Sprouts Farmers Market, Inc. (SFM) Q2 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Sprouts Farmers Market Second Quarter 2015 Earnings Conference Call. At this time all participants are in a listen only mode later we will conduct a question and answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Ms. Susannah Livingston. Ma'am, please go ahead.

Thank you, and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our second quarter 2015 earnings call. Doug Sanders, Amin Maredia and Jim Nielsen are also on the call with me today. Sprouts' 10-Q, the earnings release announcing our second quarter 2015 results and the webcast of this call can be accessed through the Investor Relations section of our website at sprouts.com. During this call, management may make certain forward-looking statements, including statements regarding our future performance and growth, product expansion, new store openings and 2015 expectations and guidance. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information, please refer to the risk factors discussed in our filings with the Securities and Exchange Commission, along with the commentary on forward-looking statements at the end of our earnings release filed today. In addition, our remarks today include references to non-GAAP measures. For reconciliation of our non-GAAP measures to the comparable GAAP figures, please see the tables in our earnings release. We believe these adjusted results provide a good basis to assess the operating and financial results of the company period-over-period. For the second quarter ended June 28, 2015, we reported diluted earnings per share of $0.20 and adjusted diluted earnings per share of $0.22. Adjusted diluted earnings per share increased 10% from $0.20 in the same period in 2014. With that, let me now hand it over to Doug.

Thank you, Susannah. Good afternoon everyone and thanks for joining us today. For the second quarter our net sales grew to $902 million, up 21% from the same period in 2014, driven by the strong performance of our new stores and comp store sales growth of 5.1% we remain very pleased with our top line revenue growth as we continue to focus on our core principles that helps selection value and service to connect with today's growing number of health conscious consumers. Our comp sales for the second quarter accelerated to 5.1% from 4.8% in Q1 despite a number of headwinds. During the quarter we saw displacement of approximately 200 basis points compared to Q1. In addition we continue cycling a strong party season from 2014. The eighty basis points benefit from sunflower from Q2 of last year along with higher than normal cannibalization in some of our more mature markets. The swing from 1% inflation in Q1 to 1% deflation in Q2 was driven primarily by significant deflation in credits which as you know has a greater impact on Sprouts due to the high volume of -- weed sales. The strong tonnage growth we achieved during the quarter was offset by deflation of nearly 10% in April which improved to mid single digits in the lateral weeks of the quarter. We expect the level of - deflation to begin to settle as we work through the rest of the summer months. As we've noted in the past the broad appeal of our healthy value focused model allows us to operate a greater number of stores in a trade area than any other natural food retailer in the industry. Our unique ability to connect with the everyday grocery shopper has been the catalyst for a tremendous growth over the years and continues to feel our aggressive expansion across the country. Our current growth plan targets 14% annual unit growth with a continued focus on growth in existing markets to offset the investment in our new market expansion strategy. This growth in existing markets has historically led the cannibalization in the 75 to 100 basis points range. However in this, in our second quarter call was impacted by higher cannibalization of a 175 basis points as we continue to take advantage of infill opportunities in several key markets. We see this as an effective long term strategy for several reasons. One, new stores in existing markets open with higher productivity and achieve expected returns much more quickly than new stores and new markets. Two, we're able to gain leverage in existing distribution, advertising and supervision cost which increases the overall profitability of the market. And three, we're able to expand both our market share and brand recognition with a greater number of stores in the trade area. We expect the cannibalization experienced in the second quarter to settle down in the back half of the year as we cycle a greater number of openings over the last 12 months. From an industry perspective, we saw increased promotional activity in the second quarter as retailers continue to make price investments in response to consumer and industry changes. Based on what we've seen today, we would anticipate this level of promotional activity to continue for the remainder of the year. Now operating in a competitive environment is nothing new to Sprout and we remain focused on providing our customers with a broad assortment of healthy and differentiated products knowledgeable customer service and engaging customer experience in affordable prices across the store. In doing so we have continue to make price investments in various regions to maintain our competitive positioning and remain focused on our strategy of providing healthy living for less. And strong promotions and solid execution, we continue to drive strong topline sales in traffic ending the quarter with improving traffic in comp sales growth that was balanced 50-50 between traffic and ticket. New store productivity continues to be strong at just over 85%, as we added eight new stores during the quarter including our first new store in Tennessee. Year-to-date we open 22 new stores in 11 states and are now operating stores from coast-to-coast. We have an additional five stores plan for the remainder of 2015 bringing us the 27 new stores for the year and a total of 217 across the country. Our current real estate pipeline includes 62 approved