Grocery Outlet Holding Corp. (GO) Q2 2020 Earnings Report, Transcript and Summary

Greetings, and welcome to Grocery Outlet’s Fiscal Second Quarter 2020 Earnings Results 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. It is now my pleasure to introduce your host, Joseph Pelland, Vice President of Investor Relations. Thank you. You may begin.

Thank you. Good afternoon, everyone, and thank you for joining us on today’s call to discuss Grocery Outlet’s second quarter financial results. Participants on this call will make forward-looking statements, which are subject to various risks and uncertainties that could cause our actual results to differ materially from these statements. Any such items, including our outlook for fiscal 2020 and future performance, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. A description of these factors can be found in this afternoon’s press release, as well as in our latest prospectus and periodic reports we file with the SEC, all of which may be found on our website at investors.groceryoutlet.com or on sec.gov. We undertake no obligation to revise or update any forward-looking statements or information. During our call, we may reference certain non-GAAP financial information, including adjusted items. Reconciliations of GAAP to non-GAAP measures, as well as the description, limitations and rationale for using each measure may be found in the supplemental financial tables included in this afternoon’s press release, in our SEC filings and on the Investors tab of our website. We reference non-GAAP measures in some of our financial discussions as we believe they more accurately represent the true operational performance and underlying results of our business. Presenting on today’s call will be Grocery Outlet’s Chief Executive Officer, Eric Lindberg; President, RJ Sheedy; and Chief Financial Officer, Charles Bracher. Following our prepared remarks, we will open the call for questions. With that, I’ll turn it over to Eric.

Thanks, Joe. Good afternoon, everyone. I hope you and your families remain safe and well. Approximately one year ago today, we conducted our first earnings call as a public company. We are very pleased to have delivered strong and consistent financial performance since our IPO. We’re equally proud of our ability to navigate the unprecedented challenges and opportunities presented by COVID-19 in recent months. I’m also extremely proud of our hard work, dedication, community support that has been demonstrated across our organization. This includes our IOs and their store associates that worked tirelessly on the frontlines to serve our customers and our communities; our distribution center teams who went above and beyond to help us keep product flowing, our purchasing teams who leveraged our strong relationships to source both opportunistic and everyday products, enabling us to deliver great values for our customers. I’m so, so grateful for all their commitment. Looking at our second quarter results, our performance reflects the strong execution across our organization. Revenue growth of 24.5% was driven by 16.7% increase in comparable store sales and sales from 32 new store openings since June of last year. Adjusted EBITDA grew 34.7%, reflecting gross margin expansion, slightly offset by modest SG&A deleverage due to higher costs related to protecting our employees and our customers during COVID-19. As we move forward, we will continue to reinvest productivity savings and leverage our flexible business model to drive long term growth. Consistent with that philosophy, we’re accelerating our investments in people and capabilities across three areas. First, advancing how we buy, as we further develop our infrastructure to drive a wider gap in our leadership position in secondary market; second, advancing how we sell by improving our ability to attract the very best operator candidates and prepare them for success, and by making our extraordinary network of IOs even better; and third, continuing to scale our business to support 10% annual unit growth. RJ will speak in a moment about the first area of reinvestment, how we buy. My discussion today will begin with the secondary how we sell, which is centered all around our IOs. We continue to expand our network of field-based educators to more effectively support our existing IOs as well as train and develop our newer operators. In terms of recruiting our new operators to the system, we’re utilizing our digital marketing capabilities to more effectively target and recruit new operator candidates. While early, we’re pleased to see the quality and the strength of incoming inquiries we received from both, those with traditional retail experience, as well as other relevant backgrounds such as hospitality and foodservice. As we look for new operators, we know that candidates must have both, the right mindset and the right skillset to succeed as IOs. We aggressively search and screen for entrepreneurs who are smart and dependent, hungry and humble. While we love to find candidates with existing grocery management experience, equally important to us are vital skills such as customer service, labor management, marketing and leadership. Once identified, these candidates go through an intensive training program, part of which is in in-store immersion experience with a seasoned operator. In order to make our training program more consistent, scalable and efficient, we’re evolving our training approach to leverage the best of our operator, field and corporate teams to create a virtual learning environment. We believe that consistency and rigor provided by virtual training workshops and simulations will be an effective supplement to the in-store training environment. We expect this hybrid approach will help improve the readiness and effectiveness of new operators when they begin managing their new store. We also believe that we’ll provide a more consistent and scalable training experience as we continue to grow our store base. Training doesn’t stop once the IO first opens their store. Our operators are aggressive and hungry entrepreneurs. We’re always looking to develop their skills and grow their businesses. To support that, we provide operational and analytical resources to our field management teams, corporate staff, as well as various data and business intelligence tools. To build upon this support, we’re developing new educational content designed to help them further grow and develop their skills. For example, sharing of best practices is always played a very important role in our culture. And the emphasis on virtual learning will make it easier for subject matter experts to work with operators across all geographies and easily share video content. As our business grows, we will continue to leverage scalable technologies to enhance our ability to support operators. Turning now to new store growth. Our retail expansion strategy remains a significant investment priority. We opened 7 new stores in the second quarter, and now expect to open 30 to 32 new stores for the year. We remain pleased with the performance of our new stores, which like our broader store base, are benefiting from the elevated customer demand. Looking forward, we remain excited about the availability of attractive real estate sites as we continue to build our store pipeline to support 10% annual growth. In summary, the strong financial results we delivered in the first half of 2020 set us up to accelerate investments in our business to support our long-term growth objectives. We look forward to updating you on that progress. Now, before I turn over the call to RJ, I want to discuss a topic of great importance to us. As we’ve shared with you in the past, our mission of touching lives for the better is deeply rooted in the foundation of Grocery Outlet. And as part of this, each July for the last 10 years, we have run our independence from hunger campaign to address critical food insecurity needs across our communities. We’re excited to share, this is a record breaking year for us. $3 million raised across our network. Grocery Outlet also donated an additional $1 million, bringing the total raised $4 million. This brings our total money raised and donated to local communities since the campaign’s inception 10 years ago to over $11 million. As proud as we are of this accomplishment, recent events have pushed us as well as many other organizations to ask ourselves, whether there’s more that we can be doing to address inequality across our society. Specifically, how can we be more effectively supporting diversity, equity and inclusion? While we’ve always served diverse communities and fostered an inclusive workplace, we know that there’s more we can do, and there’s more we will do. We spend considerable time internally discussing steps we can take to improve going forward. And our efforts will span across our employee base, network of IOs and other partners. That includes an assessment of our diversity performance and establishing scorecards and measurable goals for the future. We’re also gathering information through surveys and rolling out listening sessions to gain a deeper understanding of our team’s perspectives. Lastly, we’re providing education modules and resource guidelines to increase awareness and sensitivity across our corporate teams as well as our IOs. With that I’ll turn it over to RJ.

