Sprouts Farmers Market, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Sprouts Farmers Market Second Quarter 2020 Earnings Conference Call. At this time, all participants' lines 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 today, Ms. Susannah Livingston. Thank you. Please go ahead, ma’am.

Thank you, and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our second quarter 2020 earnings call. Jack Sinclair, Chief Executive Officer; and Denise Paulonis, Chief Financial Officer, are with me today. The earnings release announcing our second quarter 2020 results 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. 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 non-GAAP measures to the GAAP figures, please see the tables in our earnings release. With that, let me hand it over to Jack.

Thank you, Susannah, and good afternoon, everyone. Thank you for joining our call today. A lot continues to happen in our world and at Sprouts. Before I speak to the results, I want to express my thanks to our team members, who have worked so hard during challenging circumstances. What I’ve seen from the team is a true demonstration of our Sprouts culture, rooted in respect, inclusion and caring for one another. This culture shines through in everything our team members do for our customers and for each other. In true Sprouts Farm, our team members have adapted to a new way of operating and remain everyday heroes, as we provide our communities and customers with healthy food for their families. Along for the day when this pandemic is over, but for now, we are steadfast in doing what we must to keep our team members and customers safe, wearing protective gear, keeping a social distance and maintaining a sanitized and stocked store. Our results are in large part due to our team members on the front line. As such, I’m focused on supporting them with enhanced compensation and a safe work environment. I remain committed to continually reviewing these topics through these trying times. In fact, in July, we once again paid enhanced compensation and continue to encourage and pay for team members to stay home if they’re not feeling well. As for our results, our sales for the second quarter peaked in the middle of the quarter and started to settle in June. Some of the consumer trends we experienced in the first quarter related to the pandemic remained in the second quarter. Customers consolidated trips to avoid social contact, which resulted in a reduction in traffic, but with an increased basket size. Our customers’ desire to remain healthy correlated to an increase in immune-building categories we’re known for, such as vitamins and healthier products like organic and plant-based foods. The percent of organic produce sold trended up into the high-20% range of total produce sales, and sales growth of organic chicken is up three times since pre-COVID days. As the country continues to practice social distancing, our e-commerce sales have remained elevated, up more than 500% from last year in the second quarter. Our roll-up of pickup service to all our stores was successfully implemented by early May, giving our customers another option for shopping with Sprouts. The pickup service grew rapidly throughout the quarter, and as expected, home delivery remained the preferred service by our customers at six times the size of pickup. During the second quarter, we also increased our marketing spend for our owned channel, delivery.sprouts.com. This website is also powered by Instacart. But when customers order through this owned channel, we capture customer data, providing insights for future marketing. The increased marketing dollars resulted in our owned channel sales, growing more than two times that of all e-commerce sales. The supply chain for our distribution for produce distribution centers finished strong in the second quarter, rebounding from the high volumes in March and early second quarter. Importantly, for our fresh distribution, our on-time delivery to stores is nearly back to historical norms. From a nonperishable standpoint, service levels have dramatically improved since the low levels in March and the stores are doing well keeping the shelves stocked with available products. Our pinch point mainly remains with the vendor community and assortment availability, but imports are flowing through again, resulting in improved levels of private label products. And importantly, our innovation pipeline is robust. We continue to launch new items like the Snow Monkey vegan paleo ice cream and frozen vegetables from Stahlbush Island Farms, which was the first farm to build a biogas plant using agricultural byproduct and become certified as sustainable. I’d now like to provide an update on a few pillars of our strategy, starting with