Sprouts Farmers Markets (SFM) Q2 2018 Results - Earnings Call Transcript

Sprouts Farmers Markets, Inc. (NASDAQ:SFM) Q2 2018 Earnings Call August 2, 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

Karen Short - Barclays Capital, Inc.

Andrew Wolf - Loop Capital Markets LLC

Christopher Mandeville - Jefferies LLC

Kenneth B. Goldman - JPMorgan Securities LLC

Edward J. Kelly - Wells Fargo Securities LLC

Chuck Cerankosky - Northcoast Research Partners LLC

John Heinbockel - Guggenheim Securities LLC

Scott A. Mushkin - Wolfe Research LLC

Marisa Sullivan - Bank of America Merrill Lynch

Paul Trussell - Deutsche Bank Securities, Inc.

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

Erica Eiler - Oppenheimer & Co., Inc.

Benjamin Bienvenu - Stephens, Inc.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Kelly Ann Bania - BMO Capital Markets (United States)

Operator

Good day, ladies and gentlemen, and welcome to Sprouts Farmers Markets Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, there will be 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 turn the conference over to Susannah Livingston. Ma'am, you may begin.

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 second 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 second quarter 2018 results, our 10-Q, and the webcast of this call can be assessed through the Investor Relations section of our website at about.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 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. I want to start out the call today by addressing Sprouts' position in a rapidly-evolving industry. Sprouts continues to be an industry leader in innovation and health, and our value prices continue to resonate with our customers. Our new stores are performing very well, indicating the strength and differentiation of our brand when entering new communities in existing markets and new geographies across the country. Our existing business also continues to perform very well, with continued positive traffic and tonnage performance. Traffic has been consistent throughout the year and remains strong. These strengths are demonstrated in our double-digit top line and EPS growth for both the quarter and year-to-date.

Our strategic investments, which I will speak to shortly, plus our investments in technology and team members, which increased this quarter, continue to improve our overall customer experience. We expect these investments to generate operating efficiencies and savings, which will give us the flexibility to strengthen our competitive position.

Even with these increased investments, we continue to drive double-digit EPS growth. With two solid quarters behind us and a good start to the third quarter, we are confident in raising the bottom end of our EPS guidance for the year by $0.02 to a range of $1.24 to $1.28.

For the second quarter, sales rose 12% to $1.3 billion, driven by a comp of 2%, continued positive traffic and tonnage in our core business, as well as solid new store productivity. The strong new store productivity continues to be driven by product innovation, enhancements in our merchandising and new store marketing programs.

Our sales growth continues to be underpinned by positive momentum in private label and our focus on making the Market Corner Deli a destination for today's on-the-go shopper looking for convenient meal options. Overall, the promotional environment remains competitive and we continue to maintain our pricing strategies across all departments and geographies.

On the new store growth front, in the second quarter, we opened seven new stores, including our first store in South Carolina, which brings our presence to 17 states, covering many major regions coast-to-coast. And we are on track to open 30 stores this year. Our pipeline remains strong with 50 approved sites and 35 signed leases for the coming years. During this second quarter, we also passed our 300-store mark, a great achievement in our 16th year of operations.

Now, I would like to expand on our 2018 strategic priorities, focused on product innovation, customer experience, our team members and technology.

Sprouts has been a driving force for innovation in the natural and organic food segment, since its inception. We have nurtured and grown many brands that now serve as category leaders. At the same time, our sales and merchandising team is constantly researching new and trending products to meet customer preferences, whether they are national brands, private label or locally sourced. Our carefully-curated mix of products designed to appeal to customers, who may be just starting their healthy living journey, as well as those that follow a specific attribute-based diet.

Today, innovation is the driving force behind many of our initiatives, positioning us well to meet the evolving everyday customers' needs. In private label, we're proud to offer products ranging from staples like organic vegan broth to specialty items like grass-fed beef that meets strict quality standards at an exceptional value. Private label revenue is growing north of 25% and sales have reached 13% of total revenue through new product introductions and increased customer engagement and messaging. We are pleased to see acceleration in productivity of our existing private label SKUs, which is further driving private label comps.

Our Market Corner Deli initiative includes healthy ready-to-eat and ready-to-heat items that have become the cornerstone of our program. These product innovations, together with our enhancements across the department, are bolstering our sales and adding to our expansion of prepared food and meals. We continue to test product introductions and merchandising with great success as Sprouts continues to become a destination for healthy meals on-the-go.

On the convenience front, we have expanded our home delivery service through our partnership with Instacart and today we are in 190 stores with more coming on board this year, bringing this convenience to most of our major markets. We are pleased to have some of our – the best customer service scores on the Instacart platform, reflecting the freshness of our products and our strong operational execution.

Second, as we have mentioned, this Tax Cuts and Jobs Act was a catalyst to allow us to invest an additional $10 million this year in our team members. The second quarter marked the first quarter of these incremental wage and benefit investments. Our continued investments in our team members will help ensure that we provide great service in store, attract and retain great talent and develop a stronger workforce as we continue to grow across the country.

Shifting to technology, investments in technology will enable further cost efficiencies and establish a strong foundation from which Sprouts can scale and grow effectively. The implementation of fresh item management will improve our ability to have fresh products on the sales floor at all times, while reducing shrink and out of stocks. For our team members, this represents a fundamental change in daily operations and I'm happy to report that they're embracing the change with excitement.

The initial results out of the bakery department have been positive and we continue to adapt the learnings as we rollout the system across additional fresh departments. The overall project is on track to be completed by the end of the second quarter of 2019.