Thanks, Eric, and good afternoon, everyone. We remain incredibly thankful to our independent operators, our buying and distribution teams, and our valued partners for their outstanding efforts and dedication in helping us to support communities since the start of this pandemic. Our combination of extreme value, unexpected deals, localized assortment and friendly service resonates with customers now more than ever. Over the last several months, we have leaned on our flexible operations to adapt quickly to industry changes. Our inventory management capabilities and supply chain execution enabled us to consistently meet increased consumer demand throughout this period. Our inventory levels remain healthy, debt to value remains strong, and we continue to offer an exciting treasure hunt of Wow Deals for customers shopping our stores. Our execution in the first half of this year was made stronger by prior investments made in strategic business initiatives. For example, consistent reinvestments in purchasing through people, process and systems has enabled us to further strengthen our leadership position in the secondary market and scale our business for growth. These investments help deepen relationships and improve partnerships with existing suppliers. They also help to support new and better ways of pursuing partnerships with both, traditional and non-traditional suppliers. We’ve talked before about greater specialization in our buying organization, opportunistic supply remains plentiful and our specialized approach is helping us capture even more of this product. Our buying team continues to develop and strengthen supplier partnerships, ranging from our largest strategic suppliers down to smaller high growth companies. We also continue to deploy new strategies to identify, establish and develop relationships with new suppliers. Our relationships with many of our largest suppliers go back decades, and we consider them to be an expansion of the geo family. These partnerships are strategic, which means they are broad, long-term relationships that reach well beyond any individual opportunistic deal. Our buyers use a personalized, high-touch approach to engage with each supplier. We interact with each of them at senior levels and communicate regularly to identify a wide range of mutually beneficial opportunities. Access packaging, innovation planning and reconditioning opportunities are just a few examples of ways we partner with major suppliers. We also look at the total business, both opportunistic and every day and manage to shared sales and profit goals. We are equally excited about our potential with smaller high growth suppliers. These are our combination of suppliers and high growth categories and those that are on a strong growth trajectory due to their own brand and product positioning. Our objective is to be a valuable solution provider for these partners as well as to help them grow. In some cases, our partnership helps them scale their business by reducing manufacturing costs. In other instances, we help them by driving new customer trial, which increases brand awareness and loyalty. We provide an easy go-to-market retail option for them to grow their business. As with our strategic suppliers, we follow a customized approach and partner with them on long-term, mutually beneficial strategies. We also continue to invest more time and resources in establishing and developing new opportunistic relationships. We are further increasing buyer specialization with a focus on new supplier acquisition. This positions us well to efficiently identify and develop new relationships with suppliers of all sizes. In many cases, new partnerships begin with a smaller initial purchase order. Many initial purchases represent an opportunity to develop new, high-growth, long-lasting supplier partnerships. And we work to nurture these relationships with this in mind. Disruption from the pandemic continues to present a number of these new supplier opportunities, including non-traditional suppliers, similar to what we shared last quarter. In addition to investments in opportunistic buying, we are also enhancing our approach to everyday items and category management. This is a combined effort between buying, inventory management and our strategy teams. Benefits here include more relevant items, higher sales productivity and better seasonal planning. One recent example is improvements made to our relatively new seafood category. We optimize and focus our assortment according to customer demand, which grows higher sales margin while also streamlining store ordering and execution. Extreme value on quality branded products resonates with customers now more than ever. We continue to see strong engagement from existing customers and a healthy flow of new customers shopping grocery outlet. These new customers represent a mix of different shopping behaviors and patterns, consistent with our overall customer base. We are the primary store for some and secondary or tertiary stores with others. We continue to target bargain minded customers with value. This approach has served us well and offers ample opportunity for growth. Our marketing strategy is to focus on attracting new customers as well as staying top of mind to drive repeat visits with those that already shop us. We continue to evolve our media mix and messaging to capture the attention of our target customer. Our shift from print to digital provides the flexibility to communicate real time store-specific information on our ever-changing Wow Deals. It also helps us address more recent changes in customer behavior and communication preferences. Another initiative within marketing is personalization. Investments made in our email database have enabled the launch of our welcome series email campaigns. Customers that sign up to receive emails now receive a welcome message followed by a customized program of additional emails and videos that serve as an introduction and education on the unique attributes of Grocery Outlet. We supplement this brand marketing with regular WOW Alerts that communicate the best deals currently available. This is just one part of communicating the Wow beyond the four walls of the store. Customers have responded very well to this outreach, and we plan to further increase engagement as we advance our personalization strategies. In conclusion, we are extremely pleased with our progress and confidence that the investments we continue to make in talent, infrastructure and operational enhancements will further advance our strategic growth initiatives. I will now turn the call over to Charles.

