Sprouts Farmers Markets (SFM) Q4 2016 Results - Earnings Call Transcript

| About: Sprouts Farmers (SFM)
This article is now exclusive for PRO subscribers.

Sprouts Farmers Markets, Inc. (NASDAQ:SFM) Q4 2016 Earnings Call February 23, 2017 10:00 AM ET

Executives

Susannah Livingston - Sprouts Farmers Markets, Inc.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Bradley Lukow - Sprouts Farmers Markets, Inc.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Analysts

Alvin Caezar Concepcion - Citigroup Global Markets, Inc.

Shane Higgins - Deutsche Bank Securities, Inc.

Kelly Ann Bania - BMO Capital Markets (United States)

Edward J. Kelly - Credit Suisse Securities

Rupesh Parikh - Oppenheimer & Co., Inc.

Andrew R. Ruben - Morgan Stanley & Co. LLC

Kenneth B. Goldman - JPMorgan Securities LLC

Stephen Tanal - Goldman Sachs & Co.

John Heinbockel - Guggenheim Securities LLC

Karen Short - Barclays Capital, Inc.

Scott A. Mushkin - Wolfe Research LLC

Operator

Good day, ladies and gentlemen and welcome to the Sprouts Farmers Market Fourth Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder today's conference call is being recorded.

I would now like to turn the conference over to Susannah Livingston. Please go ahead

Susannah Livingston - Sprouts Farmers Markets, Inc.

Thank you and good morning, everyone. We are pleased you have taken the time to join Sprouts on our fourth quarter 2016 earnings call. Amin Maredia, Chief Executive Officer; Jim Nielsen, President and Chief Operating Officer; and Brad Lukow, Chief Financial Officer are also on the call with me today.

Sprouts' 10-K, the earnings release announcing our fourth quarter and full year 2016 results, and the webcast of this call can be accessed through the Investor Relations section of our website at sprouts.com.

During this call, management may make certain forward-looking statements including statements regarding our future performance and growth, product expansion, new store openings, and 2017 expectations and guidance. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information, please refer to the risk factors discussed in our filings with the Securities and Exchange Commission, along with the commentary on forward-looking statements at the end of our earnings release issued today.

In addition, our remarks today include references to non-GAAP measures. For reconciliation of our non-GAAP measures to the GAAP figures, please see the tables in our earnings release.

As a reminder, fiscal 2015 was a 53rd week, with the extra week falling in the fourth quarter making it a 14-week quarter and benefiting 2015 fourth quarter and full-year earnings per share by $0.02. In addition, for 2015, we have presented adjusted net income, adjusted earnings per share and adjusted EBITDA with adjusted measures stated in the reconciliation table in our earnings release.

For 2016, such adjustments would be immaterial. As such, we have presented net income, earnings per share and EBITDA without adjustments. For the fourth quarter ended January 1, 2016, diluted earnings per share was $0.12 as compared to $0.18 in the same period in 2015. For the full-year 2016, we reported diluted earnings per share of $0.83, flat to 2015 and a decrease of $0.03 compared to adjusted diluted earnings per share of $0.86 in 2015.

The payments associated with the Executive Chairman of the Board's retirement negatively impacted earnings by $0.01 per share in the fourth quarter and full-year 2016. On a comparable 13 and 52 week basis and excluding the effect of the payments associated with the Executive Chairman of the Board's retirement, diluted earnings per share would have been $0.13 and $0.84 for the fourth quarter and full-year 2016 as compared to $0.16 and $0.84 in 2015, respectively.

With that, now let me hand it over to Amin.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Thank you, Susannah. Good morning, everyone, and thanks for joining our call today. With the backdrop of a challenging deflationary environment during 2016, Sprouts continued to make significant progress in growing the brand and our business. Our team remained focused on: new store growth; product innovation; increasing customer engagement, both inside and outside the store; and continued to raise the bar on customer service.

The result of this hard work drove industry-leading results, including top line sales growth on a 52-week basis of 15% to over $4 billion, comparable same-store sale of 2.7%, new store productivity of nearly 80% and our best overall customer service scores to-date; and all of these results in a highly deflationary and competitive environment. I'm very proud of our team's accomplishments on each of these metrics, which are truly remarkable. And we look forward to continuing to build on our strategic priorities in 2017, which I will cover shortly.

Offsetting these exceptional achievements was the compression in gross margin and EBITDA margins impacted by deflation and the competitive environment. While the deflation has lasted for an extended period, I truly believe Sprouts is positioned very well when we come out of this environment.

Let me first touch on the fourth quarter. In the fourth quarter, sales rose to $986 million, up 14% compared to the prior year on a 13-week basis. Comp sales were 0.7%, driven by positive traffic of 0.4% as we cycled a tougher compare of 7.6% comp sales and traffic of 5.3% in Q4 of 2015.

This resulted in an industry-leading two-year comp of 8.3%. Despite a highly deflationary environment, we continued to experience success with one of the strongest quarters of tonnage growth during the year and continued momentum in the overall business, reinforcing the strength of our business model and the ability to maintain and grow a loyal customer base.

Though our traffic improved compared to the prior quarter, it was impacted by cannibalization from new stores opening, which remain above the higher end of our normal 125 to 150 basis points range. Our 2016 vintage had one of the highest first year average weekly sales in the history of our company, despite the deflationary backdrop and our cash-on-cash return model remains very attractive.

Comp sales during the quarter were impacted by cost and retail deflation. Cost deflation was approximately 2.5% worse than our initial expectation and mainly driven by deep deflation in produce during December. Clearly, this has been the most challenging deflationary environment we have experienced since 2009, and the longest period of sustained food deflation in decades.

