the other hand we are pretty aggressive with those who sell to us. So I feel like extrapolating from the national trend, in general, not in all cases, but in general of not how we approach our business.

Lisa Klinger

And maybe Sean, just to give you a little bit more color. If we compare what our cost inflation rate was year-over-year kind of for second quarter of fiscal ’12 versus second quarter of fiscal ’11 that cost inflation rate slowed, the increase slowed by about 170 basis points and the cost rate inflation was pretty similar to the first quarter. Most of the cost stabilization and/or the cost decreases continued to be in category by seafood, coffee and dairy, so kind of all the categories that you probably are already been aware of. We did see some major increases in some already high categories that we have talked about before which were meat bulk and candy. We continue to again monitor those cost retail relationship, we have talked about in the past. We like the fact that we have the centralized approach to managing these businesses and can pull lots of different levers, just trying to make sure that we optimize our merchandize margin appropriately, whether it’s been inflationary environment or deflationary environment.

Sean Naughton - Piper Jaffray

Hi, great. Thanks and best of luck in the second half.

Craig Carlock

Thank you.

Operator

Thank you. Our next question is from Matt Siler with Deutsche Bank, you may begin.

Charles Grom - Deutsche Bank

Hi, it’s actually Chuck Grom from DB. Congrats on a good quarter. When you take a look at your comp trends over the past few years, it’s really the traffic that seems to have changed and improved. I am wondering, when you dissected across your store base how consistent it is? And then also, when you look at the makeup of that traffic how much is it from your existing customers shopping more frequently versus a new customer coming in your door?

Craig Carlock

It’s consistent across the store footprint. We run the stores the same way with the same promotions, same management structure, same staffing guidelines, and so we approach the business similarly everywhere and when we measure sales trends and customer traffic trends or AUR trends, all those things tend to be pretty consistent. So that’s good news. The only time I can recall ever having any kind of real deviation geographically was in the mid of 2000 from Florida went into a recession, I think, well before, a couple years before the rest of the country. So right now everything is pretty consistent. The second thing with the question on promotions, existing versus new, we don’t have a loyalty card or a card. We think we are attracting more customers. Certainly, we are seeing customer traffic go up and I am hard pressed to think that existing people shopping more that it’s only that. So we do think we are drawing more people in, but we don’t have data to say this fraction of our increase was new and this fraction was existing.

Charles Grom - Deutsche Bank

Okay. Just any color on a comp trend throughout the quarter and it sounds like August to-date it is pretty consistent with that, is that a fair assumption?

Craig Carlock

I would say we don’t really talk month-to-month and we really don’t get into, “Hey, how are the first few weeks of August?” We meant no implication there.

Charles Grom - Deutsche Bank

Okay. And then just on the new store performance, particularly those in some of the new markets, how are they fairing, particularly ones up in Ohio and here in the Northeast, how are those doing?

Craig Carlock

I feel like our new stores are doing as we have forecasted and on average do well. In any geography, we will have some that beat our expectations and do better and some that don’t beat our expectations and do a little bit worse than we might have hoped. So, I just can’t suggest that you should draw conclusions about the Northeast or Southeast or our new openings in the Midwest.

Charles Grom - Deutsche Bank

Okay. And then Lisa for you, take a step back and look at your gross profit margins are up, probably going to be 400 BPs over the past say five years from 2007 to 2012. How high is high for you guys? I mean, how much, when you take a look at the model you talked about strengthening in the seventh inning and all the benefits from (inaudible) and the other vendors you use, where do you think you can go over time?

Lisa Klinger

I think that overall we are still looking for a nice improvement across both the categories of gross margin expansion, as well as SG&A leverage to help contribute to that long-term operating margin expansions. Obviously, we have got most of that OP margin expansion since becoming a public company through the growth line given the increased cost that we have had to absorb. I would say that we will start to see a more balanced contribution from SG&A leverage to gross margin over the next several years, but at this point, as Craig mentioned earlier, we continue to be pleasantly surprised at some of the opportunities that we are seeing in the marketplace. We have the tools, the approach, and the processes internally to take advantage of those, and we will continue to do that. But at this point, I am not sure we know what the long-term answer is just yet. We will keep doing it thoughtfully and diligently in the right way to make sure that we grow overall gross margin dollars because at the end of the day that’s what we are focused on in the appropriate way.

Charles Grom - Deutsche Bank

Okay, great. Thanks very much.

Operator

Thank you. Our next question is from Jason DeRise with UBS, you may begin.

