Smart & Final Stores, Inc. (SFS) CEO Dave Hirz on Q4 2018 Results - Earnings Call Transcript

About: Smart & Final Stores, Inc. (SFS)
by: SA Transcripts
Subscribers Only
Earning Call Audio

Smart & Final Stores, Inc. (NYSE:SFS) Q4 2018 Earnings Conference Call March 13, 2019 5:00 PM ET

Company Participants

Laura Bainbridge - Investor Relations

Dave Hirz - President & Chief Executive Officer

Rick Phegley - Senior Vice President & Chief Financial Officer

Conference Call Participants

Erica Eiler - Oppenheimer & Co.

Karen Short - Barclays

Judah Frommer - Credit Suisse Securities

Edward Kelly - Wells Fargo

Tom Palmer - JPMorgan

Andrew Wolf - Loop Capital Markets

Vincent Sinisi - Morgan Stanley


Greetings and welcome to Smart & Final Stores' Fourth 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] Please note that this conference is being recorded.

I would now like to turn the conference over to your host Laura Bainbridge of Investor Relations. Thank you. You may begin.

Laura Bainbridge

Thank you for joining us today as we discuss Smart & Final Stores' fourth quarter and full year 2018 financial results which was a 12-week quarter and 52-week fiscal year ended December 30, 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 Administration will also be available during today's Q&A session.

Before we begin, we want to remind you that comments made during this conference call and webcast contains 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 website for definition and reconciliation of these measures to the most directly comparable GAAP measures.

With that, I will turn the call over to Dave Hirz, Smart & Final's President and Chief Executive Officer.

Dave Hirz

Thanks Laura and good afternoon everyone. In 2018, Smart & Final recorded a year of solid operational performance across both of our store banners despite continuing challenges from a very low inflation rate sales environment.

In the fourth quarter, we grew sales by 3.2% and a 1.9% comparable store sales rate, 170 points above our rate of inflation and our seventh consecutive quarter of comp sales growth.

We also increased merchandise margin in both store banners continued the strong pace of e-commerce sales growth, selectively opened new stores, and grew both comparable transaction counts and average ticket in both store banners.

Our strong 1.9% comp sales growth in the quarter was achieved despite approximately 40 basis points of negative impact from the shift of New Year's Eve sales into the 2019 fiscal year.

On two-year stock basis comp store sales were strong, up 5.1%. We believe that we're achieving these results by maintaining our strong value proposition continuing to increase our assortment of warehouse club-pack and private label items and through improving store in-stock condition, customer service standards, and focusing on our key business customer segment.

Our cash generation from operations and reduced CapEx levels enabled us to significantly reduce overall financial leverage with a $51 million debt pay-down in the year, while maintaining a strong cash position.

For the full year 2018, net sales were $4.7 billion led by 1.2% comparable store sales growth. We estimate that inflation and product cost for the full year was less than 0.2% much lower than the historical 2% or higher over the past decade and much lower than the inflation of about 1% we expected as we entered 2018. While we're again seeing some modest product cost inflation early in 2019 in both store banners, we're being cautious in our inflation expectations.

Managing an environment with low rates of product cost inflation against the backdrop of rising operating costs in all areas of our business including wage rates has been a significant headwind to earnings growth. Our response has been to focus on transaction and sales growth including e-commerce and controlling operating expenses, while continuing to focus on great customer service.

We also continue to focus on our key business customer segment. Our efforts are paying off. In the Smart & Final banner, comp sales growth in our business segment grew almost double the rate of overall banner sales in the fourth quarter. We're pleased with the sequential improvement in our comparable store sales metric and the solid positive contribution from both the Smart & Final and Smart Foodservice store banners.

Sales growth was well in excess of the underlying product inflation rate and we had average traffic and ticket growth in both store banners for the first time in six quarters. In the fourth quarter of 2018, overall product cost inflation was 0.2% comprised of 0.1% deflation in the Smart & Final banner and 1.3% inflation in the Smart Foodservice banner.

While an improvement from the 0.7% deflation in the third quarter of 2018, it was much lower than the 1.7% inflation rate in the 2017 fourth quarter. In the fourth quarter of this year, our overall gross margin rate was stable with growth in merchandise margin largely offset by increases in distribution and occupancy cost.

Our GAAP operating results in the fourth quarter and the full year were impacted by valuation charges of approximately $120 million after-tax with the goodwill impairment charge as the largest factor. Rick will discuss those charges in more detail.

It's important to note that these are non-cash charges and do not reflect the change in our view that there are substantial future growth opportunities for the Smart & Final store banner.

In the fourth quarter, adjusted EBITDA of $41.5 million and comp sales growth of 1.9% were in line with our guidance. In today's operating environment, we remain focused on enhancing the customer shopping experience in both our store banners through online channels; in-store merchandising and customer service initiatives; continuing to invest in our people service and infrastructure to strengthen our competitive position; and maintaining the disciplined approach to capital spending, prioritizing our strong operating cash generation to reduce balance sheet leverage.

