Sprouts Farmers Market, Inc. (SFM) Q2 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, good afternoon. At this time, I would like to welcome everyone to the Sprouts Farmers Market Second Quarter Conference Call. [Operator Instructions] Today's conference call is being recorded. And now, I would like to turn the call over to Susannah Livingston, Vice President, Investor Relations and Communications. Please go ahead, ma'am.

Thank you, Sayid, and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our second quarter 2013 call. Doug Sanders, President and Chief Executive Officer; and Amin Maredia, Chief Financial Officer, are also on the call with me today. The earnings release announcing second quarter 2013 results and the webcast of this call can be accessed through the Investor Relations section of our website at sprouts.com. In addition, Sprouts' Form 10-Q will be filed within the next few days. During this call, management may make certain forward-looking statements. These statements are based on management's current expectations and are subject to change. Our actual results may differ materially. Please read our commentary on forward-looking statements at the end of our release and in our filings with the SEC. In addition, our remarks today include reference to non-GAAP measures. For reconciliations of our non-GAAP measures to GAAP figures, please see the schedules in earnings release. Lastly, we have provided summary sales and adjusted EBITDA results on a company pro forma basis as if the Sunflower Transaction had occurred at the beginning of our fiscal year 2012. We believe these pro forma adjusted results provide a good basis to look at the operating and financial results and the performance of the combined company on a year-over-year basis. Now let me hand it over to Doug. Doug?