The competitive promotional environment continued throughout the fourth quarter. We expect this environment to remain for the near-term until deflation subsides. During this time, we will continue to maintain our competitive position by being priced right and focused on customer initiatives to drive traffic to our stores.

In 2016, we raised the bar on what was already a very successful holiday program in years past and delivered on all counts. For Thanksgiving, healthy and better-for-you product sales were up significantly over the prior year, as customers continue to look at Sprouts as their healthy holiday destination.

Our marketing campaigns, both in-store and across all digital channels, during the holidays were exceptional and resulted in a significant sales lift and many customers trading up for their holiday meal. Having personally spent significant time in many of our markets over the holidays, I was extremely happy with the customer traffic, tonnage growth and customer complements during the Thanksgiving and Christmas weeks and see that the quality offering in our value proposition is increasingly resonating with customers for the holidays.

For full year 2016, we continued to make significant progress on our strategic initiatives in the areas of product innovation, customer experience, infrastructure investments and investments in our team members.

On the product innovation front, we expanded our natural and organic product label program to over 10% of our revenue, an important milestone towards the goal we set a few years ago. And private label sales and comps continue to outpace our company average in both sales growth and comps. We ended the year with over 2,100 private label items, which are made from strict ingredient standards with a great taste profile at great prices.

We implemented our food and deli expansions in 76 new and existing stores this year, offering the additional convenience of freshly prepared proteins, sides, salad bar, fresh juices and soup stations. We continue to enhance all Sprouts digital platforms with our robust following on multiple social channels with now more than 1.5 million unique digital subscribers.

We continue to increase our engagement with our customers via e-mail, mobile app and social media and our poised to accelerate personalization in 2017, which I will cover in a minute. Lastly, we expanded our Amazon Prime Now partnership to nine stores, providing home delivery to our customers in four markets.

On the technology front, as we continue to grow new stores, we're making significant investments to ensure we can scale effectively and keep the same level of operational and customer service execution that our customers expect and love at Sprouts. We successfully implemented both a human resource system and a labor management system for the non-production departments during the year. We also opened our new DC in Atlanta which will support ongoing growth in the southeast and enhance the freshness of produce in this region.

Lastly, our biggest and most important investment was in our nearly 25,000 team members. We made significant investments in training and training infrastructure for store team members during 2016. This investment has improved customer service in our stores is improving retention and is developing future leaders for Sprouts given our pace of new store growth.

On the new store growth front, I'm very excited to report that yesterday, I had a chance to spend time with our team and our customers at our first store in Florida. And later this quarter, we will open our first store in North Carolina increasing our reach to 15 states and expanding our presence in the southeast.

We have an experienced team in Florida that will carry the Sprouts' culture, passion for the brand, and customer service. Our pipeline remains strong with 69 approved sites and 43 signed leases for the coming years. Let me now turn to our 2017 strategic priorities and new store growth. Our 2017 priorities will continue our journey of product innovation, accelerate customer engagement across all touch points, and investments in technology for scale and efficiency.

First, we will continue to further advance the product offerings, centered on health, taste, and value to meet our customer needs. This includes growing our differentiated private label line even further which has grown revenue by greater than 25% annually over the last four years and we expect continued high growth from this ongoing initiative again in 2017.

We will continue to roll-out our enhanced deli program in more than 50 new and existing stores. The new deli program sales continue to increase each month and are providing a nice mix lift to the basket. We've recently added an experienced culinary chef to the team to help further drive innovation in this area and ensure product development is our trend and our high quality.

Additionally, our emphasis on meat and seafood team member training and full-service case enhancements, we believe will continue to drive additional traffic to the store. Lastly, on the product front, we will continue to work closely with our vendor partners as we jointly are focused on product innovation and compelling promotional opportunities.

Second, we will continue to accelerate customer engagement across all touch points to enhance the Sprouts experience and drive increased loyalty with the brand. We continue to feature meaningful content across all Sprouts channels to engage with customers outside the store. Our enhanced mobile app offers customers exclusive coupons and we continue to gain traction with our customers as we have seen meaningful growth in known customer IDs or KC IDs throughout 2016 to over 650,000 to-date.

Now that we have a meaningful number of KC IDs, we will expand our personalization capabilities across our digital platform and bring richer and more relevant content and personalized offers to our customers. We will also continue the expansion of our Amazon Prime Now partnership, which allows us to bring Sprouts products to our customers through home delivery. We remain extremely excited about this partnership and we will continue to add this service to new stores and new markets during 2017.

Third, we will continue to invest in infrastructure that will support our store growth and drive productivity improvements in our existing stores. We have several major store level technology projects underway, including a deal management and ad planning system, a labor scheduling system to include the production department into stores, and our more automated ordering and inventory management system. All of these initiatives are key for scale and increasing efficiency and will also enhance the category management process, marketing and in-store operations.

We will continue to focus on our team members, their training and strengthening their roadmap for career success so that we can scale with great leadership in our stores. On the new store front, we will open 32 new stores in 2017 and over the next several years, we plan to open approximately 30 stores per year. This pace of double-digit growth allows us to drive our strategic initiatives and deliver strong operations in our stores. On the financial front, this pace of growth will improve cannibalization, reduce pressure on operating margin and yield superior EPS results.

Before I hand it over to Brad, I want to say that I'm extremely proud of our team in the stores and the support office. As we continue to navigate this dynamic environment, our team is working closely together as one family and I'm extremely confident about our business model and long-term potential for a one simple reason. Every city and state I've traveled to, customers continued to tell me why they love Sprouts.