some additional color on our target customer segments. Last quarter, we highlighted two consumer segments that Sprouts resonates with, the health enthusiast and innovation or experience seeker. These two consumer segments combined cover a wide range of income and age demographics from Gen Z to baby boomers, wherever they live in the country aligns nicely with our stores and our store expansion plan, healthier foods and a pleasant store experience highlighted by friendly customer service, are two defining characteristics of Sprouts that drive their shopping habits. Both consumer segments also over-indexed to fresh produce, a foundational category of Sprouts and part of our DNA. Our produce lineage traces a long way back in history, and the bountiful fresh produce selection at great prices will always be the centerpiece of our stores. Having said this, we have significant headroom within these target groups to capture new customers by doubling down our efforts. Today, we’re only capturing a small percentage of the more than $200 billion market that makes up these two segments. Starting in June, we began to significantly adapt our marketing spend to focus on more digital, social, radio, and for the first time TV towards these two customer segments. In the past, our heavy reliance on a print ad kept us from optimizing our connection to the customers that our brand and experience resonate with the most. To bring this point home, in June 2019, we sent out 110 million print flyers of our weekly ad without having full visibility into how many were seen by customers. In comparison, in June of 2020, we had 125 million measured digital impressions of our weekly ad. We were able to achieve a significant 1,800% year-over-year increase in digital impressions of brand and promotional content by reallocating the savings from eliminating print. Another key insight is that we know from the data that customers who read the printed flyers frequently only read the front page, while the digital flyers have high readership across all pages. We’re reaching more customers, and importantly, customers that align most to our offering, and this new media strategy will continue to evolve. Our messaging and promotions are evolving as well. Gone are the days when all our marketing dollars are spent talking about price. Our promotions are starting to become more about storytelling. The products we carry are unique, like Daring’s frozen plant-based chicken alternatives, and our marketing stories will bring them to life. This in no way means we are eliminating promotions. Even during this COVID pandemic, we are still promoting, but we’re being smarter; we’re buying better, and targeting our promotions to our core customers. Our investments are focused on items that are elastic and drive volume. We stopped the deep promotions in price that did not change the customer’s decision or drive additional traffic, which only resulted in deflated sales. Moving forward, we’re promoting what we are known for: healthy differentiated products and multiple varieties of produce. A portion of the promotional dollars left are being reinvested back into a competitive everyday price. We started this promotional change in the back of the third quarter of 2019. In the fourth quarter of last year and during the pre-COVID days of 2020, this strategy was taking hold, as seen in those results, and it still is today. Outside of March and part of April, most all grocers are back with their full distribution of print promotions, and we continue to see the benefits from our strategy, as evidenced by today’s results. Being such a young company, our operating margin improvement opportunities are beyond promotion and price. We’ve already begun to experience shrink improvements from the implementation of fresh item management. For example, for the first time, the meat department has a clear line of sight of how to reduce overproduction and what products are their best sellers from an overall cost perspective, reducing the complexity of our stores, merchandising appropriately with the right number of SKUs and minor fixture changes that will result in further savings in shrink in the years to come. A smaller, less complex box with our new format will also contribute to better labor standards, helping to offset future increases in labor costs. The continuation of the rollout of self-checkout stations in our stores can create additional labor efficiencies to help offset additional labor needed for future e-commerce growth. Our future at Sprouts remains bright, and I look forward to the continued improvement in the business as we scale and grow. Now, let me hand it off to Denise to speak to the financials for the quarter and provide some additional color on our outlook for the third quarter.