I'd like to spend a few minutes discussing our progress on these fronts. We've been successful in our efforts to enhance our customer shopping experience as the customer service initiatives we launched in the third quarter began to take hold. We continue to focus on engaging with our customers, reducing front-end wait times, and maintaining strong in-stock levels.

The culmination of these efforts resulted in the highest mystery shopper scores we've ever received as well as new record level in-stock rates in the Smart & Final banner. Both of these initiatives help support positive strong comp sales and year-over-year comparable traffic increases for the first time since the second quarter of 2017.

In the Smart & Final banner, our club size offerings continue to resonate with our customers delivering comparable store sales growth well above our banner comp sales rate both among our business and household customers. These strong comp sales are a result of new merchandising initiatives, the addition of almost 300 new club size items in 2018, investments in competitive pricing, and strong execution at retail.

Private label sales were again strong in the quarter with comp sales accelerating to 2% with a strong 28% penetration rate driven by multiple sales initiatives focused on new item innovation, in-store merchandising, brand consolidation through our flagship First Street label and an exciting label refresh of over 2,400 existing First Street items.

Sales to our business customer remains strong representing more than 29% of total banner sales. Business customers are one of our key differentiators in the market and our sales efforts around this customer segment are resonating delivering comparable store sales growth that was almost double the overall Smart & Final banner growth rate, giving us confidence in our ability to continue to accelerate this highly profitable segment.

We see continuing potential in building online sales both in delivery and the buy online pick-up in store channels. In the Smart & Final banner, we recorded a 65% increase in e-commerce sales for the fourth quarter, with a primary focus on delivery where the average order remains approximately $80 more than double the average in-store sale, and with a higher margin mix than the typical in-store sale.

In the Smart Foodservice banner, we saw over 500% growth in e-commerce sales for the second consecutive quarter led by our buy online pick-up in store next day offering. Our average e-commerce transaction is more than seven times the average in-store sale with a similar margin mix.

In 2019, our focus in e-commerce is to leverage the investments we've made in our IT infrastructure during the past two years by expanding our customer-facing profile this year to include our own e-commerce order insight for both banners. Our goal is to control more the customer interactions to better market our assortment and to build customer loyalty, while controlling e-commerce costs and leveraging promotional revenue opportunities through CPG monetization.

We look forward to updating you on our progress throughout 2019. Additionally, our investments in digital and IT infrastructure over the past couple of years has resulted in many improvements throughout the company including a major upgrade in supply chain systems, new master data systems, new product buying systems, and new core SAP financial and analytics systems.

In 2019, we'll roll out five new major systems. SAP, GK registers software, a shelf tag and sign program, computer-assisted ordering, enhanced labor scheduling systems and an updated mobile app to leverage the new in-house digital platform for both delivery and click-and-collect customers.

We also continue to selectively invest in brick-and-mortar operations and believe the combination of our unique merchandising, value pricing and investments in customer focused initiatives will continue to support customer traffic in today's environment.

During the fourth quarter, we opened our 200th Smart & Final Extra! store in Long Beach, California relocated a legacy Smart & Final store to the Extra! format and opened two new Smart Foodservice stores. We ended 2018 with 326 stores including 260 Smart & Final banner stores and 66 Smart Foodservice stores.

For 2019, we continue to be cautious about new store development for our Smart & Final banner stores given the challenging industry environment. This year, we plan to open one new Smart & Final Extra! store and complete one or two legacy to Extra! store relocations.

In the Smart Foodservice banner, we plan to open four new stores in 2019, all within our existing footprint. We continue to be optimistic about growth prospects for this banner, which is strong fundamentals, good food away from home growth trends, and a robust small business environment.

Rick will provide more detail on our guidance for the first quarter and full year of 2019, but thus far in the first quarter we're seeing some continued improvement in inflation in both of our store banners and continued strength in average ticket. Partially offsetting these positive trends much of the West Coast has experienced above average, in fact record levels of rain and snow, which have been a headwind to sales and transaction growth.

So in summary, I'm pleased with our overall performance for 2018. In 2019, we'll maintain our focus on the strengths to keep our store banners unique in our market segments, providing quality merchandise and customer service to support continued growth in traffic and transaction size, and making measured investments in our people, systems, and infrastructure.

And with that, I'll hand the call over to Rick.

Rick Phegley

Thank you, Dave and good afternoon everyone. Today, I'll discuss our fourth quarter and full year 2018 results along with our outlook for 2019. There's a lot to discuss in the financial statements today, and I'll break the discussion into three parts.

First, I'll review the numbers as reported on a GAAP basis and outline the process and results of the non-cash impairment and valuation charges taken in the quarter, which drove an overall GAAP net loss for the quarter and year. Second, I'll focus on adjusted net income and adjusted EBITDA results, which we believe are the most useful metrics in understanding our operational results. And third, I'll detail our guidance for the 2019 year.

So let's begin with the GAAP statements and sales. As noted in today's release, consolidated net sales in the fourth quarter were $1.1 billion, up 3.2% versus the fourth quarter of 2017. Net sales growth was driven by the sales contribution of stores that opened over the last 12 months as well as consolidated comparable store sales growth of 1.9%. Comparable sales growth was supported by positive traffic and strong average ticket growth in both store banners.

