Sprouts Farmers Markets (SFM) Q1 2018 Results - Earnings Call Transcript

|
About: Sprouts Farmers Market (SFM)
by: SA Transcripts

Sprouts Farmers Markets, Inc. (NASDAQ:SFM) Q1 2018 Earnings Call May 3, 2018 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

Kelly Ann Bania - BMO Capital Markets (United States)

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Mark Carden - UBS Securities LLC

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Karen Short - Barclays Capital, Inc.

Benjamin Bienvenu - Stephens, Inc.

Renato Basanta - Susquehanna Financial Group LLLP

John Heinbockel - Guggenheim Securities LLC

Chuck Grom - Gordon Haskett Research Advisors

Scott A. Mushkin - Wolfe Research LLC

Edward J. Kelly - Wells Fargo Securities LLC

Judah C. Frommer - Credit Suisse Securities (NYSE:USA) LLC

Paul Trussell - Deutsche Bank Securities, Inc.

Rupesh Parikh - Oppenheimer & Co., Inc.

Robert F. Ohmes - Bank of America Merrill Lynch

Garrett Klumpar - Citigroup Global Markets, Inc.

Operator

Good day, ladies and gentlemen, and welcome to the Sprouts Farmers Market First Quarter 2018 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, this conference call is being recorded.

I would now like to introduce your host for today's conference, Ms. Susannah Livingston. Ms. Livingston, you may begin your conference.

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 first quarter 2018 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.

The earnings release announcing our first quarter 2018 results, our 10-Q 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 2018 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 SEC filings 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 a reconciliation of our non-GAAP measures to the GAAP figures, please see the tables in our earnings release.

With that, 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. Sprouts' fundamentals continue to show strength as demonstrated by our first quarter results and good progress on our strategic initiatives.

For the first quarter, sales increased by 14%; new store productivity was in the low-80s, above our historical average; and we grew EBITDA by 12%, all resulting in solid cash flow generation.

Despite tightness in produce supply and slight deflation, we achieved EPS of $0.50, which beat our internal expectations for the quarter, driven by higher gross margin and labor productivity improvements.

For the first quarter, sales rose to $1.3 billion with strong performance in new stores, a comp of 2.7%, and continued positive traffic. Our private label initiative optimizing our promotions with BI tools and products that are more relevant to our customers are driving comps and adding to the full shopping experience that our customers embrace at Sprouts.

Comps were impacted by a slight deflationary environment, calendar shift from the New Year's holiday, and tightness in key produce categories early in the quarter, which limited our ability to promote during the quarter. Despite the CPI reporting inflation for the quarter, we experienced slight deflation due to the mix of our basket.

The overall promotional environment remains competitive, and we continue to maintain our pricing strategies across all departments and geographies and our Healthy Living promise to our customers.

Shifting to new store growth. In the first quarter, we opened 9 new stores, including our first new store in Maryland, which brings our presence to 16 states coast-to-coast. Our pipeline remains strong with 47 approved sites and 40 signed leases for the coming years. We look forward to opening our first store in the State of South Carolina next month, as well as the opening of our 300 store.

Our recent vintages continue to open very strong both in new and existing markets, and our new store productivity continues to run above our historical averages. This is a direct result of our brand strength that continues to resonate across the country, driven by improved execution of store openings in new markets, as well as improvements over the last two years in our site selection process.

Now, let me provide a brief update on our 2018 strategic priorities. This is a dynamic time for the grocery industry and while we continue to remain nimble and adapt to the changing environment, our focus remains on our strategic priorities, including authentic and unique healthy product offerings, improving customer experience in and out of store, investing in our team members' developments and investments in technology to drive efficiency and lower our cost structure.

First, on the product innovation front, our private label continues to drive success in many of our categories with comps continuing to exceed the company average. An increased number of private label baskets, as well as more private label items in these baskets, has propelled our penetration to more than 12%, 100 basis points improvement over the same period last year. Our private label focus remains on better-for-you ingredients, on trend and unique products, taste and value.

We are already on our way to launching more than 200 new items this year. We also continue to innovate in deli, meat and seafood. We are evolving as a destination for ready-to-eat, ready-to-heat, and ready-to-cook items, which are resonating well with our customers. We continue to introduce new products, thoughtful and simple, to meet today's customers' preferences. Our focus remains on making the shopping experience in deli and meat and seafood areas exciting and easy for our customers.

Second, we continue to enhance our capabilities to connect with and engage customers across all touch points. In February, we launched our new Sprouts.com website and mobile app. In-store, our team members are passionate about inspiring, educating and empowering every customer to eat healthier and live a better life. And we wanted to bring these experiences to our customers on our digital platform.

Our new Sprouts.com and mobile app allows our customers to explore staple, trending, and unique products and add them to their shopping list, deliver valuable savings through mobile coupons, new continuity offers and geo-targeted weekly circulars to ensure we deliver value for our guest every time they shop. We look forward to building additional personalized features that are meaningful to our customers and empowering them on their health journey.

On the home delivery front, we began our Instacart same-day delivery home delivery partnership at the beginning of the year. The Sprouts brand and the service is resonating extremely well with our customers, and we continue to see week-over-week growth in the business.

With great customer response and strong execution, we are continuing to expand to all of our major markets and now in the early efforts of increasing awareness and marketing.