sites and 47 final leases for the coming years. Keeping us well on track to meet our 14% unit growth target. Based on the positive feedback, we received at the ICSE real estate convention in May, I'm even more confident in our ability to secure great locations as we expand healthy living for less into a greater number of markets over the coming years. We continue to make solid progress our 2015, the strategic initiatives which are focused on broadening our appeal with an even greater number of everyday grocery shoppers across age groups and demographics. This includes growing our social and digital capabilities, expanding our private label and specialty product assortment, introducing new and expanded daily offerings, updating our legacy stores with the expanded offerings introduce since 2013 and improving customer engagement through team member training. Engaging with our customers a more meaningful and relevant way through social and digital marketing continues to be a focus. So this and it was extremely important to find a talented experience and innovative Chief Operating Officer to shepherd the Sprouts brand into the future. Even though Shawn Gensch only been with the team for a few weeks, I can already see that his deep retail experience in marketing, loyalty and digital, we’ll have a positive impact on how we engage and support our customers along their journey to better health. In addition to Shawn, we continue to strength in our senior management team with experience leaders including Dan Sanders, who joined the team as Executive Vice President of Store Operations engineer and Dan Bruni,who joined a team as Chief Information Officer earlier this year. Both bring a wealth technology and industry experience to our company and we’ll play a vital role in our continued success. With many of the large natural and organic brands become mainstream product innovation, our Sprouts private label continues to be a priority. In this year alone, we’ve introduced more than 150 new private label I don’t think continue to view this as an important growth category for the long-term. Our comp and sales growth in private label exceeded the company average for the quarter as we continue to add new and innovative products and categories across the store. Items like our new sparkling lemonade for the summer have been a big hit with customers, while innovative products like our Sprouts organic to watch our Kale chips were recently recognized by government retailer as a better for using snack and stepping stone for shoppers of all agencies were trying out in natural and organic lifestyle. As far attribute driven specialty categories, we continue to experience strong sales growth that is outpacing the industry. With our depth of product in these categories, we believe throughout offering attracts a greater number of customers as we continue to see our sales growth well outpacing those of our conventional peers. Following a success test, we are adding a new, expanded do and expanded daily offering into for additional stores this quarter. This includes features like a new salad bar stock with ready healthy and flavorful salads, prepared proteins, healthy side dishes and an improved assortment of pantry meals and side dishes. Following the rollout of these additional stores, we will be looking to incorporate many of these offerings into a greater number of stores in 2016 and beyond. We continue to reinvest in our current stores to maintain the period store conditions and every model four stores this year and have completed nearly a 100% of our 2015 sales initiatives project. Once done all of our stores will feature same or all of the enhanced product offerings found in our new stores open since 2013, including expanded offerings in package grocery and frozen food, fresh meat sushi among other equipment. As perhaps we believe every meal of the choice and our team members play an essential role in educating and inspiring our customers to eat healthy. So that in our investment in team member training is more important today than ever. As one customer recently wrote, good customer service is the lifeblood of any business. This year we're focusing on improving customer engagement, increasing overall product knowledge and developing future leaders to support our rapid growth. We continue to reap the benefits of these efforts and one of reason online survey showed our customer service ranking as the highest attribute of our stores. I continue to be very optimistic about the future of our company and the tremendous growth still in front of us. Our unique combination of health and value with a proven and applicable business model continues to make Sprouts one of the most dynamic growth companies in growth in grocery today. I'm extremely proud of all of our team members who deliver on our mission to inspire healthy living for all each and every day. But before I turn the call over to Amin, I'd like to say a few words about the announcement made today regarding my transition to Executive Chairman of the Sprouts Board of Directors. Sprouts has been part of my life with 13 years during which time I've had the privilege of seeing the company grow from a single store into one of the largest and fastest growing natural food retailers in the country. This planned transition from CEO to Executive Chairman will offer me the opportunity to continue to work with the board and management in providing strategic guidance for Sprout. We’re very fortunate to have an exceptional management team and I'm honored to be passing CEO leadership role to Amin and the President role to Jim. As most of you know Amin, I'm sure you would agree that his proven leadership strategic vision and strong business skills will successfully carry the company forward. But Jim stepping up to the President role Sprout is on solid ground as it continues on its exceptional growth trajectory. It's been a real privilege to have led this dynamic company for the past decade and I look forward to the remaining part of his continued success. With that let me turn the call over to Amin to talk about our financial results and guidance.

