Good day, ladies and gentlemen. Welcome to the Natural Grocers Third Quarter Fiscal Year 2017 Earnings Conference Call. [Operator Instructions] As a reminder, today's call is being recorded. I'd now like to turn the conference over to Mr. Todd Dissinger, Vice President and Treasurer of Natural Grocers. Mr. Dissinger, you may begin.

Good afternoon, everyone, and thank you for joining us for the Natural Grocers by Vitamin Cottage Third Quarter Fiscal Year 2017 Earnings Conference Call. On the call with me today are Kemper Isely, our Co-President; and Sandra Buffa, our Chief Financial Officer. As a reminder, all statements made on this conference call, other than statements of historical fact, are forward-looking statements. All forward-looking statements are based on current expectations and assumptions that are subject to risk and uncertainties. Actual results could differ materially from those described in the forward-looking statements due to a variety of factors, including the risks detailed in the company's most recently filed Forms 10-Q and 10-K. The company undertakes no obligation to update forward-looking statements. Our press release is available on our website, and a recording of this call will be available on our website at investors.naturalgrocers.com. Now I will turn the call over to our Co-President, Kemper Isely.

Thank you, Todd. Good afternoon, everyone. The third quarter was a challenging quarter for margins and profits. However, we are encouraged by the sales trends we are seeing. Daily average comparable store sales for the quarter were positive, and we saw improving trends and mature accounts as well. Our marketing initiatives are performing favorably, and we can see a strong correlation between marketing initiatives and our sales results. As we have mentioned last quarter, we began television advertising in Denver and had developed an enhanced marketing plan, including expanded television, radio and outdoor advertising that had begun to get traction. We have also seen positive results from our strategic promotional product offers. While we continue to feel pressure in the food retailing environment, we saw a reversal of the negative daily average grocery comp trends that we had experienced over prior quarters. Dietary supplement daily average comps remained positive, reflecting our commitment to nutritional education. On unit development, the relocation of our Boulder store delivered a significant sales lift in line with our expectations. We are also optimistic about the relocation of our Downtown Denver store, which occurred early in the fourth quarter. We are also on track to achieve our goal to self-fund our fiscal 2017 unit growth, and we have no additional new store opening scheduled for the fourth quarter. We will continue to evaluate new unit development in light of market conditions as evidenced by our decision to delay plans of new openings originally scheduled for the fourth quarter. Our margins and profits did not meet our expectations during the third quarter. Several factors contributed to the margin pressure. First, our strategic promotional offers drove sales and customer traffic during the quarter and impacted gross margin. As I mentioned, we were very pleased with the impact of…

Thank you very much, Kemper, and good afternoon, everyone. During the third quarter of fiscal 2017, net sales increased 8.6% to $194.7 million and daily average comparable store sales increased 0.4%. There was one fewer selling day this quarter than the prior year due to the Easter shift, which affected total net sales growth. The daily average comparable store sales increase during the third quarter was driven by a 0.3% decrease in daily average transaction count, offset by a 0.7 increase in average transaction size. Daily average mature store sales decreased 0.9%, primarily reflecting the challenging food retail environment and the lingering effect of regional economic pressures in markets with sensitivity to oil and gas prices. However, as Kemper mentioned, while our mature comparable store sales were still negative, they are trending in the right direction year-over-year and quarter-over-quarter. The 0.9% mature store daily average comps decline improved from 3.1% decline during the second quarter and compared to a 1.3% decline a year ago. Gross profit margin declined approximately 130 basis points to 27.1%, primarily due to an increase in occupancy costs as a percent of sales as well as a lower product margin. The increase in occupancy costs as a percent of sales was primarily due to higher average lease expenses at newer and relocated stores and also reflects the decrease in mature store sales and the fixed nature of rent obligations and related occupancy costs. Store expenses as a percentage of sales rose approximately 80 basis points to 23.1% during the third quarter compared to the prior year period. The increase in store expenses as a percentage of sales was primarily due to increases in depreciation, utilities, marketing and other store expenses, partially offset by slightly lower labor-related exposes. Administrative expenses were up year-over-year in dollars as a…