In summary, while the operating environment remains competitive, our unique model, which is focused on health, value, selection and service, continues to resonate with our 175 million customers, who will visit our stores in 2018. With our strategic initiatives well on track, we remain confident in our ability to deliver strong business results this year and over the long term.

Before I hand the call over to Brad, as announced earlier this morning, I'm pleased to share that we have promoted Dave McGlinchey to Chief Merchandising Officer, which will support our continued commitment to innovation and leadership in the fresh, natural and organic industry. Dave joined Sprouts in 2017 and brings more than 20 years of grocery merchandising experience and over the past year has made significant contributions to the business in developing and implementing innovative merchandising practices and new technologies, setting us up for future growth and success.

With that, let me turn it 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 second quarter and then review our guidance for 2018. For the second quarter, sales were $1.3 billion, up 12% over the prior year, driven by comp sales growth of 2%, accelerated tonnage, consistent traffic year-to-date and solid new store productivity in the low 80s.

Overall cost deflation was just over 1% for the quarter, almost entirely driven by produce and cannibalization was in the range of 125 basis points to 150 basis points. Additionally, we continue to see momentum in private label and deli, as well as strong growth in our nonperishable departments resulting in a 2% comp for the quarter. And though our investments in people and technology are higher this year, our continued efforts in improving labor productivity and controlling store expenses, coupled with a good start to the third quarter resulted in our confidence to raise the bottom end of our EPS guidance for the year.

For the second quarter, gross profit increased by 11% to $380 million and our gross margin rate decreased by 10 basis points to 28.8% compared to the same period last year. This deleverage was primarily due to slightly-lower merchandise margins in certain categories.

Direct store expense increased 16% to $273 million, an increase of approximately 70 basis points to 20.7% of sales compared to the same period last year. This deleverage was consistent with our plan and was primarily driven by investments in our team members' wages, benefits, training and also higher depreciation expense.

As a reminder, the planned $10 million incremental investment in our team members this year represents approximately one-third of our tax reform savings for 2018. These costs were partially offset by our continued improvement in labor productivity.

SG&A increased 14% to $43 million for the quarter, an increase of approximately 5 basis points to 3.3% of sales, compared to the same period last year. This deleverage is primarily due to increased advertising expenses as well as strategic technology investments.

EBITDA for the second quarter increased 2% to $89 million, a decrease of 60 basis points to 6.7% of sales when compared to the same period last year. The decrease in margin was mainly driven by increased operating costs from the timing of our planned strategic wage investments that I previously discussed.

Net income for the second quarter was $42 million and diluted earnings per share was $0.32, an increase of $0.03 or 10% over the same period last year. The improvement of reported earnings per share is primarily due to higher sales, a lower effective tax rate and fewer shares outstanding due to our share repurchase program.

Shifting to the balance sheet and liquidity, we continued to support our unit growth and strategic initiatives with solid operating cash flows of $171 million year-to-date. We've invested $92 million in capital expenditures, net of landlord reimbursement, primarily for new stores.

During the second quarter, we were opportunistic and repurchased 4.4 million shares for $95 million. We ended the quarter with $23 million in cash and cash equivalents, $458 million borrowed on our $700 million revolving credit facility, $299 million available under our current share repurchase authorizations and 1.7 times net debt to EBITDA. Return on invested capital was 15.9%, aided by a lower effective tax rate compared to 12.8% last year. Year-to-date through August 1, we have repurchased 8.3 million shares of common stock, returning $191 million of capital to shareholders.

Now, let me turn to 2018 guidance. Due to the solid earnings performance in the first half of 2018, we are raising the bottom end of our full-year EPS guidance by $0.02 to a range of $1.24 to $1.28, resulting in EPS growth of between 23% and 27% for the full year.

We are maintaining our guidance for all of the following: Net sales growth of 10.5% to 11.5%; full-year comp sales growth in the range of 1.5% to 2.5%; and our effective tax rate will be between 19% and 20% for the full year. CapEx will be approximately $165 million to $170 million, again, net of landlord reimbursement and we'll open approximately 30 new stores for the year.

A few additional items to note on the full year 2018 guidance. We expect inflation to be slightly negative for the full-year. As it relates to margins, we continue to expect gross margins to deleverage slightly year-over-year. For DSE, the planned investments in our team members from the tax reform savings started in the second quarter and will represent the highest period of DSE deleverage this year. Looking forward, we continue to expect DSE to deleverage by approximately 30 basis points for the full year. We also expect some deleverage in SG&A for the full year.

Below the EBIT line, we expect interest expense to be roughly $28 million, including interest related to financing and capital leases. With regards to our tax rate, we expect our effective tax rate to be approximately 25% for the back half of the year and that should be our long-term rate under the new tax reform structure.

As for capital structure, our capital allocation priorities remain unchanged. First, unit growth. Second, investments in the business. And, third, returning capital to shareholders.

With regards to the share buyback program, again, we were opportunistic and pulled forward some of the repurchase dollars that we had planned for later in the year. For the full year, we expect to maintain a net debt to EBITDA ratio in the range of 1.5 to 1.6 times.

In conclusion, we remain confident that the investments we are making this year in our team members and in technology will strengthen our business and those benefits coupled with our solid free-cash-flow generation and healthy new store productivity will result in long-term shareholder value creation.

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

Question-and-Answer Session

Operator

Our first question comes from Karen Short of Barclays. Your line is open.

Karen Short - Barclays Capital, Inc.

Hi. Thanks. A couple questions. So, just on deflation. Can you maybe give a little more color on what exactly the percent decline was in produce and then talk a little bit about what you're seeing into the third quarter in terms of overall deflation in produce, and I guess, in any other categories?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Karen. It's Jim. I will say that it was the primary driver behind the deflation that Brad mentioned in there. So, over the 1%, and what we're seeing – and it was really driven by year-over-year improvements of crop deals that we saw in the veg category, what you saw in the PPI index. Not much related to the tariffs. We're seeing a little bit of that impact on apples today in the cold storage environment.

