Smart & Final Stores (NYSE:SFS) Q2 2019 Earnings Conference Call November 14, 2018 5:00 PM ET
Laura Bainbridge - Investor Relations
David Hirz - President and Chief Executive Officer
Rick Phegley - Senior Vice President and Chief Financial Officer
Scott Drew - Executive Vice President of Operations
Bill Kirk - RBC Capital Markets
Edward Kelly - Wells Fargo
John Heinbockel - Guggenheim Securities
Karen Short - Barclays
Tom Palmer - JPMorgan
Rupesh Parikh - Oppenheimer
Paul Trussell - Deutsche Bank
Vincent Sinisi - Morgan Stanley
Garrett Klumpar - Citi
Yunhee Park - Credit Suisse
Andrew Wolf - Loop Capital Markets
Greetings, and welcome to the Smart & Final Stores Inc. Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Laura Bainbridge, Investor Relations. Please go ahead.
Thank you. Thank you for joining us today as we discuss Smart & Final Stores’ second (sic) third quarter 2018 financial results, which was a 16-week quarter ended October 7, 2018. Participating on today's call will be Dave Hirz, Smart & Final's President and CEO; and Rick Phegley, Smart & Final's CFO. Scott Drew, EVP of Operations, will also be available for the Q&A portion of the call.
Before we begin, we want to remind you that comments made during this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ in a material manner from those expressed in such forward-looking statements for any reason, including those listed in the company’s SEC filings. The company assumes no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results.
During this conference call, the company will refer to certain non-GAAP financial measures, including adjusted net income, adjusted net income per diluted share and adjusted EBITDA. The company uses these as measures of operating performance, not as measures of liquidity. These measures should not be considered in isolation from or as a substitute for measures prepared in accordance with generally accepted accounting principles.
In addition, these non-GAAP measures may not be comparable to similar measures used by other companies. Please refer to the company’s earnings release made available on its Investor Relations Web site for definitions and reconciliations of these measures to the most directly comparable GAAP measures.
With that, I will hand the call over to Dave Hirz, Smart & Final's President and Chief Executive Officer.
Thanks Laura and good afternoon everyone.
There are a lot of positive developments in Smart & Final and what continue to be a very dynamic industry environment. From a high level view, our operational performance remains strong with a rapid expansion of our e-commerce business and stable in-store metrics in both of our vendors, while maintaining strong merchandise margins holding to our value prices against key competitors and continuing to increase sales penetration rates with our important business customers.
Our key competitive strengths, [indiscernible] including key products for small businesses, value pricing, industry leading private label and a dominant assortment of warehouse club-packs continue to make both of our store banners attractive places for business and household customers to shop both in-store and online.
We said it before, we are not a conventional grocery company. In the third quarter, our financial and operating performance was solid with year-to-year growth in overall sales, banner comparable store sales, banner merchandise and gross margin rates and strong growth in online sales. Net sales for the quarter increased by 2.8% year-over-year led by six tenths of a percent comparable store sales growth.
As we will describe in more detail, we achieve this sales growth despite increasing deflation in a couple of key categories which was a bit of a surprise after experiencing inflationary trends in many categories earlier in 2018. Our comparable store sales, net of inflation and cannibalization was up 1.6%, our strongest quarter of the year and stronger than our fiscal year 2017.
Gross margins remain strong this quarter and were the highest we've seen in over 10 years reflecting good merchandise mix in our efforts to reduce product acquisition costs and control margin related expenses.
While adjusted EBITDA in the quarter was $62.3 million which is a trailing 12-month EBITDA increase of over 9% as compared to the prior 12-month period. Adjusted net income and adjusted diluted EPS in the quarter increased by over 30% including an income tax benefit which Rick will review.
We've also continued to use our strong cash flow from operations to reduce overall financial leverage with $46 million of debt reduction since the beginning of the year. The key financial challenge to the stronger income growth has been the return of deflation in our key commodities. On a sequential quarter basis, we flipped from a positive 0.8% inflation to a negative 0.7% deflation or a sales growth headwind of 1.5%. Only seven of our 26 product categories were deflationary with the most meaningful impacts felt in produce, meat and cheese. These categories collectively represent more than a quarter of our consolidated sales. And early in the fourth quarter, these deflationary trends have persisted.
As we've described before deflating product prices especially challenging in an environment where nearly all of our operating costs including wage rates continue to inflate. In the third quarter, the competitive environment was stable in both of our store banners. In the Smart & Final banner towards the end of the quarter, we cycled last year's increase in promotional intensity.
In today's environment, our focus remains on what we are able to control. Enhancing the customer shopping experience in both our Smart & Final and Smart Foodservice warehouse stores both online and through merchandising and customer service initiatives. Continuing to invest in our people, systems and infrastructure to strengthen our competitive positioning and maintaining the disciplined approach to capital spending, prioritizing our strong operating cash generation to reduce balance sheet leverage.
Across both of our banners, we're working to support traffic and basket building initiatives. With a Smart & Final banner, we remain committed to our unique assortment of business and household items offered at exceptional values generally priced 6% to 12% below conventional grocers.