Thanks, RJ. Good afternoon, everyone. Our second quarter results reflect the strength of our business model and the outstanding efforts by our team and our independent operators as we continue to operate through this pandemic. Sales for the second quarter increased 24.5% to $803.4 million compared with the same period last year. This growth was driven by a 16.7% increase in comparable store sales as well as the sales contribution from 32 net additional stores since the end of the second quarter last year. Our comp growth in the quarter was a result of an increase in average transaction size, partially offset by decline in traffic. Comp performance was once again in broad-based with strength across all regions and vintages. We opened seven new stores in the quarter ending with 362 locations. We remain pleased with the performance of our newer stores, which consistent with our established stores, are benefiting from elevated food-at-home spending. Second quarter gross profit increased 27.7% from prior year to $253.8 million as gross margin performance exceeded our expectations going into the quarter. Our gross margin rate was exceptionally strong, increasing approximately [Technical Difficulty] basis points from prior year to 31.6%, largely due to reduced markdowns and throwaways as a result of faster inventory turnover. This improvement in inventory efficiency more than offset distribution cost deleverage, resulting from enhanced safety measures and higher personnel expense at our warehouses related to COVID-19. SG&A expense grew 25.6% to $198 million with the increase largely attributable to higher variable commissions to independent operators, resulting from gross margin dollar growth, higher store occupancy due to unit expansion, and continued personnel and infrastructure investment to support the growth of our business. In addition, we incurred incremental COVID-related store and corporate costs, as well as public company costs and transaction expenses related to our April secondary offering. These factors resulted in SG&A increasing as a percentage of sales to 24.6% from 24.4% in the same period last year. Stock-based compensation expense for the second quarter was $10.2 million, largely driven by the full vesting of 2014 performance-based stock options in conjunction with our April secondary offering. As a result of the tax benefit associated with employee option exercises during the second quarter, we incurred a $2.2 million tax benefit, resulting in an effective tax rate of negative 8.3%. Relative to our normalized tax rate, this option-related tax benefits increased net income by $9.6 million in the quarter or $0.10 per diluted share. As a result, GAAP net income for the quarter increased to $29.3 million or $0.30 per diluted share, compared to a net loss of $10.6 million or $0.15 per diluted share in the prior year. For the quarter, adjusted EBITDA grew 34.7% to $60.6 million from $45 million last year. Adjusted net income increased 189% to $41.8 million or $0.42 per diluted share, based on an average of 98.6 million diluted shares in the quarter. Turning to our balance sheet liquidity. Due to the sustained momentum in our business and our strong cash flow generation, we elected to repay our $90 million revolver draw in late May. As a result, we ended the second quarter with $79.8 million of cash. As RJ mentioned, we remain pleased with the quantity and composition of our inventory, which increased 13.1% versus the prior year to $229.3 million. Total debt decreased from the first quarter to $460.1 million as a result of our revolver pay-down. While we remain confident in our liquidity position, we continue to take a conservative approach of building cash on the balance sheet, given COVID-related uncertainty. For the quarter, we generated $22.2 million in operating cash flow as our strong operating performance more than offset our rebuilding inventory from our March low point. We invested $21.8 million in CapEx in the second quarter as we continue to build new stores and invest back into the existing fleet. Turning to current trends and our outlook for the back half of the year. Comp sales growth stands at 10% for the third quarter to-date. We continue to see growth in basket size, partially offset by lower traffic, as customers continue to consolidate their trips. We anticipate that our comp growth will continue to moderate as the economy reopens. With respect to gross margin, we expect that our margin rate in the back half will be roughly in line with prior year quarterly results. That expectation is driven by a moderating shrink benefit as inventory turnover normalizes, margin headwinds from commodity cost increases, and the fourth quarter margin debt we typically experience as a result of holiday product mix. With respect to expenses, we continue to prioritize making the right health and safety investments on behalf of our employees, customers and independent operators. As such, we expect to continue to incur incremental costs in the back half of the year associated with COVID-19, such as cleaning and safety costs, costs for protective equipment and supplies, and higher personnel expense. While the pandemic has been challenging to navigate, it has provided a unique opportunity to bolster talent and infrastructure as we continue to execute against our long--term growth objectives. As such, we have increased investments in people, process and tools to better position us to capitalize on the significant whitespace in front of us. Those accelerated investments began in the second quarter but will work more meaningfully in the third and fourth quarters. The same can be said for public company costs, which we believe will continue to build as we become fully SOX compliant. Taking all of those sales, margin and expense expectations into account, we believe adjusted EBITDA margins for the second half of 2020 will be modestly below prior year levels. In terms of other items on the P&L, with respect to stock-based compensation, we have now incurred substantially all of the expense associated with that time-based performance-based 2014 employee options. In the second quarter, we implemented a new long-term incentive plan to attract and retain talent. At target levels of achievement, we expect that stock-based comp expense associated with this new plan will ramp over three years to an annualized run rate of approximately $25 million. Following the repayment of our revolver, we expect interest expense to be roughly $6 million on a quarterly basis. We continue to expect a normalized tax rate of approximately 28%, which excludes discrete items. And we expect weighted average diluted share count for the year to be approximately 100 million shares. Based on our current projection of 30 to 32 new store openings in 2020, we now expect that CapEx for the year will be in the range of $95 million to $105 million. We do not expect any store closures in 2020 beyond the two we had in the first quarter. In closing, we’re incredibly proud of the performance of our team and IOs and the exceptional results we delivered in the first half of 2020. Despite the continued uncertainty surrounding COVID, we remain as excited as ever about our unique positioning in the marketplace, and our long runway for growth. We remain committed to managing the business for the long term, and making smart investments in pursuit of those objectives. With that, we can turn it back to the operator to begin Q&A.