Moving into the quarter, we would anticipate to be slightly deflationary in produce. We'll continue to benefit from those year-over-year improvements in yields and you'll start to see a little bit more impact on the – from the tariffs just on grapes and apples as we move into new crop.

Karen Short - Barclays Capital, Inc.

Okay. That's helpful. And then, just looking at overall gross margin guidance, I think originally, Brad, what you've said is that gross margin you would expect slight deleverage to largely be coming from occupancy, but you did in this call just talk to several or some categories saying lower merchandise margins. So, I guess, first question is which categories are you seeing lower merchandise margins and what's the cause of it? And then, maybe just explain on your guidance for the year.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Sure. We did see in a couple of categories just slightly lower merch margins. We're also seeing a tiny bit of occupancy deleverage in the second quarter. I think our comments and our view for the back half of the year are pretty consistent with what our expectations were that we talked about on our first quarter call that we're only anticipating slight deleverage in the overall gross margin rate and much of that is related to occupancy deleverage. So, from a competitive standpoint, we're seeing pretty consistent activity in the marketplace. But, obviously, week to week, month to month, you're managing your category mix, your promotional spend, et cetera. So, we're tracking to our plan.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

And Karen, the only thing I would say is as we continue to invest in technology, we're starting to see the benefit of that from a merchandising standpoint. Like in everyday pricing, we're using better elasticity metrics to enhance our current pricing program, as well as the promo optimization, which is improving our forecast driving sales. And then, really helping us better plan how we do we benefit the department as well as the four-wall basket.

Karen Short - Barclays Capital, Inc.

Great. That's really helpful. Thanks.

Operator

Thank you. Our next generation question comes from Andrew Wolf with Loop Capital Markets. Your line is open.

Andrew Wolf - Loop Capital Markets LLC

Thanks. On the inflation side, I just wanted to kind of ask a high-levels question. I mean, you guys set guidance earlier in the year for a bit of inflation. And now we're expecting deflation. That's sort of been the pattern for a while, and the natural foods industry is still growing, so you would expect to have some kind of pricing power in the industry certainly versus conventional where you can understand with lack of demand pricing power would be difficult. Do you guys have any high-level thoughts why inflation just has kind of not materialized? Or in your view is it just basically more to do with these strong produce crops or other commodity cycles?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hey, Andy. It's Jim. I mean, as you're referring to kind of the natural space in the nonperishable environment, we are seeing a little bit of inflation relative to the ELD and we're able to pass that through. So, this was primarily driven by produce and the year-over-year crop yields that we discussed and to a lesser degree meat. So, we're a fast follower in the produce side, and we've been testing some different things in order to optimize sales and gross margin. And we do believe we are the leader in the natural food space. So, as it relates to produce, again, if you look at the PPI index, you can see some of those year-over-year significant cost decreases. So, this is really all produce, and to a lesser degree meat.

Andrew Wolf - Loop Capital Markets LLC

So, I don't know if you would tell us this, but is there cost inflation on the dry grocery side of your business?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. I mean, I think I referred to this in Q1 when we were talking about freight and implications of freight, not only fuel which is up significantly, but freight costs. We're starting to see some of those, we anticipated back half of the year. We're starting to see some proposed, proposed cost increases that are coming through the channel and I would anticipate to see more of those in the back half. And early indicators are that we're able to pass those through, but we watch those closely as we pass those through and just make sure we're looking at – we're optimizing sales and movement as we pass those through.

Andrew Wolf - Loop Capital Markets LLC

And I just wanted to ask, Amin, when you were talking about the investment, technology and training investments and wages, you reference better eventual cost efficiencies and I would think labor productivity. But I think you said you're going to use these same efficiencies to maintain Sprouts' competitive positioning. Can you kind of elaborate on what that means? Sometimes, that just sort of automatically we think price investments, but obviously it could be other things.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Sure.

Andrew Wolf - Loop Capital Markets LLC

Service levels or something else.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. And that's a great question. I think just in terms of technology just to make sure we're all on the same page is the investments are really driven for the purpose in our fresh departments which we've continued to accelerate as a overall mix in our business, particularly in bakery, deli, meat and seafood. And as that continues to accelerate, we wanted to make sure we're putting out the freshest of products on the floor. We're in stock all parts of the day, particularly at peak hours, as well as we're managing and optimizing shrink, but the intent is really to drive sales and then to benefit shrink.

So, as we started bakery, as Brad and I talked about, we're seeing good adoption in the stores there and starting to see good in-stock positions and freshness in that. So that's what that exercise is really intended to do. It's not as much of a labor productivity exercise as it is a sales and a in-stock and shrink exercise.

And as we do that, we believe that it will enhance both sales as well as shrink and to the extent that it's a little early to call exact, we have some overall industry data on what this type of work can generate. But still a little early to call exactly the level of benefit we expect to have on shrink. But to the extent it does, it gives us greater flexibility to either take it to margin or position ourselves even stronger from a price position standpoint. So, I think in short, it provides more flexibility to the company over the next 12, 18 months as we move forward.

Operator

Thank you. Our next question comes from Chris Mandeville with Jefferies. Your line is open.

