Grocery Outlet Holding Corp. (GO) Q2 2020 Earnings Call Transcript

Greetings, and welcome to Grocery Outlet’s Fiscal Second Quarter 2020 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Pelland, Vice President of Investor Relations. Thank you. You may begin.

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

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

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

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

Our first question comes from Paul Trussell with Deutsche Bank. Please go ahead with your question.

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

Hi Paul, it’s RJ. I can address your questions about the availability of opportunistic supply. We continue to see sufficient supply from our partners. We're pleased with the health of our inventory and overall assortment. Thanks to the excellent work of our buying and inventory management teams, we're in a strong position. We've been in this business a long time and have navigated many cycles. We're in close contact with our suppliers and have a good understanding of their dynamics. Whether it involves service changes, innovations, or product allocations, our current success is based on methods we've consistently used for years. Our approach to business hasn’t changed despite the unique circumstances we face. We benefit from a diverse supplier base, which we've previously highlighted as a strength. Supply can vary by item and supplier, and balancing across multiple partnerships is always beneficial. This contributes to the treasure hunt experience in our stores, where customers enjoy seeing new items at great value regularly. Our long-standing partnerships with suppliers position us as a solution provider. We engage in strategic, long-term planning and maintain a customized and creative approach. These relationships are essential during short-term fluctuations, as we've seen historically. New supplier acquisition has also been a strength for us, especially with the shifts in the supplier landscape pre-COVID and continuing now, benefiting us from both traditional and non-traditional suppliers. Opportunities arise from food service, hospitality, cruises, hotels, fitness centers, and more. I remain optimistic about long-term opportunities in opportunistic supply. Manufacturers have boosted production to avoid the pitfalls experienced during the pandemic. We've already seen opportunities from overproduction and expect more in the future. Retail closures and store re-openings have provided us chances to assist suppliers facing challenges. Any changes in assortments, whether related to SKU, category, or packaging, present us with opportunities, and any imbalances in the supply chain positively impact us. As we look ahead, these factors will remain true. Regarding your question about changes in mix, we manage our business based on value rather than mix, which is influenced by demand, what we can purchase, and where we can deliver value. Customers aren’t concerned with the difference between everyday and opportunistic items; they focus on value. While everyday items have seen a slight increase in mix due to higher demand in certain categories, we are accustomed to short-term mix changes as demand and supply fluctuate. Our flexible buying and merchandising model enables us to adjust accordingly. We have no set SKUs or volume commitments, so we can comfortably manage fluctuations in mix while maintaining healthy value to drive sales and margin.

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

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

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

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

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

Yes.

Yes, sorry. My first question is a follow-up for RJ. Can you provide some additional background on the expansion of your supplier base during the pandemic, including cruise lines, hotels, and others? Specifically, could you quantify how the supplier base has changed over the past six months, five years, and ten years? I'm asking because during the Great Recession, TJX experienced a significant increase in their supplier base, which led to an extensive partnership network. Additionally, the nature of their relationships with these suppliers evolved. Based on your comments, it seems that your relationship dynamics with these suppliers are deepening, possibly resulting in more preferential treatment as a preferred partner, including maybe exclusive products rather than just opportunistic sourcing. Could you provide some insight into quantifying that supplier base and elaborate on how the nature of your relationships has been changing over the past three months and the past few years?

Thank you for the question, Randy. Much of what you've shared is accurate and reflects our experiences over the years, particularly in terms of our growing supplier base. We have expanded our selection of suppliers as our product assortment has changed. While we focus on categories like NOSH, I would emphasize that the natural and specialty-healthy segments are experiencing exceptional growth, along with the development of new supplier partnerships. This growth is partly due to the evolution of our assortment and the emergence of new and high-growth suppliers in the market, which has allowed us to build and nurture relationships with them. Regarding the evolution of our relationship dynamics, we prioritize strategic partnerships that go beyond mere transactions or one-off deals. We engage with suppliers for the long term and conduct ourselves accordingly. This involves offering creative solutions when they face challenges. In considering elements like costs, margins, and overall value, we take a longer-term view. We’ve transitioned into a more hybrid model that combines opportunistic and everyday strategies with many of our larger suppliers, which has proven to be beneficial for both parties. We serve as a high-growth channel for them and continue to tap into more of their opportunities. Our focus on specialization within our team enhances our management of these relationships. We adapt our approach for strategic suppliers and smaller high-growth suppliers, tailoring our efforts as needed. Our ongoing emphasis on acquiring and developing new suppliers helps us stay focused. We believe we are a preferred partner and regularly seek feedback from suppliers on how we can improve our collaboration, which has led to positive changes. Our aim is to discover new and effective ways to work together. We constantly communicate with our contacts and expand our organizational reach to identify opportunities that assist them, whether that involves innovation, supply chain challenges, or scaling their operations. These strategies have contributed to our long-term evolution as a company, resulting in mutual benefits for both us and our supplier partners. Lastly, regarding non-traditional suppliers, we consider them just like any other new supplier partnership, focusing on cultivating and growing those relationships. While they represent a smaller portion of our purchase order and sales volume, these partnerships generally start with an initial purchase order and can develop into more significant collaborations over time. We anticipate that many of these non-traditional opportunities will follow a similar growth trajectory.