As of May 1, we also discontinued our Amazon Prime Now home delivery partnership out of our existing 15 stores. The transition will impact comps for the next several quarters, but we remain very confident about growing our home delivery business as it brings a unique health and value proposition to our customers.

Third, we are continuing to focus on our team member development, which is allowing us to provide great service in-store and build our bench for future growth.

As we mentioned on our last call, the Tax Cuts and Jobs Act was a catalyst which allowed us to invest an additional $10 million, or $0.06, in our team members in 2018. These strategic investments focus on wages, health benefits and training. We have seen for the past two years that our thoughtful approach to team member investments have resulted in improved customer satisfaction scores, better operations, including in-stock position and significant improvement in team member retention. We look forward to the incremental investments further strengthening our team, our brand and our culture.

Lastly, we're investing in systems to support our growth and gain operating efficiencies. We have begun implementation of our fresh item management technology to reduce operating complexity, drive better in-stock position, reduce shrink and integrate our production needs with our labor management system.

We began testing this software in one department with early success and are currently expanding work into other departments. We remain on track with the rollout to the other departments. And as the year progresses, we expect to gain efficiencies beginning in 2019.

Before I close, I'm proud to speak about one of the sustainability successes we achieved in the first quarter. More than 80 Sprouts stores received the Grocery Stewardship Certification, which recognizes our commitment to operational practices, to reduce our stores' environmental impact and save resources. It measures cost savings through operational sustainability efforts, revenue generating sustainability opportunities, and employee engagement strategies, as well as metrics on waste, water, energy and other conservation initiatives. We continue to move forward towards our Zero Waste goal by 2020.

In summary, our strategic initiatives are progressing very well and will further strengthen our business model, and our results today provide evidence that we have a strengthening business model, which continues to deliver double-digit sales and earnings per share growth, further supporting our confidence in delivering long-term success.

With that, let me turn the call over to Brad to cover our financial results and 2018 guidance.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Thank you, Amin. I'll begin by discussing some of the business drivers for the first quarter and then review our guidance for 2018. For the first quarter, sales were $1.3 billion, up 14% over the prior year, driven by strong new store productivity in the low-80s and comp sales growth of 2.7%. As Amin stated, private label, promo optimization and product innovation continue to drive comps.

Contrary to our original expectations, we experienced slight deflation, which negatively impacted our first quarter comps. In addition, the shift in the New Year's holiday impacted Q1 comps by approximately 25 basis points. And as Amin mentioned, we experienced a tight produce supply early in the quarter. Despite these challenges, we delivered strong earnings growth, mainly driven by an improvement in merchandise margin, solid new store and labor productivity, helping to partially offset our strategic investments.

For the first quarter, gross profit increased by 15% to $387 million, and our gross margin rate increased approximately 25 basis points to 30.1%, compared to the same period last year. The majority of this leverage was due to improved merch margins. While our ability to promote produce was limited and negatively impacted our comps for the quarter, it did result in a favorable gross margin mix.

Direct store expense increased 15% to $263 million, an increase of 10 basis points, to 20.4% of sales, compared to the same period last year. This deleverage is primarily driven by the holiday shift, holiday pay related to the calendar shift in New Year's as well as increased benefit costs and depreciation. This was partially offset by our continued improvement in labor productivity and operating efficiencies in the stores.

SG&A increased 29% to $41 million for the quarter, an increase of 40 basis points to 3.2% of sales compared to the same period last year. This deleverage primarily reflects cycling lower stock-based compensation and bonus expense in the prior year and costs associated with our strategic technology investments. These investments pertain to the fresh item management system and cost associated with the improved website and mobile app that we released in the first quarter, which will enable future operational savings and sales growth.

EBITDA for the first quarter increased 12% to $107 million, a decrease of 10 basis points to 8.3% of sales when compared to the same period last year. The decrease in margin was mainly driven by the holiday shift, increased operating cost from the timing of our strategic initiatives, partially offset by improved gross margins.

Net income for the first quarter was $67 million and diluted earnings per share was $0.50, an increase of $0.17 or 52% over the same period last year.

The exercise of expiring pre-IPO options reduced our effective tax rate in the first quarter of both 2018 and 2017, resulting in a benefit to earnings per share of $0.08 and $0.03, respectively. The improvement in reported earnings per share is primarily due to higher sales and margins, a lower effective tax rate, and fewer shares outstanding due to our share repurchase program.

Shifting to the balance sheet and liquidity. As reported in the first quarter, we amended and restated our credit agreement. Our total commitments increased to $700 million from $450 million, and we extended the maturity through March 2023. This expanded facility provides us with greater financial flexibility to execute on our capital allocation strategy.

We continue to utilize our solid operating cash flows, $104 million in the first quarter, to support our unit growth and sales initiatives. We invested $38 million in capital expenditures, net of landlord reimbursement, primarily for new stores.

During the first quarter, we repurchased 3.3 million shares for $83 million. We ended the quarter with $21 million in cash and cash equivalents, $368 million borrowed on our $700 million revolving credit facility, $394 million available under our current share repurchase authorizations and 1.4 times net debt to EBITDA.

Now, let me turn to 2018 guidance. Due to lower inflation than originally anticipated and the transition of our home delivery model, we are lowering our comp and sales guidance for the year. We are maintaining all other guidance, including EPS, based on solid first quarter earnings performance.