In the Smart & Final banner, sales increased by 2.7% over the prior year and average ticket in the fourth quarter increased by 1.1% despite an underlying estimated deflation rate of 0.1%. Comparable store traffic in the Smart & Final banner improved to a positive 0.2%, an improvement of 160 basis points from the prior quarter and represents the first quarter of positive traffic in the banner in over a year.

The gross margin rate in the Smart & Final banner was 15.6% slightly lower than the fourth quarter of 2017 as improvements in merchandise margin were offset by increased distribution and occupancy costs.

In the Smart Foodservice banner, sales increased by 5% from the prior year quarter with a comparable store sales growth rate of 4.3%. Average transaction amount in the fourth quarter increased by 3.5%, with an underlying estimated inflation rate of 1.1%. Store traffic on a year-over-year basis improved by 0.7%, an improvement of 90 basis points from the prior quarter including the impact of cannibalization from new stores.

The Smart Foodservice banner gross margin rate in the fourth quarter was 15.2%, an improvement of 60 basis points compared to the prior year quarter. Our stronger merchandise margin accounted for most of the increase with distribution and occupancy expense rates fairly flat as a percentage of sales.

On a GAAP basis, our fourth quarter net loss was $121.8 million and full year net loss was $112.2 million. These results include the unfavorable effect of non-cash impairment charges and tax valuation allowances taken in the fourth quarter. In total, these charges amounted to $119.6 million on an after-tax basis.

The largest of the charges was a $94 million impairment charge related to goodwill. Goodwill on our balance sheet was established in 2012, when the company was acquired and by GAAP rules is not amortized.

The accounting standard ASC 350 requires an annual assessment of the carrying value of goodwill in light of external factors such as equity market valuations and internal factors such as projections of future sales and cash flow. In light of the ongoing declines in industry market equity values during 2018, we have taken a non-cash impairment charge related to the Smart & Final banner only.

It's important to remember that this is simply an accounting judgment within the context of ASC 350. And as Dave noted, this is not an indication that we have changed our view of the attractiveness of future store investments in either of our banners.

We also recorded other non-cash impairment and valuation charges related to certain assets, including store fixed assets and deferred tax assets of $25.6 million after-tax. The same overall factors which led to the goodwill impairment led to these charges as well.

It's important to note, when viewing the segment reporting detail presented in today's release, that these impairment charges have been allocated to the reporting units and the store fixed assets impairment charges impact the operating and administrative expense line in both store banners. We will more fully detail all of these charges on our report on Form 10-K, which we expect to file by this Friday.

Now moving on to the second part. To better understand operating performance, we focus on adjusted EBITDA, which by excluding unusual and certain other charges is more useful for comparison and analysis in conjunction with sales trends.

In the fourth quarter, adjusted EBITDA was $41.5 million and for the full year adjusted EBITDA was $181.8 million in line with the guidance provided on our last quarterly call. As anticipated in that guidance, adjusted EBITDA on a year-to-year basis was pressured by the low sales inflation rate particularly in the Smart & Final banner.

Adjusted net income was $6.0 million or $0.08 per fully diluted share in the fourth quarter and was $31.4 million or $0.42 per fully diluted share for the full year 2018. Adjusted EPS was below our guidance range as a result of a change in the effective tax rate from our prior assumption.

Turning now to the balance sheet and cash flow statements. We ended the year with cash and cash equivalents of $67.2 million. Our working capital remains well controlled and in line with our expectations, with investment in inventories of $301.9 million.

For the full year 2018, we projected capital expenditures of $80 million to $90 million, approximately 40% lower than the prior year and actual spending was about $86 million after adjusting for landlord and other third-party allowances and reimbursements.

Our cash flow allowed us to pay down $51 million of revolving credit debt for the full year. This reduced our total debt balance to $648.3 million at year-end. As of the end of the year, we had borrowed $30 million under our $200 million revolving credit facility. And the net debt-to-adjusted-EBITDA ratio at the end of 2018 was about 3.2 times, in line with our expectation for the year. We ended the year with cash generated from operations of $141.2 million and we remain in a solid liquidity position.

Now for the third part of today's discussion, turning to 2019 guidance. Factored into our guidance for 2019 is slight inflation in product cost in the range of 0.8% and a stable competitive environment. At this level of product inflation, we expect that we will continue to experience income statement pressure from inflation and operating administrative cost at rates higher than product cost inflation.

For the fiscal year 2019, we expect to see net sales growth in the range of 2.5% to 3.5% including the effect of new stores and relocations. We expect to see comparable store sales growth for fiscal 2019 in the range of 1.5% to 2.5%.

Capital expenditures are expected to be in the range of $65 million to $75 million, including expenditures related to new stores, store maintenance, remodels and relocations and infrastructure and digital investments. And we expect our effective tax rate for 2019 to be approximately 27%.

Based on this, we expect adjusted EBITDA in the range of $185 million to $195 million for the full year 2019. Adjusted net income is expected to be in the range of $32 million to $36 million and adjusted EPS is expected to be in the range of $0.41 to $0.46 per share for the full year on a fully diluted basis based on an assumption of 77 million to 78 million fully diluted shares.