Thank you, Susannah, and good afternoon, everyone. We enjoyed speaking with many of you while out on the road earlier this month and look forward to transparent communications as we move forward as a public company. We're very pleased to have started off our initial earnings as a public company with such strong results. To quickly hit the EPS for the quarter, we reported adjusted diluted earnings per share of $0.14, a significant improvement of 56% from pro forma adjusted diluted earnings from the same period in 2012. The drivers of our strong performance include new store openings, continued momentum in comparable same-store sales and the resulting operating leverage. Amin Maredia, our CFO, will discuss these in more detail shortly. For those of you who are new to our story, I'd like to take a few minutes to explain Sprouts Farmers Market. Sprouts is a fresh, natural and organic retailer with a model that's built to make healthy eating easy, understandable and most importantly, affordable. Two of the biggest trends in the U.S. today are health and wellness and value. So put simply, consumers want to feel better about the foods they're eating, but they don't want to feel like they paid too much. At Sprouts, we offer the right combination of health, selection, value and service that successfully meets the needs of today's consumer. First, we sell healthy products because we're a natural food store. We don't sell Coke, Tide or Lucky Charms, so we're not a traditional grocery store that just happens to sell natural foods. Second, we're a full line healthy grocery store with a great selection of everything you need for a healthy diet, all in one place, including a wide selection of natural and organic packaged groceries, a scoop-your-own bulk foods department, a vast assortment of vitamins and natural body care items, a fresh meat and seafood, deli and bakery department and an expansive fresh produce department. Third, we make healthy eating affordable because that's our mission at Sprouts. And that's what separates us from our competitors and gives us that broad appeal that no other natural foods retailer can match. And lastly, we provide knowledgeable and engaging customer service. There is a lot to know about natural foods. Spending time educating our customers is how we eliminate many of the challenges they face when trying to improve their diet. Overwhelmingly, the main questions we received on our IPO road show were, "How are you different from other natural foods retailers?" and "How do you sell your produce at produce prices and still make money?" The answer lies on our go-to-market business strategy. Most natural foods retailers go to market with natural and organic packaged foods or vitamins, basically limiting their appeal to the lifestyle customer. At conventional supermarkets, go to market with their center store CPG offering, focusing solely on price as their primary differentiator, then depend on higher margins and their perimeter departments like produce to offset their price investment at center store. At Sprouts, we go to market in a completely different way. We attract both the lifestyle customer and everyday supermarket customer by featuring fresh produce at prices that are significantly lower than the conventional supermarkets. We use produce for several reasons. Produce is good for you so it fits our healthy mission. Produce drives repeat traffic because you can't pantry fill with produce. Produce is easy to understand because everybody understands apples and bananas. But most of all, it's because produce is relevant. It's something the everyday consumer is buying every single week, so they know the prices and can see that Sprouts offers far more value for their money than any other store in the market. This gives us something that no other natural food retailer has, the ability to take market share from the $600 billion supermarket industry by targeting the everyday grocery customer with the product they understand and buy every week. Now we still make good margins on produce, so it's not a loss leader, and we accomplish this by flipping the conventional supermarket model. We use our massive fresh produce department in the center of our store to drive traffic and then offset our price investment in produce by surrounding it with differentiated departments such as bulk foods, packaged grocery and vitamins to blend to the solid margin that still allows us to offer the best prices in the markets we serve. The broad appeal of produce also attracts a wide range of customers from a variety of demographics. We then utilize our weekly promotions across the entire store to promote trial of our fresh, natural and organic products and to prove that healthy eating doesn't have to be expensive. Through the education delivered by our knowledgeable team members, our customers gradually begin shopping more departments throughout the store, transitioning a greater portion of their food spend away from the traditional supermarket. Over time, many of our customers will actually begin using Sprouts as their primary grocery store. Now this transition doesn't happen overnight, but it can be seen in our store financials. As a new store matures, sales will increase 20% to 30%, and gross margins will increase 150 to 200 basis points over the first 3 to 4 years as the store's sales mix shifts towards higher margin departments. Another competitive advantage is our relatively simple store design. On average, we only spend approximately $2.8 million per store. This low-cost investment allows us to be the value leader in our segment while achieving industry-leading cash-on-cash returns of 35% to 40% within 3 to 4 years after opening. We've been able to successfully generate these strong returns across varying demographics and geographies across the country, which excites us about our future growth. Being one of the leaders in an involving industry like natural and organic food requires tremendous industry and product knowledge. Our recent acquisitions have allowed us to assemble the finest talent from all 3 companies to create one of the strongest and most experienced teams in the business. In addition, our executive management team brings a wealth of experience in both high growth and large publicly traded companies. As we told everyone on the road, growth is in our DNA at Sprouts. During the recession, when most retailers were cutting growth, we actually accelerated our growth plans. From June of 2009 to September of 2010, we opened 23 stores in just 16 months on a base of only 32 stores, all while maintaining positive comp sales growth throughout the recession. Since 2011, we've completed 2 major acquisitions, integrating and rebranding more than 70 stores, adding 4 new states to our portfolio and adding another 20 new stores during the same time period while again, posting industry-leading comp sales growth. Our proven ability to grow, coupled with the tremendous whitespace opportunities in compelling new store economics make Sprouts one of the most dynamic growth companies in retail today, with more than 15 years of growth runway ahead of us. Speaking of growth, during the second quarter, we opened 6 new stores, 4 in California and 1 each in Oklahoma and Texas. In addition, by the end of August, we will have opened an additional 6 stores since the end of the second quarter, bringing our new store count to 18 with 1 remaining to be opened in September as we to continue to invest in our future growth. The 19 stores represent a split of 68% of stores in existing markets and 32% in new markets. This will position our unit growth at 13% for 2013, slightly ahead of our 12% long-term target. The positive response we received from our customers during brand openings has been amazing. Our compelling prices, knowledgeable customer service and differentiated retail format presents an exciting new shopping experience that resonates well with today's consumers. Not to mention, we've continued to raise the bar on grand opening day sales throughout this year. In fact, our new stores opened this year have sustained weekly sales above our expectations and historical measurements as our improved merchandise offering and more recognizable brand has bolstered our sales even in new markets like Houston and Oklahoma. We have also experienced enhanced profitability from our new stores in existing regions as they leverage our current infrastructure. As for the future, our new store pipeline remains robust with well over 40 sites approved for the coming years and plans to open 20 stores for 2014. Of course, none of these accomplishments will be possible without the tremendous efforts of our more than 14,000 team members. We continue to build a successful organization with a deeper bench and additional skills needed to run a public company, putting Sprouts in an even stronger position to continue improving the health of the communities we serve. With that, I'll turn the call over to Amin to speak about our second quarter financials. Amin?

