Sprouts Farmers Market, Inc. Q1 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by and welcome to Sprouts Farmers Market's first quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Ms. Susannah Livingston, Vice President of Investor Relations and Treasury. Please go ahead.

Thank you and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our first quarter 2020 earnings and long-term growth strategy call. Jack Sinclair, Chief Executive Officer and Denise Paulonis, Chief Financial Officer, are with me today. The earnings release announcing our first quarter 2020 results, our long-term growth strategy slides and the webcast of this call can be accessed through the Investor Relations section of our website at investors.sprouts.com. During this call, management may make certain forward-looking statements, including statements regarding our 2020 expectations and outlook as well as our long-term growth strategy and financial targets. 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 SEC filings, along with the commentary on forward-looking statements at the end of our earnings release issued today. Our remarks today include references to non-GAAP measures. For a reconciliation of our non-GAAP measures to GAAP figures, please see the tables in our earnings release. As well, to accommodate the additional time needed to discuss our long-term growth strategy, we have added an extra 15 minutes to the call today. With that, let me hand it over to Jack.

Thank you Susannah and good afternoon everyone. Thank you for joining our call today. We could not have expected the magnitude of change in our business that has occurred due to the COVID-19 pandemic. And I want to start the call by emphasizing how critical our team members, particularly our store team members, have been in this time of crisis. Grocery store workers around the world have become everyday heroes working on the front lines to ensure people have the food and products they need to feed their families and frankly to survive. The more than 32,000 hardworking and profoundly dedicated team members of the Sprouts family have served countless hours under the most difficult of circumstances in order to ensure our customers have healthy food to feed their families. It's extraordinary how people are changing their view of our grocery store workers. Every day, they are rising to the occasion, showing up to their jobs donning masks and gloves, carefully following ever-increasing safety measures and altered operational procedures and taking it in stride as they continue to prioritize customers and their needs. Right now, we are focusing primarily on our people. The entire leadership team is inspired by the amazing work our team members and our partners are doing. It takes a community of dedicated individuals to keep our stores open in a time that none of us have ever experienced. I want to thank not only our dedicated team members at Sprouts but also all parts of our supply chain, our distribution centers, our drivers, our vendors and our farmers and growers, who are all part of keeping the food supply chain running. I am inspired by not only our store team members but by the decisiveness and agility of our leadership team and our management team, who when all this began immediately jumped into contingency planning as we prioritize team member and customer safety while ensuring we maintain stock on fresh, healthy food for our communities. We are laser-focused on ensuring our team members are taken care of and I want to share some of what we have been doing to support them during this global pandemic. We accelerated and maximized bonuses and are paying monthly incentives in addition to bonuses for store and distribution center team members to ensure they are getting compensated at a time when they need it most. This is equivalent to more than $2 per hour. We want to ensure that nobody comes to work if they are feeling sick. So we enhanced paid sick time and leave and we are guaranteeing every team member's job should they feel the need to stay away for any reason during the crisis. We have also created a disaster relief fund to help with things like medical bills and rent for those affected by the Coronavirus. We have relaxed our attendance policy and shortened store hours to provide our team members more opportunities to rest. The health and safety of our team members is my number one priority and we have implemented a number of safety measures in stores to keep team members and customers safe. We have installed plexiglass at all the registers and we limit the number of customers in the store at one time. We have also enhanced cleaning timelines for stores including registers and production departments and we are providing every team member with masks and gloves to wear throughout their shift. I have said it before, team members are the foundation of this organization. The success we have seen is due to them, through their tireless and diligent work keeping the wheels turning during these extraordinary times. And while all this is happening, we continue to drive our transformational strategy to ensure Sprouts' long-term success. I will talk more about our strategy in a bit. But first, Denise will discuss Q1 financials. Before I hand this off to Denise, I want to welcome Gil Phipps, our new Chief Marketing Officer, to the team. Gil's experience will be instrumental in shaping Sprouts' long term strategy to build brand awareness and loyalty with our target shopper. He brings a wealth of experience on development and building brands and we look forward to his contributions to define and strengthen our private label.