Jason DeRise – UBS

Hi, it’s Jason DeRise, UBS. I just wanted to ask on the gross margins, particularly about Q3. You are coming up on a very easy year-over-year comp and actually if we would start thinking about the two-year trend, or the three-year trend, maybe if we just look at the first half, the three-year trend is something like up 260 basis points. I am just trying to understanding if that three-year trend should continue to kind of get rid of some of that noise from the prior quarter or year’s quarter in Q3 when it was down?

Lisa Klinger

Yes. So we don’t comment on sort of our forecast on a quarterly basis. But last year in the third quarter we did experience some gross margin compressions due to the dead rent occupancy costs for stores that weren’t open, which obviously we will cycle on this year. The other item that you need to keep in mind if you are looking at your quarters is that last year in the fourth quarter we did book an initial gift card breakage amount of $1.4 million, which had 100% margin impact on that. So, we will have to cycle that in the fourth quarter as well. So those are kind of the two I would say extraordinary events from last year’s third quarter and fourth quarter that you need to be mindful as you are thinking about your own model for this year.

Jason DeRise – UBS

Do you think that three-year trend is kind of a fair trend to think about so we can get rid of some of that noise in the prior couple years?

Lisa Klinger

No. I think that until we get to on kind of study state here. Again, we are implementing new shrink management, inventory management tools. We continue to find better ways to leverage our supply chain, processes, we are always going to have some lumpiness from the occupancy cost. I think that in this stage of our growth cycle, being so early, we continue to be pleasantly surprised by all of those things. And quite honestly, our people just keep running the stores better and better and better, and that sort of tailwinds as well. So we just keep running the business better.

Jason DeRise – UBS

Okay. If I can ask just one more. We kind of touched on it earlier in the Q&A, but maybe in terms of the basket size by storage, if you can shed some light on your $31 average basket size, but how does that progress as the store moves through the comp years?

Lisa Klinger

To be honest that’s not a calculation that we have done. Again, we do return by vintage years and then we do baskets by the dollar limits, we don’t bring that down by stores.

Jason DeRise – UBS

Okay. Could be interesting for future conversation. Alright, thanks.

Operator

Thank you. (Operator Instructions) Our next question is from Mark Miller with William Blair, you may begin.

Mark Miller - William Blair

Hi, good morning. As the new stores are meeting expectations or better and as your store growth looks to be more front weighted in 2012 versus prior years, I am wondering whether Fresh Market has any capacity to perhaps modestly increase the rate of new store growth in the years ahead. It seems reasonable to expect there’s going to be more competition in the specialty food space.

Craig Carlock

I think that we are real comfortable with the 15% unit growth objective that we have outlined. Honestly, this is where we look at history and there’s a lot of retailers who got excited about what they were doing, ran pretty fast, and then had to close some stores. So we want to be disciplined, thoughtful. We want to build a great, enduring, coast-to-coast retailer and make a few mistakes along the way as we can. So if we can grow units 15% and comps middle single-digits and get some operating margin improvement, that’s our plan and that’s the path we are going down. Any retailer could open up more stores. So the answer is yes, we could, but our plan is to hit the 15% or so.

Mark Miller - William Blair

Great, it does seem to be working. There was a question earlier about competition we are seeing across a lot of food retail discounters the clubs, dollar stores that are pressuring the conventional. Can you remind us your process of doing price checks versus competition? Just fundamentally, why do you feel you are not feeling those same price pressures? How much of your assortment is differentiated on a unique item basis? And then what portion of your base do you feel cross-shops some of the other players?

Craig Carlock

I think the fundamental reason that we aren’t in quite a price sensitive position. It’s just we sell to great customers. We sell to folks who are there and not for the price. They are there for the quality, they are there for the service, the cleanliness, the ease of getting in and out, and while we don’t execute perfectly, I mean in general that’s what we deliver and that’s why they are there. So prices, number 5 or 6 on our list of shopping attributes every time we have studied it. So that’s part of our success is we would have – we serve customers who are very interested in what we are selling.

Lisa Klinger

And Mark, to get kind of the specifics on the surveys that we do, we do utilize a third-party to go out and shop about 100 items and to tag on to Craig’s point, it’s pretty hard for us to find 100 items that truly are comparable across the conventional space. And so we run those 100 items, we pick different regions, we have them shop us as well as conventional, as well as other specialty food providers in those regions. We track the differences, not only by the different categories that we are looking at, but by regions versus conventional versus specialty. We try to be very mindful of that as we move forward across the chain. So, it’s a data point that we are actively monitoring. We want to make sure that our customers do feel like they have a relationship with us and we are being fair with our pricing proposition. It’s not something that consumes a team of people’s efforts every day like I am assuming it would at the conventional folks.