Thank you, Doug, and thank you, everyone, for joining us on the call today. Before I start, as a reminder, in our comparisons, we refer to 2012 financial results on a pro forma basis, giving effect to our May 29, 2012, acquisition of Sunflower Farmer Market as if it had occurred at the beginning of our fiscal 2012. Net sales for the second quarter of 2013 increased to $622 million, up 22% of the same period in 2012 on a pro forma basis. Pro forma comparable same-store sales growth was 10.8% as we continued to accelerate comps from recent quarters with balanced transaction count and ticket growth. As a result of our great brand recognition, tailwinds from the natural and organic industry, a more robust merchandise offering and an improving economy in many of the states in which we operate, Sprouts achieved comparable store sales growth on a 2-year stack basis of 21% for the quarter. This is the 25th consecutive quarter that stores that we manage have seen positive comparable same-store sales, including through the recessionary years of 2008 and 2009. These sales were driven by continued strong performance in our core stores and new store openings performing above expectations as a result of brand-building efforts which were focused on accelerating the maturity curve of stores in new markets. In addition, same-store sales momentum remains strong on a year-over-year basis across geographies, vintages and departments as the increasing focus on health and wellness trend remains intact. We continued to see solid performance in not only our core departments, including produce, bulk, vitamin and supplements; but also in other departments, including grocery, meat and seafood and bakery. These strong sales were a result of our efforts to continue to innovate, expand our offerings and broaden our value positioning to create an even better shopping experience throughout the store. In addition, we are seeing the benefits of our brand-building efforts ahead of our new store openings that we started this year, particularly in the social media arena. Shifting to gross profits. Gross profit for the second quarter, which includes occupancy, buying and utility cost, increased 23% to $187 million over the same period in 2012 on a pro forma basis. Gross margin as a percentage of sales increased 10 basis points to 30.1% over 2012 on a pro forma basis. The increase of 10 basis points was driven by leverage of occupancy and buying costs, which was offset by 2 items: First, normalization of produce costs in the first half of 2013 versus the prior year; and second, alignment of pricing in our vitamin department across the Sprouts and legacy Henry's and Sunflower stores. Direct store expenses of $123 million decreased as a percentage of sales by 50 basis points over 2012 on a pro forma basis, driven by leverage in labor cost and other direct store expenses of 20 basis points and a $1.3 million or 30 basis points charge from the loss on disposable of -- disposal of assets in the second quarter of 2012. Selling, general and administrative expenses of $21 million decreased as a percent of sales by 120 basis points over 2012 on a pro forma basis as a result of leverage and corporate infrastructure and advertising cost of 30 basis points and $4.3 million or 90 basis points of acquisition and integration cost in 2012. Excluding the one-time items, adjusted EBITDA for the second quarter totaled $53 million, up 27% over the same period in 2012 on a pro forma basis. This increase was driven by higher sales and improved margin from leverage in occupancy, labor and SG&A. Adjusted EBIT for the quarter totaled $41 million, up 33% over the same period in 2012 on a pro forma basis. On a GAAP basis, net income for the second quarter was $12.5 million, up $7.2 million or 135% from the same period in 2012. Adjusted net income for the second quarter totaled $18 million, an improvement of 51% compared to 2012 on a pro forma basis. This increase was driven by continued momentum and business performance, including strong sales on new stores opened and the operating leverage at store level and corporate costs from higher comparables store sales. Year-to-date, for the 26-week period ended June 30, 2013, net sales increased 19% to $1.2 billion when compared to pro forma net sales for the same period in 2012, driven primarily by strong performance in the core stores, as well as new store openings performing above expectations. Gross profit increased 18% to $361 million when compared to pro forma gross profit for the same period in 2012. Our gross margin rate of 30.2% decreased 30 basis points from the same period in 2012 on a pro forma basis. The decrease in margin year-to-date is attributable primarily to produce inflation in the first 5 months of 2013. Again, 2012 is a great produce year, a very moderate winter and an early growing season. We've seen a more normal produce during 2013 with a few freezes and hence, produce inflation over 2012. Year-to-date, adjusted EBITDA totaled $105 million, up 21% compared to the prior year, driven by improved business performance discussed earlier. In summary, our sales and growth and profitability continue to be anchored by strong traffic to our stores, underwritten by our laser focus on providing healthy living at the best prices in every market we serve. Moving to the balance sheet and liquidity. We continue to build a strong balance sheet and improve our liquidity. Year-to-date, for the 26-week period, we generated cash from operations of $101 million and reinvested $52 million in capital expenditures primarily from new stores. The company ended the quarter with principal balance on its term debt of $700 million at $66 million in cash and cash equivalents and $52 million available under its undrawn revolving credit facility. On August 6, 2013, Sprouts closed its initial public offering of 21.3 million shares of common stock, including 2.8 million shares issued as a result of the exercise of the underwriters' option to purchase additional shares. The company received net proceeds from the offering of approximately $345 million after deducting underwriter discounts and offering expenses and paid down $340 million of outstanding debt under our term loan facility. After this payment, our current principal balance on our existing term loan is $360 million. Additionally, as a result of this debt paydown, the interest rate on our term loan will drop 50 basis points to LIBOR plus 3% in the fourth quarter of 2013. We're extremely pleased with our cash flow from operations and a stronger capital structure following the IPO. The strong performance in the first half of 2013 gives us great confidence for the remainder of the year in achieving our targets. We expect to open 19 stores in 2013 and generate pro forma comparable store sales growth of 8.5% to 9%. We expect to generate full year 2013 sales growth of 19% to 21% compared to pro forma 2012 sales. Keep in mind that our average sales and gross profit margin are typically lowest in the fourth quarter of the year due to seasonally slower produce sales in the winter months and increased promotional activities during the holiday season, which have an adverse impact on our overall margins. We expect to generate adjusted EBITDA of $180 million to $185 million, a growth range of 22% to 26% versus the prior year on a pro forma basis. Lastly, our net income is expected to be in the $44 million to $47 million range and adjusted net income in the $57 million to $60 million range and adjusted diluted earnings per share of $0.41 to $0.43. Based on the issuance of shares in the IPO, weighted average diluted shares outstanding will be approximately $145 million for the third quarter, $153 million for the fourth quarter and $140 million for the full year 2013. In addition, the company forecasts approximately $70 million to $75 million on capital expenditures. I will now pass it back to Doug for some closing remarks. Doug?