Net sales is expected to be between 10.5% and 11.5%, and we expect full-year comp sales growth to be in the range of 1.5% to 2.5%.

In addition, we are maintaining our guidance for the following: Our effective tax rate will be between 19% and 20% for the full year; diluted earnings per share will be in the range of $1.22 to $1.28, resulting in EPS growth of 21% to 27% for the full year; CapEx of approximately $165 million to $170 million net of landlord reimbursement; and approximately 30 new stores for the year.

A few additional items of note on the full-year 2018 guidance: Our original guidance contemplated an inflationary environment, and we now expect inflation to remain flat for the year. Currently in the second quarter, we continue to experience some cost deflation in certain categories.

As it relates to margins, we still expect gross margins to deleverage slightly year over year, primarily related to deleverage in occupancy. In regards to DSE, the investments in our team members from tax reform savings will account for approximately 20 basis points and commences in the second quarter.

The remaining DSE leverage is due to investments predominantly training to support our system implementations. Our team member investments from tax reform savings as well as cost associated with the training component for the new systems will step up in the second quarter of 2018, resulting in the highest amount of deleverage during this period. We still expect DSE deleverage to be between 20 and 40 basis points for the full year.

Due to the timing of our strategic investments as compared to the prior year, SG&A deleveraged more in the first quarter. We continue to expect only slight deleverage in SG&A for the full year.

Below the EBIT line, we still expect interest expense to be approximately $27 million, including interest related to financing and capital leases.

With regards to our tax rate, most of the pre-IPO options have been exercised in the first quarter of 2018. As a result, we expect our effective tax rate to be in the range of 24% to 25% for the remaining quarters.

And as for capital structure, our capital allocation priorities remain unchanged. First, unit growth; second, investments in the business; and third, returning capital to shareholders.

As for share repurchases, we expect to maintain a net debt-to-EBITDA ratio of approximately 1.3 to 1.7 times.

In conclusion, we remain confident in our business model and based on our continued strong EBITDA growth, our solid free cash flow generation and healthy new store productivity, that will continue to drive long-term shareholder value creation.

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

Question-and-Answer Session

Operator

Our first question comes from Kelly Bania of BMO Capital. Please proceed with your question.

Kelly Ann Bania - BMO Capital Markets (United States)

Hi. Good morning. Thanks for taking my question. I was wondering if you could just talk a little bit about the produce – the tightness in the produce supply. And it sounded like that maybe got better in the back half of the quarter. Just curious if you can explain how that's maybe impacting traffic and your ability to promote your key produce category.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Kelly. It's Jim. As it relates to traffic, we were positive for the quarter, but we did see some tightness in the first half of the quarter related to produce on the import side of the business. And if you look at last year, obviously we had a much better supply in the first part of the quarter on the import side.

As the quarter progressed, we saw the import improve. And as products moved up into the Northern Hemisphere into California, we saw some deflation, which negatively impacted us on the sales side. In the first half, we were negatively impacted from the ability to promote as it relates to supply.

Kelly Ann Bania - BMO Capital Markets (United States)

Got it. And can you just maybe help us understand the lower inflation outlook and just lower inflation overall? Which category is, is that really stemming from? Is that produce or is there other categories in the store? I thought maybe produce would have been inflationary for the quarter but maybe it's now deflationary. Maybe you can just help us understand that a little bit more.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, Kelly, this is Amin. I'll start and Jim can add. As Jim mentioned, we saw beginning of the quarter is relatively mute, just slight inflation on produce, but as the quarter progressed we saw quite a bit of deflation as we moved to the hemisphere. And we're continuing to see deflation today and expect it to settle down as we get into the early summer months and summer months. So most of the deflation that we're seeing is coming out of produce. There's some in meat, but it's primarily in produce.

Kelly Ann Bania - BMO Capital Markets (United States)

Okay. Thank you.

Operator

Our next question comes from Vincent Sinisi of Morgan Stanley.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Hi. Great. Good morning, guys. Thanks very much for taking the question here. Wanted to ask on the digital front. A few months in now, of course, with Instacart and you mentioned the 15 stores that had previously been with Amazon no longer, can you just maybe give a little bit of color on kind of the impact that you're expecting from that, specifically? Like, are those 15 stores already now switched over to Instacart? And maybe just any initial color that you're seeing within the data would be helpful. Thanks a lot.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, Vincent. Good question. As you know, we started our beginning of our Instacart partnership at the beginning of the year. For the quarter, there were only about 12 or 13 stores that were on Instacart and they have a very different gravity model. So what we would expect is we'll continue to ramp. And as we've seen great response and operational execution, we've ramped up the partnership fairly quickly. And as we continue to see strong operations, we'll increase now or starting to increase our marketing efforts around it. We want it to be very methodical and ensure that we had exceptional customer service before we expanded our marketing efforts.