With that, let me turn the call over to Brad and speak about our financial results and 2017 guidance.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Thank you, Amin, and good morning, everyone. I'll begin by discussing some of the business drivers for the fourth quarter and full year, and then review our guidance for 2017. For the fourth quarter, sales were up 14% on a 13-week comparable basis with comp sales growth of 0.7%, in line with our expectations.

As Amin mentioned, cannibalization remained at elevated levels, but the new stores net of cannibalization are extremely productive and while the impact comps in the near-term, they provide very attractive financial returns.

Deflation of 2.5% in the fourth quarter reached its highest level for the year, mainly driven by deepening produce deflation during December. For the fourth quarter, gross profit increased by 4% to $278 million and our gross margin rate decreased 70 basis points to 28.2% compared to the same period in 2015.

Nearly 20 basis points of this reduction was due to cycling leverage from the 53rd week in 2015. As well recall, we began to experience higher margins in the fourth quarter of 2015 when deflation started to set in for certain categories, particularly poultry without the corresponding promotional environment.

In addition, occupancy expense deleveraged slightly due to an increase in average square footage growth in our new stores and higher rent expense. For the fourth quarter, direct store expense increased 13% to $211 million and as a percentage of sales was 21.4%.

Excluding the pre-tax loss on disposal of assets in the fourth quarter of 2015, DSE as a percentage of sales increased to 130 basis points compared to the same period last year. The increase was primarily due to deleverage of fixed expenses associated with the lower comp sales growth, higher payroll expense from planned increases in wages and training costs, and from cycling the positive impact of the 53rd week. SG&A increased 11% to $35 million for the quarter, an increase of 20 basis points to 3.6% of sales compared to the same period last year. This was primarily due to payments associated with the retirement of the Executive Chairman of the Board, as well as cycling the positive impact in 2015 from the 53rd week, partially offset by lower advertising expense.

Excluding the impact of the retirement expense and on a comparable 13-week basis, SG&A was flat as a percentage of sales compared to the prior year. EBITDA for the fourth quarter totaled $51 million. On a comparable 13-week basis, EBITDA decreased 14% when compared to adjusted EBITDA in the same period last year.

This reduction was primarily driven by lower gross profit margins and increased labor costs. Net income for the fourth quarter was $17 million, a decrease of $11 million from adjusted net income of $28 million in the same period of 2015. Diluted earnings per share was $0.12 for the quarter, a decrease of $0.06 from adjusted diluted earnings per share for the same period in 2015.

On a comparable 13-week basis and excluding the impact of the retirement of the Executive Chairman, diluted earnings per share would have been $0.13, a decrease of $0.03 from adjusted diluted earnings per share of $0.16 in the same period last year, again, on a comparable 13-week basis.

For the full year 2016, net sales grew to $4 billion, up 15% on a comparable 52-week basis. Gross profit increased 12% to $1.2 billion, resulting a gross margin rate of 29.2% or a decrease of 10 basis points from 2015. Direct store expense increased 17% to $829 million, an increase of 90 basis points to 20.5% of sales excluding adjustments in 2015.

And SG&A increased 19% to $127 million, an increase of 10 basis points to 3.1% of sales compared to 2015. EBITDA totaled $294 million, down $8 million compared to adjusted EBITDA in 2015 and flat on a comparable 52-week basis.

EBITDA margin decreased 110 basis points to 7.3% compared to 2015 on a comparable 52-week basis. Net income for the year totaled $124 million, down $10 million compared to adjusted net income last year. On a comparable 52-week basis, net income decreased 5%. Diluted earnings per share for 2016 was $0.83, down $0.03 from 2015's adjusted diluted earnings per share of $0.86 and down $0.01 from adjusted diluted earnings per share on a comparable 52-week basis in 2015.

Excluding the $0.01 effect of the payments associated with the retirement of the Executive Chairman of the Board, diluted earnings per share would have been $0.84 for 2016 flat to adjusted earnings per share in 2015 again on a comparable 52-week basis.

These results were driven by growth in top line sales and fewer shares outstanding due to our share repurchase program offset by higher payroll expense from planned increases in wage and training costs, as well as additional investments to build out infrastructure to support our growth.

Shifting to the balance sheet and liquidity. For the year, we generated $254 million of cash from operations, up 6% from last year. Through 2016, we utilized our strong operating cash flows to fund the business through unit growth, sales initiatives and infrastructure projects and invested $167 million in CapEx, net of landlord reimbursement, primarily for new stores.

In 2016, we undertook a comprehensive review of our capital structure in the context of our projected growth and strong free cash flow generation over the next three to five years. This resulted in a realignment of our capital structure through the use of a stepped up share repurchase program, which increased our leverage from 0.5 times to 1.3 times net debt to EBITDA at the end of 2016, with net debt inclusive of capital and financing lease obligations on the balance sheet.

During the year, we repurchased approximately 13.2 million shares for $294 million, representing approximately 9% of our diluted shares outstanding under our share repurchase authorizations. We ended the year with $12 million in cash and cash equivalents and $255 million borrowed on our $450 million revolving credit facility.

Looking forward, our expectation is for our net debt to EBITDA to be in the range of 1.2 to 1.5 times. We believe this range provides optimal leverage for Sprouts while maintaining a prudent level of financial flexibility. Subsequent to the end of the year and through February 10, we purchased an additional 4.1 million shares for a total investment of $80 million year-to-date, fully utilizing our $250 million share repurchase authorization. And as announced today, our board has approved a new share repurchase authorization for $250 million to be used through the end of December 2018. With our strong operating cash flows and modest debt levels, we are well positioned to self-fund our growth plan and enhance shareholder returns through our ongoing share repurchase program.