[Operator Instructions] Our first question comes from the line of Paul Trussell with Deutsche Bank. Please proceed with your question.

Yes. Good afternoon, and congrats on another good quarter. To start, maybe we could touch on the availability of goods as well as the performance, kind of breaking down between everyday items as well as opportunistic items.

Hi Paul, it’s RJ. I can take that one -- those two questions. I’ll start with the availability of opportunistic supply. We continue to see ample supply from our partners. As mentioned in our comments, we’re pleased with the health of the inventory and the overall assortment. And according to the great work done by our buying inventory management teams and maintaining inventory levels that we have, we’re in a unique situation for sure. But, we’ve been at this business for a long time, and we’ve been through lots of different cycles. I’d say, we’re keeping very close contact with all of our suppliers. We understand supplier dynamic very well. Whether it’s changes to a service being made or innovation or where product may still be on allocation. I’d point to our success right now being a result of the same method and approach that really we’ve followed over many, many years. We haven’t changed the way that we conduct business, even in this unique situation. We continue to benefit from doing business with lots of different suppliers. We pointed to the diversified supplier base as a strength on previous calls. Supply does cycle by item and supplier. And so to be able to balance that across many supplier partnerships, helps at all times. And important to remember here that this just contributes to the treasure hunt experience in the stores and that customers are used to changes in items and they get excited by new and different items showing up a great value on a regular basis. Always come back to the partnerships we have with suppliers, strong long-lasting partnerships. We’re a solutions provider to them. We partner strategically on long-term goals. We follow a customized approach. We work creatively. All of these things -- they’re long-term in nature, so they help during any short-term fluctuations that we see. And that again has been true throughout our history. And then, it also points to focus on new supplier acquisition as a real strength in pre-COVID times with amount of change in the supplier landscape, but certainly now, as it’s benefited us both with traditional and non-traditional suppliers. And we’ve mentioned previously on the non-traditional side, you’ll continue to see opportunities from food service, hospitality, more recently cruises and hotels and fitness centers and other opportunities that have come our way. Maybe last point I’ll make on opportunistic supply, I continue to be bullish on a long-term opportunity here. Manufacturers have increased production. They don’t want to get caught again, like what happened back in March and April. I’ll say, we’ve already seen some opportunities that have come our way from overproduction, we expect more to come in the future. We continue to benefit from retail closures and store re-openings and that time will time will tell how quickly others open. But, we’ve been able to help out some suppliers in tight situations there. And anytime there are changes in assortments whether its SKU related or category related, packaging related, we see those opportunities. And ultimately any type of supply chain imbalance is a positive thing for us. So, all of those things will continue to be true as we look forward. And then, just as quickly in terms of mix. Have we -- I think your question was, have we seen any material change in mix? What I’d say here is we don’t manage our business to mix, we manage to value and mix continues just to be the result of where demand is, what we’re able to purchase and ultimately where we can deliver value. As a reminder, customers don’t know the difference between everyday and opportunistic. That’s all internal speak. But, they do recognize values. So, we continue to orient around that. That said, everyday has tracked a bit higher in terms of mix as some of the higher demand items and categories do skew more to the everyday side. So, that sums it up a little bit. But, we’re used to short term changes in mix as demand and supply fluctuate, and always come back to our flexible buying and merchandising model that allows us to adjust. We don’t have set skews or hierarchy or any volume commitments there. So, perfectly comfortable managing these fluctuations and mix, and always maintaining healthy value to drive both sales and margin.

That’s really helpful color. Thank you. And just as a follow-up, is there any metrics or color you can share on what you’re seeing from a new customer count standpoint or just overall bringing awareness. And while food at home is obviously benefiting, all stores. Charles, is there a way that you kind of strip that out and kind of gauge new store productivity that you can speak to? Thank you.

Yes. Paul, I’ll take the first part and then Charles can pick up on the second. I’d say, in regards to new customers, we’re pleased with the number of new customers that continue to come into our stores. New customer levels are attracting at very, very healthy levels, particularly in our developing markets, specifically Los Angeles and Pennsylvania, so, seeing really nice new customer account growth there. In terms of metrics, we conduct regular surveys. I would say, we look at profile of the customer, we look at shopping behaviors, we look at satisfaction with Grocery Outlet. I’d say a couple things. One, new customers are mix of those that shop with us primary, secondary tertiary, very consistent with what we’ve seen in the past and consistent with the overall mix, and having a great experience. So satisfaction is high, they’re very satisfied with the store experience. And we believe there’s incredible stickiness to that experience, and we’re seeing it in the metrics from our survey. The treasure hunt resonates with them, value, the convenience of a small shop, the operator, the connection to community, Health and Safety of course is critically important to customers now and they’re satisfied with the things that our operators are doing around health and safety and cleaning. And so, they’re coming in and they’re having a good experience. And we think that bodes well for us looking forward. Charles?

Yes. Paul, just to add RJ’s comments on new store productivity. We’re really pleased to see performance in these stores. Again, the rising tide is lifting all boats. And so, we’ve seen new stores open this year, as well as the ramping vintages for the past several years continue to benefit. And importantly, as RJ mentioned, a big part of that is new customer acquisition. So, feel really good about where we are. It’s important metric for us and one that we track very closely.

Our next question comes from the line of Randy Konik with Jefferies. Please proceed with your question.

Hey, guys. How are you? Can you hear me?

Yes.