We're leaning into our strengths in deep value warehouse club packs, unique SKUs for small business customers and our high quality private label products. As a reminder, we offer twice the number of warehouse club pack SKUs when compared to a typical club store and more than 10x the variety found in a conventional grocery store.
Our club size comparable store sales in the quarter increased at 4x the rate of the overall Smart and Final banner accounts. In the quarter, 30% of our banner sales continue to come from our business customers. Business customers are one of our key differentiations in the market and our business customer remains healthy, delivering comparable store sales growth that was double the overall Smart & Final banner growth rate despite greater exposure to deflationary product categories in their sales mix.
As you know, our private label offerings deliver an especially compelling values in both price and high-quality products. And during the quarter, we continue to see total sales growth in our private label products above our consolidated rates. Growth continues to be led by our flagship private label brand First Street and our natural and organic brand Sun Harvest.
Over the last several quarters, we've been consolidating some smaller private label brands into the first three labels for a better brand recognition and more cohesive marketing. Overall response has been positive and sales of First Street branded products now account for almost 85% of our total private label sales.
Our Sun Harvest line continues to deliver strong sales growth along with the exceptional margin rates led by an expanded SKU assortments and innovation in this important and growing category.
In both First Street and Sun Harvest, we have an active private label brand development program to ensure that we remain current with market trends and expand the breadth of products available to all of our customers.
We've also made customer service a major focus since 2018 with measurable benefits. To-date we've seen reduced front-end wait times, meaningful improvements in our mystery shopper scores and higher levels of on-shelf in-stock rates which are based on independent audits are impressive at over 90%.
At the same time, we're investing in both our delivery and buy online pickup in-store offerings. Across both banners, we're seeing strong adoption rates for our e-commerce offerings. With Smart & Final banner recorded a 100% increase in e-commerce sales in the smart foodservice banner saw over 500% sales growth led by our buy online pickup in-store click and carry offerings. And after a successful pilot in the San Francisco Bay Area, we recently added a second delivery pilot for our Smart Foodservice banner in the Portland, Oregon market.
With this third party delivery option, we're serving small businesses and restaurant customers with temperature controlled vehicles up to a 50 mile radius from our pilot stores. We're supporting this continued growth of our e-commerce and delivery channels through a measured investment in our back in infrastructure and more aggressive online and print, promotional campaigns.
In particular this year, we've employed a new warehouse management and purchasing systems upgraded our core financial backbone to SAP S4 financials and strengthened our system security infrastructure all of which are a stronger base for online commerce. Our key focus in our e-commerce investment strategy is greater capture and leverage of customer specific information and purchase history, so that we can serve our best customers even better.
We also continue to invest in our brick and mortar operations and believe the combination of our unique merchandising, value pricing and investments in customer focus initiatives will continue to support customer traffic in today's environment. This includes our work with Nielsen where we are beta testing select pricing and promotional strategies to identify learnings that can be implemented on a broader scale. We've invested over $4.5 million in pricing refinements since we started working with Nielsen earlier this year and we're already beginning to see improving traffic at the Smart & Final banner stores.
Key to supporting our growth is having the right mix of stores and locations and ensuring they are maintained regularly. In our Smart & Final banner we opened three new stores in the third quarter. We ended the third quarter with 324 stores including 260 Smart & Final stores and 64 Smart Foodservice stores.
Early in the fourth quarter, we opened a new extra store in Long Beach marking our 200 Smart & Final extra stores since the introduction of the extra format ten years ago. In the balance of 2018, we expect to close one additional legacy format store for a total of four strategic legacy store closings in 2018. The quality of our Smart & Final banner stores remain strong with over 90% of our stores being new or remodeled in just the past 10 years.
In the Smart Foodservice banner, we now expect to open two new stores in the fourth quarter for a total of three new stores in 2018.
Looking forward to 2019, we continue to be cautious of our new store development given the challenging environment for our Smart & Final banner stores. In 2019, we plan to open two to three additional Smart & Final extra stores and complete up to three legacy to extra store relocations or expansions.
The planned new stores in Southern California and Las Vegas represent attractive and opportunistic real estate locations. In the Smart Foodservice banner, we plan to open 45 new stores in 2019 all within our existing footprint. We continue to be optimistic about growth prospects for the banner with strong food away from home trends, a robust and healthy small business environment in the Pacific Northwest and a well positioned store format with an attractive niche. And we're actively planning for a future store growth options for this Smart Foodservice banner.
Consistent with our past practice, we expect to provide a more complete guidance for 2019 and our fourth quarter earnings call. In addition to store development, we also recognize the importance of investing in our 12,000 associates, who are the most important component of making our stores a great place to shop.
We have several programs in place to support the ongoing education of our associates and their families. Since 2016, we've invested over $2 million in support of our associates education through tuition reimbursement and scholarships. To assist in our associates education goals, we offer to cover all costs including books for eligible associates attending community college. We currently have hundreds of associates participating in the program. Because almost 45% of our sales are from small businesses and local clubs and organizations, we believe that we play a special role in every community in which we operate becoming part of the fabric of that community.
We support our communities through the Smart & Final and the Smart Foodservice charitable foundations where we fund hunger relief programs and partner with local organizations including Little Leagues, AYSOs, local food banks, K12 schools and a wide range of other non-profit community groups.