Thank you, Sandra. As I mentioned earlier, so far during the fourth quarter of fiscal 2017, we have relocated one store in Denver. We do not plan any additional store openings or relocations this year. We have signed leases for nine additional new stores to open in 2018 and beyond. We continue to monitor new store performance and we'll remain flexible with new unit development plans going forward to adapt to this operating environment. Moving to our 2017 outlook. We are revising the outlook we issued on May 4. During fiscal 2017, we expect to open 14 new stores, down from 15 to 17 previously, resulting in a 11% unit growth; achieve daily average comparable store sales growth of minus 1% to 0.5%; achieve net income margin of 0.9% to 1%; achieve diluted earnings per share between $0.31 and $0.34; and deliver EBITDA margin of 5.7% to 5.9%. Additionally, we now expect capital expenditures in fiscal 2017 in the range of $39 million to $41 million. We are proud of the growth we have accomplished over the last five years. Over this period, we have more than doubled our sales. We have increased our store count from 55 to 140 stores at the end of the third quarter. We have provided support for our local communities by offering quality products at affordable prices and free nutritional education. We have also roughly doubled our total employee count from approximately 1,600 to approximately 2,200 in five years, a significant growth. Now we are slowing our growth to really focus on the operations. We intend to continue to adapt to the food retailing environment and focus our efforts in enhancing long-term shareholder value. I remain very confident with our strong positioning in the vibrant national inorganic product industry. We remain confident in the principle that founded this company and the strategies that continue to differentiate us from the competition. We continue to focus on our customers who support us, building value for the communities we touch as well as our shareholders. Now I'd like to open the lines up for questions. Thank you.

[Operator Instructions] Our first question comes from David Magee with SunTrust.

This is actually Mitch in for David. Just first I want to talk about the new marketing initiatives that you're doing. Kemper, which avenue do you think has been the most promising?

I think that the most promising has been targeted postcards around stores with particular, really aggressive pricing on commodity items. That's driving customer account and sales at the stores that we've tested that out.

And have the number of stores receiving marketing support increased? Or do you plan to increase that percentage moving forward?

We have started out with a small number of stores, and we intend to increase it substantially starting in September.

So I can assume the level of marketing spend will increase moving forward.

No. We've reallocated money out of areas where we do think that our marketing dollars weren't as effective to this new approach.

Our next question comes from Rupesh Parikh with Oppenheimer.

Kemper and Sandra, as you look at your store network right now, and as we go into next year, do you see a need to close any stores? And is there any disclosure you can provide maybe in terms of whether you have any stores that have negative EBITDA at this point?

No. We don't intend to close any stores next year. We do have some young stores that have negative EBITDA, and we have two stores that are mature that have negative EBITDA. But they are very slightly negative EBITDA in their - if we close the stores, then we would really take a bigger hit on rent than otherwise.

And then as I look at, I guess, really gross margin then SG&A margins going forward, is there any guidance you guys can provide in terms of how you're thinking about the stability to stabilize those lines or what your expectations are going forward?

In margin we include rent, and that's been a definite negative on our margin because of the negative - I mean, for the quarter we have had actual negative comp, if you take out the one day that we lost, and so we're not getting any leverage from that. Until we get positive comps, we're going to have a hard time improving our margin line. So far, we're encouraged that June was positive in comp and that July was similar, it was positive in comp. And that's the first time we've had two months in a row that we're positive comps not only on a daily basis but on a full - on actual sales basis because we didn't have any differences in days opened during those two months. And so we're hoping that, that trend continues for the rest of this quarter.

Our next question comes from William Kirk with RBC Capital Markets.

This is Shiyao on for Bill. So there was a big snowstorm in Colorado in May. We're just wondering if there was a stock-up benefit or a closure headwind during the quarter, anything you can quantify for us?

Big snowstorms actually are always over - you usually lose sales when you have those storms. And so May was a very soft month for us.

And then our other question was on the earnings revision. We're wondering how much was unexpected fixed cost of leverage versus price investment. Any color you can give around this?

I didn't catch the first part of the question.

The earnings revision, the EPS guide revision.

The what? You asked about two parts, one was on price and the other one was on...

Yes. How much was - just the breakdown between fixed cost and leverage on the negative comp? And just any price investment.

There was definitely some price investment during the quarter, we ran our [indiscernible] better at a very low price and lost margin then, and then we've been very aggressively promoting some new commodity items at very aggressive pricings. We've lost some margin on those. So I would say that about half - about half and half on the deleverage and the investment in pricing.

Our next question comes from Chris Mandeville with Jefferies.

This is actually Aaron Eisenberg on for Chris. So just starting off, you guys gave a pretty wide range for the comp with just one quarter remaining in the year. Can you maybe just walk us through what the puts and takes are there to guide to those numbers?

Well, this year has been really up and down. We'll have one month of positive comp, and then we'll have a really hard month the next month, and then we'll have another positive comp month, which is what we kind of had this last quarter. As I've said, this is the first time in a long time we've had two months in a row that we're on positive comps, two months in a row. Our hope is that we'd get towards the 0% comp for the year with a strong finish for the year.

And then following up on that, is there any color you can give us on how the performance of the stores are outside of those oil patch markets are doing?

Todd, do you want to take the question?