Let me now turn to 2017 guidance. Given the current deflationary environment and the expectation that it remains consistent through at least the first half of the year, we are maintaining a cautious outlook for 2017. We would expect many of our fresh categories to remain deflationary for the first half of the year until we cycle the deflationary events from 2016.

Guidance for 2017 is as follows. We expect: comp sales growth to be in the range of 0% to 1% for the year; diluted earnings per share of $0.86 to $0.90, resulting in EPS growth of 4% to 8%. This includes an estimated $0.02 benefit of the 2017 change in accounting standard related to reporting of the excess tax benefit for stock-based compensation. This accounting change will serve to lower our effective tax rate to approximately 36% for the year. We expect net sales growth of approximately 12% to 13%.

We plan to open 32 new stores and enter 2 new states, Florida and North Carolina. And CapEx will be in the range of $155 million to $165 million, net of landlord reimbursements. As we know, we are currently in an unusual operating environment. Our mid-term guidance set in late 2015 was established with the assumptions of a normalized operating environment and inflation of between 1% and 2%.

We believe that as we cycle this difficult deflationary environment, we will show improvement in our comps and earnings. As we exit this environment, we will revisit our mid-term guidance, but our expectation is a return to double-digit EPS growth.

A few additional items of note on the 2017 guidance, our tougher compares will be in the first half of the year as we cycle the higher gross margins in 2016 when deflation started to set in for many categories. We expect EPS to be slightly positive in the first half of the year, with stronger EPS growth in the back half of this year.

We anticipate that the deflationary environment will continue for at least the first half of 2017, with the expectation that we cycle through the higher points of deflation in many categories as we enter the third quarter.

As it relates to margins, we will continue to make price investments as necessary to drive traffic and to maintain our competitive position. We would expect gross margins to be lower than the prior year in the first half of 2017. For the full year, we expect gross margins to be relatively flat year-over-year.

On the direct store expense line, we expect to delever DSE as a percentage of sales for the year due to deleverage from our expected comp sales growth. As well, we expect depreciation and amortization expense to increase approximately 20%, driven by higher store unit growth in 2016, as well as higher average square footage in our new stores, now typically at 30,000 square feet.

On the SG&A line, we expect to be relatively flat to slight deleverage as a percentage of sales, mainly attributed to our expected comp sales growth. Below the EBIT line, we expect interest expense to be approximately $19 million, including interest related to financing and capital leases.

In conclusion, we remain confident in our business model and our strategic priorities to drive sustainable growth and shareholder value for the long-term.

With that, we'd like to open up the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you. And our first question comes from Alvin Concepcion of Citi. Your line is now open.

Alvin Caezar Concepcion - Citigroup Global Markets, Inc.

Thanks. I just had a quick one for you. It sounded like you expected inflation to return in the back half of the year. Did I hear that right? And what's your expectation for the full year? Thank you.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Alvin. It's Jim Nielsen. Yeah, inflation or deflation, for that matter, we anticipate it being highly inflationary in the first part of the year and dissipating on the back half. Our outlook is roughly 2% deflationary.

Alvin Caezar Concepcion - Citigroup Global Markets, Inc.

Got it. And just a quick follow-up, just about your partnership with Amazon Prime Now. Just wondering if you can provide any color on if it's driving significant incremental sales if so. Are you getting new customers this way or is it more additional basket from existing customers. And if you could, any metrics on profitability relative to your in-store business would be very helpful. Thank you.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I think it's been a great partnership and we've learned a lot in the first nine stores and we're seeing good results. We're not providing specifics on the results, but we're looking forward to expanding the partnership in both existing and new markets. And I'm actually very much looking forward to seeing how it impacts our – positively impacts our brand awareness in new markets. So we're in four existing and mature markets today, and we're going to be expanding to probably between 10 and 15 stores this year.

And I think, all I'll say is that overall we're seeing good results and it's positive to traffic and profitability at the same time, it's only nine stores. So it's not going to have a material impact on the overall financial statements today.

Operator

Thank you. And our next question comes from Shane Higgins of Deutsche Bank. Your line is now open.

Shane Higgins - Deutsche Bank Securities, Inc.

Hey. Good morning, guys. Thanks for taking the question. Yeah, just on produce deflation, obviously, it's been getting worse in the recent months. I'm just curious where did it shake out in the fourth quarter and what are you guys seeing so far, 1Q to-date and kind of what do you think has really been the key factors behind the deflation that we're seeing today.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Shane, it's Jim Nielsen. As it relates to Q4, we did see a significant acceleration and deflation on produce and it was in veg, berries, apples, tomatoes some of those categories, so some of that import stuff that we had as moved into the first quarter, some of those same categories that we continue to experience deflation, which you've probably seen in the CPI results that came out this week.

So we would anticipate on the back half of the year having a more favorable influence from inflation on the back half Q3 and Q4.

Shane Higgins - Deutsche Bank Securities, Inc.

Yeah, and just...

Amin N. Maredia - Sprouts Farmers Markets, Inc.

And the only...

Shane Higgins - Deutsche Bank Securities, Inc.

I'm sorry.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Sorry. The only thing – this is Amin. The only thing I would add is that despite the deflation our tonnage growth looks good, so we're pretty happy and excited about how we're positioned right now given the current environment.

Shane Higgins - Deutsche Bank Securities, Inc.

Do you guys know what's driving that? Is it because of growing conditions have been so favorable? Does that have anything to do with the stronger dollar?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Well, it's a combination of both, the stronger dollar growing conditions and surpluses. I think I'll look at year-over-year, berries last year were highly inflationary and supply was tight, so this year was much more favorable in Q4 and early part of Q1.