We provide our employees with paid time off to volunteer for the charities they care about the most. In the third quarter, our associates dedicated over 1100 hours towards coastal cleanups, helping feed the homeless, supporting charity walks and many other important causes.
Turning back to the larger picture, we're not conventional in our stores or our approach to our business. We remain focused on solidifying our unique position in the market supporting growth in traffic and transaction size for our merchandising and shopper experience initiatives and making measured investments in our people, systems and infrastructure.
And with that, I will turn the call over to Rick.
Thank you, Dave and good afternoon everyone.
Today I will discuss our third quarter results and our outlook for fiscal 2018. So let's begin with sales. As noted in today's release, consolidated net sales in the third quarter were $1.5 billion up 2.8% versus the third quarter of 2017. That sales growth was driven by the sales contribution of stores it opened over the last 12 months as well as consolidated comparable store sales growth of 0.6%. Comparable store sales growth was supported by strong average ticket growth in both store banners. This represents our sixth consecutive quarter of positive comparable store sales where Smart & Final banner comps increasing by 0.2% and Smart Foodservice warehouse banner comps increasing by 2.0% during the third quarter.
In the Smart & Final banner sales increased by 2.6% over the prior year, average ticket in the third quarter increased by 1.6% with an underlying estimated deflation rate of 0.6% and a decreasing comp traffic of 1.4% a rate which was an improvement from both the first and second quarters of 2018.
The gross margin rate in the Smart & Final banner were 16.8% up 1% from the margin rate in the third quarter of 2017 reflecting strategic sourcing, business customer growth and our strong merchandising initiatives.
In the third quarter, operating and administrative expenses as a percentage of sales in the Smart & Final banner were 14.8% about 100 basis points higher than the year ago quarter reflecting increases in store level, labor costs due to the impact of minimum wage increases and increase in third-party e-commerce fees as a result of our growing sales and other inflation driven store level cost increases.
In the Smart Foodservice banner sales increased by 3.3% from the prior year quarter with a comparable store sales growth rate of 2.8%. Average transaction amount in the third quarter increased by 2.1% with an underlying estimated deflation rate of 0.9%, store traffic on a year-over-year basis declined by 0.2% an improvement of 20 basis points from the prior quarter and including the impact of cannibalization from new stores.
The Smart Foodservice banner gross margin rate in the third quarter was 14.9% up 40 basis points compared with the prior year quarter a stronger merchandise margin accounted for most of the increase with distribution and occupancy expense rates fairly flat as a percentage of sales.
Operating and administrative expense including store and label costs as a percentage of sales in the Smart Food service banner or 7.3% in the third quarter up slightly from the prior year quarter.
On a GAAP basis, our third quarter net income was $10.2 million. On a year-to-year third quarter basis, interest expense increased as a result of higher market rates and also reflecting book interest expense related to accounting for built-to-suit store development projects.
Income tax expense in the third quarter reflects a lower rate than we recorded in the second quarter including the favorable tax effect of accelerated depreciation deductions included in our 2017 income tax return. This brought the effective rate for the third quarter to about a 2% tax benefit which we expect will reduce the full year effective tax provision expense rate below 10%. This positively impacted our third quarter GAAP EPS by approximately $0.04 per share bringing our third quarter earnings to $0.14 per fully diluted share based on about 74 million shares.
To better understand our operating performance, we focus on adjusted EBITDA which by excluding unusual and certain other charges is more useful for comparison and analysis in connection with sales trends.
In the third quarter adjusted EBTIDA were $62.3 million with solid EBITDA growth in both banners. Adjusted net income was $16.9 million or $0.23 per fully diluted share, a 35% increase from the same period in 2017. Also as noted in our earnings release, we closed one additional legacy Smart & Final store in the third quarter as the lease was expiring and the store's performance was marginal.
Turning now to the balance sheet and cash flow statements. We ended the quarter with cash and cash equivalents of $62.2 million as compared to $60.9 million in the year ago quarter.
Our working capital remains well controlled and in line with our expectations with investment and inventories of $292 million. Our strong cash flow allowed us to pay down debt in the quarter bringing our total debt balance to $660 million at quarter end. And at quarter end we had $35 million outstanding under our $200 million revolving credit facility a reduction of $46 million year-to-date were half of that paid down in the third quarter.
Net debt to adjusted EBITDA at the end of the third quarter was approximately 3.2x and we expect to see further reduction by year end. We ended the quarter with cash generated from operations of $109.5 million and we remain in a strong liquidity position.
Turning now to our guidance for 2018, we continue to refine our store development plans in two stores scheduled to open late in 2018 will now open in early 2019, one each in the Smart & Final and Smart Foodservice banners with both stores impacted by construction delays.
In the key sales metrics, we expect full year sales growth in the range of 3.5% to 3.75% with the revised guidance incorporating inflation at 0% additional legacy store closures in 2018 and the delay of two stores to 2019. For comparable store sales, we expect full year comps of 1% to 1.25%, at the lower end of our previously guided range and also reflective of the lower than originally expected inflation rate.