So as we go through the year, we'll remain really confident in how the brand is responding and the week-over-week sales growth we're seeing in the business. So we were in our former relationship for about 18 months. So any time you switch over, there is always going to be timing differences to grow the business, but we're very confident that throughout this year we'll grow this business in a similar fashion if not better than what we had with our previous relationship in the markets that we operated in.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And, Vincent -

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Sorry. I was just going to say, so it will impact – specific to your question is, is it'll impact our – slight impact to our comps for the next several quarters, but we would expect it to normalize as we go towards the end of the year.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And, Vincent, the only thing I would add is we only had 16 stores for the full quarter. And what we did see in those 16 stores since we had a good line of sight on those, we saw good growth, accelerated growth throughout the quarter, so we're able to really view that and look at the back half of the year with the implied growth we've had on the stores with the longest runway, and get really comfortable with the back half of the year numbers from the home delivery front.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Okay. And if I could just slide one fast, I know you guys have said in the past that with the online orders, the majority of them were coming in from kind of beyond that 5 to 7-minute drive time. Is that still the case today?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, we're doing some insights with our new partnership. It looks like it's early days. We've been in for 12 weeks. So we're actually in the middle of understanding that. But I think the expansion of the trade area given the number of units that we have in the market still applies, and the key for us is to make sure we have enough stores to be able to service this model as Instacart has a different gravity model. So we feel pretty good that we can expand our trade areas to capture that outside of 5, 7-minute sales.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

All right. Perfect. Thanks a lot, guys. Good luck.

Operator

Thank you. Our next question comes from Mark Carden of UBS. Please proceed.

Mark Carden - UBS Securities LLC

Good morning, guys. Thanks a lot for taking the question. I wanted to dig into gross margin a little bit. What were the primary drivers in the merch margin improvement? Was it related mainly to mix, deflation, or something else? And have you found competitors to be ramping up their price investments more or less than you initially expected following tax reform? Thanks.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Thanks, Mark. It's Brad. As we pointed out, because we had some supply tightness on the produce side in the first half of the quarter, it limited our ability to promote in the produce category. And as a result, we saw a more favorable product mix, category mix within our business that drove the improvement year over year on merch margin.

From a competitive standpoint, we continue to see a competitive environment similar to the fourth quarter. You see some spikes in certain categories at certain weeks. But, overall, I would say, it's a consistently competitive environment.

Mark Carden - UBS Securities LLC

Great. Thanks. And then as a follow-up, a few quarters ago, you mentioned that you were considering adding a click-and-collect option to supplement your online offering. Is this still in the works for you guys? And if so, do you have any update on any rollouts on this test?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

We want to really get our home delivery. We think we can expand our gravity model and drive incrementality through home delivery. So we're really focused on that and make sure we get that service right, marketed right and customer experience right.

We'll certainly look at other types of tests, including click-and-collect as we sort of move forward and see how that's adding value to our customer. And so we don't have a rollout planned for click or collect (sic) [click-and-collect] (27:07) or others at this point, but we're going to look at it once we get really I would say our home delivery honed in and feel good about maximizing that potential because we actually see more incrementality from there.

We do know from research that click-and-collect for the most part creates cannibalization from in-store. And because we're a small box, we're already convenient to come in and out quickly, so that's why we've prioritized home delivery.

Mark Carden - UBS Securities LLC

Great. Thanks again.

Operator

Thank you. Our next question comes from Ken Goldman of JPMorgan. Please proceed.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Good morning. It's Tom Palmer on for Ken. I wanted to clarify what has changed in your same-store sales outlook. You issued guidance in late February. You cited New Year's eve shifts and produce availability early in the quarter. I would have thought those items were known when you issued guidance. So could maybe you just quantify how much of the reduction is related to those items versus like the Amazon and inflation ones that you mentioned as well?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, I think the items you just mentioned a minute ago were first quarter drivers. When we think about the full year, the changing guidance for the full year, it's primarily driven out of our expectation at the beginning of the year of an inflationary environment to now a more near flat environment is the primary driver, and then a secondary driver is transitioning the partnership. As you can imagine, we were in the Amazon partnership for over 18 months, and we continued to build that business over time. So as we re-ramp this new partnership, we'll have transitional impact that will last for the next several quarters and then will fall away.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Okay. Thanks. And I just wanted to quickly follow up on the pricing question from earlier. You indicated last quarter that your earnings guidance factored in the (29:13) need to make price investments to respond to the actions of others but that you did not necessarily have then current plans to cut pricing. Has there been any change in this outlook?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, it's Brad. As we set out in February and again today, our EPS guidance range for the year does contemplate should we need to make incremental price investments. We remain diligent and focused in our consistent approach to look at our competitive pricing position market by market, week by week, and we feel very good about our competitive positioning.

Thomas Hinsdale Palmer - JPMorgan Securities LLC

Okay. Thanks, guys.

Bradley Lukow - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. Our next question comes from Karen Short of Barclays. Please proceed.

Karen Short - Barclays Capital, Inc.

Hi. Thanks. Just a clarification, then another question. So I guess back to the comp guide down, I'm still a little confused, because I would have assumed in February when you gave your full-year guidance that you would have known that you would be transitioning the Amazon partnership or is that not the case?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Karen, per the contract, I won't get into the details. We considered it in our guidance, and as we look at the information we know today and how we're ramping up versus the timing of the wind down, it's causing a slightly higher impact on the transition than we would have originally expected. But I think the primary driver, Karen, really is our expectation of the inflationary environment to what Jim had alluded to earlier is the deflationary environment we're seeing in produce today we would expect that to settle down over the course of the summer.

But certainly, it's something that we don't see a flip back to an inflationary environment or a highly inflationary environment for the full year. We do expect the back half of the year to be more muted or perhaps even slightly inflationary. We'll see how the summer proceeds, but we don't see ourselves getting into the inflationary environment that we expected in February.