Shane Higgins - Deutsche Bank Securities, Inc.

Okay. Thanks guys. Best of luck.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Right.

Operator

Thanks. Thank you and our next question comes from Kelly Bania of BMO Capital Markets. Your line is now open.

Kelly Ann Bania - BMO Capital Markets (United States)

Hi, good morning. Thanks for taking my questions. I just wanted to ask more about the long-term outlook. I think I heard you guys say about 30 stores a year after 2017. I think we're just a little bit lower than what we had previously. Can you just maybe talk about the decision there?

And I think I heard some confidence in kind of returning back to a mid single-digit comp in a normal environment, inflationary environment. I guess can you just talk about that, how do you feel about returning to that and what do you really need to get back to that inflationary environment to achieve that or is there anything you can do to drive comps back to the desired level next year and the following year?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. Hey, Kelly. I'll split that into two. First on the growth rate is, what we've seen is that we have a lot of strategic initiatives going on and this pace of growth which will still be double-digit growth will allow us to deliver better on both our strategic initiatives and strong operations. As you know, we have a lot going on in deli, in Amazon, improving our execution in meat and seafood, more training in the stores, rolling out of new technology.

Over the next 18 months, we'll be positively impacting the stores, but nonetheless we have to have good execution of that roll-out. And so, what this does is this pace allows us to have much better consistency in staffing at our existing stores while we're rolling out all these initiatives. And what we've seen over the last year is markets where we've had less openings or lower openings, those teams are performing much better and stronger than markets which have a lot of openings and absorbing – and having to move a lot of staff.

So, and then on the financial front, couple of benefits here is that, certainly, it will improve cannibalization as we go through time in 2018, 2019, forward and it also reduces margin compression, because as you know, our model takes four to five years to mature. So it's really focused more on execution. And as Jim and I have been travelling together a lot in our stores, we felt that this was a better way to operate over the mid-term.

The only comment I would make with this set is I think it will also position us well to have stronger teams, to take advantage of other business or strategic opportunities that might come up.

Operator

Thank you.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

And I think we add a second piece to your question. Kelly, I don't know if I answered all of it, but remind the second piece I think you may have asked another question within your question.

Kelly Ann Bania - BMO Capital Markets (United States)

Yes, sorry. Just curious about the thought process around I think you've said 30 stores a year in 2017 and beyond.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, yeah. So, I think the thought process on the 30 stores was really that is allowing us to better execute in the stores on a strategic – new initiatives that we're rolling out. And the second part of your question was on comp sales, what I would say is, we're certainly doing some things to drive both comp sales and margins with our strategic initiatives.

On the margin side, we would expect generally to reinvest back in the business where it's needed. And I would tell you that from a comp perspective, if you look at our 4% to 6% model which we've always had, contemplated 1% to 2% inflation. So the way I frame or mid to long-term 4% to 6% comp is still intact from a perspective of – today, we have a 3% plus swing on inflation to deflation, and then also cannibalization and intrusion has kicked up combined by about a little over 100 basis points of which having the 30 plus store growth will positively improve on the cannibalization.

So I think in short, as we get out of this deflationary environment and move into positive inflation, we think we can still continue to deliver our historical model that we've had in the past.

Operator

Thank you and our next question comes from Edward Kelly of Credit Suisse. Your line is now open.

Edward J. Kelly - Credit Suisse Securities

Yeah, hi guys, good morning. I'd like to start maybe just by digging into the comp guidance. Can you give a little bit more color on why you guided to a comp of flat up 1% next year given that – in that range in Q4 despite a difficult comparison, deflation should ease. I mean you've been conservative in the past year and I'm just curious, are you taking a conservative tone or is there something in Q1 or is the first half that we should be thinking about, as we look at the cadence of your comps next year?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. Two points and then I'll let Brad add. Certainly, we're comping over higher compares in the first half of 2016 compared to the back half of 2016, the year we just completed. So, there are two elements to it. One is the compare then second which is probably the similar levels of delta there, which is the deflation.

We're expecting deflation to be significantly higher in the first half of the year than the back half of the year as we lap last year and also worked through the short cycle produce deflation that we've been experiencing the last couple of months.

Edward J. Kelly - Credit Suisse Securities

Just to follow-up on this then – you normally give guidance comp wise for the upcoming quarter, can you give us some expectation around what you expect for Q1. Do you think based upon all this, do you expect Q1 to be below that range of flat to up 1%?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Ed, it's Brad. We've decided going forward we're going to provide comp guidance for the entire year. I think what both Jim and Amin have indicated is that starting in late Q4, we saw a considerable step up in produce deflation which we saw also continuing into January and spiking up in January. So, for sure, deflation can swing in the produce area, fairly short-term basis. But we're looking at 0% to 1% for the whole year and that's our – we're not providing the quarterlies.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. And the only thing I would add is that, I would not affect the material deviation from that range in early part of the year, if any.

Edward J. Kelly - Credit Suisse Securities

Okay, great. That's helpful. Thank you.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. And our next question comes from Rupesh Parikh of Oppenheimer. Your line is now open.

Rupesh Parikh - Oppenheimer & Co., Inc.

Good morning and thanks for taking my question. So I want to start off with a quick housekeeping question. Does your full year EPS guidance include future share buybacks?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Rupesh, it's Brad. What we set out in our guidance was, we're going to remain in the 1.2 times to 1.5 times leverage net debt to EBITDA. That's our intent going forward, so you can do the math on that. We ended the year 2016 around 1.3 times.