In adjusted EBITDA, we have narrowed the guidance range to $180 million to $185 million for the full year 2018. To sum within this outlook is 0% product price inflation for the full year. As you may recall, when we first offered guidance for 2018 we were anticipating approximately 1% inflation for the year.
Given the year-to-date performance this guidance implies a fourth quarter adjusted EBITDA in the range of $40 million to $45 million. For guidance on adjusted net income and adjusted EPS, we expect to achieve results at or slightly above the upper end of the prior guidance range. We now guide to a range of $34 million to $36 million for adjusted net income and $0.46 to $0.48 cents share per adjusted fully diluted EPS. This reflects in part our favorable income tax rate year-to-date and our expectations for interest expense at current market rates.
Guidance for capital expenditures and weighted average number of shares remain in the previously issued ranges.
Looking beyond the current year to 2019 as Dave mentioned we plan to open two to three Smart & Final banner stores and four to five new Smart Foodservice Stores along with three relocations or expansions of Smart & Final legacy stores to new extra format stores.
As a result, we expect that our 2019 capital spending commitments will remain relatively modest which provides the opportunity to continue to deploy our free cash flow to reduce financial leverage. And with that, I'll turn the call back to Dave.
Thanks Rick. Thanks again for your participation in today's call. As we discussed, the third quarter was marked by solid sales growth and strong margins in spite of inflationary pressures. We're making targeted investments and tools to support digital commerce in our infrastructure and we're building on our core strength and value pricing and merchandising. We're excited about many of the trends we saw in the third quarter and are continuing to see early in the fourth quarter.
On a more serious note, California has recently been severely impacted by wildfires and for this Smart & Final and Smart Foodservice families this has really hit home. Many of our associates in the impacted areas had to be evacuated. Sadly a couple also lost their homes. During this difficult time, our thoughts and prayers are with our associates, customers and communities impacted by these fires. Through our foundation and our generous customer contributions, we've raised funds for relief efforts provided donations of food and supplies to first responders, evacuation centers, churches and animal shelters.
Even in the midst of this tragedy, I'm inspired by our associates always step up to support first responders efforts on the ground. I want to thank our associates for their ongoing commitment to make Smart & Final stores not only a great place to shop and work but a positive and meaningful partner for our communities.
And now we'd be happy to take your questions.
Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Bill Kirk with RBC Capital Markets. Please proceed with your question.
Thank you for taking the questions. So over the last couple of months, Costco has called out some strength in some of your most important markets. Has their success in those regions has that limited your comp store sales growth?
I don't believe it's had an impact. If I look at our sales growth in the quarter, the beginning of the quarter is actually fairly consistent with sales growth in the second quarter. In the back half of the quarter sales and traffic really strengthened in our five weeks into quarter four continued to strength. We think much of the change in the quarter has to do with cycling the competitive intensity that started a year ago late in the third quarter. But we don't we don't see any real competitive impacts over and above normal.
Okay. Got it. And when I look at your merchandise margin, am I seeing the benefits of capturing some of that input deflation or is that the benefits of not chasing some of that lower margin promotion activity?
On product margin, we have a strong product margins really just leveraging CPG cost of goods, more success in our strategic sourcing initiatives primarily around lower cost of goods for our private label and in mix changes from some of our merchandising initiatives helped. But on gross margin Rick?
Sure. I think what you'd see is most of the improvement came from merchandise margin, but we had a little bit of improvement in terms of the other margin elements and distribution and occupancy cost as well.
Okay. That's it for me. Thank you.
Our next question comes from the line of Edward Kelly with Wells Fargo. Please proceed with your question.
Hi guys. Good afternoon. I wanted to ask some question about the guidance, you've been keeping EBITDA like reasonably stable even up in some quarters for most of the year, but Q4 looks like it's expected to be softer. Can you just provide a bit more color on what's driving this and how we should be thinking about some of the individual pieces in Q4?
Sure. And I think to a large extent this is reflective of what we see in inflation and deflation. And we started the years with a much stronger inflationary picture coming out of a decent Q4. And with that at that point we're forecasting 1% inflation overall for the year. And we've seen a fairly steady deterioration albeit recently a little moderating, but pretty steady deceleration through Q3 and early into Q4. And it just makes it tough to leverage costs.
So I think we have a story that's very consistent on the EBITDA front with what we see on the inflation front.
Okay. And just thinking about 2019, I know it's a little early to give color, but as we think about 2018, I mean this has clearly been a tougher year given the return of deflation outsized cost investments, the competitive environment. You generally did a pretty good job I think from an EBITDA standpoint, as we think about next year, how do we think about the potential areas of relief, the potential areas of risk, what has to happen for you to grow EBITDA next year?
Number one would be, we do believe that we'll see some spring back in inflation to a more normalized level. This is a very sustained period of deflationary activity over the last few years really unusual. And many of the underlying statistics including most recent PPI statistics would point to a more normal level of inflation on a go forward basis or at least less deflationary which will help leverage costs.
In addition, we continue to see good growth in average ticket in both banners very strong and stable gross margins in both banners as Dave mentioned. Overall gross margin rate is the highest it's been in 10 years and a growing e-commerce business. And we think all of those can provide the impetus for stronger 2019. And we also look forward to continue deleveraging in financial leverage in 2019.