Thank you, Amin. 2013 has been a very exciting time for our company. Our mission to bring fresh, natural and organic products at compelling prices to more and more communities continues to drive our company today as much as it did on day 1 back in 2002. With strong sector tailwinds, our dedicated team's focus on our customers and a strong operations and management team in place, we're very pleased with the result in the first half of 2013 and confident in delivering on our financial results for the remainder of the year. We will now open it up for questions. Operator?

[Operator Instructions] Our first question comes from John Heinbockel from Guggenheim.

Drilling down on new store performance, how would you rank order what has driven the new store performance between better real estate, better brand awareness and sort of better execution, advertising and so forth? And do you think new store performance can get better still from where we are today?

From a ranking perspective, I think our brand awareness has grown tremendously. Obviously, we went from 50 stores to 160 plus in just a matter of a couple of years. So brand recognition has really improved and is really driving some of the performance and the new stores especially in existing markets. Our improved offering across the store has also contributed to that and then obviously, the quality of the real estate. So the stores are performing extremely well this year. And as far as has that changed as far as the growth cycle of the stores, it's still kind of early to figure that out. So we'll continue monitoring it and seeing what happens as we go forward. But again, it's a little bit too early to make that determination at this point.

But you also think you're opening them better in terms of advertising and just the pre-opening process, correct?

First, you're right. Yes, we're doing a lot more on the pre-opening marketing side and the post-opening marketing side for that matter, with the combination of grass roots marketing and a big effort in social media.

Okay. And then secondly, talking about produce, I have not seen this in my travels, but has any store think -- maybe think back historically, any single store chain in a market made a concerted effort to really cut the price spread with you on produce, it could be organic or traditional? And what was the end result of that if anybody has done that?

Not really. In all the markets that we've opened in, you see -- you typically see some initial response from some more aggressive pricing. But it typically doesn't last more than maybe the first quarter or 2 and then they're -- and then they kind of returned to the normal levels. So we really haven't seen any one, just like a long-term permanent aggressive approach to reducing their produce pricing when we enter the market.