Yes, sorry. So, I guess, my first one, maybe back to RJ, kind of a follow-up on the first question there. So, can you give us a little bit more background? You talked about expanding the supplier base during the pandemic, cruise lines, hotels, et cetera. But, could you maybe frame out a little bit more quantitatively just how the supplier base has grown maybe in the past six months, past five years and past 10 years? The reason I’m asking is, during the Great Recession, we saw TJX had a similar thing happened to them where their supplier base exploded during the Great Recession, and it kind of led to a really kind of expansive partnership network. And then, the other thing that happened with that particular company was the nature of the relationship or the dynamic of that relationship with those suppliers also changed. And when I’m hearing your comments on the script -- with the script with the call, it sounds like the dynamic relationship with these suppliers is deepening even further, meaning you’re getting even more preferential treatment -- mostly as a preferred partner, getting more maybe some made for product or something beyond just opportunistic close, that kind of stuff. Maybe just give us some perspective on quantifying that supplier base, and then, kind of giving us a little bit more meet around the dynamic of the relationship with the supplier base and how that’s been changing over the past, three months, and the past few years?

Yes. Thanks for the question, Randy. Yes, a lot of what you just said there is true and what we’ve experienced over the years, and certainly growth in terms of number of suppliers. We’ve expanded our supplier base as the assortment has evolved. So, you think about categories and we talk a lot about NOSH. But I’d point to natural, again, specialty-healthy is seeing tremendous growth and the establishment of new supplier partnerships. That’s in part because of how we’ve evolved assortment and of course, what’s happening within the supplier landscape with new upstart suppliers and higher growth suppliers coming into the industry and we’ve been able to establish those relationships and grow with them. To your comment about the types of relationships, and how that’s evolved, we talk a lot about strategic partnerships. And in the comments there, what that means to us is it is much more than a transactional type of relationship. And it’s much more than an individual opportunistic deal. So, we partner with them together for the long term. And so, -- and we treat the relationship accordingly. So, if you think about things like creative solutions to instances where they’re stuck. Certainly, as we think about costs and margin and value in that equation, it’s over a longer period of time. We, I’d say, we’ve evolved into more of a hybrid opportunistic and everyday mix with many of our larger suppliers. And that’s proven to be mutually beneficial. We’re a high growth channel for them and we continue to access more and more of their opportunistic. Specialization within our team is a part of managing these relationships better. So, we think about strategic suppliers. And an approach that works well there. We think about smaller, high-growth suppliers and tailoring our approach needed there. And then, this continued focus on new supplier acquisition and development is something that allows us to be more focused. We do believe that we are preferred partner. We ask suppliers all the time what more we can do to be a better partner and we’ve gotten better as a result. And so, we have that type of relationship and communication. And for us, it’s about finding new and helpful ways to partner with them. And so, we’re constantly working with our points of contact, broadening our reach throughout the organization and exploring opportunities to help them whether it’s specific to innovation or supply chain situations that they’re in or on the smaller side and helping them scale to grow. And so, all of these approaches, I’d say have been part of a longer term evolution, as the Company has grown as we’ve invested in people and systems to be able to do things better. And I think both, we and our supplier partners have benefited as a result. And then, just lastly, I think, on your question related to non-traditional suppliers. We think of those no different than any other new supplier partnership, and that we want to cultivate that relationship and grow with them. It has been a smaller part of the mix in terms of PO volume or sales volume. But as with most new supplier partnerships, it starts with an initial PO and then develops into longer bigger partnerships from there. So, we expect many of those opportunities to play out the same way on the non-traditional side.

Very helpful. And I guess, real quick follow-up. Just maybe there is a progress report on younger market progress, let’s say, like Pennsylvania or Southern California and how that compares to mature market performances, just so we get a flavor for how the younger markets and the East Coast are doing relative to the historical markets. Thanks, guys.

Hey, Randy. It’s Eric. Good to talk to you. We’ve said it before that the East business is still a very young business. Super excited to have Heather back there. She started really in earnest in February. I’d say great progress this year in terms of comps and sort of her leadership in the market and sort of getting us set up for growth transfer out to Southern California. And that market’s done really, really well. We really started opening stores there sort of 2014-2015. And it’s taken us a while to get up to what I think is going to be around 85 to 90 store account by the end of this year. And, our market shares are still fairly small, but we’re doing really well down there. I think the brand is growing. We’ve concentrated a lot on supply chain in the last few years and making sure we’re buying product, putting it in LA and distributing from there. We’ve also focused our recruiting locally for placement locally. And so, everything’s sort of clicking together. And obviously, as we build that market share and build that position, things will continue to get even better. So, we’re really pleased with both of them.

Super helpful. Thanks, guys. I really appreciate it.

Our next question comes from the line of Robbie Ohmes with Bank of America. Please proceed with your question.

Hey, guys, great quarter. And thanks for taking my questions, actually just two quick questions. The first was just on the sequential slowdown to the 10% comps. Any color on whether the slowdown is more traffic or ticket-driven, sort of maybe just more color on the slowdown. And maybe are there any category things that are -- any categories slowing sequentially more than others? And then, my other question is just on the incremental COVID-19 costs. Can you remind me what the IO cost structure is in terms of how much should the COVID-19 -- are you guys helping them with the store level COVID-19 costs or are your incremental costs all your side of the business? Thanks.

Hey, Robbie, it’s Charles. Let me tackle both of those. So first, with respect to the comp flow. I would say that the trend -- the enduring trend that we’re seeing is that safety is really top of mind for customers. So, beginning the second quarter and continuing now, they continue to consolidate their trips into the store. And so, the overall traffic trend has been steady. And I think that’s true across our markets. It’s really been the average basket size as well as remains elevated. That is starting to moderate as the economy is slowly reopening. So, really hard to say how traffic and basket are going to trend as we move into the fall and winter. But, I think, broadly speaking, this trend of overall moderating cost is one that we would expect as markets continue to reopen. So, that’s comp flow. Secondly, your question on COVID costs. Yes. So, we are absorbing some costs and helping support the operators and costs that would normally fall onto their P&L, things like supply costs in the store for personal protective equipment and safety-related costs, cleaning costs. Again, it’s not per the letter [ph] of the operator agreement, it wouldn’t be a cost of ours. So, we think it’s the right thing to do. And so, we’ve absorbed those costs in the second quarter, and we would anticipate continuing to absorb those costs as we move through the balance of the year here.