Great. And just Dave one last question for you maybe as we think about the foodservice business, comps were pretty good this quarter despite the fact that you're over indexed to some of these deflationary categories, just overall what are you seeing here, how are you feeling about the new stores that you've been opening maybe some color on how they're ramping. And then just an update on the strategic emphasis to this business going forward it sounds like you do remain optimistic about store growth?
We really do -- we're really happy with what's going on in foodservice does seem like that foodservice customer continues to strengthen, we continue to benefit from the trend for food away from home. New stores, again, they were new to us so we spent some time studying them. But I would tell you -- although we still study them we're pretty happy with the results. We've opened 11 new warehouse stores in the last 36 months and on average they are at or above platform expectations. We're seeing good success in existing markets where we suffer a little bit of cannibalization but they then ramp much faster than a new market, but even in new markets, they're ramping sales and EBITDA in line with expectations. So we're pretty bullish on the growth prospects of the banner.
Our next question comes from the line of John Heinbockel with Guggenheim Securities. Please proceed with your question.
Just two things, I want to go back to the gross margin drivers, so strategic sourcing it sounds like that was the biggest driver in the quarter of gross margin improvement in both the segments. Is that fair?
I don't know it's a biggest driver, but it's a big driver. Our private label margins continue to get stronger than overall margins and a lot of that is better cost and goods from our strategic sourcing department that we run here internally. But we also have had some success with lower cost of goods from a CPG companies although we listen to the press they say they're all here trying to raise costs, but we've had some luck there. In some of our merchandising initiatives have continued to help us with the mix changes and help us with the product margin growth.
The other thing you called out was business customer mix. Now is that business -- the business customer versus the retail customer being higher margin or is that within the business customer segment mix improving what they're buying specifically?
Overall business customer penetration is continuing to be really strong even though now 80% of our sales are coming from extra stores. And historically extra stores penetration is around 27% and legacy stores around 36%. Now we're up to 80% of our sales from extra stores. Yes, penetration is still really, really strong in the quarter.
Average sale from that business customer continue to be about double, the household customer and that business customer really over indexes in private label, so it's a more profitable customer both on sales side and the margin side than wholesale customers.
And then, just lastly one of your -- one of the large traditional live foodservice competitors in your market right FSA is being acquired. Is that an opportunity given the disruption that could occur there and an opportunity for Smart Foodservice and how do you take advantage of that?
I think Derek and the team are watching that really close, let's say big acquisition, an expensive acquisition and it's too soon to tell, but we think potentially could present opportunities in the Pacific Northwest, but again, it's too soon to tell. But, we're watching it really closely.
All right. Thank you.
Our next question comes from the line of Karen Short with Barclays. Please proceed with your question.
Hi. Thanks. So I guess I just want to go back to your comment on net comp, so net comp is not necessarily definition that we are using. I guess I'm asking this obviously because at the end of the day cannibalization and inflation or deflation are just a function of the industry you're in. So I mean maybe talk a little bit about why you think that's the right way of thinking about it?
And then going with the net comp definition, it implies cannibalization of 30 basis points so maybe help us think through how we should think about cannibalization going forward given the unit growth kind of coming down?
Sure. Cannibalization in the quarter was 20 to 30 points in both banners. We expect on an ongoing basis, it will be in that range again probably depending on the stores whether open for 20 points in the Smart & Final. When we look at comps historically in what used to be the normal world where we would run 2% inflation was pretty normal inflation with about a 10-year period, we would be running comps in, call it 3.5% comps maybe 4% with some new stores. So running about 150 points above inflation. When you're running your negative deflation it makes it much more difficult to get to 3.5% comps.
So I think a lot of the analysts historically have looked at kind of what's your net comps? When we looked at the last quarter, our total accounts were up 60 points. We had a 150 point swing in inflation from 80 points positive to 70 points negative and net of inflation we feel pretty good about the growth of the strength in the third quarter versus the first and second quarter particularly towards the end of the third quarter. Towards the end of the third quarter, we began seeing closer to flat to positive traffic in early in the fourth quarter. We're feeling pretty good about traffic and comps.
Sorry, fourth quarter is flat to -- it's the fourth quarter traffic…
We are five weeks into the quarter and I would say the traffic has improved over Q3, it is flat to slightly positive in both banners and so traffic is stronger and comp sales is stronger than then quarter 3. But really started the last month of quarter 3 was by far our strongest quarter both for traffic and comps. And then now five weeks into quarter four we're seeing the same trend we saw at the end of the quarter three.
Okay. So I guess appreciating that there is several puts and takes two reported gross margins and obviously you call those out. I guess what I'm wondering is given that traffic hasn't been overly robust although it seems like it's improving a little bit. I mean isn't potentially greater price investments something that you need to consider to get traffic in. And I guess the overall comp into more leverable territory?
Our take on investment -- we've worked hard to maintain our gap in prices position versus our competitors at 6% to 12% from conventional. We have purposely not over-invested in promotional activity. And again, it was difficult cycling through the intensity of promotional activity but since it ended about a month -- before the end of the third quarter, we've seen an up tick in traffic an up tick in comps. And we think our promotional strategy today is the right strategy. And our level of pricing to our competitive and club competitors is the right place to be.