Thank you, Doug. And good afternoon everyone. Following Doug’s highlights of the business drivers let me cover the operating results and guidance. For the second quarter, gross profit increased 18% to $264 million resulting in a gross profit margin of 29.2% a decrease of 90 basis points compared to the prior year period. This reduction in gross margin was primarily a result of cycling a strong [indiscernible] season from last year as well as investments and price to maintain our competitive positioning. These were partially offset by leverage and buying cost and continued leverage in occupancy from our pre-2014 vintages. As Doug mentioned, we continue to be aggressive in making smart price investments to bring healthy living for less to our customers every day. We also continue to see good traffic from expansion of differentiated offerings across the store. Direct store expenses were $177 million for the quarter and as a percentage of sales was 19.7%, an increase of 50 basis points compared to the prior year. The leverage from higher sales in a pre-2014 vintage stores was offset by higher expenses from stores open less than 12 months. In the second quarter, we also experienced increased healthcare costs as recycle the lower utilization from last year. SG&A totaled $12 million for the quarter and as a percentage of sales was 2.6% and improvement of 50 basis points compared to the same period last year. This improvement was primarily driven by lower bonus expense, partially offset by higher advertising expense to support a higher number of new store openings in the second quarter of 2015 compared to the prior year. Adjusted EBITDA for the second quarter totaled $78 million, up 12% for the same period in 2014. Adjusted EBITDA margin rate was 8.6%, a 70 basis points decrease compared to the prior year driven by timing of new store openings as well as price investments. Adjusted net income for the second quarter totaled 35 million and improvement of 16% from 2014. This increase was driven by higher sales as well as lower interest expense as a result of additional voluntary pay down on our revolver and a decrease of interest rate from April, 2015 refinancing. Shifting to balance sheet and liquidity. Our balance sheet remain strong as we continue to generate robust operating cash flows. Year-to-date, we generated $121 million of cash flow from operations and invested $61 million and net capital expenditures primarily for new stores. As you are aware during April we secured a new credit facility a five year $450 million revolver at attractive rates which replaced our term loan. As a result of this transaction, the company recorded a loss on extinguishment of debt totaling $5.5 million related to the write-off deferred financing costs and issue discount. During the second quarter, we voluntarily pay down an additional $100 million of outstanding debt resulting in a balance of $160 million on this revolver and ended cash and cash equivalents for the quarter at $97 million. As a result of the voluntary pay down the interest rates under revolver will drop the LIBOR plus 1.25% effective in the middle of August. Let me now turn to 2015 guidance. Due to the increased competitive environment and then inflation and environment close to zero, we’re adjusting our guidance for the year to the following. Net sales growth changed slightly to 19% to 21% comp sales growth of 4% to 5%, adjusted EBITDA growth of 10% to 12%, adjusted net income growth of 13% to 15% and adjusted diluted earnings per share up $0.80 to $0.82. We expect no change to CapEx, which will be in the range of 100 million to 110 million. In addition we are guiding comp store sales growth for the third quarter in the 4% to 5% range. A few additional items to note on our 2015 guidance. First comps for the third quarter and full year are seeing near zero inflation of this drop basket, nor retails from a higher promotional environment and higher cannibalization through the third quarter. Our full year inflation nears zero to 1% range compares to 3% inflation rate last year. Keep in mind a 4% to 5% comp in a near zero inflationary environment is above our long term comp sales target when adjusted for normal inflation. We continue to generate increased traffic and tonnage volume growth as well as continue to outpace both the conventional and specialty channels - on organic products sales which is a clear indication of our value proposition that our value proposition is resonating with our customers. Second, as it relates to margins we will continue to make price investments during the back half of the year to maintain our pricing strategies. We expect the third quarter gross profit margin to be slightly less compressed than the first half and start to level out in the fourth quarter. The leveling off in the fourth quarter is driven by cycling the significant number of stores opened less than 12 months which have lower gross margins as well as coming off the exceptional produce season in the first half and early part of the third quarter last year. Third given the number of new stores opened over the last twelve months we expect continued pressure for the third quarter of approximately 50 basis points and expect this trend to normalize in the fourth quarter. The above items the expected to yield an overall EBITDA margin for the year of approximately 8.2% to 8.3%, bringing up EBITDA margin closer to at the 2013 EBITDA margin of 8% and believe this range is an appropriate for Sprouts at this point in a growth phase. And overall environment and that margin equivalent to our guidance for this year, our cash and cash returns by years three to four still remain healthy and consistent at 35% to 40% returns. This is both in line with our long term economic model and shows the resiliency of the company to maintain its strong economic model in a competitive environment. Lastly, our weighted average share count will be approximately 156 million shares for 2015 and our corporate tax rate will be approximately 38% and you have received enhanced reductions for our food donation initiatives. In conclusion our focus remains on driving top line sales growth for our broad healthy product offering, affordable prices and knowledgeable team members providing great customer service. Despite the impact of the inflationary and promotional environment on our guidance. We feel confident about our business given the strong customer traffic comp sales well above sector average, our ongoing strategic initiatives and continued unit growth across the country. Our balance sheet is healthy, our business model is solid and we look forward to delivering on a great good opportunity that are ahead. Lastly I’m honored to succeed, Doug, CEO of Sprouts and I know we will continue to be nimble, innovative and customer focused to deliver on a mission of healthy living for less. I’m excited about having Jim as a partner in his new role as President and Chief Operating Officer and to continue to work with Doug in his new role as Executive Chairman of the Board. Over the past few years Doug and I spent significant time in the field and the office discussing Sprouts mission, strategy and culture as well as customers evolving expectations of grocery stores and we have great confidence in the future of this company. I look forward to working with the Board of Directors Sprouts exceptional leadership team and our committed 20,000 team members to grow the brand successfully and profitably. With that, we would like to open up the call for questions. Operator?