That’s great. That makes a lot of sense and really helpful. Thanks, guys.

Our next question comes from the line of Michael Lasser with UBS. Please proceed with your question.

Good afternoon. Thanks a lot for taking my question. If you look at the customer base by shopping behavior, so the full shops versus those who are just doing a filling in, which I think you had some nomenclature and how you refer to those different buckets earlier in the call. How are those two baskets doing quarter-to-date versus where they were doing in the first two quarters of the year? So, my question is, basically, are you seeing a slowdown in those filling shops -- shoppers or is the slowdown occurring more in those who are doing their main shop at Grocery Outlet?

Yes. Hi, Michael. Yes, I’d say, across different shopping behaviors or groups, if you will, we talk about primary, secondary, tertiary, we’ve seen consistent trends So, no particular trends specific to one versus the other.

And for those customers who you are able -- who you’ve been able to attract new into the pool, have you been able to trade them up from being tertiary or secondary into a primary shopper, and how do you do that?

Yes. So, we -- as I said, we -- they’ve been a healthy mix. They’re newer, so there isn’t a ton of history there for movement, if you will. And then, beyond that, we don’t necessarily think of all tertiaries as potential for secondary or secondary to primary all the way up. Customers shop us in different ways. They put us into shopping patterns specific to their needs and how that works for them. So yes, certainly to the extent that we’re -- they have the propensity to become primary, as we continue to offer great value and a great shopping experience, they’ll move there. But, we don’t really think of our business so much in that way in terms of customer migration, as you’ve described it, just given the unique nature of our store and how we appeal to different customers in different ways.

Okay. Thank you very much and good luck.

Thank you.

Our next question comes from the line of Oliver Chen with Cowen. Please proceed with your question.

Hi. Thank you. Inventory management was tightly managed this quarter. As we look ahead, should we expect inventory growth to underpay sales growth in the back half as well? Do you expect that trend to continue? Also, your comments on buyer specialization. Why was now the right time for that to happen? And what do you see happening in terms of timing of impact of that decision?

Hey, Oliver. This is Charles. Let me take the first part and then I’ll send it over to RJ. But with respect to inventory, yes, really pleased with the current composition and level of inventory that we have. Of course, we saw a nice rebuild from the end of the first quarter. So, as we look towards the back half of the year, I would think in general, it’s going to trend roughly in line with sales growth. Of course, given the nature of our business and the opportunistic purchasing it can fluctuate a bit more than traditional retail. But, I think that general rule of thumb of in line with sales growth is pretty safe.

And in regards to specialization, we’ve been talking about that for a number of years. I’d say, the first piece was when we introduced inventory management back in 2013, those were tasks handled by the buying team previously. So, the first piece there. And then, more recently, really two years ago started the planning and moving people into everyday and opportunistic. And really just a reflection of being able to better manage the business, recognizing that opportunistic and every day are unique parts to buying and with the change, we’ve been able to go deeper. So, on the everyday side, still growing into better category management, and everything involved with that. And then on the opportunistic aside, it’s been hugely beneficial to have 100% focus from that team as we think about the different tiers and types of suppliers as well as new supplier acquisition.

Thank you. And as you do look ahead curbside pickup and delivery, what are your thoughts about how that may be a factor in your future and what your customers want and how the specialness of the treasure hunt may or may not relate to those digital options?

Yes. Our long-term position on e-commerce hasn’t changed. We have a long runway for growth with -- through both our existing stores as well as new store growth. And ultimately, our customers enjoy the in store Wow shopping experience, the treasure hunt, the value the personal engagement. So, it’s still hard to replicate online. And we don’t want to sacrifice value for that. So, we’ll continue to evaluate e-commerce relative to other long-term priorities. And then, in the meantime, we continue to develop with digital marketing, things like personalization and social media and growth of email database, all those things have been impactful for us. And we think that helps us quite a lot in terms of new customers and share of wallet growth.

Okay. And lastly, on that point you’re making about digital marketing and marketing spend. How are you thinking about the incremental dollar and spending at what medium and customer acquisition costs, as you look at different options online and you also allocate your dollars from print media?

Yes. It’s really been a shift. So, we’ve become more efficient with our marketing spend and a lot of digital has come as we’ve shifted away from print. And, traditional conventional marketing media, print is still very prominent. And we’ve just shifted those dollars more efficiently, more effectively. And I’ve always said, it’s better for this business, real time store-specific items, digital supports that in a way that print never could. And so, it’s been beneficial both from an efficiency standpoint, but also from an effectiveness standpoint in fitting with our model as well.

Our next question comes from the line of John Heinbockel with Guggenheim. Please proceed with your question.

Maybe for RJ. I know a lot of the stuff you’ve done with the procurement department has been with internal folks. Have you expanded that group here or intend to with the part of the investment? One is on that. And then secondarily, where you think you could end up here on the private grand journey, particularly we’re in a downturn and it may last for a while?

Yes. So, we have expanded the group. So, one of the best investments we make is in people. And so, the group has grown as the business has grown. Part of that related to specialization, part of that just related to a growing business. So, we’ll continue to invest in people and would expect that to continue to be a very positive return for us. And then for private label, we haven’t increased the priority on that. It still remains on the list as far as feature roadmap goes. We continue to see plenty of supply from an opportunistic standpoint. So, that’s always preferred. And it’s something that we’ll keep on the list and will determine when or if it becomes a higher priority in terms of assortment strategy.