Okay. And then, very last question for me. Just on CapEx given what you went over in terms of unit potential unit growth. I mean it seems to be like CapEx total for fiscal '19 could be kind of in the $60 million. Is that fair or are you going to be reallocating or allocating more CapEx to some of these, I guess e-commerce type or just IT related initiatives?
We have Karen some special initiative in the year that tends to be in the range of $10 million. So I think we -- although we haven't given a specific number obviously for 2019 range that you cited, it seems a little bit low to us.
I'll tell you any investment mix and digital in 2018, the $16 million investment capital, we would expect that will be lower going forward really the heavy blocking and tackling and to build out of the infrastructure. A lot of that is being completed in 2018 and it should be lower in future years. Although, overall, market continues to evolve and we will still continue to invest in innovation in the future.
Okay. Great. Thanks.
Our next question comes from the line of Tom Palmer, JPMorgan. Please proceed with your question.
Hey, thanks for taking my question. On the inflationary front, you mentioned that perishable categories are rolling over. And we've also heard from several packaged food companies who plan to take less price increases. I guess more of an 2019 event. Is this consistent with what you are seeing. And if so based on the timing of these planned price increases at what point might we start to see center store inflation accelerate and maybe be a little bit of an inflationary tailwind for you/
Soon we hope. Again, the deflation in the quarter -- just started in quarter three and it really was pretty isolated. I think we set seven out of the 26 categories and the lion's share of that was in the first in produce and then also in the meat department. We saw when we were in an inflationary environment we saw competitors being very rational passing through price increases and inflation. But we're not seeing the same thing here when we're seeing produce costs come down 3% to 6%. We're seeing competitors lower retails in many cases and then produces deflationary depending on which banner you're looking at 4% to 7% inflationary and we're seeing retails coming down there too. So unfortunately retailers get passed through in a deflationary environment has they do in an inflationary environment.
Okay. Thanks. I know you've been asked a lot about the gross margin up tick, I had maybe a little bit different of an angle to ask about it. You talked about how you're using more analytics maybe to kind of refine merchandising and promotions. How much have you let your price gaps drift on items that maybe customers are not as price sensitive to? So I know that you kind of stated that your gaps remain consistent, but is that across the entire store or have -- is this a key drivers that's what helping to kind of drive this margin higher.
Yes. That's a great question. If I look at our gaps were you know 6% to 1% lower than our conventional competitors. That is wall to wall, so we're price second every item carried in all of our conventional competitors or mass merch competitors or competitors on a monthly basis and strong commodities on a weekly basis.
We actually since we began our analytics with Nielsen earlier in the year, we've actually invested $4.5 million in lower retails to drive traffic. Most of that focused on a highly elastic and sensitive items that are really important to our value shoppers. We think that's part of what's helping us build traffic here at the end of Q3 and now in Q4 is the price investments that we made. So again, the investment has been really an item that as you mentioned are highly elastic and highly price sensitive items. And we think it makes sense to put our investment dollars there.
Great. Thanks for the color.
Our next question comes from the line of Rupesh Parikh with Oppenheimer. Please proceed with your question.
Good afternoon and thanks for taking my questions. Maybe first on the SG&A line, we saw pretty meaningful leverage during the quarter. So just hoping to understand, what type of leverage point you guys believe you need to or what type of comps you believe you need to leverage SG&A line. And I was just hoping to get more clarity in terms of how you're thinking about some of these cost winds, headwinds going into next year?
Great question. So we've said before that in an inflation environment that's more normal kind of a 2% inflation environment which is Dave said has really been more of a long-term trend. That if we can get top-line inflation in that same range that we can leverage the P&L quite well.
I think in a current environment, we would say that we just need to leverage the cost in the top-line that's something that's a positive number and the negative deflation has really been a challenge. So rather than give you a specific number, I would just say a closer correspondence to the underlying cost inflation, you'll see meaningful leverage in the income statement.
Great. And then, switching topics, it sounds like [indiscernible] your commentary and traffic just an improvement what you're seeing this quarter? I'm just curious, I know you guys laid out a number of traffic driving initiatives earlier this year. Just wondering which ones you think have been most effective in helping to drive the improvement there?
We think -- we have many traffic driving initiatives around our business customer. We had it -- so we had some initiatives in pilot in a seven store MSA in Central California. Early in the quarter we rolled that out to 45 more stores. We think that helped us drive some traffic for the business customer specifically household traffic or tell you one of our main focus is initiatives is really around Nielsen analytics, both pricing and promotion.
In addition to that, I think we're making good traction at customer service and I already talked about our shopping experience in-store I think is better, our wait times are better, our in-stock I think is industry leading. I think in quarter 3 our in-stock was actually 98.4% in the Smart & Final banner really, really strong in-stock. I think that builds a ticket but I think it also builds traffic when you can be relied upon to have the items exactly customers looking for. So I think it's a combination of things. And then, of course, just cycling the promotional activity that started in the third quarter in 2017 has helped to stabilize and then let us begin growing traffic again.
Okay, great. Thank you.
[Operator Instructions] Our next question comes from the line of Paul Trussell with Deutsche Bank. Please proceed with your question.