Karen Short - Barclays Capital, Inc.

Okay. And just to clarify, the deflation, is it cost, it's not a retail deflationary environment in produce because of competitive challenges?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Correct.

Karen Short - Barclays Capital, Inc.

Okay. And then I just want to switch gears for the, I guess, the full-year comp overall in terms of the guidance. So, I mean, I understand inflation may be less of a headwind as we get into the second, third, fourth quarter, but when I look at what your comps would need to be in specifically more the third and fourth quarter to get to the full year, you really have to look at a pretty meaningful acceleration in the two year. So I guess maybe just help me get comfortable with that a little bit. I mean, I know I can look at the three-year and it's not as tough on the three year, but it is pretty tough on the two year. So maybe just talk through that a little bit.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Sure, Karen. It's Brad. The acceleration in the two year in the back half is really related to 2016 back half where the front half of 2016 was about a 4.5% comp and it dropped to 1% in the back half. So specifically on the two-year, it's a much easier compare against 2016.

Karen Short - Barclays Capital, Inc.

Right. But I'm talking about the two year – you're saying this three year is easier. I'm talking about the two year.

Bradley Lukow - Sprouts Farmers Markets, Inc.

I'm talking the two year from 2016 to 2018.

Karen Short - Barclays Capital, Inc.

Right. Okay.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah, Karen, the only thing I would add is that we did have a small shift this year in terms of our remodels and sales initiatives, the timing. So they're more back-half loaded, so we get the tailwind from that. As we talked about, we're looking to move to a flat state, potentially slightly inflationary in the back half and then the acceleration that home delivery gives you that, that stack's filled up and that growth in a two-year stack.

Karen Short - Barclays Capital, Inc.

Got it. That's helpful. Thanks very much.

Operator

Thank you. Our next question comes from Ben Bienvenu of Stephens Incorporated. Please proceed.

Benjamin Bienvenu - Stephens, Inc.

Hi. Thanks. Good morning. Thanks for taking my questions. I just want to ask about the implied margin guidance in light of the more muted expectation for same-store sales going forward. It sounds like maybe gross margins are going to be a little bit better than you would've thought going forward versus your prior expectations. You executed nicely on direct store expenses. But at a lower sales rate, just help us understand about the inherent deleverage there and what you need to do from an execution standpoint in order to hit your maintained earnings guidance range.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, with regards to gross margin, obviously, we exceeded our expectations in the first quarter with a more favorable product mix, because of the lack of availability on produce earlier in the quarter. And our expectations for the balance of the year on gross margin are consistent with our original guidance. And our original guidance was an expectation of only slight deleverage, which is primarily driven by the occupancy deleverage for the year.

With regards to DSE, as we set out at the beginning of the year and maintain today, we're looking at 20 to 40 basis points of deleverage for the full year, and half of that is related to the team member investment from tax savings, which is about $10 million spread over Q2 to Q4. And the balance of that, much of which will be experienced in the second quarter, relates to the operating expenses associated with training specifically with regards to system implementation like fresh item management that's going to drive operational efficiencies once fully implemented in the early part of 2019.

Benjamin Bienvenu - Stephens, Inc.

Okay. Great. Thanks. And then it sounds like – I appreciate the clarification on your backdrop for deflation versus inflation and now expectations of cost deflation. Do you think with where we are in the broader grocery landscape that if we see broader-based moderating inflation or even potentially flat or deflationary environment on a broad-based basket that the instinct to get more promotional will return? Or have we learned our lesson in the most recent cycle and that's perhaps not prudent? Just your thoughts broadly on the posture in the market from a competitive standpoint.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, it's a good question. As we said, we've been seeing deflation in produce over the last couple of months. We think that's going to moderate as we – based on the crops that we see sort of into the summer. I think that this environment's a little bit different than 2016, where we had a sustained deflation for a long period of time and you had multiple retailers with negative comps and perhaps even negative traffic, driven by that sustained environment. This environment feels pretty different. So while people remain competitive, I think people – what we sense is from what we're seeing certainly is it'll be – it will remain competitive, yet a – more rational than what we saw back in 2016. And we don't see the deflationary environment sustain because it's limited to a couple of categories.

Benjamin Bienvenu - Stephens, Inc.

Okay. Thanks and best of luck.

Operator

Thank you. Our next question comes from Renato Basanta of Susquehanna. Please proceed.

Renato Basanta - Susquehanna Financial Group LLLP

All right, good morning, everyone. Thanks for taking my question. Just quickly wanted to touch on occupancy. It's a bit of a headwind this year. But how should we think about it next year and beyond, presumably more attractive real estate could be available given the retail landscape, maybe pressure on rents ease. Do you expect that to sort of turn in your favor?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, it's Brad. Part of the reason for the deleverage again this year is related to the fact that all of our new stores that we're opening are 30,000 square feet, whereas if you look at our total network of stores, the average is slightly below 28,000 square feet. And so once we get into 2019, we would expect that to be more muted. We do see pockets of the U.S. where we're opening stores where there is a tighter supply on construction, and it drives a little bit higher occupancy cost. But I think by and large, we'll see a muted impact on overall leverage, deleverage, and occupancy in 2019.