And then, maybe just a quick follow-up, WOW Alerts in a consolidating trip environment, right? So, I know they were very effective and getting people in more frequently. How effective are they in COVID? And then, have you changed your approach in COVID?

Yes. So, very effective, John. For one, it’s a great way to communicate to customers what we have in the store. So, if they’re not sure about making a trip or they’re trying to decide where to go, we think it’s a great guide -- it’s even more relevant now than ever, great way to communicate that to customers. When we think about personalization, it’s really about expanding WOW Alert. So to show them more of the sore, take it outside the four walls and make it more specific to the customer for the items or the categories that they’re looking for. So, really pleased that we have that and we expect that to be important part of digital marketing for us ahead.

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

Hi. A couple of questions for you, maybe a little more housekeepingish. But, first would be, can you give us a little bit of an update on the promotional environment and whether, say from your conventionals if you’ve noticed an uptick in the promotional environment from them? The second is, you called out commodity costs increases going forward. So, could you just give a little color on what you’re seeing on inflation and what your expectations are? And then, I just have one question related to the IOs.

Hey, Karen, Eric. Thanks for the question. Yes. I would say nothing unique in the promotional environment that you all haven’t seen and read about. I think, if you paid attention to the I think Albertsons and Safeway call, they just couldn’t rely on suppliers. Inventory was down and it’s very difficult to promote, people are starting to get back into the fresh side where controls is a little bit is better. But we have not seen a whole lot different than what you all write and describe. We’re not seeing any new competitive activity or any gimmicks in any of the markets, but I’d say it’s pretty much status quo to what we’ve read as well.

And, Karen, this is Charles. Let me address the inflation question. So, we didn’t feel much inflationary cost pressure in the second quarter. But, we are now starting to feel that across a number of categories, including meat, and deli and produce. So, we do expect that’s going to be a bit of a gross margin headwind in the back half of the year that we didn’t see in the first half. Again, we love the fact that our model allows us to mitigate some of those inflationary pressures because we can buy and merchandise flexibly. But, we do think nonetheless, it will be some somewhat of an impact in the back half.

Okay, thanks. And then, just one quick question on the IOs. Can you just give us an update, if you did, I missed this, but on the interest rate relief that you had called out in 1Q for the IOs?

Yes. So, that continues to be the case. We’ve given relief to the IOs to the tune of a 50% reduction in their interest rate. And as I mentioned before, it’s one of many COVID-related costs that we’re absorbing. And we would anticipate to continue to do so as we work our way through the pandemic.

Our next question comes from the line of Simeon Gutman with Morgan Stanley. Please proceed with your question.

Hey, guys. It’s Simeon. So, my first question is a modeling one with two parts. The first part is, could gross margins be up again in 2021 for any reason? And then, related to it is incremental margins in general for this business have been in the mid-single digit range, and that’s what your normalized comps of let’s say 4% to 5% or 6%. When we start normalizing to those levels, should the incremental margins follow? And any reason why they should be stronger or weaker than those historical numbers?

Yes. Simeon, this is Charles. Let me try to tackle both of those. So, first of all, with respect to your gross margin question. So, yes, really pleased with the performance we saw in the first half of the year. Again, shrink was a big benefit just because of the sustained momentum on the top line. So, we saw much lower markdowns and throwaways. We’ve always said that over the long term, we take the view of managing for stable margins. And I’d say, that’s true, both with respect to the gross margin line as well as adjusted EBITDA margin lines. So, we’re just starting our initial planning for 2021. We very much expect it will be a fluid environment in which we’ll be operating. But again, what I can tell you is longer term, we manage the business for stable margins. And again, both gross margins and adjusted EBITDA margins. The reason is because of the reinvestment that we’ve talked about. You will definitely have quarters, you can have quarters like we had in Q2 where really up and down the P&L stars aligned and we saw some nice flow through. But our objective would be to make sure that we’re doing the right things, to reinvest in talent and an infrastructure to ensure our success as we continue to grow stores.

Okay. And then, my follow-up just with regard to the IOs and some of the training that was mentioned. First, I don’t know if you’d say this, but what was the tone that you use this quarter in terms of the script around training, was a little bit more urgency or heightened I importance? And second of all, if it was, can you talk about the performance gap over the past two quarters among stores, or is it widening? And is there anything in terms of the IO P&L that’s differing? And so, what is the urgency or let’s say the heightened importance on the training?

Yes. Hey, Simeon, Eric. I think you picked up on it correctly. I think, the urgency is all about scaling and just the reflection that we have, 70 to 75 to 80 inbound AOTs per year that we’re training and getting ready to go out into the system. I’d say, second, if your traditional grocery manager that’s thinking about another opportunity, this is probably not the year that you’re looking. So, we’re dipping our toe into some other candidates from outside of the grocery arena. So, it’s an opportunity for us to upgrade the training and both from a forced virtual training to combined with what we’re doing in the stores and then two train people on the grocery business that may possess other skills, entrepreneurial or customer service or back office. So, I would say it’s all of those things. And then, I think you’ve heard themes throughout from us that if it’s working well, that’s a good time for us to pick at it and see if we can improve it. So, just a threat of continuous improvement would be probably the final.

Thanks Eric.

Our next question comes on the line of Joe Feldman with Telsey Advisory Group. Please proceed with your question.

Hi, guys. Thanks for taking my question. I wanted to go back. RJ, you were talking about personalization in your response to John about it as well. But, how are you hearing the message on those WOW Alerts? That’s kind of how I think about personalization, or is it just like you’re increasing the number of WOW Alerts and to people, like, what is actually happening there?