And while we don't normally give quarterly guidance, our expectation is that the first quarter of 2019 will produce overall sales comps in the 1.75% to 2% range and adjusted EBITDA in the $25 million to $28 million range.

And with that, I'll turn the call back over to Dave for some concluding remarks before we turn to Q&A.

David Hirz

Thanks, Rick. As we've discussed, I'm very proud of the solid operational execution our teams achieved in 2018 in spite of a difficult operating environment. We're confident that our plans for 2019 will continue to build solid growth in both the Smart & Final and Smart Foodservice store banners and provide the opportunity for continuing earnings growth and financial deleveraging, while maintaining our strong value position in the market.

I'd like to thank our 12,000 associates for their hard work and dedication every day to making both of our store banners attractive places for business and household customers to shop, both in-store and online.

Before I open up the call for questions, I'll note that there have been recent press reports and market speculation regarding our equity ownership and the potential for ownership change. We've consistently maintained a no-comment posture regarding market rumors and we won't comment today regarding any such speculation. We appreciate your participation in today's call.

And with that, we look forward to taking your questions.

Question-and-Answer Session


At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Rupesh Parikh with Oppenheimer & Company. Please proceed with your question.

Erica Eiler

Good afternoon. It's actually Erica Eiler on for Rupesh. Thanks a lot for taking our question. So first, I was hoping, maybe you could touch a little bit more on gross margins and maybe just walk us through some of the key puts and takes for the year that we should be thinking about. Just any color you can share with regards to your outlook for the year would be super helpful?

A – Dave Hirz

Let me talk about product margin a little bit and I'll have Rick talk about gross margin. Product margin, we are pretty happy in the quarter. It was up about 40 points I think from the prior quarter in the Smart & Final banner. We're really benefiting from leverage in strategic sourcing. Now that private label is over 28% of our sales. Strategic sourcing plays a more important role. But as you saw in some of the prepared remarks, our sales to business customers which are really profitable for us, high margin, higher private label penetration, our penetration in private label and club size all grew at about two times the comp rate of the rest of the stores. So that really, really helps.

The other thing that's benefiting product margin is we continue to benefit from the continued maturation of new stores. A new Extra! store over the course of the first three years their product margin goes up about 300 points, right, because their first year is just such an aggressive promotional year for the new stores. And we had 14 stores opened in 2017, a lot of those stores and end of the store. So that maturation is helping us a little bit.

And then just the mix of Extra! stores in general. If you look at our Extra! Stores, the margin in an Extra! store is 100 points product margin is 100 points higher than a legacy store. And as we've transitioned over the last several years, we actually have 132 more Extra! stores than we have five years ago. And just that mix shift into Extra! while having a negative impact, G&A is having a positive impact in the margin. So I think all those things are increasing product margin. But gross margin Rick?

A – Rick Phegley

So Erica as you know, our reported gross margin is product gross margin or merchandise margin as Dave has just talked about less three factors, less the cost of buying a product that small, cost of distribution and cost of occupancy. And while we've seen good growth in product gross margin and actually growth in overall gross margin across the years, in the last couple of years, we've seen erosion of the product gross margin increases by the inability to leverage the increases in overall inflation in distribution cost, including fuel and distribution labor as well as inefficiencies in passing through increases in the overall occupancy cost line. So we do think that we'll see some improvement in overall gross margin on a reported basis this year, but the inflation assumptions are key to being able to see more efficient pass-through.

Q – Erica Eiler

Okay. That's helpful. And then just last one for me. I mean, there's obviously been some reports that Amazon is going to be opening up new brick-and-mortar grocery concept in some of your markets. I was just curious, how you're thinking about the potential for this new competitive dynamic. If there's any initial thoughts you can share on that that would be great.

A – Dave Hirz

Yes I would say there's not really -- we saw the same articles. We understand they're going to open one store in Los Angeles initially. So it's hard to determine what impact if any they could have on Smart & Final. I'd tell you Smart & Final has had a number of new entrants in the market over the years starting five years ago when Walmart opened 100 supercenters and neighborhood stores. All these entered the market.

In all of the new market entries, the impact in our stores is regardless whether it's supercenter neighborhood all the -- the impact in our stores had been very similar 1% to less than 2% on any individual store. And a year later as we cycle the stores turned positive and we think it really speaks to our differentiated strategy. The business customer is so unique. The club-size customer -- club-size sales in the quarter in Smart & Final hit 30% of our sales, really unique. We carry two times the number of the club stores and far more than the conventional guys.

And then private label keeps building. We think it's adding a component of loyalty to our customer base and it's just helping us with new market entries. So while we don't know what to expect, we feel really good about our position in the market.

Q – Erica Eiler

Okay. Great. Thank you so much.


Our next question comes from the line of Karen Short with Barclays. Please proceed with your question.

Q – Karen Short

Hi, thanks. Just a couple questions. In terms of the reduced unit growth for fiscal 2019, I'm assuming that's a function of these other initiatives like SAP, self-tag and things that you called out. But any color on that? And then I wanted to find out -- I mean on one hand it would seem that reduced unit growth would actually help EBITDA dollars for fiscal 2019, but there will obviously be an offset from these initial -- or these initiatives. So if you could kind of triangulate those.