Christopher Mandeville - Jefferies LLC

Hey. Thanks for the question. Brad, you referenced a good start to 3Q. Can you just talk a little bit about the comp gains during Q2 and what you're seeing quarter-to-date? And then, along with that, can you just remind us of what type of impact you're seeing from those stores that have transitioned from Amazon to Instacart?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Sure. As we set out on our first quarter call, we talked about our comp sales range for the full year being 1.5% to 2.5%. And clearly that results in a fairly-meaningful increase in the two-year stack. And sitting here today, where we are in the third quarter, we're very confident with regards to the previous guidance that we put out there. So, we're absolutely in line with our internal expectations that is based on our 1.5% to 2.5% for the full year.

We're very pleased with the number of elements with the Instacart program. Obviously, we talked about during a transition period, having a slight negative impact for the full year. But from an operational standpoint and adoption from customers, we're seeing very strong adoption. We're seeing tremendous results in customer service, satisfaction scores, and so we are absolutely tracking to our expectations in plan for the Instacart. And we continue to expect and we are seeing increased weekly sales according to our plan and would expect that to continue through the balance of the year and into 2019, as we add more and more markets.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

One thing I would add on the Instacart piece is for Sprouts, it's a little bit unique in that it benefits us from a trade area expansion standpoint because the stores are placed further apart. So, we're pretty excited about continuing to take our products to more customers to eliminate that driving inconvenience to the extent that they live 10, 12, 15 minutes away from the store.

Christopher Mandeville - Jefferies LLC

Brad, just a really quick follow-up. I apologize for this, but would you go as far as to say that quarter-to-date comps are trending better than what you observed in Q2? Or has the continuation towards deflation actually maybe crimped the numbers a little bit?

Bradley Lukow - Sprouts Farmers Markets, Inc.

We're tracking very well with regards to our expectations. And, again, clearly the back half of the year has a meaningful step-up in the two-year stack and we're very comfortable sitting here today.

Christopher Mandeville - Jefferies LLC

All right. Thanks, guys.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Sure.

Operator

Thank you. Our next question comes from Ken Goldman with JPMorgan. Your line is open.

Kenneth B. Goldman - JPMorgan Securities LLC

Hi. Thank you. I jumped on a little late, so please forgive me if this was asked already. But at the start of the year, you had indicated that the EPS guidance range, I think you were really talking about the lower end, considered maybe the possibility of matching some price investments of competitors, if tax reform led to that, and so forth.

I'm guessing part of the reason you took up the lower end of the range today is that you haven't really seen that kind of incremental price investment yet. Just trying to get a sense of where you're seeing the rationality or the relative rationality in pricing today and how the competitive environment is and whether your guidance still factors really that possibility of heightened competitive levels.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I'll speak to competition and then give it to Brad from a guidance perspective. From a competitive standpoint, as Jim said, it remains competitive. We have good disciplines. And then, with technology that's really helping – starting to help us even have stronger disciplines around our framework of competition.

I think what's different this year than past years, particularly when we think back to 2016, is lot of the deflation today is driven in produce. It's one category, whereas in 2016, if you recall, you had extended period of deflation in multiple categories, which was starting to lead to negative comps for some of the conventional retailers. So, people started getting much more aggressive. So, I think, while it remains competitive, particularly on ad and promotions, the environment is different, very different today. I would phrase it at maybe – frame it as more rational than back in 2016. So that allows us to really stay with our plan and continue to execute what we're seeing as consistency and good strong results in tonnage and consistent traffic in the business.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Yeah, Ken. I would say that in the context of our full-year guidance that we issued in February, it was right on the heels of recently-announced tax reform, and so there was uncertainty around what companies would do from a reinvestment perspective, whether any of those savings would go incrementally into price versus labor cost increases. And, clearly, we saw the latter, investments in incremental labor.

And you're absolutely right, the lower end of our guidance range was wider to the downside just because of that uncertainty at the beginning of the year. Now, clearly, sitting here today through the first half of the year with EBITDA up over 7% year-over-year to-date and we're seeing a pretty stable environment, it certainly gave us the confidence to bump the bottom end by $0.02.

Kenneth B. Goldman - JPMorgan Securities LLC

Thank you very much. Can I ask a quick follow-up also? The call was cutting out a little bit earlier. You gave a deflation number for the quarter. Could you repeat that again for us?

Bradley Lukow - Sprouts Farmers Markets, Inc.

Just over 1% total company on cost deflation...

Amin N. Maredia - Sprouts Farmers Markets, Inc.

For the second quarter.

Bradley Lukow - Sprouts Farmers Markets, Inc.

...in the second quarter.

Kenneth B. Goldman - JPMorgan Securities LLC

In the second quarter.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yes. For the year, we would expect a slight deflation for the overall. Yeah.

Bradley Lukow - Sprouts Farmers Markets, Inc.

Overall. Just slight.

Kenneth B. Goldman - JPMorgan Securities LLC

Okay. Great. Thank you so much.

Bradley Lukow - Sprouts Farmers Markets, Inc.

You're welcome.

Operator

Our next question comes from Edward Kelly with Wells Fargo. Your line is open.

Edward J. Kelly - Wells Fargo Securities LLC

Hi. Good morning, guys. So, I have a question actually just sort of thinking about beyond 2018. I know, it's early to think about next year, but just looking at things sort of bigger picture, it seems like you could see quite a bit of an improvement in the (31:16) cycle, deflation, labor investments, your investment in technology. New store productivity is obviously very good. Just sort of thinking about things bigger picture here, what are the puts and takes as we think about next year? And are we on the right track in thinking about how we could see some more meaningful acceleration in performance?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I think from a broader perspective, I'll put the inflation aside. It's too early to call what we would see in 2019 at this point. But from a core business perspective, when we look at the business, you're right that the new store productivity continues to work well. And as we continue to develop our meat and seafood program and deli program, which is really starting to resonate with the customers, our sales and merchandising team has and marketing team have done a fantastic job of relooking at how we can merchandise some of those innovations even better in our stores and we're trying some new things in newer stores and we're starting to see great results from that. So, we're excited about our new store program. First.