Hey, good afternoon. Just wanted to circle back on the deflation commentary, just for clarification, you mentioned I think 150 basis points or so sequential headwind from 2Q to 3Q. As we think about the fourth quarter, should we expect deflation levels, where is your expectation that deflation will be very similar sequentially or has it actually been further deflationary?
And then, also just wanted to get more details on the adoption and growth trends of the online business. I think you highlighted like triple digit growth. So if you can just give us maybe a bit of an update on what you're seeing and kind of customer response and how you're thinking about the cadence of that going forward?
On your first point on comps, again, comps were -- I mean inflation was 70 points negative in the quarter, in quarter 2 they were 80 points positive so that 150 point headwind obviously was a battle. We're five weeks into quarter four and we're still seeing deflation. I would call it slightly better than it was in quarter 3. But we still have inflation in the quarter, but if you look at our guide for the year know year-to-date we're in about 1% comps, our guide for the year is 1 to 1 in the quarter. So we're feeling pretty good about comps in the fourth quarter based on the trend in the last 4 weeks of Q3 and the first five weeks of Q4 we feel pretty good about where comps are going.
Online delivery or online sales in the Smart & Final banner was actually up 102% that over 100%. And Smart Foodservice up 500%, again, online and Smart & Final is really primarily delivery that's where most of the volume is coming from. We're pretty happy with our investments in delivery a lot of our infrastructure build has been to support delivery in the Smart Foodservice warehouse stores. A lot of the growth has been in the Click & Carry model where it continues to grow that explained a lot of the growth in the year -- in the quarter. And average sale in that Click & Carry continues to be over $700 per customer versus about $100 in-store customer. So overall digital delivery and Click & Collect is working pretty well in both banners and growing quickly.
Thank you for the color.
Our next question comes from the line of Vincent Sinisi with Morgan Stanley. Please proceed with your question.
Good evening, guys. Thanks very much for taking my question. I wanted to go to Dave you mentioned earlier on in the prepared remarks about a more aggressive marketing campaign. Just to be clear is that something that is within both banners or is that more, I know you mentioned more around kind of the household customers with pricing but as you mentioned your traffic has sequentially improved, so is it -- anything outside of that is -- are you doing different sorts of mediums or cadence of advertising that be great.
I don't know in prepared remarks talked about an increase in marketing intensity. But we continue to focus all of our marketing efforts pretty evenly on both household and business customers. And as I mentioned business, business traffic and business customers in the quarter was really strong. Household traffic was pretty flat up until the last month of quarter three now as we enter quarter four, traffic and comps are better than both.
Okay. And then maybe just a quick follow-up. I know you gave kind of the 19 store growth by banner guide. Just more kind of holistically longer term, you guys are getting certainly more and more comfortable with the Smart Foodservice banner growth there. Just maybe any qualitative thoughts on going forward, are you at the point now where we should see that we know it's obviously bigger in terms of percent, but in terms of unit growth going forward you think we should see that over time meaningfully outpace your extra stores.
Sure. I think we've seen faster growth in Smart Foodservice this year and we'll see it again next year. As I mentioned we're pretty happy with the -- with the new store performance and the 11 stores we have opened in the last 36 months. The economics are actually pretty strong. I think I've mentioned before our average Smart Foodservice extra store capital investment is about $1.8 million. So the return you need for a 25% cash and cash return is about $450,000 in the third year of performance. So we are getting pretty bullish on Smart Foodservice and we think we see that growth outpace the Smart & Final growth certainly this year and in 2019.
Okay. All right. Thanks very much guys.
Our next question comes from the line of Greg Badishkanian with Citi. Please proceed with your question.
Hey, guys. It's actually Garrett Klumpar on for Greg. I'm just going back to the 4Q Dave's inflationary commentary. Where are you seeing some moderation? Are you actually seeing any of that category that were deflationary bringing to inflationary or where's the moderation coming from?
Again, it's early in Q4 and the moderation is pretty small. We're still deflationary, but it has gotten slightly better than Q3. And it's been -- I would say primarily in meat more than produce. And again, keep in mind about 19 of the 26 categories are not deflationary. It's really just been a few categories and those categories improved slightly as we entered quarter four.
Okay. That's helpful. And then just switching gears, I know you talked about obviously in the Smart & Final dinner delivery is driving a lot of the online growth, but I think you've also talked about piloting Click & Collect both in-house and using instacard, wonder if could just provide an update there and what you're seeing from a demand perspective and basket size and incrementality and do you anticipate kind of using both models moving forward? Or did you think that you'll end up going with either the in-house or the third party?
In which banner, in both banners?
In the Smart & Final banner.
In the Smart & Final banner our growth was primarily from delivery, delivery is really strong with our customers both on instacard.com and also shop.smartandfinal.com, where 25% of our Internet sales now are flowing and that's where really the fastest growth is on our Web site. Click & Carry at Smart & Final, we have a couple of different models going. One is in pilot in a six store MSA in Central California for the business customer. We're trying a Smart Foodservice warehouse stores type Click & Carry program. It's resonating but not as strongly as delivery, delivery both with our household customer and our business customer appears to be really the preferred model for the shop, the Smart & Final customer versus Click & Collect. It has not taken off in the pilot stores yet in the Smart & Final banner.