A – Dave Hirz

Sure. Yes. New stores in the Smart & Final banner, we're going to open one store this year and last year we opened a few. So it's down a little bit. And we think again in this market environment that we're in now waiting for inflation to come back, every new store we've opened in 2015, 2016, 2017 and 2018, the last four years, none of those new stores have existed in an inflationary environment. So we think it's prudent to open a really small number of stores and we picked a great location for this year.

And in Smart Foodservice, we're targeting four stores. We think it still makes sense to grow that banner. They're doing well. We've opened seven in the last couple of years. They're doing good. It really isn't trying to balance with digital investment. The digital investment this year is -- I talked in the prepared comments about all the programs coming online during the course of 2019 and some of it came online in 2018. It really for us wasn't an either/or. We just think that store growth is prudent. And again even in this environment of investment in digital, we've reduced our capital last year by about 40% and now in 2019 down again to again $65 million to $75 million. So we think it's the right strategy and the lower store count makes sense for us.

Q – Karen Short

Okay. But just on the unit counts so that is a reduction just from your call back in November? So, I guess, what I'm wondering what's changed since November because it didn't appear in November that we're going to be in an inflationary environment in 2019?

Rick Phegley

So, Karen I think we are just being cautious about exposing additional capital dollars to what feels like an increasingly uncertain industry environment, uncertainty primarily because of the long-term view of inflation. So while our view of the current year may not have changed much, I think we are more cautious about thinking about a return to higher rates of inflation in years beyond 2019.

Karen Short


Rick Phegley

Not to say that, it can't happen or won't happen, but there seems that there's more uncertainty.

Karen Short

Okay. And is there any way to frame what the potential expense headwind could be from the initiatives like you called out the SAP self tag? Because as we look at your EBITDA guidance, obviously you hit consensus on the high end but – this probably a little bit later than people would have expected.

Dave Hirz

Sure. Yeah. It's still an investment year for us. As we look at the need for e-comm growth and digital investments we did an awful lot of work in 2017 and then a lot of heavy lifting in 2018. And again, in 2019 it looks like expenses on digital and IT infrastructure in general will be similar to last year about $8 million in operating expense and probably close to $50 million in CapEx. And again, it's all supporting the programs I talked about the ones that we rolled out already and the ones coming in 2019. I think e-comm and digital will continue to evolve. We'll probably always be evolving with it, but the heavy lifting really is in 2018 and 2019 for us.

Karen Short

Okay. And then just last question for me. Any update you can give us on the progress with your relationship with Nielsen? And I guess, I want to elaborate on that specifically, you're kind of testing different price gaps on different categories, I guess. And is there a wide range on where you're shaking out on price gaps meaning some categories may – you may not have price gaps and some categories you may have very wide price gaps, or are you trying to average out at that 6 to 12 across all categories? Is that…

Dave Hirz

Yeah. Again, the Nielsen relationship really is still a work in progress and we're working with them in three different areas, and the one you're talking about is just optimizing everyday pricing. And that really has been our two focuses. One is to look at the items that they believe based on our data are Smart & Final strengths, where we really should be priced right. The items are sensitive to our customers. And then items that are market strengths, right? They may not be ours, but they're – to continue to build traffic by looking at items that are market strength. So to make sure that group volumes are really priced well. Today, we have our own list and we've had it for a few years now of really sensitive items. Those are the 2,000 everyday low price tag items, where we price really competitively with mass on those items in every store.

So based on their market intelligence the list has changed. There's still a couple thousand items, but they were items that we thought were sensitive that apparently no longer are to the customer. Nielsen feels there's a different set of numbers. So the pricing policy, while there's 2,000 items switched they're different items, it's still about the same investment in 2,000 items. The different price zones we're testing is really based on competition. Our goal at least initially is to probably take some margin on items that are inelastic and items that aren't important to our customer, but also to be more aggressive on items that are Smart & Final strength or market strength. And our goal would be continue to price check all the competitors every week like we do today and maintain the similar gaps to competition that we have today.

Karen Short

Okay. That's helpful. I’ll get back in the queue. Thanks.

Dave Hirz



Our next question comes from the line of Judah Frommer with Credit Suisse Securities. Please proceed with your question.

Judah Frommer

Hi. Thanks for taking my question. Maybe just to follow-up on the square footage growth first. I'm trying to square kind of your commentary that there's a goodwill impairment, but that doesn't change the growth prospects for the business along with slow growth given the inflationary and competitive environment. Can you just help us with all those pieces?

Rick Phegley

Sure. So Judah, I think the way to think about this is and it's a great question is that the ASC guidance around store impairment and goodwill impairment, it's very formulaic, it's very mechanical and it looks at the near-term and long-term earnings prospects of a store or of a banner and it looks at historic investment in that banner and included in that is reconciliation to what's happening in the overall market values of equities within the relevant industry.