Second, I think from a product perspective, our private label and deli is really starting to – not only the uniqueness, the trend, the quality, the attributes of the program are really starting to hit strides with the customer in a more meaningful way. I think, we alluded – we've alluded to this before, but this quarter was given us good forward look as that we're starting to see private label growth not only from unit or increased number of items, but also we're starting to see acceleration in penetration of our existing set. So, great work there.

So, I think, we've got some – from a puts-and-takes standpoint, we feel really good about continuing to be a leader in the industry and driving sales in the core departments. We'll let inflation deflation do what it's going to do and play its course. So, we're really focused on the controllables. And then, as we go down the P&L, we'll provide additional color probably on our year-end call as to what we think the benefit of the fresh item management program will be because we'll be halfway through that program and have better visibility of what we're tracking. So, it's starting to feel better and more consistent in terms of our business and the health of our business and so we're feeling positive today.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

The only thing I would add is that the tailwind you could catch and I'm really excited about one is the people that we're putting on board here in terms of our senior leadership position and we called out Dave McGlinchey today as someone who reports to me in the chief merchandising space. He's bringing on better talent. We brought in two senior leaders in operations as well that have a great pedigree. So, we're continuing to building out that kind of middle to upper management that is going to be helpful. But our intentionality around that knowledgeable service in our stores we talked about the customer service program in meat, the ongoing product training that we continue to do in the stores. In fact, next week, we're having our Sprouts Fest. We're bringing all of our department managers in both the vitamins and the grocery space and we educate them for two straight days. I think that could continue as everybody is kind of adjusting the other direction in terms of knowledgeable friendly service, that could provide strong tailwinds in 2019 as well as beyond.

Edward J. Kelly - Wells Fargo Securities LLC

Great. Thanks, guys.

Operator

Thank you. Our next question comes from Chuck Cerankosky with Northcoast Research. Your line is open.

Chuck Cerankosky - Northcoast Research Partners LLC

Good morning, everyone. Nice quarter. Could you be – give us any detail on what benefits you're seeing in store or anticipate from the increase in compensation, so lower employee turnover, more customer engagement, et cetera?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. And that's a great question. We're seeing a meaningful step change in our team member retention. And based on our team member survey, we have fairly good disciplines in understanding what our team is thinking. We're continuing to see team member engagement scores come higher and we're still attacking some areas that we can get better at. And Jim alluded to the training and really the mission and what we stand for.

So, from a people perspective, we feel very well-positioned from a pay and benefits perspective, as well as what we're starting to see we're getting close to best-in-class in the industry in terms of turnover, but we don't want to stop. We want to continue to drive that because we know that retention is sort of a key element to service.

Jim talked about spending a lot of intentionality around training. And over the last couple of years, our board and the management team have been very aggressive in investing in our team and that's on purpose to make sure that we can deliver and differentiate this Sprouts model in terms of service and we're really starting to see that both in terms of operational execution and customer service scores in the stores.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

The only thing I would add is as the brand gains strength, our ability to be fully staffed, I think, I mentioned in the last quarter, we were 100% staffed, which was the first time we've been 100% staffed in close to 52 weeks. So, I think, one, we've got a great recruiting department that we've assembled here. But beyond that, the brand is starting to resonate. The high growth, the potential for moving up through the organization and having this as a long-term profession is really helping us in that arena.

Chuck Cerankosky - Northcoast Research Partners LLC

Thank you.

Operator

Our next question comes from John Heinbockel with Guggenheim Securities. Your line is open.

John Heinbockel - Guggenheim Securities LLC

Actually, a couple of questions on private brand, maybe for Jim. When you look at your private brand penetration, new customers versus those that mature, so you think about that education process. How much higher roughly speaking is the private brand penetration with those more mature loyal customers, number one? Two, when you think about what's going to happen with space allocation in private brand. So how much greater do you think that ultimately gets? And then, the third piece as you get scale here, right, are private brand margins actually getting a lot better? Or will get a lot better over time? Or do you put that back into pricing?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

All right. So, one question, John. All right. I'll nail them all for you.

John Heinbockel - Guggenheim Securities LLC

That's it.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

So, in terms of penetration, up 160 basis points in the quarter. We should finish around over 13% for the year, and what's giving us a lot of confidence is the acceleration of existing items. Early on, we were getting a lot of tailwinds from the new item launches, but now as those kind of taper a bit, we're seeing much better acceleration of existing. I'd likened that to the quality of products, the packaging, the trust that people have in our brands. So, we're seeing 70% growth in baskets, but we're also seeing an increase in traffic. So, we're having a good adoption to those items.

So, we have mentioned it before. I really think that by 2020 we can probably get to closer to 16% to 18% penetration, which is a bit of a step change from what I talked about. And that's just based on the run rate that we have, some of the great products we have in the pipeline, and just the trends that we've seen in that space.

As it relates to space on the shelf, look, what we do is we optimize the sales per square foot, on the shelf or any area of the store and you've got to prove that out. So, it's just a simple game of math, but I wouldn't see a big step change over the next couple of years of that private label dominance. We love our vendor partners. They've done – we have a lot of great strategic partners that have helped propel us in the industry, helped us with innovation, exclusive products. So, over the next couple of years, I'd see it to be somewhat muted in terms of how that's positioned and allocated.