Rupesh Parikh - Oppenheimer & Co., Inc.

Okay, great. And then I guess my real question, if you look at the competitive environment and promotional environment currently, has it all gotten better? And if look in your markets, are you seeing any signs of disrupts from maybe some of the weaker players?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Rupesh. This is Jim Nielsen. As it relates to competition just promotionally, let me back up a little bit. As it relates to kind of everyday pricing, it's been pretty consistent quarter-over-quarter with just a few price investments in produce and a couple of markets, but nothing significant. Promotions in Q4 continue to be aggressive on the protein and produce side and we've continued to see that into the first quarter and we anticipate that for the majority of 2017.

And then as far as what is it doing to some of the weaker players? I don't want to comment on that. I can't speculate on that.

Rupesh Parikh - Oppenheimer & Co., Inc.

Okay. Great. Thank you.

Operator

Thank you. And our next question comes from Vincent Sinisi of Morgan Stanley. Your line is now open.

Andrew R. Ruben - Morgan Stanley & Co. LLC

Hi. This is Andrew Ruben on for Vinnie. Just want to ask about 4Q itself. Your guidance had implied somewhere in the down 2% to flat range and you came in above it despite deflation seemingly worsening. So, I think we just talked about what some of the positive drivers were there? And if we can kind of expect some of those to be continuing throughout 2017?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I would say the biggest components with the holidays as we have talked about in our script are, our holiday programs with our natural and organic program, our meals, the team did a fantastic job of executing and what we're seeing is more and more, customers are filling up the entire basket for the holidays, just not single or unique items from Sprouts. So that's exciting for us and that's the program we've built over the last really three, four years.

And as always, we had a handful of learnings this year that we'll deploy next year and get even better. So those weeks are really strong this year to help offset some of the unanticipated deflation that started in December.

Jim, I don't know if you'd add anything on that...

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. The only thing I would add on top of the holidays program comment, which mind you, we were sitting on a 6.1 tonnage growth last year in Q4 and still realized real strong tonnage in the Q4 this year. So, very pleased with the plan that we have for the holidays.

But as Amin alluded to in the script, our private label continues to be a strong tailwind for us, over 11% penetration, Q4 up 130 basis points on a year-over-year basis. So, continue to be very optimistic where we're headed and more optimistic that most of that growth is coming from new baskets. So we're getting new customers who try our product. And then the deli initiatives continue to gain tailwinds. We're seeing stronger penetration in the stores that we have VSI, (43:17) which you would assume as well as a stronger comp growth. And again, that's a component of not only items in the basket, but new baskets for the deli initiative items as well. So, the sales initiatives are really providing some nice tailwinds for us.

Andrew R. Ruben - Morgan Stanley & Co. LLC

That's helpful. Thank you.

Operator

Thank you. And our next question comes from Ken Goldman of JPMorgan. Your line is now open.

Kenneth B. Goldman - JPMorgan Securities LLC

Hi. Thank you. In terms of vitamins and supplements, we've certainly seen some of your competitors continue to get more aggressive in their pricing. Has this affected your sales or pricing trends at all? And just curiously, what are you assuming for vitamin pricing in your guidance? Are you assuming any further pressure on that or sort of more of the same, as it goes?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi. This is Jim. We don't give specific department detail. But if you relate in to VSI and GNC, we do price checks. We have price rules by category and by department. So we'll continue to adhere to those and it's been successful. I will say that VMS as well as HBA have provided some nice tailwinds, not only top line but tonnage as well.

And I give the team a lot of credit here because we're on trend. We're relevant, not only item relevant, but attribute relevant. But most importantly, we continue to separate ourselves from all the other competitors in terms of our level of service and our knowledgeable servicing out there. While some people kind of are moving away from that, we continue to double-down and invest in our people and the knowledge that they provide to our customer.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

I'll just give you to what Jim said, one small anecdote. I was at our first store opening in Florida yesterday and I spoke to several customers in the VMS department, and one of them, as an example, told me, that they used to shop three, four different places to find all the items and then also try to figure out what all they need to buy, and they've truly found a one-stop shop with Sprouts. And actually that was our biggest basket that we had for the day. So I think it's both the depth and breadth of product as well as the great service from our really knowledgeable team members in that department and that have continued to give us tailwinds actually for the last five years in that department, so.

Kenneth B. Goldman - JPMorgan Securities LLC

And can I ask you a very quick follow-up? That's very helpful. I just want to make sure because there's a little bit of confusion and maybe I misheard it. Your guidance for minus 2% deflation, is that for the whole year or just for the first half?

Bradley Lukow - Sprouts Farmers Markets, Inc.

That's for the entire year.

Kenneth B. Goldman - JPMorgan Securities LLC

Great. Thank you so much.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. And our next question comes from Stephen Tanal of Goldman Sachs. Your line is now open.

Stephen Tanal - Goldman Sachs & Co.

Thanks, guys. Good morning. I wanted to ask a couple of other things, but just following up on that. I assume that that would imply that we're much tougher here in the first half. And I guess are you assuming inflation at any point this year in that kind of a guide?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

It will really be a combination of produce and where produce and bulk fit in the back half of the year will be the driver behind it. We think that some of the other categories will lap and turn positive. And so, it'll really depend on produce and bulk, how that settles in as we go into the summer and the fall. And to the extent that they're better, not – don't necessarily need to be inflationary, but just even close to flat, then I would expect that we could see inflation in the back half of the year.

Stephen Tanal - Goldman Sachs & Co.