This is Jim Nielsen, COO. I think what's important here is we price check every week. So we react appropriately and we take a very aggressive stance to protect our business, so...

Yes. I guess I just wonder, just with the way you set your model up, could anybody do that economically without meaningfully hurting their P&L? That doesn't look like they can.

It doesn't appear that way obviously, and with our model being kind of inverted from the way the traditional supermarkets operate, it would be a bit challenging for them.

John, this is Amin. Just we have -- supermarkets have 8%, 10% or more of their business in produce, and you start looking at cutting that by 20%, 30%. It puts a substantial dent on your profitability in a pretty small margin business.

Our next question comes from Edward Kelly from Crédit Suisse.

It's actually Lauren in for Ed. So we wanted to ask you about comps. Can you give us any color on the trend throughout the quarter and maybe what you're seeing into August?

We don't give cadence throughout the quarter. What I can tell you is that comps were strong throughout the second quarter, and we're pleased with the progress that we're making into Q3.

And are there any areas of strength that you might want to call out just by vintage or by geography?

Well, obviously, the comps -- we've seen some solid economic recovery in several of our markets like California and Nevada. And again, like I mentioned earlier, our brand recognition is really starting to gain traction, especially in some of our newer markets, which is driving strong comps in our -- some of our recent vintages.

In some of our departments, we've seen some strength in where we've taken a lot of product innovation, merchandising innovation, specifically grocery, deli, bakery, we're getting paid back for that investment.

Okay. And then can you just talk a little bit about the trends you're seeing and maybe your outlook for inflation going forward?

Yes. In the last couple of months, inflation has been fairly low. As we had talked about during the remarks here is that the first half of the year, we saw good amount of inflation in produce that has subsided over the last month or 2. And on the other end, the only other inflation we're seeing is in poultry, which is a fairly small piece of our business. But in all other areas, we're seeing inflation in the range of 1% to 2%, so fairly modest inflation.

We don't anticipate a material change in the back half of the year.

Our next question comes from Karen Short from Deutsche Bank.

A couple of questions for you. Just wondering, on your net CapEx number, I thought that you guided to a slightly lower number, not landlord reimbursements. I thought the guidance was previously a little lower. Is there anything to talk to there?

No. I think in overall, I think we had anticipated $65 million to $75 million of CapEx at the beginning of the year. And as we've gone through the year, as we're firming up some of the projects, that's running up towards the $70 million to $75 million overall, so nothing significantly different. And then we also had, of course, purchases from last year, which also impact this year. And then, as we're looking at our pipeline for 2014, we'll also spend dollars in November, December for stores to be opened in early 2014.

So it's not a function of new stores costing, like the cost going up per unit or fewer dollars in reimbursements, it's just timing?

Yes, it's really timing. We're not seeing any major pressure or inflation on building costs or overall costs or increases in FF&E.

Okay. And then within the basket, you talked about the mix of traffic versus basket in terms of your comps, so pretty evenly split. And then I guess just to extrapolate within the basket, you're talking maybe 2-ish percent inflation, or is that reasonable and then the rest would be units?

Yes, it's about 1.5% to 2% inflation and the rest of it is just improved mix and basket growth.

Okay. And then any cannibalization in the comp?

There's some cannibalization this year. Obviously, we've opened a handful of stores in some existing markets, but there's -- so there is some that is -- it's insignificant.

Okay. And then I guess just a last question. Obviously, you've provided full year guidance. I didn't know what your thoughts are on -- maybe providing some directional comments on a quarterly basis into the third quarter. It doesn't -- obviously, you haven't in this press release. Is there anything to think about and be -- or be aware of for the third quarter as it relates to modeling?

Sure. Just a couple of things. As Doug spoke about, is we've got good momentum in the first half of the year, driven by innovation, improved merchandising and execution and synergies. We expect that to sort of continue in the back half of the year, which will be partially offset by cycling certain promotions that we implemented during and post integration of Sunflower in Q3 and Q4 of last year. So our guidance assumes 8-plus percent comp for the back half of the year and a 2-year stack of 17%. In terms of specific items, the only thing I would point to is, in the third quarter last year, we invested in price during the integration of the Sunflower acquisition, and so we expect higher margins in 2013 compared to 2012, which will -- which we have accounted for in our 2013 forecast. And the only other item I would mention is, in the third quarter last year, is we had a nearly $3 million settlement charge in 2012, which will -- which was nonrecurring, which will lap -- which we don't expect obviously this year.