Thank you. [Operator Instructions] And our first question comes from the line of Edward Kelly of Credit Suisse. And in the interest of time we are asking that please limit to one question. Mr Kelly please go ahead.

I guess my one question would be related to competition. Could you maybe provide a little bit more color on what you are exactly same from a competitive standpoint? What is changed since Q1 talk a little more about how you’re reacting and the thoughts really on margins for the business beyond this year?

Hi, this is Jim Nielsen. I’m going to break it into three buckets on the competition we’ll look at outlet out of the assortment and then kind of what we’re seeing investment and promotional pricing. So from new outlet standpoint, we’re relatively neutral on a sequential, on a year-over-year basis. Added assortment we have seen retailers add assortment we’ve seen some retailers put natural organic items into print. However we cannot connect this to any negative sales impact. In fact, the non-perishable side of the business continue to see uptick in sales throughout the year attribute a lot of that to the buying team and some the new promotions and pricing and the new products they're delivering, in terms of promotion we've seen a little investment in the price in the non-perishable side but nothing that we haven't seen in quarters past what we've seen a little bit more aggressive approach and promotions has been in the produce and meet side. And we would anticipate to see that through Q3 and possibly through Q4 and beyond that I wouldn’t like project.

And Ed this is Amin, just on your latter question about sort of looking out obviously from a visibility of competition standpoint, we really look and price competitively, as you know our model is build on health and value and we position to be both, every day and really our focus is on continuing to drive the sales on new initiatives in some of the departments like daily and private label et cetera, which gives both incremental sales and also higher margin sales in some of those departments which then provides us even more flexibility to the extent that we need to reinvest in price required by fair customers.

Amin, can I just maybe ask one quick follow-up here, your model I think historically right as where you talk about is the stable sort of gross margins and you get leverage right, because you grow and I guess you have the opportunity to invest that leverage back within pricing and sort of continue improvement, can you may be put into perspective, how much you would typically invest in the model and then how different it is, so today and what you sort of react to the market?

I think based on some of the gross margin like lines, like occupancy and utilities and buying cost is sort of a natural flow through is maybe 10, 20 basis points of investment. I think the couple of things that are really driving the compression in gross margin this year is we're just giving back a great produce season from last year, where we had some exceptional margins if you look from ‘13 to ‘14 in the first half for the year, 2013 to 2014. If you look in the first half for the year, we just had huge margin expansions. In addition, we obviously have a greater number of new stores which are less than 12 months old this year. As an example at the end of Q2 of ‘15, we have 32 stores which are open less than 12 months and at the end of Q2 of ‘14, we had only 18 stores, which were open less than 12 months. And as you know our new stores start off with lower margins from promotions as well as the mix as well as the mix is higher produce in the stores. So it's just not investment and price or competition, it's really more about the produce season that we saw last year and then also the new stores less than 12 months old.

Thank you. Our next question comes from the line Meredith Adler of Barclays. Your line is open. Please go ahead.

So I guess, Ed already asked questions about competition and pricing, I will ask about inflation why is it that you're still seeing as much deflation as you are? I thought I'd spoken to Amin and said that it had sort of flattened out in June but we're still seeing it. And can you talk maybe about the dynamics that are causing that?

I think in my the last earnings call we projected it to kind of subside throughout the quarter and we didn’t see that and obviously you can look at the C.P.I. and CPI indexes I think they're both have actually about negative 5%. And we sale a disproportionate amount of fruit and that's really the categories you're seeing a lot of pressure in and also we are starting to see a little bit of pressure on a year-over-year basis because chicken and pork become a very deflationary over the course of the last two periods.

Hey, Meredith, if you recall this just to kind of touch on that little bit more just monthly is as we saw as Doug said about 10% deflation in produce in April then subsiding to mid single digits. And at the time based on the patterns we were seeing we were thinking inflation would be flat to 1% inflation where we ended up in the quarter was actually a deflation of negative 1% which hurt our comp side 200 basis points in sort of May and June as we sort of ended the quarter. And as that deflation continues to sort of level off and get back into a flat inflationary environment that should start bringing the comps back up.

And I'll just go back to what Ed was asking about. Maybe I didn't understand but were you saying that competition is not really the biggest driver of the decline in the gross margin that it's a comparison with last year and the opening of new stores?

I think there's definitely some increased promotional activity that we're seeing on the perishable sides of the business. But it's not the only factor is what I wanted to point out. So based on what we're seeing right now know we're going to start lapping the strong produce season here in the next three weeks from last year and then also the new store start lapping. So when we see gross margin in the third quarter and into the fourth quarter in the third quarter we'll see compression. We expect lower compression than what we saw in the first and second quarter of 90 basis points. And then right now in the fourth quarter we see it really subsiding to close to flat, probably slightly negative but much closer to flat. And that sort of proves out that there's a point that it is a combination of the produce season as well as the new stores open less than 12 months as we cycle those.

Thank you. Our next question comes from a lot of Stephen Grambling of Goldman Sachs. Your line is open. Please go ahead.

Hey, good afternoon and I guess I have two clarifications on the competition inflation started that [indiscernible] here. But first can you help us parse out maybe even how much of the deflation you’re seeing in produce is being driven by cyclical supply demand issues versus by competition. And as a relates to that is there a philosophy on year-end to maintain a certain price gap relative to these peers?

Hi Steve, it’s Jim Nielsen. We definitely have a price schedule produce I would, we’re not going to dispose it on the call. We also have target margins for add retailers. And when you look at the overall market and looking at the tightness, yes there is a little bit of pressure due to demand from potentially some of the conventional is being a little bit more aggressive on the produce side. But some of it is just relative to a flash market on the fruit side, the strong fruit side, the grapes, apples and cherries the some of the choice.

Okay. And then maybe a follow-up question on just given the solid free cash flow generation and now the low levels of debt. Maybe how do you prioritize redeploying that in terms of either accelerating square footage growth or even thinking about redistribution and shareholders at some point? Thanks.

I think that, at this point as you know we saw in the second quarter we pay down internally and other $100 million of debt and as we move through probably over the next 12 months, we’re now beginning to develop with our board about alternatives we’re continuing to work hard and building out the infrastructure. From a growth standpoint as we are spending across the country and into the Southeast and start moving into other states in the Southeast and up. So we’ll revisit the growth rate, but we want to always make sure that our teams consistent out there in the field and we’re able to execute before we would consider accelerating the growth rate. And lastly as far as redistribution, we’ve not built a policy on that at this point in time Steven.