Thanks Jack and good afternoon everyone. First, I hope all of you and your families are healthy and safe. I will begin by discussing our business results for the first quarter and then hand it back to Jack to discuss the current environment and strategy. I will join again to discuss the long-term financial targets for Sprouts. First quarter profitability was very strong with adjusted earnings before interest and taxes up 61%. The quarter was really a tale of two cities, so to speak. The first few months of the quarter were on track to deliver sales in line with the high end of our expectation and margins above our expectation due to the smarter promotional strategies we implemented late last fall. March followed with a dramatic increase in demand for food from the COVID-19 crisis resulting in additional sale and leverage in the business. First let me review the highlights. In the first quarter, net sales grew 16% to $1.6 billion and comparable store sales were up 10.6% compared to the same period last year. We estimate that COVID-19 positively impacted sales by $146 million and comps by 9.6%. For the first quarter, gross profit increased 23% to $594 million and our gross margin was 36.1%, an increase of 180 basis points compared to the same period last year. SG&A increased 16% to $436 million or 26.5% of sales, flat compared to the same period last year. SG&A included a pretax special charge of $1.2 million related to our ongoing strategic initiatives. As for the story behind the numbers, the quarter started off with January and February on track to post comps at the high end of our outlook with slightly negative traffic. Our early efforts to refine and balance our price position, comp and improve margins through the elimination of inefficient promotions were positive to the business. In fact, gross margins were on track to exceed last year by at least 100 basis points. In addition, in the beginning of the quarter, SG&A continued to experience deleverage from higher healthcare and labor costs, the expansion of our home delivery program as well as higher occupancy costs due to larger stores. Starting in March, consumer behavior dramatically changed as customers began to fill their pantries as COVID-19 stay at home order led to less eating out. We experienced tightened comps in the middle of March led by grocery, frozen and vitamin categories which settled by month-end to a much higher new normal, resulting in a 26% comp for the month of March. Sales were up in the stores as well as direct digital home delivery and pickup. For the quarter, e-commerce was 4% of sales, up more than 160% compared to last year. As March progressed, we continued to experience strong margins with stockpiling attributing to a shrink improvement as inventory reduced and the mix benefit. Recall, grocery, frozen and vitamins are higher-margin categories for us and so these increased sales provided a better margin mix. As the COVID-19 pandemic escalated, we leveraged the higher sales on fixed costs like occupancy and marketing due to our reduction in spend. As well, we were challenged to keep labor in line with the heightened sales. Offsetting this leverage, we made significant investments in pay and benefits to recognize our team members' instrumental commitment to serve our community and to implement additional safety measures. We maxed out and paid early store and DC team members' first quarter bonuses as well additional bonuses. Sick pay also began to increase during March. Moving down the rest of the income statement, our depreciation and amortization costs increased 5% to $31 million or 1.9% of sales, a decrease of 20 basis points compared to the same period last year. Store closure costs and other credits were a $1 million credit compared to $500,000 in cost in the same period last year, mainly related to a true-up of a 2019 store closure charge. For the quarter, our adjusted earnings before interest and taxes were $129 million, an increase of 61% when compared to the same period last year. Our interest expense was $5 million and our earnings before taxes were $123 million, an increase of 65%. Our effective tax rate was 25%. First quarter diluted earnings per share was $0.78 and adjusted diluted EPS was $0.79 compared to diluted and adjusted diluted EPS of $0.46 in the same period last year. We estimate the positive EPS impact of COVID-19 was approximately $0.22. Excluding the positive COVID-19 impact, we estimate that adjusted EPS would have improved by 24% compared to the same period last year, which we attribute in large part to our ongoing strategic promotional improvements. Throughout these uncertain times, we have been able to maintain healthy cash preservation. As most of you know, Sprouts' cash generation has always been strong and this quarter was no exception. In the first quarter, we generated cash flow from operations of $277 million, up 146% for the year. We paid down $87 million on our revolver in the beginning of the quarter and allowed cash to build on the balance sheet for the remainder, ending the quarter with $247 million in cash and cash equivalents. Reflective of our strong balance sheet, we ended the quarter with a net debt to adjusted EBITDA ratio of 0.6 times, reducing our borrowing spread on our revolver by 25 basis points to 1.25%. Under the current pandemic environment, our near term focus is to utilize the robust cash generation this business produces to invest in the business and maintain a strong cash balance for financial flexibility. Lastly, we invested $17 million in capital expenditures, net of landlord reimbursement, primarily for new stores. For the first quarter, we opened four new stores ending the quarter with 344 stores in 23 states. We remain on track to open approximately 20 new stores this year. So far, only one store has been delayed due to COVID-19 pandemic. We have been closely monitoring our results and certain trends we saw in the latter part of the quarter have continued into April. Elevated levels of grocery spend have continued as many consumers have increased their food-at-home spend. Social distancing has changed consumer behavior, including customers consolidating trips and increasing the use of e-commerce services. As a result, for the month of April, comparable store sales increased 7.2% compared to the same period last year, notwithstanding the closure of all of our stores for Easter Sunday, the first time in company history. Our average basket was $51, nearly double the historic average. And e-commerce sales represented 13% of our net sales in April. While the increased sales and our strategic initiatives around smarter promotions remained a benefit to margin, the timing of heightened investments to enhance team member pay benefits and costs to implement additional safety and cleaning measures will weigh heavier in the second quarter compared to the first quarter. Because of this, we don't believe we will sustain the same level of operating margin expansion experienced in the first quarter. The COVID-19 crisis has created a lack of visibility for the remainder of 2020 with many unknowns. We remain uncertain as to when the consumer behavior will return to normal or what may emerge as the new normal. This environment is making it difficult to predict specific outcomes and accordingly we are not reaffirming or stating a new outlook range. However, due to the strong sales and earnings to date, we currently expect that we would be able to meet or exceed our previously released annual outlook. Our business is strong, our cash position is robust, enabling us to continue to build an even stronger Sprouts for tomorrow. Now let me hand it back to Jack to discuss the current environment and strategy.