And that whole process at the store level has led us to impair some or all of the assets of only nine stores out of 326 stores and to take an impairment in the banner for the Smart & Final banner. It really as I say very mechanical formulaic, but its reconciling back to how the banner is viewed within the industry. And valuations as you know in the industry are lower than they were a year ago. That is separate and distinct to get back to your question separate and distinct from whether an individual new store can produce a acceptable return on capital on a cash-on-cash basis. We believe that there are lots of opportunities for new stores.

The near-term challenge is do we want to invest capital in an uncertain environment even though we believe that long-term there are good growth opportunities? And the challenge has been resolved in our mind to say in 2019, let's be more cautious than we might otherwise be and constrain capital use that cash to pay down debt and to maintain the opportunity set for the future.

Judah Frommer

Okay. That makes sense. And then it seems clear that Smart Foodservice is more of a focus, maybe it just happens to be more of a growth vehicle right now. But is there anything beyond kind of the under penetration of that concept and its markets? Is it the inflation prospects being better? Is it the online activity being much better that maybe gets you more excited about that banner near and medium term than maybe the Extra! banner?

David Hirz

Smart Foodservice is really attractive banner to us. Number one, it's much less exposed to this digital disruption that we're having. In fact, I think Smart Foodservice is actually more upside than digital disruption, because there are already -- the competitive set already is into the delivery business and delivery and click-and-carry is new for us. We think it's added incremental sales and helping to drive traffic and growth. The banner is really benefiting from the strong food-away-from-home trend.

Food-away-from-home expenditures the last couple years are actually higher than expenditures food-at-home. So we're benefiting from that trend from the help of small restaurants and we just think it's got a lot of legs and has a lot of room for growth. Again, the economics also to open a new store versus a Smart & Final store at about $2.8 million to open a new Smart Foodservice store at about $1 million makes a lot more economic sense in today's environment. We just think it's got a lot of opportunity and a lot of white space.

Judah Frommer



Our next question comes from the line of Edward Kelly with Wells Fargo. Please proceed with your question.

Edward Kelly

Hi, guys. Good afternoon. Can we just start on the EBITDA guidance? I'm just kind of curious as to one the cadence of the EBITDA guidance for next year. It looks like Q1, it looks like it'll be down a little bit. Then as we think about sort of like the full-year, full year EBITDA up and to a level actually that $190 million at the midpoint you kind of haven't seen for a few years, despite the fact that there's not going to be or at least in the guidance much inflation. So I'm just kind of curious, if you could help us bridge to return I guess to some EBITDA growth next year particularly if Q1's going to be down?

Rick Phegley

Sure. So I think it's less complicated than you might into it. In Q1, we have sort of a normal expectation in Q1, a little bit of inflation and a couple of factors that are weighing contra to that. One is as Dave said, proportionately a little more of the digital investment in Q1 than the average quarter in the back half of the year. And second, some weather effects and we don't -- as Dave said, we don't like to cite weather as an effect on a normal basis.

But we really have had an extraordinary amount of weather in all of the western states including in the Smart Foodservice banner in the Pacific Northwest, the heart of their country an unusual amount of snow in the major cities, which depressed customers dining out. And so those are factors that are kind of weighing on the Q1 guidance. But on the overall guidance, I think it's a confluence of many factors, a little bit of inflation, a little bit of margin growth and maturation of stores. And when you put all of that together, it gives us some confidence to be in the guidance range of $185 million to $195 million. And obviously, we were in that ballpark on the lower end in 2018.

David Hirz

Building -- growing traffic in the Smart & Final banner in Q4 and even a little more in Q1, obviously gives us more confidence. And plus, the penetration that we've achieved recently with our business customers and our private label the comps that we've had in Q4 and now especially in Q1 really, really drives average transaction size. It drives a higher margin and again gives us -- even in an 0.8% inflation environment, which is what we're projecting for 2019, it's still hard to leverage those fixed costs and that's why we're not north of the $185 million to $195 million, but we think it's right in the range where we ought to be.

Edward Kelly

I just wanted to follow-up Dave on what you were just mentioning on the comp side. Q4 comps particularly on a two-year stack basis actually did take a bit of a step up. Could you just maybe speak a little bit more about what's driving that, particularly on the Foodservice side? And then, as you think about comp guidance for next year, how do we think about the expected performance at each of the banners?

David Hirz

Okay. Yes, Q4 was actually strong comps in both banners. The two-year comp is really strong. If you go back to Q4 2017 that quarter it seems like forever ago, we had 1.7% inflation in that quarter. So that was an especially powerful quarter. In fact in Q4 of 2017 EBITDA was up 30% in that quarter. So cycling that in Q4 of 2018 was a challenge, but happy with comps, happy with where trends are going. Quarter one I would tell you start now good and gives us confidence in the guidance that we just gave.

Rick talked about weather. We don't like to use weather as an excuse, but it's had a negative impact in quarter one, because of the record rainfalls in southern and northern California, the record snows in Oregon, Washington, Salt Lake City, Reno et cetera. It's had over a 1% negative impact on comps in quarter one. But with that, we're still pretty comfortable with quarter one. You can see we guided to 1.75% to 2%.