Sure. So we're seeing some stability in the oil and gas market stores. The differential between those stores and the stores that are not impacted by oil and gas has been fairly steady now through this year. And that's about a 200 basis point differential. That had been, back a year ago, like 400 and 500 basis points. So we're seeing a better trend there. And the oil and gas market stores were slightly negative in terms of comps overall for this quarter, which is an improvement over where they were last quarter. They were a couple of percent negative.

And then I guess the last one from for me. Can you maybe just give us an updated view on inflation/deflation for you guys for the rest of the year and how you guys kind of feel about going out of a prolonged period of deflation and into inflation?

Pricing is very aggressive in the grocery business right now. And the way that you're able to attract customers and increase - have positive comp in your customer accounts is by having aggressive pricing. And so I would say that our pricing would be aggressive for the rest of the year and going into next year so that we can continue our trend of having positive customer account comp and store - and comp at our stores.

Our next question comes from Shane Higgins with Deutsche Bank.

So the gross margins were down 130 basis points. Obviously, that's a step-down? Could you, Kemper, just kind of flesh out how much of that was occupancy deleverage versus merchandise margins or your price investments and promotional activities?

The majority of it was in merchandise. It wasn't...

Yes.

I'll let Sandra answer that question or Todd.

So consistently, what we see is most of our pressure in gross margin comes out of occupancy. I think the maybe interesting piece this quarter is that we have had consistently an increase in product margin. And this quarter, we did not see that, for the reasons that Kemper has been communicating about price investments. We also have some slip in product margins because of sort of some good news, which is we had a shift toward grocery, which means that we're getting some pretty positive results from the advertising that we've been running.

So just kind of thinking about maybe some of the promotions that you were in. I know, you guys talked about running bacon and eggs, Kemper, last quarter. Are you guys seeing a nice lift in terms of the returns on those investments? I mean obviously, you're starting to see your comps come back a little bit. But just in terms of kind of the overall return on that investment, the gross profit dollar lift, is that something you guys are looking at internally and thinking that this will be something that you're going to continue for the - at least for the rest of this year?

Yes. We are definitely seeing positive results from - at the stores that we've been running those promotions at. And as I said earlier, we're going to kind of expand that out to at least 30 stores in September. And actually, we're going to have an egg promotion starting at August 11 at all of our stores. So we're liking the results that we're seeing from those aggressive pricing - being aggressive in prices on the commodity items, particularly eggs.

And just the last one from me, on the competitive environment. Has it - have you guys seen much of a change? I mean, obviously, it's been very competitive year. But just anything you can call out in terms of any particular region that's changed? Or just in general, has the environment gotten even more promotional you think for you guys in the last couple of months? And then I'll yield.

I would say there hasn't been a lot of change. I think that there's been aggressive pricing all year long by our competitors, and I don’t think that it's changed in the last couple of months, but it's been aggressive all year.

Our next question comes from Ryan Gilligan with Barclays.

Just a quick clarification on product margins, how much were they down this quarter?

We don't disclose our specific product margins.

How should we think about gross margins then going forward? Do you think they need to be reset lower? Or is there an opportunity to get more efficient with promotions in order to get the comp?

Well, as we've said until we get comps going up, we're going to lose leverage because of our rent factors. For the quarter, we were negative 0.7% in revenues compared to a year ago. And so all of our comp stores lost leverage on rent. And so that caused the compression in our margin because we include the rent in our margin number. And so if we can continue the trend that we've had in June and July through August and September this quarter, then we'll gain some leverage on our rent as a percentage - and that will help the margin numbers.

So I guess, do you think product margins are going to be stable going forward? Or do they need to continue to come down? Do you think they're competitive where they are right now?

I think that we are pretty competitive across the board on our product margins. We have some room in some areas to increase margins. And in some areas, we need to lower margins.

And just switching gears to unit growth for next year. Can you give us a sense by how much - or for how much you're thinking those falling it by?

We'll be at 10 or less new stores next year and probably four relocations.

That's helpful. And I don't know if you mentioned this already, but can you share the quarter-to-date trends for the comp?

We don't give the exact amount. But it was, I don't know, it's above what our range is.

The guidance?

Yes.

Our next question is from Alvin Concepcion with Citi.

Just a question about your increased promotional spend. It sounds like the environment has been stable, so your increased activity is something more proactive? Or are you just catching up to the elevated environment that's been around for a while?

I would say that it's more proactive. We found a particular vehicle that drives traffic into our stores. And so we've refocused some of our money from other areas that wasn't driving traffic into our stores to this new area.

And then could you talk a little bit about your focus on labor productivity and the improvements that had been occurring but it sounds like there was a little bit of a step back? And how should we think about that in 2018 as they're more leveraged to hold the - keep that momentum going?