Our next question comes from Scott Mushkin from Wolfe Research.

It's a couple of questions here. And I just wanted to talk about expanding outside your core territories. I know there's been some thought process put into that. Kind of where do we stand on that? When do you think that's going to happen? And then I had a follow-up on the same subject, actually.

To take out -- we're going to be expanding outside of -- into a new market next year, which will include end of the Southeast. So we'll be expanding into the Atlanta market probably second quarter of next year. And the additional expansion will all be in existing or adjacent markets.

And Scott, just to -- our excitement on the Southeast -- obviously, we've done our footwork and visited the market, really like the demographic. But we've already secured supply chains, so the supply chains are not an issue. Evaluated market from pricing and very excited about the opportunity there, and recently hired an SVP of Operations who's from the Southeast, who will really help us go out and recruit the best people within the market.

It's always where it is, perfect, I appreciate that. So as we think about the cadence as this happens and as we think about margins and other things, I mean, is it enough? We've seen other retailers kind of expand and it's a good thing, but at first, it pressures margins a little bit. Can you walk us through a little bit how we should be thinking about this -- the move to the Southeast, which is obviously a very exciting situation, but kind of how it's going to impact kind of little bit the P&L as we move through next year?

Yes, Scott. As we think about -- we have a fairly balanced growth strategy with 70%. We expect that in 2014 also with 70% of our stores in existing markets and adjacent markets and 30% of our stores in new markets. So with that sort of a balanced strategy, that really allows us to continue to accrete margins in the stores that we open in our existing markets, and then that is partially offset with margins in new stores. So we don't expect the move to the Southeast to have any significant compression or in fact, any compression into our margin expectations for the -- for our overall business.

Okay, that's perfect. I appreciate your thoughts. One final question. I mean, obviously, the drought in California, there's been some articles written about, if -- what's it, Lake Havasu or whatever it is, drops a certain level, they're going to really cut back the amount of water to a lot of the farmers in Arizona, maybe even California. I know we talked about this before, but just kind of refresh me. If that actually takes place, does that have a fairly significant impact on you guys? Or are you able to adjust pretty quickly, I guess, in terms of [indiscernible]

[indiscernible]

Yes, as far as sourcing goes.

Yes, I mean, I think it's equal across all retail formats, right? So we'll price accordingly with -- and react to what the competition does. But historically, we haven't had an issue and we don't foresee huge crop availability problems here in the back half of the year.

Okay. Do you think like this -- as newspapers do, they're probably blowing a lot, blowing a little bit out of proportion in the sense that we could see some significant curtailment?

Yes.

Right.

And our next question comes from Stephen Grambling from Goldman Sachs.

On the new market expand -- or the new store productivity here, are you seeing any difference in the mix of product? And as part of this, are you seeing maybe even increased adoption of some of the higher-margin categories?

Sure. The new stores this year have opened up very strong, and we are seeing a higher basket size and obviously, higher traffic count within those stores. The mix itself have stayed pretty consistent. We're obviously seeing a little bit faster growth in the nonperishable side, especially the packaged grocery side. But overall, the basket size has been higher and obviously, you're seeing that in the higher performance of the sales.

And then changing gears a little bit. As you think about SGA leverage, it looked a little bit better than I think I expected. Can you elaborate on the components and maybe the sustainability of the flow-through you saw this quarter?

Yes. And I think the SG&A leverage this quarter primarily came from advertising costs being or continuing to negotiate our contracts, and we're seeing the benefits of that contract, one. And then two, we also, as we've opened stores in many of our existing markets that hasn't added any incremental advertising costs. So it's primarily coming from the advertising spend from our existing markets.

And I'm showing no one else in queue at this time. I'd like to hand the conference back over for any closing remarks.

Thank you for your time today and for your interest in Sprouts. We look forward to speaking with many of you in the coming months. Thank you very much.

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect, and have a wonderful day.