All right. Thanks so much for the color.
Our next question comes from the line of Judah Frommer with Credit Suisse. Please proceed with your question.
Hi. This is actually Yunhee for Judah. Thanks for taking our question. Quickly on the e-commerce front. You mentioned your focus is getting a greater capture of customer data and project history. Can you share with us how much data you actually have currently on the customers? Are they new customers to Smart & Final? Thanks.
Sure. The data that we get from our customers go through the instacard site is actually fairly limited. The data that we get from the now 25% of our shoppers in Smart & Final are going through shop.smartandfinal.com. We're getting all of that data. Again, the customer that goes through our Web site, is they purchase -- average purchase is higher than when they go through the market. The market site, the instacard site, we think about 50% or so of those customers are new customers. We don't have really -- when it comes our site we have all their data, we know often they shop with us on our site et cetera, et cetera. But it is more difficult to tell, if they shopped at Smart & Final previously, but today we think it's probably a little north of half of our customers are new to Smart & Final.
Thanks. Then on the Foodservice side, it sounds like it's benefiting from the online options. Can you comment on the types of customers that are utilizing the service, highway restaurants or commissaries? And then, quickly what is the charge the quick service customers are paying for delivery or Click & Collect. Thanks.
It is primarily restaurants. And it's a mix of new customers and existing customers. But even when it's an existing customer their average purchase order size before was $100 in-store are now outside of the store. On the Click & Carry, it's $700, so a really meaningful increase in the size of the order. The mix is very similar of a normal restaurant customer. And then, the charge in the Smart Foodservice warehouse stores, we actually up charge individual items to offset the costs of the labor involved in the Click & Carry.
The other thing that really helps us in Click & Carry is in every case, these are next day deliveries. So we're taking the orders for the restaurants for next day, it allows us to be much more flexible in our labor when we put the orders together and have ready them the next day for the customer to pick up.
Great. Thank you.
Our next question comes from the line of Andrew Wolf with Loop Capital Markets. Please proceed with your question.
Thanks. Good afternoon. With the fourth quarter looking better on the comps and traffic, I guess a little bit less deflation. I'm trying to reconcile that with the bringing down the high end of guidance and obviously you said there's less than -- environment turned deflationary and I understand why that's the main thing. But as you look at the third quarter versus the fourth quarter how would you kind of a portion bringing down -- bringing down the high-end was -- I guess what I'm really asking in plain English is, was the third quarter a bit low -- lower than you expected due to deflation and maybe the fourth quarter is going to be closer to your plan doing a bit your traffic and your comps are better and I'm just trying to understand the mix there between your expectation and your guidance.
Sure, Andy. So I think if you think about where we guided for the year, initially we guided $10 million EBITDA range and we're looking for 1% inflation. And as we've said the inflation has steadily dropped through the year 1.4% positive in Q1, 1.8% in Q2, negative 0.7% in Q3. And what we've done now by narrowing the guidance range from a $10 million to $5 million range has recognized the income effect of that lower inflation assumption for the year. So it's really embodied within the overall average relative to inflation more than anything else.
If you look at the guide that we gave for the year is 1% to 1.25%, on a year-to-date basis, today we're 1%. So 1% to 1.25% really implies that in the fourth quarter comps will be somewhere between 1% and 2%.
Yes. And I saw that obviously with the traffic turning up that quickly. That's pretty, I assume you feel somewhat good about the fourth quarter with what you saw. And then, with the traffic turning up at the stores, I mean, I can go back and look at how much of that is not a comparison sort of give it being a little easier with a promotional environment, the anniversaring and no longer getting worse on a year-over-year basis and how much of that is your own initiatives bringing back some customers.
Yes. It's a good question. There is no doubt that when we cycle the promotional intensity increased from the end of Q3 a year ago that we were cycling easier comps. But I think a lot of what's driving traffic beginning -- middle end of the third quarter is really around our initiatives. The pricing and promotional activity with our Nielsen analytics, the customer service initiatives, in-stock, I think is all helping to drive additional traffic. And again, ticketing is also improving although ticket was strong in Q3, ticket is improving because we continue even in Q4 to drive comps in club and business and private label ahead of total store comps in the Smart & Final banner.
Okay. Just one last question if I could on the wage inflation, you cited I guess you've referenced the minimum wage increases in mainly California and your other markets. Where is Smart & Final and Smart Foodservice where those banners relevant to the market and are the minimum wage increases that are to come going to continue to inflate that line or you guys in front of that?
So Andy, Scott here. What I would tell you on that relative to other players, we have a much smaller percentage of our workforce that's really tied to minimum wage under 5% of all of our associates or at minimum wage. So this really strengthens our position relative to the other players who have more exposure in that area. But to-date, while we along with others we started passing this through and pricing we've had a modest impact to our O&A. We absorb these incremental costs and we expect this to continue with the minimum wage increases. When you look at our average hourly rate out there at Smart & Final, it's north of $17, at Smart Foodservice stores it's over $20 dollars. So we're well positioned in the marketplace.
Great. Thank you very much.
Okay, Andy. Thank you.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.