Our next question comes from the line of [indiscernible] of Bank of America Merrill Lynch. Your line is open. Please go ahead.

Congrats to all you in all your promotions. And I mean being promoted as a person not promotions a caused deflation. But a couple, just I was hoping to get some clarification on just the comp guidance. If I understand the comp guidance for the year, you’re guiding to a lower comp for the back half and the five you just put up. And so you had 200 basis points more deflation in this quarter you just reported you had very high cannibalization. So what's incrementally getting worse to make the comp slow more in the back half from the 5 that you just put up and maybe in the context of I think you should have more comp support from year one stores coming into the comp base in the back half supporting comps as well. So if you could just help me work through all the variables? And is cannibalization getting worse and what should we think normal cannibalization should be for the back half and then as you look over the next couple years?

Sure. Ravi it's a couple of things; one, as you may recall is last year we actually saw inflation tick up in the back half of the year. So for the quarter as the inflation numbers or 1% 3% 4% 4% as we went through last year in our basket and we're calling for sort of flat inflation at this point maybe even slightly down for the third quarter. So you've got a pretty wide lack of inflation if you will. I think the second so I think the inflation element in it and the other piece is we're also seeing some early in the third quarter last year we were still in a very-very, we were in a fantastic produce season in fact all of July we were running 99 cent cherries which just drove tremendous amount of traffic throughout the system and we just didn't have that availability this year. So we were lapping very significant near 20% produce comps in early part of the quarter last year which we're now starting to lap. So it's really this cycle here that we see. And I think as we get to the fourth quarter we think to the extent that inflation is back in normal swings then I think that we could see that number be above kind of that full year range.

And have you seen competition focus more on being promotional with the perishables versus center store in the past? And if so how did it normally play out? Was it just sort lasts for about a year in the new cycle and then the conventional go back to focusing on non-perishables? Any sort of insight would be great.

Yes. So I think that if you look at the past history I think there's couple of cycles we can look to in 2009 and 2012 where deflation in 2009 that for about 12 13 14 months and so you saw things normalize again in 2012 to slightly less than that Jim if I recall is about 8 10 months that deflation lasted. And so as we sort of come back to normal I think competition also starts settling down and we're not calling for that in our guidance at this point but to the extent that happens then perhaps that would suggest we're conservative in our model.

Our next question comes from one Karen Short of Deutsche Bank. Your line is open. Please go ahead.

Just a question on the increase in protests and meat promotional activity. Can you just clarify was that coming from all forms of competition or is it isolated to conventional competitors, isolated the specialty any color you can get there?

As primarily coming from our conventional competitors within each geography, we’re seen some specialty retailers do some in-store, but we don’t, we haven’t seen any negative impacts for that. So as you look at this geographically, it’s primarily conventional.

And it is across all geography?

It’s not all geographies, but it’s probably have two geographies.

And then just curious in terms of your pipeline for next year, I don’t know, if you could maybe give some early thoughts on split between existing and new markets and how we should think about cannibalization into fiscal '16?

So Karen couple of things as you know Doug mentioned we had 62 approved sites and 47 sign leases. We’re still kind of focus on that 70-30 mix and one of the things that we’ve done is based on what we saw from a cannibalization standpoint, I think Q2 and Q3 of this year coming up this quarter that we’re in. We’ll see cannibalization peak and then we think that’ll starts up siding. One of the things that we started to do is our data is not better and better. We’ve started to, I call it a running meter and cannibalization. So that we know at all times as we’re approving sites what type of cannibalization that we would expect. Now with that said we’re now going to pass on great sites in existing markets, but we just want to be aware of what level of be more aware, of what level of cannibalization that we might expect. But I think in short 70-30 still a good mix and our goal would be to perhaps from the number that Doug talk about a 175 basis points that we saw this quarter to start bringing that cannibalization back down not, but at the same time not passing on great sites where you would cannibalization a store.

So any sense of what normalized cannibalization rate will be going forward, I mean obviously or understanding there will be of them flows?

Yes I think there will be of them flows, but we’ve historically seen about a 100 basis points. And so as we look to that 70-30 mix of course as we get into Georgia will be in the third year in Atlanta of stores there. So we’re really starting to see some a good number of stores there and a lot of times we see that the delayed effect of benefit on comps and leverage and distribution in those types of markets when we do that. But that’s only generally the cycle we see.

Thanks and congratulations on your new roles.

Thank you, Karen.

Thank you. Our next question comes from the line of Scott Mushkin of Wolfe Research. Your line is open. Please go ahead.

Hey guys, thanks for taking my questions. So it seems like to summarize a little bit, you cannibalize a little bit more competitions little greater, I guess with the new company’s -- the Harvest Market Committee, Houston I mean do you feel, my first part of a two part question, do you feel like the competition in cannibalization you can really say have stabilized? And then the second question and I think I heard you right about the EBITDA margin, Amin its going to be 82, 83 is kind of what you were implying in your comments, so I guess the second part of the two part question, is your thoughts not on this quarter, next quarter but when you think normalize comp in a normalized installation environment would be a normalized kind of EBITDA margin that would be really great just to understand kind of where the model is where you think it is right now?