I would tell you that Smart & Final banner in quarter one we're about 10 weeks into the quarter, but Smart & Final banner is still running about 2% comps and about one-third of that is from traffic and about two-third is from ticket. So I think we have a lot of momentum that really started building at the beginning of quarter four continues to strengthen in spite of the weather headwind in quarter one and gives us confidence in that 1.5% to 2.5% comp for 2019.

Smart Foodservice started out really strong out of the gate. I don't -- like 4.5 comps or something in P1. The snow in Oregon and Washington, six snow days this year already had a huge impact probably cost them almost $5 million in sales. We're still going to finish positive for the quarter. The weather's cleaned up -- cleared up in both places and Smart Foodservice is getting right back on track to the trends they had before the snow hit. And we think we have good momentum in both banners that will take us into quarter two here in a couple of weeks.

Edward Kelly

Great. Thanks, guys.

Dave Hirz



Our next question comes from the line of Tom Palmer with JPMorgan. Please proceed with your question.

Tom Palmer

Hey, thanks for the question. Wanted to start off just following up on the inflationary environment. It's been a few years since we've seen on-shelf inflation in the food retail industry running at 1% but we did see it in February. Are you seeing a similar uptick in the pricing environment in your regions over the past month? And if so could you talk about what's driving it? Specifically are we starting to see list prices tick up? Or do you think it's more temporary factors in that?

Dave Hirz

No, we think -- we saw -- again we measure inflationary cost. We saw inflation okay in the first period call it January. The second period we saw an uptick in both banners, probably in line with what you see in CPI in February. So we feel pretty good about that. But if we look at on a retail environment in the Smart & Final banner, retail inflation is almost the same as cost inflation. So we don't see a big uptick in retail. It just seems to be moving with the cost inflation.

Tom Palmer

Okay. Thanks for that. Also just wanted to ask about capital deployment. You've slowed down unit growth a couple times now. You had talked in the past about three times net debt-to-EBITDA being the target. Based on your guidance it looks like you might get there like midyear. Are you willing to go lower than that? Is your target kind of a lower number? Or is it some other use of cash we should be thinking about?

Rick Phegley

So, Tom at the moment you would be correct to think that our priority is to continue to reduce debt over time to be closer to three times at the end of this year whether it's just over or just under, and we made very good progress last year.

We are not clearly saying that we won't invest in new stores. We think we have a lot of new store opportunity. We're particularly excited by the opportunity to find and develop more Smart Foodservice stores. And we do think there's a day that we will come back to developing additional Smart & Final extra stores in greater numbers than we're projecting for this year.

So I think absent the presenting of those opportunities for new store growth, the alternate use is to continue to pay down debt. But I wouldn't want you to think that that's just the only use of capital and that we would not be open in the right environment to resuming a posture store growth.

Thomas Palmer

Okay. Thank you.


[Operator Instructions] Our next question comes from the line of Andrew Wolf with Loop Capital Markets. Please proceed with your question.

Andrew Wolf

Thanks. I was wondering if you'd like to give some visibility into your profit projections by banner qualitatively I guess. Is it fair to assume that the Foodservice banner has accelerated profit growth given where your numbers have been and how you talked about your competitive positioning?

And the Smart & Final banner will either stay flat or start to grow -- well don't stay flat -- get to flat let's say. And I'm just trying to comport with like, how do you get to your guidance at the midpoint, which is almost mid-single digit growth or roughly mid-single digit growth and how that decomposes for the two change?

Rick Phegley

Sure. Andy, I think the factor that you are intuiting is one that we should emphasize, which is that we've had more -- on a proportional basis we've had more new unit growth in the Smart Foodservice banner in the recent years than we've had in the Smart & Final banner.

And so on a full year basis, we will expect more proportional growth in EBITDA in that banner in 2019. But we also look for growth in the Smart & Final banner as well for all the factors that we've outlined and Dave has talked about and the things that are positively influencing margin. We're looking for EBITDA growth in both banners in 2019.

Andrew Wolf

Got you. And the other thing I just wanted to ask one other question on the -- I think Dave you commented on, I believe this was at the Foodservice -- Smart Foodservice that the average Internet order was 7x the normal order. Just wanted to confirm that. And then was it -- you said at the similar margins. Is that gross margin? Or is that a current…

Dave Hirz

No, that's product margin but it's probably gross margin. The $700 we're talking about is our click-and-collect program. It's click-and-carry we call it, and that's -- there is some delivery through Instacart in the Smart Foodservice banner, but the majority of their digital sales really is coming from click-and-collect. And in click-and-collect, the average order size is over $700.

And the reason it makes sense for us from a productivity standpoint because again productivity is so important to both banners, we run very low labor rates relative to our competitive set whether it's in Foodservice or here in the Smart & Final banner with our conventional grocer competition and mass competition. Our labor rates are much lower and we want to keep it that way.

So, the only reason that click-and-collect works in the Smart Foodservice banner is everything we do is next day. So, the orders come in today. We will pick those orders for the customer. It saves them time away from their restaurants. We'll pick those orders for the customer during the day. We'll finish it overnight if we need to. So, when they show up the next day, it's ready for pick up.