Well, it's really difficult to achieve labor productivity. The revenue per day in the previous quarter is higher than the revenue per day in this quarter and since we're running on a very lean staff, it was very difficult when we have a very choppy quarter, particularly in May, to respond to the sales choppiness and get our labor down where we needed it to be. If going forward we're able to achieve a higher comp - well, even though it's not a lot of comp, a positive comp, we will be able to manage our labor a lot better. Just to further clarify, over last year, our labor percentage - our labor as a percentage of sales did improve by quite a few basis points. It's just that we think that's sequential improvement from our second quarter to this quarter as we had been doing through the year.

Our next question comes from Scott Mushkin with Wolfe Research.

Kemper, I really appreciate, all the commentary's been really good to hear in terms of what's going on with the business. I guess my question is more broad, my first question. Obviously, this is a business you guys that have been in your family for a long time, been running it. Where do we go from here? I mean obviously, you're taking a lots of actions to try to stabilize the business. But just as we move out, there's a lot of changes going in food, retailing landscape, I think Amazon precious number move to Denver after buying Whole Foods. How do you see the business evolving over the next one to three years? Would you be able to give thought to that because it's the most - things are so difficult right now? So just kind of want to understand kind of your thought process on kind of the strategic direction of the company as things change rapidly?

Well, at the moment, our strategic initiatives are to slow down our growth, so that we can concentrate more on operations. We believe that there isn't going to be a land shift in the next year or two years from people visiting grocery stores to ordering online or having delivery to their houses. Kroger, which operates some supers in Denver, has had a fresh delivery service for at least 10 years in Denver. And I don't believe it's a very - I think it's like 2% of their business. And Walmart has also been in the grocery delivery business. We're also - we partnered with Instacart and are getting a small amount - I think a very, very small amount of revenue from that part of our business. And it isn't growing at leaps and bounds. I mean, Amazon definitely is a threat because they are not under any pressure to make money. So that's a really difficult competitor. But they also offer us a lot of opportunities because when they buy Whole Foods, they will probably change the way that they're operating. And those changes could cause a lot of dissatisfaction with their loyal customers. And if we market properly and position ourselves properly, we could pick up a lot of customers because of that. Nonetheless, we are looking at alternative methods of distribution, and we're investing some time into that. But until we have that finalized, we really don't want to talk about it. But we have to make a return on investment, we have to make money off of our endeavors because unlike Amazon, we're not rewarded for not making money.

So I mean, I guess, that's my concern when we see the gross margin, I think your comments, again, refreshingly honest, but you got to be in the game discounts and you get people in the door. The most logical thing for Amazon to do, or seems logical when they buy Whole Foods, is to get those prices in line. And that - I get emails all the time from like Groupon offering $40 worth of consumables for $15, price cuts on cost per memberships. I guess, in this environment, it's hard to see how we cycle out and how a smaller operator like you guys can go alone if this continues. I mean, do you give that any thought?

We have no thoughts about being acquired or have been approached to be acquired. We really aren't shopping ourselves. We believe that we have a fundamentally strong business based upon principles and that we have a core base of 80% of our customers that are incredibly loyal because of that. And if we execute on our operations properly, we will be able to achieve the profitability in the future that we should be achieving. And by slowing our growth, we should be able to stabilize our operations and achieve the profitability that we believe that we should be able to achieve.

Our next question comes from [Dean Jaeger with Intricate Services Limited].

Maybe a follow-up to the previous question. Help me wrap my mind around the following. When I compare legacy store sales and earnings to the new store openings, it appears that there's a big disparity between the 2. Most of the growth is coming from new stores. As you limit growth into the future, as you limit new store openings, how much do you think that's going to negatively impact your sales growth?

If we don’t - well, our goal right now is not necessarily sales growth. Our goal right now is to stabilize our operations and make all of our stores more profitable. And then we will look at - we're still going to expand our store base but on a more strategic basis where we - our stores that opened in 2016 and some of the stores that have opened in 2017 haven't performed up to the productivity that we would like them to. And we believe that we need to - we see which markets we haven't performed well and we see which markets that we did perform well with our new stores. And we're going to concentrate our growth into the markets where we believe that our stores can perform well and give us a good return on invested dollars.

All right. Do you have a well laid-out, documented plan of how you're going to be improving efficiencies?

Yes, we do. We have a very good president of operations, and she has a very good plan in place on how we're going to achieve our efficiencies our efficiencies at our stores, better operations in our stores that aren't performing as well as they should.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Isely for any closing remarks.

Thank you very much for joining us to discuss our third quarter results. We remain confident that Natural Grocers 62-year history is successfully adapting to an ever evolving natural products landscape. We look forward to speaking with you on our next call. Thanks, everybody. Have a good day. Bye.

This concludes our call. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.