So, I let James answer the first question and then I’ll pick up the second half of your question.

So, Scott in terms of stabilization and looking at our competition are there being more aggressive less aggressive, it's been fairly consistent over the last 12 to 16 weeks; we haven't seen any material change in the markets where people have heated up. I think one point put to note, that we really haven't talked about here is that our overall items per basket are the highest we've seen in two years. And our tonnage in produce there's a highest we’re seeing in five quarters. So as we continue go back to competition the pressures of competition, I understand that but there is a lot of pressure from deflation and the product side of the business so. And in terms of your first one, last 12 to 16 weeks pretty consistent Scott.

And then sort of overall model Scott as you probably heard us talk about this before is this year with that 82, 83 EBITDA margin, we still expect from a DSE perspective, our most significant compression is actually going to happen in Q3 from the new stores that are open less than 12 months and then gross margin as I said earlier, we expect it to compression to be slightly less than what it's been in the first half for the year and then really settling down to a 20, 30 basis points compression of margins to around out the year at that 82, 83 based on our visibility now. And as we move forward I think it's really going to depend on what inflation is doing what competition is doing do we need to reinvest in price. We had a pretty rough first half for the year produce this year, I think that the marketplace will dictate how much we need to invest. Investments promotions have been heavier and perishables this year. If we have a decent season going forward then you sort of stick to that 8% to 8.5% model that what excites us Doug, Jim and I about the model is that even at 8% to 8.5% margin business if you're driving that top line sales which we had in the last three years have gone from 14 million to 17 million a store and with some of our initiatives continue to drive that number up it just gives us more flexibility to invest if we need to. But the marketplace will dictate the amount of investment that we make and our job here is just to keep building the flexibility.

To maintains that 35 cash return.

Yes. That's right. And we've not even at that 82, 83 we are still running in the range and in some regions above that 35% to 40% cash on cash return.

So you're not -- but what you said I mean is that, that the comp maybe is 6% when -- through your I.P.O.'s kind of where you had but you do think you could lever a little bit. You may want the flexibility to reinvest that price depending on what competition is that may hold EBITDA margins to hold a bit more flat, is that fair?

Yes. And as we've always been consistent with this is we would never hesitate to invest in margins to drive sales is we're very top line focused company.

Thank you. Our next question comes from the line of Rupesh Parikh of Oppenheimer. Your line is open. Please go ahead.

Thanks for taking my question. So I just wanted to touch on the marking in front. I know you appointed a new marketing officer recently. Just want to get a sense of how you guys are thinking about some of the opportunities going forward on the marketing side.

We were extremely excited to have Sean join the team just probably we're about five weeks ago. So he's still obviously getting its feet on the ground and raise just a wealth of knowledge and experience when it comes to the digital and royalty sides. So obviously there's not a lot to do here at this time, obviously we have a lot of things that we're working on in Sean's expertise is going to take it in the new direction but again not a lot to report at this time just yet, but we will be reporting more as you get things settle we start looking at some of our strategic initiatives and where we're going to take those.

Okay. And if I could sneak in one more question. Just on the real estate front there's been some noise out there that real estate costs continue to escalate. So just want to get a sense if you guys are looking in your mortgage -- are you seeing any pressures right now on rental rates?

Not primarily in the Southeast, a lot of there have been some increases in certain markets, but they’ve been market-by- market, so it hasn’t been across the board, across the country. But there are certain market Los Angeles is a perfect example where market rates have been pretty high and pretty volatile. But we have necessarily seeing that across the Southeast.

Our next question comes from the line of Sean Naughton of Piper Jaffray. Your line is open. Please go ahead.

Just if we look at the overall space just the food and home market, we’re obviously seeing a lot of square footage growth and specialty, I guess the value side [indiscernible] and then obviously have some channel shift with online delivery. Do you think that the overall sector maybe growing too quickly in terms of square footage at this particular point in time and what was the last time you guys maybe went back and thought about your overall addressable market at this, of 1,200 stores?

I think there is couple of pieces there. I think from a new outlet perspective we obviously keep track of new competition and potential competition that’s looking in our trade areas. And over the last couple of years, that’s been relatively flat as Jim alluded to earlier. So we’re not seeing any additional impact on comps from new competition. In terms of specialty, I think there is a combination of things going on as you’re seeing food and the consumer kind of redefining food and how they shop. You are seeing more specialty stores open, but on the other hand they are also seeing consolidation and shattering of some of the smaller regional players. The traditional players who are struggling, who are bringing dollars back to the market and we feel like we’re pretty well position in the help and value proposition particularly the value side of the equation puts us right square peg and where customers are headed today and we think tomorrow.

So there is enough displacement at this point or to support kind of some of the square footage growth we’re seeing in that and some of the…

Sean at this point, we’re not seeing anything in any of our markets that would suggest that if that new capacity coming which is at such a high pace that starting to hurt the overall market there. So not seeing anything there right now.

And then just quickly on the performance of categories maybe across the store and maybe specifically looking at the non-perishable categories. Sounds like those are performing a little bit better for you. Any comments on food, DMS or health and beauty on how those performed in the quarter?