Renato Basanta - Susquehanna Financial Group LLLP

Okay. That's helpful. And then just a quick follow-up. You're obviously investing in team members, salary, training, promotions. Are there any metrics that you can maybe share with us regarding how those investments are paying off? Maybe employee turnover, service level metrics, et cetera? And then maybe just touch on how that relates to your store expansion strategy, and how those investments might be contributing to new store performance?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, no, great question. This is an area we're actually quite excited about. We continue to see improvement and execution in the stores, and from a metrics' perspective our customer service scores continue to improve. The one that amazed us as we've continued to invest in team members is our retention – even in a tight unemployment market, our retention has really taken a step change, and so we're really excited about that because as we grow, having team members with trained and experience continues to resonate.

And then our overall team member engagement score which we measure, we do an annual pretty in-depth survey, that's continuing to move up. And we just came out of a Store Manager Summit last month, and it was our third all Store Manager Summit that we've done at the company, and I've never seen sort of the engagement and motivation, and people being behind the brand and the culture and what we're doing at the company, and the difference that they're making in our customers' lives every day, and healthy food has never been higher. So we're really excited about how that then translates into better operations, consistency, especially for a growing retailer like Sprouts.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

The only thing I would add to is we're 100% staffed, and our ability now to attract new talent as we continue to enrich our pay and benefits plan as well as training is really helping us in a really tight unemployment market. So that's been a huge benefit to us.

Renato Basanta - Susquehanna Financial Group LLLP

All right, great. Thank you.

Operator

Again, ladies and gentlemen, we do remind you that in the interest of time, we do ask that you limit your questions to one. And our next question comes from John Heinbockel of Guggenheim. Please proceed.

John Heinbockel - Guggenheim Securities LLC

So, Amin, if you think about the – you guys have always had this transition right, acquire customers, trial, and then they buy more and become loyal. Where is that trajectory today if you can track it versus a year ago or two or three years? Same trajectory? Is it faster, slower? Where does that stand?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Good question, John. What's amazing is even as our new store productivity is continuing to improve, we had thought a year or two ago that perhaps with higher new store productivity our comps in the second, third, fourth year might flatten a little bit. But they haven't. They remain on the same trajectory in the second, third, fourth year and the benefit that it has to comps. So we're pretty excited about that step change in our model.

And as we continue to see the impact that private label, deli, meat, and seafood is having to our new store productivity and the fact that the overall business is resonating more and more to customers and we're doing some interesting test to merchandise better and the form and flow and function of the store. And those stores are doing extremely well.

So in our new stores, in both existing and new markets, particularly in new markets, we've seen continued step change of new store productivity. So very bullish on that front.

John Heinbockel - Guggenheim Securities LLC

Okay. Thank you.

Operator

Thank you. Our next question comes from Chuck Grom of Gordon Haskett. Please proceed.

Chuck Grom - Gordon Haskett Research Advisors

Hi. Thanks. Good morning. It sounds like about three-quarters or so of the change in the comp guide from earlier this year is from your inflation expectation with the balance, the switch away from Amazon. I guess one, is my math right? And then, two, I'm curious why the Instacart partnership would not only help offset that but why wouldn't that be a tailwind? And then, I guess, could you discuss the number of markets that you expect Instacart to be in as 2018 progresses?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, one thing is even though we were only in 17 stores and then 15 final before we transitioned, we covered most of our major markets. So in terms of the Instacart partnership, we wanted to make sure, because we were switching to a different platform. What was most important to us was getting customer experience right and operations right, and we've been very happy.

So as Jim stated that for the full quarter we only had 16 stores, but we've really meaningfully accelerated that. And as we do that throughout the year and now are starting to – just starting to increase our marketing efforts, we did not want to push marketing efforts as well as awareness with the customer hard until we were sure that our operational and customer service scores were nailed down. And we're only 14 weeks into the partnership, so we're pretty positive on that front.

I don't know if you want to add anything here, Brad.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, I think the split is roughly three quarters, one quarter.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Again, as Amin said, there's a ramp period. We certainly built the Amazon business over a two-year period, and we'll do the same and feel very comfortable that we'll do so. But when you turn off one system, you obviously have some transition headwinds, but we're feeling very confident and feel really good about the business model and how the customers are responding to it.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

And we feel good that it's not going to take us two years to build to the same level that we had the other partnership in, because of our muscle memory and how the brand is resonating with our customers looking for help and value online.

Chuck Grom - Gordon Haskett Research Advisors

And just to follow up on that, do you think your guidance is somewhat conservative in that effect that you're not baking in much of a lift? But in theory, if it does take off, there could be some upside?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, because it's early, you always don't want to be overly bullish on it. So I think as our awareness and marketing campaigns take off, if we were seeing increased momentum, we'll share that with you on future calls.

Chuck Grom - Gordon Haskett Research Advisors

Okay. Thanks a lot.

Operator

Thank you. Our next question comes from Scott Mushkin of Wolfe Research. Please proceed.

Scott A. Mushkin - Wolfe Research LLC

Yeah, hey, guys. Thanks for taking my questions. This is really more of a taking a step back and taking stock question. If I look at you guys, and we're in stores a lot, I'd say compared to when you went public, you're much better operators. I think the stores are really operating well. And I'd also say that one of the things that doesn't get talked about is your merchandising. And then, of course, we're in a better economy. But back then, when you talked about 4% to 6% comp, half through traffic, half through inflation, but also kind of the new store maturation.