And as it relates to margin, as we continue to get bigger and have bigger buying power, we'd anticipate some slight relief in cost that we would be able to take here as an organization and not necessarily pass it through. We're already priced extremely well in the category not only against the CPG brands, but also against our competition.

John Heinbockel - Guggenheim Securities LLC

Okay. Thank you.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yes.

Operator

Thank you. Our next question comes from Scott Mushkin with Wolfe Research. Your line is open.

Scott A. Mushkin - Wolfe Research LLC

Hey, guys. Thanks for taking my questions. So, I wanted to talk about obviously we just went through Prime Week with Whole Foods and our data shows since Whole Foods has been acquired by Amazon, there's some pretty big reductions in fresh particularly on the produce side. Our data also shows that they're probably going to start next week at 25% discounts for Prime members on the vitamin area. So, I just wanted to get some insight on what you think this is doing maybe not directly to you but just in marketplaces like a Los Angeles or a Houston or a Denver and just get some insight on what you guys are seeing out there. Thanks.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I'll stay broad here because obviously as far as Sprouts is concerned, we don't speak to any specific competitors. But what I will say is as different competitors have deployed different strategies over the last year, call it, during that period and particularly this year speak to the first six months and into third quarter, we see our overall tonnage is accelerating, our traffic is very consistent. And when we put – when we look at core stores, which are not being cannibalized by our own new store openings, those core stores are very consistent and strong in terms of traffic and overall performance. So, a lot of that has to do with our overall business model around health, value, service and selection. So, it's not any one pillar and we remain competitive in price obviously in the marketplace. So, I think, there's probably a lot of concern around what can one or other competitor do to Sprouts. And I think, we're laser-focused on our business and to-date we feel pretty good about what we're seeing or not seeing.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

And to your comment around the industry, it's hard to comment on what it's doing to the industry because it's – I know there's lot of estimates out there in terms of what margin investments they may have made or what comps drivers may be happening, but we can only speak to what we are seeing in our business. It's hard to see. It's hard to clearly see what it may be doing to other competitors.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And, Scott, the only thing that I would add is not related to – just trying to be macro here, but just in this space coming from the natural space which requires a higher touch as you're focused on kind of that health-enthusiast-type customer. As we've done – the team here has done a fantastic job of just really enhancing the products that we carry, making sure we're trend leading, we're not trend following. We've talked about the private label and some of the other enhancements on the deli side, which is where the consumer is going tomorrow.

But when you think about price, we talked about data-driven decisions. We're making better decisions there, but we've always had a strong price advantage against those in the natural space on the produce end. So, there's a long way to go to get to our current price position as it relates to the natural specialty space.

Scott A. Mushkin - Wolfe Research LLC

All right. Guys. Thanks for your thoughts.

Operator

Thank you. Our next question comes from Robby Ohmes with Bank of America Merrill Lynch. Your line is open.

Marisa Sullivan - Bank of America Merrill Lynch

Hi, it's Marisa Sullivan on for Robby Ohmes. I just want to circle back to the Instacart discussion earlier and see if you can quantify the Instacart transition impacts in Q2 and then just when will the transition turn from a headwind into a tailwind? And then what does it look like in the back half of the year? Thanks.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. So as we pointed out on our previous call and again today, we do have a bit of a hit on the transition period, which commenced in the second quarter in terms of what we're seeing now in performance and the growth in the number of stores that we're offering the service in and the adoption by customers, I think that becomes – there's no more headwind once we get into the fourth quarter is what our line of sight is. And that's consistent with our expectations and our plans that we talked about last quarter.

Marisa Sullivan - Bank of America Merrill Lynch

Got it. Do you expect it to become a tailwind in the fourth quarter?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. We certainly based on the path that we're seeing is we would expect it to sort of transition in that period and then going into next year, we will see continued acceleration as a positive.

Marisa Sullivan - Bank of America Merrill Lynch

Got it. If I can just follow-up really quickly, you talked about advertising expenses being an incremental spend. Can you just give us some more detail on what you guys are doing differently in this space that's driving the incremental cost?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. I think, the primary driver is we're being more intentional in our new markets in terms of both marketing grassroots, being in the market well ahead of the store openings. And we learned that in one of our major markets that we entered last year, where it worked extremely well, so that's become part of our core plan as we entered the Mid-Atlantic this year and parts of the Carolinas. We want to ensure that our brand awareness is strong leading into the first store openings.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

And I would only add as you look long term, Marisa, the cost of paper and distribution of paper, when we talk about freight, and all those things are obviously headwinds currently. But as you look forward and you look at the digital space and what we're able to do today would not only prompt to sales that we can do, we can do them from an advertising perspective very cost effectively. So, as you look out, there should be good benefits to the P&L as it relates to advertising out it 2020 and beyond.

Marisa Sullivan - Bank of America Merrill Lynch

Got it. Thank you.

Operator

Thank you. Our next question comes from Paul Trussell with Deutsche Bank. Your line is open.

Paul Trussell - Deutsche Bank Securities, Inc.

Good morning. On the store footprint, you obviously have the Georgia DC helping you build out on the east coast. If you can just talk about the Mid-Atlantic regional performance that you saw (46:41) for additional units, up and down the (46:44). And then, also I apologize if I missed it, but wanted to ask about product category performance in 2Q. How was the fresh business in other areas of the store?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. I'll go in the sequence you ask. Mid-Atlantic, we just opened our second store. We're pretty excited about the region in terms of what we see in terms of competition and how we can be positioned and bring value to the customer in that region. So, the first two stores are performing very well, so a good start there. And, again, the last question, we spend a lot of time in grassroots and getting to the market early to drive brand awareness there also. To your second question around – can you repeat your second question?

Paul Trussell - Deutsche Bank Securities, Inc.