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

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

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

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

Hey, everyone, great quarter. Thank you for taking my questions. I have two quick inquiries. First, could you provide some insight into the sequential slowdown to the 10% comps? Is this decline primarily due to decreased foot traffic or lower ticket size? Are there any specific categories that are experiencing a greater sequential slowdown? My second question relates to the additional COVID-19 costs. Can you clarify the IO cost structure regarding how much of the COVID-19 expenses are being covered by you? Are you assisting with the store-level COVID-19 costs, or are all the additional costs coming from your side of the business? Thank you.

Hey, Robbie, it’s Charles. Let me address both of those points. First, regarding the comp flow, the key trend we're observing is that safety is a top priority for customers. Since the beginning of the second quarter and continuing now, they have been consolidating their visits to the store. Overall, the traffic trend has remained steady across our markets. The average basket size has also stayed elevated, but it is beginning to moderate as the economy gradually reopens. It's difficult to predict how traffic and basket sizes will shift as we approach fall and winter. However, we generally expect this trend of moderating costs to continue as markets reopen. Regarding your question on COVID costs, we are currently absorbing some expenses to support the operators, including supply costs for personal protective equipment and safety-related cleaning costs. While these costs are not outlined in the operator agreement and typically wouldn’t fall on us, we believe it's the right decision to cover them. We've absorbed these costs in the second quarter and expect to keep doing so for the remainder of the year.

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

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

Good afternoon. Thank you for taking my question. Regarding the customer base by shopping behavior, could you provide insights on how full shop customers are performing compared to those who are just doing quick fills? I'm curious about how these two groups are doing so far this quarter compared to their performance in the first two quarters of the year. Specifically, are you noticing a slowdown among the quick fill shoppers, or is the slowdown more noticeable among those doing their main shopping at Grocery Outlet?

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

For the new customers you have attracted, have you been able to convert them from being occasional or secondary shoppers into primary shoppers, and what methods do you use to achieve that?

Yes. As I mentioned, we've had a good mix. They are newer, so there isn't a lot of history regarding their movement. We don't necessarily view all tertiaries as potential to shift into secondary or primary. Customers shop with us in various ways that reflect their needs and preferences. To the extent that they are inclined to become primary as we continue to provide great value and an excellent shopping experience, they may make that transition. However, we don’t really analyze our business in terms of customer migration as you've described, due to the unique nature of our store and how we attract different customers in different ways.

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

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

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

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

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

Yes. Our long-term outlook on e-commerce remains unchanged. We have significant growth opportunities through both our current stores and new store openings. Ultimately, our customers appreciate the in-store shopping experience, including the excitement of finding unique items, the value, and personal interaction, which are challenging to replicate online. We do not wish to compromise on value for online convenience. Therefore, we will keep assessing e-commerce in the context of our other long-term priorities. Meanwhile, we are focused on enhancing our digital marketing efforts, such as personalization, social media engagement, and expanding our email database, which have all positively impacted us. We believe these efforts support our goals in attracting new customers and increasing their spending.

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

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

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

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

Yes, it has been very effective. It serves as a great way to inform customers about what we have available in the store. If they are uncertain about visiting or deciding where to go, we believe it acts as an excellent guide, especially now. When we consider personalization, it revolves around enhancing WOW Alerts to showcase more of the store and tailor it to the individual customer based on their interests and the categories they are searching for. We are pleased to have this capability, and we anticipate it will play a significant role in our digital marketing moving forward.

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

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

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

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

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

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

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

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

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

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

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

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

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

Yes, we are still in the early stages of planning how to become more customized and personalized. We have launched a welcome email series specifically for new customers to introduce and educate them about our different shopping model. Currently, the WOW Alerts are not personalized for individual customers; they remain focused on specific stores and items, providing real-time information on our best value and highest velocity products. As we begin to gather more customer-specific information, the next step with WOW Alerts will be to tailor them to each individual based on their preferences and purchasing behaviors. These WOW Alert emails have a high engagement rate, and customers actively look for and respond to them. We believe that we can enhance this engagement even further by making the alerts more relevant to individual needs. Yes, it's really broad-based. In cases where there may be heavier or lighter fluctuations, these are just normal variations and cycles that occur within the company’s long history of operating with this model. Overall, it's healthy over a reasonable period of time, and there's nothing specific to any one category; it's generally ample across all areas. While things do shift, there's no significant reason to highlight one category over another.

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

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

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

Okay, that’s great. I wanted to follow up on PPE costs. Now that we're several months into the pandemic, it seems like we've found some efficiencies in managing these costs, mainly because we have a clearer understanding of what's needed, and there's less urgency around obtaining PPE for the team. Can you share whether the impact of these costs is starting to decrease in relation to the overall total cost or the percentage of cost of sales? Any additional insights you can provide on this would be helpful.

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

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

Yes. Our perspective is that until we have a clearer view following COVID, we should take a cautious approach and continue to strengthen our balance sheet with excess cash. We are confident in our liquidity position. As you mentioned, we have sufficient internal cash flow to support our growth investments, especially after successfully repaying the revolver in May. However, we have decided to postpone discussions on the ideal leverage ratio for our business and on how to manage excess cash moving forward. We plan to revisit these topics once we gain more clarity on the situation with COVID.

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

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

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