And, I guess, what I'm sitting back and trying to understand given that I think you're actually a much better company today than you were back then is what's changed. Why is comp so low? And the retail price is not just about the cost of the good. It's also about what's going on with your labor cost, what's going on with the shipping costs, what's going on with delivery. And so usually that retail price in an economy like this would be growing. And if your cost of goods were falling, you could actually see a nice widening out of your margin and your comps should stay real strong. So I'm just trying to get my arms around it. I know it's a long question, but maybe you can comment on it.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, Scott. No. That's a great question. And if you really step back and we've done this analysis, I think the two biggest drivers are one is inflation/deflation. And if you recall, when we first went public and then back into 2014, 2015, we were running 3-plus inflation. And so when you go from 3-plus inflation to deflation, that's a pretty big swing. So I think that's one of the biggest deltas.

I think the second part around the business is our East Coast business continues to accelerate and we're seeing good. All of our new vintages are continuing to see acceleration in the business. And in our more mature markets, it's really the tailwinds of some of the initiatives that were driving some of the early success.

While we still continue to have initiatives like private label, meat and seafood and deli, those tailwinds are just different today than they would have been when we were just coming up with some big initiatives in the overall environment, so. And then, as you know, competition and margins obviously weigh in. So we've always – even today we think of this as in a flat inflation/deflation environment, a 2.5, 3 comp business. And if you're in a deflationary environment, then you're going to come off of that. So it's the biggest punch line here is inflation/deflation.

Scott A. Mushkin - Wolfe Research LLC

Perfect. Thanks. Appreciate the answer.

Operator

Thank you. Our next question comes from Edward Kelly of Wells Fargo. Please proceed.

Edward J. Kelly - Wells Fargo Securities LLC

Yeah. Hi, guys. Good morning. Thanks for taking my question. I just wanted to ask a question on produce. What I'm hoping you can help us understand is the optimal environment from a produce standpoint for you. You talked about earlier in the quarter tightness of supply that obviously hinders you to some extent from driving traffic. Supply has gotten better, but now we have deflation in the category associated with that and that's not good either. So I'm just trying to understand what you would see as the most optimal environment there.

And then just kind of a follow-up to Scott's question is, how are you now thinking about growth of the business over time? You did slow or pull back on growth to some extent, but you seem to be having a lot of success on the East Coast. Just wondering how we should be thinking about unit growth going forward.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, I think I'll start and then let Jim add and I'll do it in reverse order so Jim can add to the inflation/deflation.

As far as growth concern, what we've seen is when we went to about a 30-store growth and a more balanced growth in existing markets and new markets, we're really seeing really great, one, ability to pick better sites and be more selective frankly and walking away from sites when the economics are not strong. Second is our training in our new store and our operations are starting off much stronger in the new markets. As well as we feel like we're starting to hit near that tipping point where our brand is leading us now being in 16 states and 18, 19 states by the end of the year.

We're starting to tip a point where more and more people already know Sprouts when we go into a new market because they've been into a Sprouts somewhere else during their travels. And that's resonating also as we're going to new markets. So I think that's helping our new store productivity. So all of those pieces we feel really good about. But we've learned that having that 30 stores seems to be very manageable and very strong on operations, so we like that place.

In terms of inflation/deflation, I'll start and then let Jim jump in. Optimal what's for us is slight inflation or flat to even slight deflation. What tends to happen from time to time is, particularly in winter months, but it can happen at other times of the year is when you get a deep deflation on a particular item or category. That hinders us from – it just hinders sales, right, because you have a lower cost and lower retail. And when you have significant inflation on items for Sprouts, it hinders our ability to promote, because when you tend to have tightness and significant inflation, a lot of times the quality of the product is not great, and we as a company don't like promoting items even if it's peak season if the quality is not great. So meaningful inflation actually hurts us. So narrow bands are ideal for us on items and categories.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Just to follow up, I mean, 0 to 2 (51:14) would obviously be ideal, but being consistent against all major categories and key items as everybody looks at CPI, that's a mix of a baskets. We just like that level of consistency across major categories and items, which would imply obviously consistent supply and rational pricing in the competitive environment.

Edward J. Kelly - Wells Fargo Securities LLC

Thank you.

Operator

Thank you. Our next question comes from Judah Frommer of Credit Suisse. Please proceed with your question.

Judah C. Frommer - Credit Suisse Securities (USA) LLC

Hi, guys. Thanks for squeezing me in here. Just another one on the produce tightness. Sorry to beat this one to death. But if you had your druthers in the quarter, do you think you would have promoted more heavily on produce, and do you feel like maybe you lost some traffic because of that? And kind of connected to that, what did you see in other channels, conventional Walmart, Whole Foods? Did they have the same tightness? Did they promote more heavily than you were perhaps able to?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

No, as we've mentioned on the call, the only change to the promotional activity and as we reported in Q4 was in the – uptick in protein. So we didn't see others promoting. Tightness in markets make it very difficult to promote aggressively in that first six weeks. So we didn't see in our competitors. But as the market did free up and we moved into Mexico and to Southern California and supply became more abundant, we saw others jump on board and promote on the back half of the quarter.