Sure. Just about product mix performance.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Oh, yeah. I think, product mix performance is, as we said in the remarks, opening remarks, is nonperishables is performing very well. On the perishable side, we're seeing very good momentum in our food area, the deli area. We're also continuing to see good performance in meat and seafood. But overall stepping back, the tonnage of the store is very healthy and we're really pleased with where the tonnage continues to move.

Paul Trussell - Deutsche Bank Securities, Inc.

Thank you.

Operator

Thank you. Our next question comes from Judah Frommer with Credit Suisse. Your line is open.

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

Hi, guys. Thanks for taking my question. Maybe first just another one on the competitive environment. If we try to look out past deflation in produce, it still seems like fresh and produce specifically are a battleground area in the industry. So, what are you seeing competitively kind of in fresh versus the rest of the store? Maybe even if you could parse out deflation and then just a quick follow-up on Instacart. Are customers coming to you through Instacart or through Sprouts, and are you getting customer data there?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. So, we'll do it reverse order. I'll answer Instacart. So, Instacart, we're doing through both Instacart.com and our private label. The benefit there is there are many customers who have the $149 membership, and they use multiple retailers, so many of the customers use Instacart.com, but we also have a good mix of white label customers coming through our sites, and we're working on some enhancements there, which we're excited about.

And in terms of data, anything that's coming through white label, we have access to that data, and anything that's going through Instacart.com, as long as that customer has provided a affirmation to provide the data, then we also see that data there. So, we're starting to be able to see some interesting things around customer data and where we can go in the future with that.

Jim, I'll let Jim cover the other question.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah, as it relates to the fresh side of the business and this is general competitive activity, consistent with prior quarters in terms of what we're seeing in promotional spend, in everyday price there has not been a step change. And there's just a handful of retailers that are making those investments across the country on an everyday price perspective. But no material change in that. But extremely pleased.

As we continue to look at how do we continue to create even more points of difference in produce, in our assortment, as we look at our value add and organics, the specialty items and that experience we have in store in terms of that engagement and messaging around different products and – different products and messaging about our growers is something that we're very focused on. But no real step change on the competitive front.

And then as it relates to meat and seafood, you know, look we sell a different grade of meat, it's natural meat. We've done a better job of communicating to customer not only from the marketing vehicles we have print and digital, but the customer service plan that we put together where we have deeper educated a service person in the store that's specifically identified to help the customer kind of navigate through those and tell them about the points of difference in the attributes.

And even lead them into some of the new products we have, the ready-to-cook stuff where we have one-pan meals and a great marinated cryolock (51:13) program. It's just helping to accelerate those launches. So overall, feel very comfortable in the space and don't see any step changes in terms of prior quarter of everyday pricing or promotional activity in both of those arenas.

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

Great. Thank you.

Operator

Thank you. Our next question comes from Rupesh Parikh with Oppenheimer. Your line is open.

Erica Eiler - Oppenheimer & Co., Inc.

Good morning. This is actually Erica Eiler on for Rupesh. Thanks for taking our question. So, you mentioned before that you're seeing a little bit of an impact from tariffs on apples and cold storage. I was just curious how you're thinking about the potential impact of tariffs on the business with regards to food deflation.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. Look, it's – I hate to say too much because again I'm making assumptions and we're projecting, so cold storage apples as you transition, you want a clean crop going into that storage, so not only the category itself had headwinds, so inherently you have a little bit heavier supply. So, you've got the apples in really back half, materially you've got grapes that could have some potential negative impact, but you can put those into cold storage through October, November. So, we'll see. Right now, it's not super deflationary in terms of grapes. So, we'll continue to watch.

In the nut side as that tree crop continues – gets harvested this year, it's a big exported category. I would anticipate that a lot of the growers will try and move that at not excessive cost discounts, but the longer this potentially goes in the back half of next year as you get backed up a little bit in the cold storage, you could see a little bit pressure on the cost side. But that said, the data, insights that we have and everything that we're doing today, some of these things can better be accretive to gross margin or create a good promotional opportunity for us to drive in foot step. So, there are puts and takes on both ends, but it's really too early to tell of the overall implication. It will be really more of a 2019.

Erica Eiler - Oppenheimer & Co., Inc.

Okay. Great. Thanks for the thoughts.

Operator

Thank you. Our next question comes from Ben Bienvenu with Stephens, Inc. Your line is open.

Benjamin Bienvenu - Stephens, Inc.

Hi. Thanks. Good morning. You highlighted the continued success of deli, I'm curious to hear a little bit more around where in the day you're seeing the lion's share of the success. And then, as you look at the opportunity within private – within the deli offering both across the daypart and then across the total store penetration how the continued success of the program has made you think about the long-term opportunity.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah. Where we're really invested our time and effort has been around we had some good ready-to-eat programs. We have added some things there, where if you walk our store today compared to two years ago, it's really the ready-to-eat and the fresh products that people are taking home. So, we're seeing good traffic in the 5 o'clock or the evening shop and then also on the weekends where people are adding items to the basket for multiple days for the weekdays so for the next two, three days.

So, we're continuing to see that home program develop nicely and besides health one of the things that we're pretty excited about is some of our recent launches. We hired a new head chef last year, and the taste profile of our products has meaningfully step changed, and our customers are starting to notice it. And so that's really providing a lot of good tailwinds in that program. The deli case and then to go home quick heat for the same day or next day.