Thanks Denise. Before I discuss our strategy, I wanted to share a few comments around today's environment. Given the unusual circumstances, I am going to give color on the current trends. Denise's numbers show elevated sales levels that continued into April, though not at the same level as March. We believe the stockpiling is over. More importantly, our observation is the industry is experiencing a significant change in consumer behavior. In order to avoid social contact, customers are consolidating their shopping trips and shifting their visits more throughout the week and less on the weekend. The fewer trips are resulting in many more items in the basket but at a reduction to traffic. No one knows how long these behaviors will last. Social distancing has changed consumer behavior as well, leading to a significant surge in e-commerce sales. For April, our e-commerce sales increased over 950% from last year. This change in consumer preference prompted us to swiftly roll out our pickup service from 55 stores to all stores. We aggressively implemented this service to Los Angeles and Central California in mid-April and are on target to implement it to all 344 stores in early May. This service in partnership with Instacart utilizes an innovative model with our team members performing the picking and delivery to cars. Many of these pickup roles will be filled with existing team members, which has presented even more opportunities for us to bring in new talent. Throughout COVID-19, we have been aggressively hiring creating thousands of new careers at Sprouts. Though it is much too early to define a new normal, COVID-19 has been a catalyst for trial of our e-commerce offerings which could stick with many customers as we exit this pandemic. Though we are keenly focused on the present, COVID-19 has provided us the opportunity to create trial and awareness of our brand as well as capture new customer emails and recruit more customers to our app to establish longer-term loyalty. Currently, we have paused many of our print ads as they are less relevant during these times. We have adapted our marketing spend to focus on customer acquisition and communication through more digital, social and streaming radio with messages to stay connected with us. This was highlighted by leadership videos, cooking at home ideas and #TeamSprouts, which gained a tremendous positive response from customers, well above others in the industry. As well, we have discovered that in our newest 2019 vintage, we have seen an outsized lift in sales compared to the chain average. It's too early to tell, but perhaps the maturity curve for these stores is being accelerated as new customers are experiencing Sprouts for the first time. Anecdotally, we have heard from many customers in our new markets that it was their first visit into our store as they were unaware of us before the crisis. The changing dynamics during this health crisis has prompted consumers to opt for healthier food, resulting in a mix increase to more organic sales and produce and more grass-fed beef and more antibiotic-free chicken. As I mentioned earlier, our investment in our team members is our top priority. In fact, for the month of April, these expenses have increased from March with additional sick pay, added benefits and enhancements to safety and health measures implemented to protect our team members and customers. In addition to alleviate safety concerns, starting in March, we temporarily shut down salad, olive and soup bars and pre-packed all our bulk into individual serving bags. I believe there are always opportunities to be found in a crisis and we are making sure to learn from this one. We are finding that customers are reacting well to pre-packed salads, pre-packed olives and grab-and-go meal solutions as well as the pre-packed bulk options. All of these measures we have taken will help us become more efficient in the future. One last topic to discuss before I move on to strategy, our supply chain, from our internal fresh distribution centers to our partner KeHE, have been adjusting to the daily changing demands to keep our stores stocked. Excluding a few weeks in March, our produce distribution centers have been and remain in good shape. The reduction in restaurant activity has created plenty of supply to flow through to our stores. To keep up with the new heightened demand at our distribution centers, we have leveraged idle labor capacity from other industries. And to alleviate some pressure from KeHE, we have leveraged our five fresh distribution centers to deliver fresh items like eggs and milk to the stores. From a non-perishable standpoint, our buying teams took advantage of what we could to fulfill heightened demand. We are fortunate the products we carry in our grocery assortment are unique. And as a result, we have not been competing for limited supply against some of the larger players in the industry. Our service levels in April improved from our March lows and we believe our stock levels have been better than many in the industry, in part due to this product differentiation. Overall, I am humbled by the team's response to the crisis, from the stores to the distribution centers to the support office. I am very proud of the quick and decisive actions we took to ensure our stores remained open with food to serve our communities. It is a testament to the strong values of all team members at this company. Now I would like to transition into our strategy review. Despite the ongoing crisis, the team was able to finalize our strategic plan to drive the company forward. If anything, I am more confident about our growth potential in a post COVID world. Our proposition of healthy, affordable food, supported by a compelling vitamin department and enhanced assortment in a smaller box will be exciting for our target customer in the future. Please follow along with the slides posted to our Investor website and linked in the press release today.