Yes. So, personalization, we’re in the very early innings still Joe of planning how we can come more customized and personalized, mentioned in the comments, this welcome series email campaign that we put out to new customers. So it’s specific to them. They’re new to the model. So it is about introducing and educating them because it is a different kind of shopping. We want customers to understand that. The WOW Alerts are still now not personalized to customers. They’re specific -- as they’ve always been specific to stores and items. So, they’re local and they’re real time and they reflect some of our best value, highest velocity items. The next phase then with WOW Alerts, once we start tracking more customer specific information would be to have that specific to you Joe versus someone else based on what you like what you buy and other suggestions or things that you find interesting. We have super high engagement from these WOW Alert emails that go out. Customers look for them, they open them, they react to them, and we think we can engage -- we can increase that engagement further still, when it becomes even more relevant to you, and your specific needs.

Great. Thank you for that. And then, I guess, follow-up maybe also for you RJ was the opportunistic buys that you’re seeing out there, are there any categories within the space that’s like really heavy, and like there’s too much of it, and you can’t take all of it, obviously, but -- or is it pretty broad-based, as if where you’re seeing the opportunities?

Yes, it’s really broad based. And to the extent that there ever are situations where it’s too heavy or lighter, so to speak, I mean, I’d say those are -- those in for long history, this company operating with this model is just part of normal fluctuations and cycles that happen. And so, -- but yes, on the whole and over reasonable period of time, it’s healthy. And, nothing specific to categories, it’s ample really across all and things move around but not have any significance to point to that it would -- call out one category versus another.

Our last question comes from the line of Jeremy Hamblin with Dougherty and Company. Please proceed with your question.

Thanks and congrats on the strong results. I wanted to start with a question on store openings. You increased your guidance by a couple of units. In terms of as we look forward into 2021, can you provide any commentary on the quality of the real estate opportunities you’re seeing, the quantity of real estate opportunities, and whether or not kind of what’s transpired here in 2020 makes you think a little differently about the types of locations that you might look at going forward? And then, I had a follow-up question.

Hey, Jeremy, Eric. I’ll take the latter part of the question. No change in direction in terms of the types of sites that we’re going to consider. We’re always looking for a great real estate, whether it’s a dense market or rural market, we want to be sort of where people are, and they’re used to shopping. So, I’d say that would be an overarching for us. Relative to long term, the target we think the 10% unit growth works really well. The pipeline for 2021 is very strong. We’ve continued having a real estate meetings, monthly approving sites, getting lease assigned, we continue to go out and look into markets. And we’re excited about both, the finish of this year and the prospects for next year. I think, relative to the big question that we’ve gotten from a number of people is what do we think is going to happen in years ‘21 and ‘22, relative to supply? I would say, the markets that we operate in, for many years have been pretty competitive. Lots of people looking into 15,000 square feet, up to 30,000 square feet, we’ve been able to be really flexible, split up boxes, like Kmarts and Sears and other retailers that are giving up sites and get into 10,000 square feet all the way up to 30,000, 35,000 square feet. I think what is going to happen is this greater real estate markets where it gives back square footage, we’re getting more opportunities versus less. And if we have more opportunities, I think we’ll have a good focus on quality but at the same time, I think there could be some opportunities relative to what we have to pay to get into those sites.

Okay. That’s great. And then, just in terms of -- I wanted to ask a follow-up question actually on PPE costs. In terms of now, we’re many months into the pandemic, it seems as though there’s been some efficiency gains in terms of managing simply because we have better visibility on what needs to be done and there’s less of a scramble in terms of getting PPE to the team. Can you give a sense on whether or not the impact of those costs, is that starting to diminish as it relates to the overall total cost, percent cost of sales. But, just any color you might be able to provide on that would be helpful.

Jeremy, this is Charles. Let me try to provide a little bit of insight there. I would say and I should emphasize everything we’re seeing for COVID cost for us, given our model, it’s across a number of areas and hits several different lines in the P&L. Some of that’s expense, some of it’s capital. But everything from our distribution centers to cost in our corporate office for the staff that remains and all the work from home costs, everything where I talked about that we’re doing stores, both from a support standpoint for IOs as well as incremental capital that we’ve put into the stores. So, it is a number of things. It was a significant impact to us in Q2, and really was one of the key drivers as to why we delevered SG&A in the quarter. I do think that while there may be some efficiencies we’re seeing, it’s going to continue to be a significant cost for us, until we get on the backside of COVID. So, from a modeling standpoint, it’s really one of the reasons why we’re trying to orient folks towards the back half of the year, and adjusted EBITDA margins again being slightly lower than prior year.

Okay, great, guys. One last question may be on your debt and kind of replace or pull bad debt down. In terms of thinking on a go-forward basis, you’re generating a lot of cash. Is that a priority to potentially reduce the overall debt levels here as you move into 2021 or into 2022?

Yes. The way we’re thinking about it, Jeremy, is that until we get -- again on the backside of COVID, let’s just take the conservative approach and continue to put excess cash back into -- back on the balance sheet. We feel great about the liquidity position. As you point out, we’ve got plenty of internal cash flow to fund our investments in growth as a result of how good we felt we did take the opportunity to repay the revolver in May. But, I think, what we’ve done is decided to table the longer term discussion around what’s the right leverage ratio ultimately for this business and then what do we want to do with excess cash after that? I think again, that’ll be a conversation we can revisit once we get some more clarity around COVID.

This concludes our question-and-answer session. I’d like to hand the call back to Eric Lindberg for closing remarks.

Hey. Thanks, everyone, for joining us. I appreciate all your questions, and we look forward to catching up with you individually after this call. Thanks so much. Take care.

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.