Got it.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And the only thing that I would add is, some of the rain in Northern California may have disrupted some of the planting. So, you may see some harvest a little bit later this year. We're not sure. It's difficult to determine right now, but as things dry out, we'll see. So there is potential of a slight tailwind there, but we'll have to wait and see.

Stephen Tanal - Goldman Sachs & Co.

Got it, okay. And then just on to my actual questions, I was wondering as we think about kind of gross margin here and margin overall on the gross side, (47:25) if you could kind of tease out what occupancy did in 4Q sort of ex the extra week and/or with it. And then just secondly on the DSE deleverage, I'm wondering if clearly you have some exposure to some states that are hiking minimum wages, which probably flows through the spectrum. And I wonder if we maybe got ahead of that a little bit in 2016 or if you could comment on the year-on-year step up as a result of that would be helpful.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Sure, Stephen, it's Brad. From a gross profit perspective, we were down 70 basis points in total, but excluding the impact of the 53rd week in the prior year, we were down 50 basis points and that compares to down 60 in the third quarter. Now, of that 50 in the fourth quarter, about 20 basis points of that decline related to occupancy. So, a step up in the number of stores, the average square footage is now closer to our average prototypical store, 30,000 square feet. So, I would say the merch margin component of that was only about 30 basis points.

As it relates to DSE, again, we've seen similar performance that we've seen year-to-date, about 50 basis points of the 120 decline, after, again, the 53rd week is stripped out, is related to the wage increases that we put in place since the beginning of the year and the increased training. So that leaves about 70 basis points of year-over-year deleverage, which about 10 of that was related to the step-up in depreciation. As you know, the number of stores increased significantly from 27 to 36 from 2015 to 2016. (49:00)

We've made adjustments as we've moved throughout 2016, as we do our review market-by-market and make adjustments. Clearly, we've made investments in infrastructure and technology. As we've spoken about before, we've put in a labor scheduling system into the stores in 2016 mid-year for the non-production departments, and it's our intent to expand that to the production departments in 2018. We're starting to see some early wins on putting those systems in place. And so we fully anticipate getting some productivity improvements on an ongoing basis that will help offset wage pressures in various markets.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And, Steve, the only thing that I would add on the labor side in terms of being proactive. We're in the best state of readiness in terms of open positions and lack of open positions for that matter across the enterprise. So we're extremely pleased with the work from HR as well as the ops team. And then you couple that with the training program that we rolled out early 2016, that's certainly helped with the retention. So we're pretty optimistic about where we're headed from a labor front and where we've been – being proactive as well as, in the future, seeing more productivity.

Stephen Tanal - Goldman Sachs & Co.

Awesome. That's very helpful. Thanks, guys.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. And our next question comes from John Heinbockel of Guggenheim. Your line is now open.

John Heinbockel - Guggenheim Securities LLC

So I guess maybe for Amin and Jim. When inflation does come back, how do you think about merits the sort of dragging your feet on pass through, right, where some competitors maybe quite eager since we had a deflation – inflation in a while to push that through. Is that an opportunity to pick up share – a unique opportunity or that's not a good way to think about it?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I think it just depends on what the environment looks like when category-by-category as that inflation resumes. At times, there's a little bit of lag in passing the prices through and more so it can tend to be by market and more competitive markets, it can tend to be a little bit longer and lesser competitive markets, it can come back pretty fast.

So, on average I would say that it takes a few months that people do tend to pull up and I think when leverage starts kicking back in, everybody gets back to a less stressful and more normal environment sooner rather than later. And, as you know, when deflation persists, people just get antsy. As I've said in the past, that we tend to seek the food fights resume. And so hopefully as we see some turn, as we go through the year that will really settle everybody down.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And John, the only thing that I would add is that we do have a really good proven pricing model that we use. So, we'll continue to follow that and everything really just depends on the elasticity of the item and whether or not it's a highly promoted item, whether or not we take a position on it. So it's a little bit of wait and see, but we'll make sure that we're continuing to follow our price model which is proven to be successful for Sprouts.

John Heinbockel - Guggenheim Securities LLC

And just as a follow-up to that, given the importance of produce to you. Do you look at that as that's one that would have more sort of value to you in being one of the last to move or no?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

I think that in certain areas of a stores, we actually do weekly price sets, right. In other areas, we do monthly. So we have our pulse on the market and certain of the perishable departments really closely. And so as Jim said, we use our pricing model.

And in terms of trying to pick up tonnage, to your earlier question. You can try to do that to some degree, but at some point then you're just creating a more competitive environment overall. And over time, we found that that's disruptive for cumulative the industry. So, it just depends on market-by-market, how competitive this set looks is where it ends up at the end of the day on the ground.

John Heinbockel - Guggenheim Securities LLC

Okay. Thank you.

Operator

Thank you. And our next question comes from Karen Short of Barclays. Your line is now open.

Karen Short - Barclays Capital, Inc.

Hi. Thanks. I just want to clarify one thing, and then I have another question. But as deflation has gotten worse into first quarter, can you just comment on whether the competitive environment has deteriorated also into the first quarter or is that kind of stable from still fairly competitive in the fourth quarter but not worse?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

As I mentioned earlier as it relates to competition on the promo side, again, it's produce and meat. It's fairly in line with Q4. You can say it's slightly more promotional but that's only one or two markets. But we are experiencing a high rate of deflation on produce in the first part of the quarter, which, again, as I alluded to earlier, with the recent rains, the heavy rains in Northern California, some of that could change very quickly. So we'll wait and see.

Karen Short - Barclays Capital, Inc.

Okay. Thanks. And then I guess I just wanted to go to the slightly reduced G&A growth in outer years. I understand double-digits is important to you, but I guess looking at the environment and who knows how long it does or does not remain challenging and obviously that depends on deflation. But why wouldn't you consider maybe even reducing your unit growth further to stay high single-digits because I mean...