So, it's very low labor for us to pick those orders, because we kind of do it during downtime and it works really well. The average order size in-store is right under $100 and click-and-collect, it's around $750.

Andrew Wolf

Got it. That's great. And it sounds like that's just an amplification or expansion of a business practice you are already doing, right? You're already staging orders. They just want to come in over the phone or the Internet before I mean -- actually. Is that accurate?

Dave Hirz

Yeah, we've always had some form in both banners where some of your best business customer is giving you order by fax or over the phone or e-mail, but on a much smaller scale. The penetration that we're achieving in click-and-collect in the Smart Foodservice banner is much stronger than when we were doing the old manual process. And like I said when we get on our own app e-comm site this summer, it'll make it so much easier for our business customers to be able to place those orders. Today, it's just a little bit clunky, a little bit cumbersome and this new app is going to, I think, really accelerate growth in e-comm, in particular in that banner.

Andrew Wolf

Great. Thank you.

Dave Hirz

Thank you.


Our final question comes from the line of Vincent Sinisi with Morgan Stanley. Please proceed with your question.

Vincent Sinisi

Awesome. Thanks guys for fitting me in here. Just wanted to ask, I know it's early, of course, with the work with Nielsen, but just kind of thinking of the balance between pricing driving traffic what you're starting to learn maybe by category. Just the basic question is, are you seeing so far that there's a lot of room in certain areas? And where do you think -- that you do price all the time, of course. Do you think ultimately we're going to see more of almost like a category by category, by store by store level type of pricing, or where do you kind of -- maybe just early thoughts where that can go?

Dave Hirz

Sure. We're working with Nielsen in three different areas and shelf pricing is really only one of them. They're helping us optimize shelf pricing with their market analytics around individual items, but also though SKU rationalization. They're really helping us understand do we have the right product in the shelf for their shoppers. And the third one is to build circular.

So, I think what you'll see in pricing, you'll see us maintain similar gaps to what we have in today's competition, but be more relevant to our customer. I think you'll see more price regions. We only have a couple price regions today. The Nielsen analytics tells us we should probably have more price regions, depending on the competition set whether it's Northern California or Southern California or Vegas or Arizona.

From the assortment front, I think there's a lot of upside there. Our category managers today have weekly assortment strategy meetings with the Nielsen teams. And now they can really quickly assess as they're looking at their categories really much, much more streamlined than before assess key items that are missing from the sets or items in their sets that they don't need to carry.

And then the third one, the promotional piece, I'm really excited about. Nielsen over the last couple months now has been immersed in our pre-planning process for ad development. And they've developed a post analytical tool, that's helping us to measure success of tests that we're doing either in ad or at the shelf.

And so, there's a lot going on, but I would still say it's a work in progress and we're early stages. We're just -- we're optimistic about where it's going to take itself.

Vincent Sinisi

Okay. Dave, that's helpful. Thank you. And then maybe just a quick follow-up, just back on store growth for a second. Obviously, you're getting more comfort with the Foodservice banner. I guess, just kind of fast forwarding. Should we think -- when you do, maybe at some point, go into more of kind of unit growth overall again, should we think that maybe there's a good chance that more will come from Foodservice in the future as well or as you mentioned there's still good opportunities maybe for Extra! too? How should we just kind of think about that longer term, any thoughts there?

Rick Phegley

I think Vinnie the way I would mentally model it is to think that for the foreseeable future the percentage allocation of capital would be to a greater extent unit growth in Smart Foodservice than in Smart & Final. So, as a numerical example if, for instance, we went to 10 units a year in each banner that would be 10 divided by 66 in the Smart Foodservice banner and 10 divided by 260 in the Smart & Final banner.

So, we think we have good opportunities in both, but from a capital allocation standpoint, we view a future where that allocation of capital on a percentage basis to Smart Foodservice is higher, is likely where we're headed.

Vincent Sinisi

Okay. Okay. And maybe just one super fast. So, at this point, is it fair to say that since you are starting to put more numbers of units out in Foodservice the last few years' worth of workaround that you do feel like the basic kind of prototype go-to-market strategy is kind of down path now?

Dave Hirz

Yeah, I don't know if it's a down path, but yeah, it's going well. Overall, we're happy with the results. You're going to -- always going to have a couple outliers and those are the ones that we're focused on and learning from. But on average, we feel like the seven stores that we've opened in the last two years, so 2017 and 2018 on average. So, they're achieving their pro forma results, both sales and EBITDA. But again just as with most growth, there's outliers that we continue to focus on.

And I'll tell you every time we open a new store in -- especially in a new market, there's new learnings for us and I think it's making us better at opening new stores, looking for ways to faster ramp up that customer acquisition. That really is the key in a foodservice store versus a more conventional grocery store is those foodservice customers are so loyal at their existing location and the key to success is accelerating growth and get them to make that change faster than they normally would. But it's working well, and we're learning with every store we open.

Vincent Sinisi

Okay. Great. Best of luck, guys. Thank you.

Dave Hirz

Thank you.


Ladies and gentlemen, since we have no further questions left in the queue, this does conclude our Q&A session, as well as the call. You may now disconnect. We thank you for your participation and have a wonderful day.