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

The only thing I would add on the deli side is we're seeing great – I think, we talked about the quantitative, but as you look at the qualitative on our ForeSee scores and Customer Service scores for those stores that have these components, which are 150 – about 50% of our stores, we think we can get to about 70% over the next three years as the stores have these elements. We're seeing the customers respond with more customers are making deli and Sprouts their primary shop. So, as we baseline that against the other stores that don't have the elements we're seeing a nice uptick from our consumers. So, nice gravity there as well.

Operator

Thank you. Our next question comes from Vincent Sinisi with Morgan Stanley. Your line is open.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Terrific. Good morning, guys. Thanks for taking my question. Just wanted to go back to produce deflation for a second. Obviously, the results were in line with expectations this quarter which is great. But just maybe kind of more holistically, how would you compare where you're sourcing from, your supplier relationships now versus the last time we kind of saw certainly heavier than what we're seeing as of today deflation in produce kind of – I know, folks of course still remember that. So, seems like you're certainly dealing with it well so far, but maybe just if anything further changes as we get into the back half from a cost or a promotion standpoint, how would you compare your supplier relationships now versus the past?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Yeah. I'm only going to step back as an organization, what we want for our customers is the highest level of quality delivered to our customers and product that you can eat today and you can eat two or three days from now. So, we're just trying to get closer to the source. So, a long time ago we went more direct with our growers. Not only we could focus on the quality, the quality of product, some of the potential new innovations they may have, the insights that they have. And that's really served us well in terms of what our customers are saying about us on our minimal complaints in terms of quality.

And look it's a marketplace, right, so prices are going to change, and couldn't tell you that it's going to be materially different with those. It's really around a focus of innovation, breadth of assortment, consistency of supply, and quality of products and well positioning us for innovation. I think everybody is in that same boat in terms of what is overall cost, unless you want to buy products that's ten days old from a broker that is not a long-term good strategic decision for any high growth business.

Vincent J. Sinisi - Morgan Stanley & Co. LLC

Okay, That's fair, Jim. Thank you. And then, maybe just a fast follow-up. Just on Instacart, still obviously early days but in about 190 stores I think you said today. How much advertising are you guys doing around that? Is that part of some of the increase in advertising, or is it more you're kind of letting folks discover whether it's through Instacart or in store? That would be great.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Good question. As we had spoken about previously, early on we wanted to make sure that our execution was solid and the customer service scores were solid because we do think that once a customer attaches, they can attach for the long-term. So, we started the – not only the launch slower initially in the first quarter, but as we accelerated the launch we've continued to monitor closely our execution. And that execution is topnotch I would say today as well as the customer response is accelerating. We're now starting to – we have been for the last month or so integrating our home delivery messaging as well as driving awareness across most of our marketing channels including in-store and digital. So, we're just starting to accelerate that and feel good about taking that direction and we'll continue to come up with innovative ideas ourselves, as well as with Instacart to drive greater awareness and grow this business.

Operator

Thank you. Our next question comes from Kelly Bania with BMO Capital. Your line is open.

Kelly Ann Bania - BMO Capital Markets (United States)

Hi. Good morning. Thanks for fitting me in. Just wanted to ask about freight. It seems as though the challenges in freight market are still out there and you guys have been pretty so far immune to that. But just curious if you're seeing any challenges with fill rates or on-time deliveries and – or you are just working through that or are you seeing that at all?

James Leroy Nielsen - Sprouts Farmers Markets, Inc.

Hi, Kelly. It's Jim. As it relates to just fill rates and on-time deliveries, no negative impact on that arena. Where you would see the impact – I'm not suggesting that we do – is if you're not well planned and well-focused, if you have to play the spot market in freight, you could experience, obviously, not only higher cost, but fill rate challenges. But to-date we are not seeing any fill rate opportunities not only from our third-party distribution, but as well as our own. And again, I'd likened that to better people here in the building making better decisions and now having access to better data that is helping us better forecast what the needs are for the business.

Kelly Ann Bania - BMO Capital Markets (United States)

Okay. Great. And then, just maybe another one on Instacart. As you think longer term over the next several years, is that enough for Sprouts in terms of delivery of groceries? I know you talked about maybe considering a click and collect option, but with others maybe investing in their own proprietary delivery or other technology solutions, just curious if you're still considering anything else or is the focus really going to be on Instacart?

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Yeah, I think that we're continuing to look at – we're developing some enhancements and deeper enhancements on Sprouts.com and on our channel because we think it's important for us to fully integrate the shopping experience on our website, so whether a customer is looking at content and wants to push that into the cart and wants to either pick it up at the store or do home delivery, we want to ensure that that full custom experience is on the Sprouts app. So, we've got a good roadmap of making enhancements there. So, I think that's the first element.

Once you go from there, then it's a matter of saying do you want to build your own delivery capability or not, and of course things can continue to evolve, but we think that Instacart has a good platform where they're able to leverage and be really close to the customer from many retailers, and has – it's a more efficient network certainly today than Sprouts could execute on its own. But over time, I think as technologies come in and as – whether it's driverless technologies, voice technologies, and other technologies, as that evolves, we'll certainly look at all options and make sure that Sprouts as a company can avail the lowest cost structure to fulfill what our customer wants ultimately, which is groceries at their doorstep.

Kelly Ann Bania - BMO Capital Markets (United States)

Thanks.

Operator

Thank you. This concludes the question-and-answer session. I'd like to turn the call back over to Amin Maredia for closing remarks.

Amin N. Maredia - Sprouts Farmers Markets, Inc.

Thank you very much. Thanks for the questions and the engagement and we look forward to speaking with many of you. And I think we needed time, weren't able to get to two or three analysts, but we'll make sure we reach out to you shortly here right after the call. Thank you very much.

Operator

Ladies and gentlemen, this concludes today's conference. Thanks for your participation and have a wonderful day.