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah.

Karen Short - Barclays Capital, Inc.

...you're not getting the valuation credit for now and then it would even alleviate even more of the pressure on the cannibalization in the margin?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. Karen, it's a great question. It's a – really, at the end of the day, it's balanced between near-term and long-term, right. So, as I'd mentioned that it certainly in the near-term, it helps improve cannibalization, it reduced margin pressure. With that said, when we look at our ROIC model and our cash-on-cash return model, it's still superior. In fact, our cash-on-cash returns is similar or higher than it was three, four years ago.

So, what that would tell you is every unit you could open, you would and so the framework is simply around operations, great execution and consistency and making sure we're executing well. And I think what's different today from a Sprouts business model versus three, four, five years ago is, we have more initiatives that we're pushing which are somewhat resource intensive like deli, Amazon, real focus on meat and seafood. It's not simply putting items on the shelf, there are certain components to them. So I think it's a balance. And we feel that now that we have 17 regions, to be 18 soon, across the country, it's still fairly manageable when you have 17, 18 regions to grow 30, 32 stores a year. It's pretty manageable if you have good strong execution on the ground.

Karen Short - Barclays Capital, Inc.

Great. That's helpful. Thanks.

Operator

Thank you. And our next question comes from the line of Scott Mushkin of Wolfe Research. Your line is now open.

Scott A. Mushkin - Wolfe Research LLC

Hey, guys. Thanks for taking my questions. I had a clarification and then a question. So I thought I mean I heard you say that as far as the first quarter goes, it's not deviating much from the guidance for the year 0% to 1%. I'm curious because you obviously – a lot of people commented on the slow start of the year so far, just kind of in the food and home industry, plus, we have more deflations. So I was just wondering if you can clarify that and then I had a question.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, I think that as we've gotten started at the year, we've actually seen a couple of abnormal leaks kind of bump around. We had some real tough weather in some of markets in the West Coast particularly. California doesn't seem to be seeing much sun right now as we look at especially the month of January. So we've kind of moved around in the quarter certainly produce deflation has not helped the overall comp, but kind of just still strong.

Our execution is very strong and in recent weeks, it looks our execution continues to get stronger and stronger. So we feel good around where we sit, but we don't want to try to pinpoint comp within 0.5% or 1% in this deflationary – when you have deflation bumping around. So it's much more of a – when we look at the business and how do you pinpoint comps, it's as much of a trying to pin down deflation as much as it's to pin down tonnage or traffic.

So that's where really the comment comes from is that we don't sit in here today, we don't see much deviation from the range. But if we see bump around in deflation then it can sneak to the up or the down.

Scott A. Mushkin - Wolfe Research LLC

All right. Perfect. And then my question is really more on a long-term basis. The consumables industry is changing pretty rapidly at this stage. And so, I guess on the long-term basis, what makes you guys convince that produce or just the fresh categories and organics are permanently more competitive as maybe other people that didn't use to focus on these areas as much or focus there now because some of their businesses are under attack from online and other places. So I guess – there might be something here that some of the categories are permanently more competitive, and I want to get your thoughts on that and I appreciate it?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. As Jim and I both are in stores all the time, and we're both in competition many times more than we're in our own stores. But what I would say is, when you look at Sprouts, and what really resonates with the customer is the – in our minds, it's two things, is that, it's health and value certainly, but it's the convenient full shop, more and more so. In fact, two reporters yesterday in Florida pointed out to me and saying, wait, you're not a natural and organic food store, you're actually just a full shop. You happened to have pretty much all natural and organic products, but I can buy everything here.

So that's where we feel that we're really well positioned in high-quality product at value prices, and the service. Again, we say this as – we keep getting the same customer complement over and over as, I love Sprouts, and your team is so nice and helpful, right. So, at the end of the day, that's where we know we win is, in that full convenient shop with authenticity of health – natural and organic products, and just as important in service. So, Karen asked the question earlier about pace of growth. The pace of growth is a pure function of how well you're executing on the ground and we feel really good about how the execution has been. We have some opportunities certainly and this year was a big growth year because of taking extra Haggen stores and we opened 17% unit growth on top of 76 new deli initiatives on top of Amazon.

So, certainly, the teams have to really roll hard and I think as we go through time with this sold double-digit, but reasonable growth rate, I think, we're really excited about driving better execution on the team and when we share with the team that we want to moderate to low double-digits. You just saw this huge sigh of relief and excitement about being able to take on all the things that they haven't been able to take on. So, we knew that was the right thing to do.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hey, Scott, this is Jim. Hey, listen, fresh, natural, organic and value, as a platform, it's the exact place to be. We're extremely confident that we're obviously a little exposed on the fresh side where some of these highly deflationary categories have been hitting us. But if we just have the flip side of that, everybody – you're going to be asking that question.

So, we feel extremely well positioned in terms where we are on fresh and as we get better and better deli and our customers are telling that which is coming back in our customer survey data that we're growing one of the primary reasons people come to us in the deli department. But natural and organic continues to grow at 8% to 10%. So, I believe we're in the sweet spot there and tomorrow's consumers are always looking for value. So, we feel like those three pillars are definitely the bull's-eye and we'll continue to get better at each of those.

Operator

Thank you. And that concludes our question-and-answer session for today. I'd like to turn the conference back over to Amin Maredia for closing remarks.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

We would thank everybody for joining us today and I look forward to speaking to many of you on the road in the coming weeks. Thank you very much.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Have a great day, everyone.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!