Thanks again Jack. Over the last few months, we have challenged our internal performance expectations, our past practices, our box economics and our expansion plans. We set a high financial bar grounded in long-term targets, which we believe we can obtain. While the current environment affects our ability to predict the precise timing of when each of these strategies will impact our results, I am confident the strategies will lead to future earnings growth. Starting on slide 15. The basis of my discussion today is our goal of driving attractive profit growth and expanding ROIC by reducing our cost to build, driving annual 10% plus unit growth and delivering comps in the low single digits while stabilizing or expanding our EBIT margins.

It's difficult to be exact on that, Karen, in terms of how things are evolving and changing. It's difficult to know how much PPE we are going to need going forward. We are clearly going to need some and it's difficult for us to evaluate exactly what that number is going to be. One of the reasons we are a bit reticent to be clear about where it's going to be going forward is some of these pressures going forward. I think the likely impact of a post-COVID world is probably broken into three things for us and costs are certainly part of it. How much impact will it have on our wage rates? How much impact will it have long term on our cost in operating the stores? How much will social distancing impact us going forward? So I think it's difficult for us to put numbers to it. But it's clearly part of our planning going forward and we are doing a lot of work on it at the moment.

And Karen, I think with the math that we gave you specifically as to what impacted Q1, you should be able to back into pretty well what the SG&A weight was in the quarter. But it was all really geared to supporting our team members and PPE.

Hi. Thanks very much and really appreciate the color on the longer-term outlook and focus. I mean I do want to ask some questions about that but obviously things are extremely abnormal now. So wondering if you could just answer a couple of shorter-term questions to begin with. Specifically on SG&A, is there any way to give us the actual dollar amount of investments in labor that you had in place for 1Q? I realize that's small but then some color on how to think about that dollar amount in 2Q? And then once things normalize, what the stickiness would be on costs from a cleaning, PPE perspective? Anything you could give on that would be really helpful.

Yes. Well, I think, Karen, you just have to evaluate it from the numbers we gave you in terms of what we saw and the sticky costs. If we look at SG&A over the next quarter, you have to take into account that we are likely to need some level of PPE and labor for the foreseeable future. So there are some additional costs we need to account for as part of our models.

Yes. Karen, what I would say is, it’s difficult to predict exact SG&A trends since we are early in this situation, but we know that the general trend would involve some level of elevated costs which, as Jack mentioned, will evolve depending on our ability to manage the business effectively through these changes.