Judah C. Frommer - Credit Suisse Securities (USA) LLC

Okay. Thank you.

Operator

Thank you. Our next question comes from Paul Trussell of Deutsche Bank. Please proceed.

Paul Trussell - Deutsche Bank Securities, Inc.

Good morning. I apologize if I missed it, but I wanted to inquire about category color. Specifically, how did produce perform in 1Q? And then curious on other areas of the store: Deli, nonperishable departments, et cetera. And also, are you able to discuss traffic and overall comp trends quarter to date?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, so as you know, we don't give department-specific comps. I think the overall theme I would say is – three things is during the first quarter because of the tightness early in the quarter, particularly because of the tightness in the supply in the produce market, it impacted our traffic somewhat as well as our ability to promote in that area, so certainly impacted comps there. We're seeing really good – second, we're seeing really good traction overall in our nonperishables department, including private label. And third, our initiatives in deli and meat and seafood continue to resonate well and are – we're excited about how that continues to evolve as we go through the year. There's some more work we're doing in those departments based on what we've learned about the consumer. So that's all – those initiatives are on positive traction. So that's how I would characterize it. The only headwind was produce, as we talked about.

Paul Trussell - Deutsche Bank Securities, Inc.

Thanks for the color. Best of luck.

Operator

Thank you. Our next question comes from Rupesh Parikh of Oppenheimer. Please proceed.

Rupesh Parikh - Oppenheimer & Co., Inc.

Good morning, and thanks for taking my question. So I had a question on Instacart versus Amazon Prime Now. So as the Amazon Prime Now clearly is free for Amazon Prime members, so I was just curious, how are you guys thinking about maybe the potential consumer resistance in paying a delivery fee under Instacart versus what you previously had with Amazon Prime Now?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, based on what we've seen early on here as the business has been building is clearly the higher it is, the more resistance you're going to get from a customer. But to date, based on the sales that we're seeing in the markets that we've launched in and have been operating in for 10, 12 weeks, without much marketing, we're pretty positive around how this sort of business builds out. And we're continuing to always test different approaches.

But I think one of the big differences is even if the customer is paying a fee, they're getting a great value with almost all of our pricing in store being the same pricing online. So I think the customer really appreciates the consistency of being able to walk in the store or online having majority of our promotions being there online. So the total value of the baskets seems to be resonating. And of course the price elasticity for the online customer is a little bit different than what you might be in the value customer coming to the store.

Rupesh Parikh - Oppenheimer & Co., Inc.

Okay. Great. Thank you.

Operator

Pardon me. Our next question comes from Robby Ohmes. Please proceed.

Robert F. Ohmes - Bank of America Merrill Lynch

Oh, hey, guys. Thanks for taking my question. Just, I know you don't like to give too much quarterly guidance, but can you just – the Street got a little high on the comp expectation for the first quarter there. It got well above your annual comp guidance. For the second quarter, can you maybe help us think about Easter shift; how much we should think about deflation pressure in 2Q? And how much Amazon – maybe just a little bit of the guidance on how we should be thinking about what we should factor into our thinking on the comp for the second quarter. Thanks.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, Robby. It's Brad. I would say what we're seeing to-date in the second quarter is continued deflation in certain categories including produce, which will weigh on comps in the second quarter. And, obviously, we just ended the APN service out of our 15 stores, so the impact of that on the business as we ramp Instacart will be more felt in the second and third quarters. And beyond that, we'll start ramping up; and as Amin pointed out, doing a lot more from a promotional and advertising and awareness perspective. So I'd say that those are the two key elements that will impact the 2Q comps.

Robert F. Ohmes - Bank of America Merrill Lynch

Be reasonable to think 2Q would be lower than 1Q?

Bradley Lukow - Sprouts Farmers Markets, Inc.

I'm not giving specific, but the fact that we have a new item in the second quarter, being the transition of APN out and Instacart ramping up, that was not existing in the first quarter, so I think that would be a fair statement.

Robert F. Ohmes - Bank of America Merrill Lynch

Great. That's really helpful. Thanks so much.

Bradley Lukow - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. Our next question comes from Alvin Concepcion of Citi. Please proceed.

Garrett Klumpar - Citigroup Global Markets, Inc.

Hi. Good morning. It's actually Garrett on for Alvin. Thanks for fitting us in. So just wanted to see how you're thinking about the balance of comp versus margin. It looks like the scale tipped towards the profitability side of the equation in 1Q, because of the tight produce issue. So is that something we should also expect in 2Q and 3Q, maybe before reversing out as the year progresses that you're still calling for kind of slight gross margin deleverage for the year?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, I think in the second quarter, we'd be more looking at roughly flat overall total gross margin rate from a year-over-year perspective.

Garrett Klumpar - Citigroup Global Markets, Inc.

Okay. And then should we expect that to reverse out in 3Q and 4Q as the comp headwind kind of mitigates a little bit?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, I don't think you're going to see very much in the way of movement, plus or minus. We still anticipate the full year to be only slightly deflationary from a total gross margin rate point of view.

Garrett Klumpar - Citigroup Global Markets, Inc.

Okay. Great. Thanks so much.

Bradley Lukow - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Thank you. I would now like to turn the conference back to Amin Maredia.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

We really appreciate everybody joining the call today, and we look forward to seeing you in person in meetings over the next couple of months. Thank you.

Operator

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