Mark Miller - William Blair

Great, thanks. Final question from me is, can you give us some perspective on the growth in your prepared foods offering whether changes you are making or the rate of consumer purchase in that category, and is that a material factor in the better comps we have been seeing?

Craig Carlock

Well, I would say that prepared foods is a very popular category for retailers and restaurants. It’s a category that has been growing for us in the past. It is growing nicely right now. It’s an area of interest and investment for us as we try more full-serve items, more self-serve items. This is something we want to do well. I don’t think I would say that anything dramatic or step change has happened with respect to the sales pattern. It’s been a good area, it continues to be a good area, we are real proud of it.

Mark Miller - William Blair

Terrific. Thank you.

Operator

Thank you. Our next question is from Tim Moore with Cabot Money Management, you may begin.

Tim Moore - Cabot Money Management

Thanks. All three of my questions have already been answered, but congratulations on the quarter.

Lisa Klinger

Thank you.

Craig Carlock

Thank you.

Lisa Klinger

Operator, I think we maybe have time for one more call.

Operator

Our last question is from Colin Guheen with Cowen and Company, you may begin.

Colin Guheen - Cowen and Company

Great, thanks. First of all, great quarter.

Lisa Klinger

Thanks, Colin.

Colin Guheen - Cowen and Company

I guess my first question is, there is some noise in the numbers because of the growth but the four wall cash flow margins seem to have expanded since you last published a presentation. Can you just kind of put that in context for us? What are you seeing four wall [ph] cash margins looking like at mature stores and some of the newer stores?

Lisa Klinger

We don’t provide that level of detail. When we do track that internally by our vintage, we are seeing a slight increase in all vintage years, but again, there is fairly consistent performance across each of those vintages as well. So again, when you are growing the merchandise margin as we have, we are certainly able to make those existing stores more profitable.

Colin Guheen - Cowen and Company

Okay. So it is fair to say that the increase in the merchandising margin is equal to what the four wall cash margin is increasing as well?

Lisa Klinger

No, no. I wouldn’t say that. What I said is that, all of those -- the store contribution rate across all vintage years is better in the second quarter than it was in the first quarter.

Colin Guheen - Cowen and Company

Year-over-year your margins are higher, correct?

Lisa Klinger

Correct.

Colin Guheen - Cowen and Company

Four-wall cash margins during the first half of ‘12 versus the first half of ‘11 or my read would be 100 basis points higher, but it’s somewhere in that?

Lisa Klinger

I mean, we are more profitable today than we were a year ago, that’s for sure.

Colin Guheen - Cowen and Company

Right, which is a step-up in your long-term return structure in your economics, there is no reason –

Craig Carlock

That’s right. So, one of the interesting things about improving your margin structure is that it helps make new stores or potential new stores more attractive. So it could mean that the stores that were on the bubble from a real estate pipeline, a few years ago, or markets that were on the bubble are all of a sudden now more attractive than they would have been. So it makes us even more confident in our ability to achieve our growth plans. That was very exciting to me about the margin growth, so you have the effect on the comp stores on the existing store base, but you also have, “Hey, what does this mean about our ability to enter new markets or smaller markets or more expensive markets?” It’s all of those things are a little more attractive when the unit economics improve.

Colin Guheen - Cowen and Company

Sure. Alright, great. Second one, just on the lease pipeline, I know that’s lumpy kind of just give us a sense of where you are? I know you have 14 leases in the pipeline, all kind of important period to --

Craig Carlock

So, I think we said, “Hey, we are going to open 14 to 16 this year” and the pipeline has 16 that are called signed sealed, maybe not yet delivered but signed and sealed for the rest of this year and in the future. So we feel real good about the pipeline. There are many more deals in that being negotiated right now but that’s what’s have been inked.

Lisa Klinger

Right. And so, we have already opened 11 this year, so we have 3 to 5 left this year. So we have a significant amount of our 2013 pipeline ready to go.

Colin Guheen - Cowen and Company

Okay. That’s the 14 number in the release is the actual number of leases that are signed but not opened?

Lisa Klinger

Well, those are leased stores. And then you also see the two below which are ground leases and owned properties.

Colin Guheen - Cowen and Company

Okay. I see what you are seeing. Great. That’s all for me. Thanks again, great quarter.

Lisa Klinger

Thank you.

Craig Carlock

Okay. Thank you all for listening and participating today. We look forward to speaking with you again on November 28th when we will talk about our third quarter. Have a good day.

Operator

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. Have a wonderful day.

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