Yes, we generally don't get into sorry category specific but as Jim alluded to is are non-perishables have been performing quite well. The perishable for all the reasons we’ve talk about on this call, deflation as well as some promotional increase in promotional activity we’ve impacted comps to some degree on that side. But overall we feel, the perishables are preparing pretty wide, and Jim you want to add something?

No, I mean it’s in same categories, they're just not the uptake in the attribute categories that we saw last year we talked about this in the last call, organic non-GMO, gluten-free all of which were outpacing the sector and to north of 20% topline growth, it’s obviously good growth but relative to last year was in excess of 30 and so we're just not -- keeping pace with that but there's other attributes and things that are driving the business and they're just a little bit smaller in terms of overall impact of sales. But the grass spades and probiotic, snacking alternative protein, so there's a lot of little tailwinds in there and the big tailwinds just are still strong just not as strong as prior year.

Thank you. Our next question comes from the line of Charles Grom of Sterne Agee. Your line is open. Please go ahead.

Hi thanks good afternoon, just on the price investments that you're making and some of you could just discussed the degrees of success that you are having from the elasticity standpoint unit increases on those price increases across categories, where have you found success and where have you not?

This is Jim. I’d like I said before, we're seeing great increases in terms of overall produce tonnage in terms of just growth in the overall business which is helping us drive that traffic that drove it from a 60-40 to a 50-50 in this quarter versus prior quarter. So we're starting to see that when the non-perishable side of the business we're just seeing the overall penetration of the ads go up and traffic and some of our new promotions that we've launched here in the third quarter provided even more tailwinds in that area and really helped in terms of just overall brand awareness and brand awareness for other partners that we have better supporting our promotions.

Okay. Fair enough and then just philosophically when you see your traffic starting to slow anyway that relative to where your gross margins are, how willing are you guys to sacrifice gross margin compression to get traffic back? And I guess alongside that when you look at your cost structure do you find that there's opportunities outside of the buying leverage that you have to kind of fund those price investments to get the traffic back in your store?

Yes, Charles, we’ve got, as you know we’ve got a number of pricing zones over 15 pricing zones in the company. And so when we see any sort of traffic movement, we’re pretty quick to try to pinpoint what’s driving it, obviously we’re watching competitor pricing, with price very frequently on the perishable side and then on a regular basis on the non-perishable side. So we feel like we’re pretty intuitive, we’ve got a pretty good process of understanding the dynamics of what’s happening in each of the local markets and the teams do a phenomenal job by category watching movement at the local, on the ground in seeing what type of investments we may or may not need to make. So if your question is are we going, the good news is we’re not seeing as you heard were 50-50 traffic even this quarter, we’re not seeing traffic degradation a lot of our challenges are being caused by deflation as well as a couple of the things we talk about here. So it’s not been a concern. Couple of markets has been a little bit more competitive from a promotional activity standpoint. And that’s we don’t hesitate to make the price investments. And as Jim said it’s been in the back half of the markets but not in all of the markets.

The other thing is I mean there is some offsets to gross margins that we’ve started to do as late and I will continue to give us more pricing power so that we got and more aggressive and obviously improving supply chain keeping our trucks we’re actually just starting with some self distribution and some key items that improve the land it costs of store. Some of those promotional partnerships that I talked about earlier, we’re going to strong partnerships for vendor community and that’s just obviously related to how great our stores are executing, how good or buying banking some does here developing those promotions. The deli mix, deli has been a leading comp driver for us that we’re continue to get some improvements there especially 2016 when we rollout a lot of the new enhancements that we’ve done over here typical store. Then just continued growth of our private label but this quarter 30% of top-line growth and continues to be in a very favorable for us and drive our overall sales.

Our next question comes from the line of Joe Edelstein of Stephen. Your line is open. Please go ahead.

You had a store closure this quarter we haven’t really seen to do that before I was hoping you could add some color around that where was the store located was it a lease that was getting kind of towards the end of life. Just any comments it would be helpful?

Joe that’s exactly right. We had a lead that at the end of life and we had a store as part of our couple of acquisitions in 2011 and 2012 with acquired stores which were fairly close to each other they were both profitable and making money and when it came to end of life we felt like consolidating the traffic into once for we remodeled these store and had good movement to the consolidated stores. So is this a market consolidation opportunity for us.

And the good news we were able to move half of that business through two stores within the city.

Okay. Thanks. And also you spoke about doing some fill in on existing markets. I was hoping you could maybe speak a little more directly to the Atlanta area, the plans that you have been terms of looking to set up a distribution center for that region and also is that something that we would be expecting a step up in expanses as we look at the 2016.

Yes. So I think that in the Atlanta area generally we're looking for two plus million cases produce to be able to look to set up a DC for meeting that efficiency. At this point it will be sometime in 2016 perhaps late 2016 and we'll likely lean towards a third party logistics at three PL. that just gives us more flexibility and doesn't require us to go and get a massive warehouse which sits empty for several years for growth and we can really go into it with a partner. We've had good successes on that front in California so we're leaning in that direction. And even we're not leaning that way but even to the extent that we were to do our own DCs because it's probably only that it generally costs $2 million $3 million dollars of CapEx and not a significant CapEx investment and not a proportionally not a significant P&L investment it would be all relative.

And when we look at the DCs that we put in the -- area it's more to support growth and expand our reach so we can continue our growth. 70% of our products are going to be coming from California potentially Mexico still you are in bound tasks are going to go up, you're going -- some of that will reduce transportation costs. So it's going to be somewhat of a net neutral but it's really going to give us the opportunity to have a fresher product, do a much better job with the local programs and in the local markets.

Thank you. Our next question comes from the line of John Heinbockel of Guggenheim Securities. Your line is open. Please go ahead.

One for Jim and then one for Amin. So Jim if you think about the step up in promotional intensity, it sounds like that's more cyclical than structural or than secular driven by deflation people hold this money to play with. Is that fair? And then your response as merchant is you sort of just have to go with it when it's cyclical like this and maybe analytics go a little bit out the window in terms of sort of not losing, mind share traffic with customers versus if it had been more secular. So that sort of for Amin if you think about the long term growth algorithm, it tells from a lot of what you've said that that really hasn't changed. Right this notion of high-teens EBITDA growth hasn't really changed in a normal inflation environment, is that fair?

Hi John this is Jim, relative to investment, I think if you look back we talked about 12 to 16 weeks Scott have asked the question is it getting hotter, is getting a little bit down lighter in terms of competition, it has been pretty consistent, but beyond that we uptake -- pass a 16 weeks it's been there, I don't see a change really in competition that's where we built in the models kind of being relatively neutral where we're at today and in terms of how do we price against that we have a model. We have a price image to project and we'll stick to our competitive pricing and it's been extremely successful for us in the past and I think that -- as we continue to go back I think it's important for everyone to remember that we're running again the highest tonnage numbers that we've seen in five quarters. So we're moving a ton of produce [indiscernible] there. And we're seeing the basket size in terms of number of items grow at the highest level in two years. So I don't anticipate the conventional backing off in terms of their investment and if they do there's going to be upside for us if they don't it's built into our guidance.

Great thanks Jim and then John to your second question I think that sort of that mid to high-teens 16% to 18% that we've guided to if you look over a multi-year basis we're not seeing anything in our business model assuming all that in a comps and inflation and in a normalized setting, we're not seeing anything in the business as structurally changes that growth rate as you've seen this year when you have tough deflation or tough produce cycle or inverse of last year, which was a great produce cycle, it will allows you to capture dollars at some point and give back in other years. But if you look on our two, three year basis I think that our model is performing very consistent but what we've always seen in the business.

Thank you. Our next question comes from the line of Vincent Sinisi of Morgan Stanley. Your line is open. Please go ahead.

Hey great thanks very much for taking my question. Best of luck everyone with the upcoming position changes. Don't want to [indiscernible] a little bit more here but I do just want to be clear with your second half outlook it sounds like certainly from what you've said so far during the call the deflation the competition obviously the two greatest factors. But it sounds like you’re expecting generally kind of maybe late your improvement as both of those factors hopefully kind of moderate. But in terms of what’s officially big into your guidance. Are you running at, basically you’re running within the comp ranges, what you’re seeing from a competition standpoint, what you’re seeing right now is factored into that? I guess another way to ask it is. Do you think that, you’ve reset expectations low enough now where know even if there is some back and forth you still have given yourselves and some room in the back half?

I mean, I think we’re making an assumption and zero inflation in the back half of the year and trend that we’re seeing where competition is today. And I think that the other thing, I would point out is also taken into account the inflation from last year and having a relatively sort of a flat inflation expectation for the back half of the year. And I think the last thing I would say if you look at the timing of the new stores our EBITDA margin rate sort of compression kind of peaks in the third quarter and that rate probably looks very similar to the first quarter, the EBITDA margin compression in the third quarter, which is going to give us a very modest EBITDA growth in the third quarter. And a relatively flat EPS growth in the third quarter, but that really starts picking back up as that DSE is normalize as we lap, as we lap the DSE expand from recent new stores as well as the gross margin start to normalize again as we expect.

And if I could just add one more question, if you don’t mind. In regard to the comment earlier on, now you’re seeing some of the greatest growth in terms of the number of items that’s going into the basket. Can you give any more color as are the incremental items that are going in or good portion of those related to your current in-store initiatives, I know you said for additional deli this year and then maybe just any other updates on some of the rollout plans for those in-store initiatives?

So I think that we gradually over the program as we put the three companies together as well as the initiatives done in ’13 and ’14. If you look at the average items in a basket that’s grown very nicely and very consistently it’s grown slowly overtime. So it’s just we’ve not seen any spikes up or down, so it’s nicely growing and I think that as we move forward, the deli each we think is a big one and I think the private label kind of continues and continue to go deep into specialty items and drive more consumers for more destination type of shopping. The one area that I think overtime we also as a company need to score is more basket building initiatives and those are some things that we are going to be talking about as a leadership over the coming months.

I mean you look at the -- you look at the mix in that basket, what's growing. And I mentioned before and there has been some reports out on some, specially the retailers and reported comps and we are beating those to the perishable side of the business. So it is a combination of the non-perishables and I give a lot of credit to the group case and the better community for coming up with some fantastic promotions. But the majority of that -- department system at the purpose.

Thank you. And ladies and gentlemen this does conclude our question and answer period, I would like to hand the conference back over to Mr. Doug Sanders for any closing remarks.

Thanks for joining us today everyone and we forward to talking to you again on an upcoming call. Have a great evening.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Have a great rest of your day.