Thanks, Jack, and good afternoon, everyone. First, I hope all of you and your families are staying healthy and safe. The COVID-19 pandemic continued to positively impact our business in the second quarter. Net sales grew 16% to $1.6 billion, and comparable store sales were up 9.1% compared to the same period last year. Our comp sales peaked in May at 13%, led by the grocery, meat, and frozen categories. As state reopenings became more widespread in June, comps came in at 8%. E-commerce sales continued to remain strong. For the quarter, e-commerce was 12% of sales, up more than 500% compared to last year. It’s hard to delineate a precise amount of sales that were driven by the COVID-19 environment, but needless to say, the comp trends are substantially above the prior guidance we provided back in February of this year. For the second quarter, gross profit increased by 32% to $613 million, and our gross margin was 37.3%, a positive increase of 450 basis points compared to the same period last year. Two main buckets drove this margin expansion. First, were the positive strategic changes we made that were in-flight prior to COVID. This includes utilizing more thoughtful promotions that are focused on more unique, differentiated products, instead of just price and eliminating inefficient promotions in addition to the benefit of ongoing shrink initiatives. The promotional changes were an outsized benefit in the second quarter as we cycled very deep promotions from last year. The second bucket included COVID-enabled benefits and accounted for approximately 250 basis points of the improvements. We were able to accelerate our planned shift from printed to digital for our weekly ad, resulting in a reduced number of items on ad and more sales at everyday retail prices. As well, our produce team was able to procure excess products in the marketplace at great prices and we benefited from shrink due to sales leverage and lower sales on high shrink items like deli. While some of the COVID benefits will not repeat post-pandemic, others like the mix shift between promotional and retail-priced sales may carry forward depending on customer sentiment. Offsetting some of the gross margin leverage, SG&A increased by $106 million to $489 million or 29.8% of sales, which is a deleveraging of 270 basis points compared to the same period last year. SG&A included a pre-tax special charge of $3.4 million related to our ongoing strategic initiatives. As we discussed in our last call, we took significant steps to adjust to the impact of COVID-19. Most importantly, we made investments in bonus pay and benefits to recognize our team members’ commitment to serving our customers during these unprecedented times. Sick pay and ongoing safety measures in the store contributed to these costs. In total, we estimate the additional costs associated with COVID-19 was approximately $47 million for the quarter. Additionally, with increased e-commerce sales, we realized increased e-commerce fees, which were partially offset by lower marketing expenses, as we shifted from a printed circular to more digital spend. Moving down the rest of the income statement, our depreciation and amortization costs for the second quarter were $31 million or 1.9% of sales, a decrease of 20 basis points compared to the same period last year. For the quarter, our adjusted earnings before interest and taxes were $96 million, an increase of 87% when compared to the same period last year. Our interest expense was $4 million, and our effective tax rate was 25%. Second quarter diluted earnings per share was $0.57, and adjusted diluted earnings per share was $0.59, compared to diluted and adjusted diluted EPS of $0.30 in the same period last year. Our cash position remains strong. Year-to-date, we have generated cash flow from operations of $393 million, up 58% for the year. We ended the quarter with $328 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 0.3 times. Subsequent to the end of the quarter, we paid down $76 million on our revolving credit facility. We continue to prioritize our strong cash generation for organic growth opportunities consistent with our strategic growth plan. Lastly, we invested $48 million during the second quarter in capital expenditures, net of landlord reimbursement, primarily for new stores. For the second quarter, we opened six new stores, ending the quarter with 350 stores in 23 states. We remain on track to open approximately 20 new stores this year. To date, only a few stores have been delayed for a short period of time due to the COVID-19 pandemic. As for current trends, elevated levels of grocery spend have continued into July. Our comps have reaccelerated in July, and we estimate them to increase approximately 9% compared to the same period last year. Similarly, e-commerce trends remain elevated, and we estimate they will finish the month at approximately 11% of sales for July. The trajectory of the COVID-19 situation remains uncertain, clouding the impact on the food retail industry over the coming quarters. While our sales continue at elevated levels, so too are additional costs associated with operating our business. Additionally, at the end of the third quarter, we’ll begin to lap the first phase of our promotional efficiency efforts that drove merchandise margin improvements starting in the fourth quarter of 2019. That said, at this time, we expect increased gross margins in the second half of the year. Predicting specific outcomes remains difficult, and accordingly, we are not providing a new outlook range. We remain confident in the financial strength of our business, our strong balance sheet, and our new long-term growth strategy presented last quarter, which we believe will strengthen the Sprouts brand and set us up for long-term success. At this, we can open up the call for questions.

[Operator Instructions] Our first question comes from Chuck Grom with Gordon Haskett. Your line is now open.

Thanks. Good afternoon. Congrats. Jack, curious when you’ve dissected your customer base here in the second quarter, if you’ve done any work on new versus existing shoppers and if any of the new ones have started to repeat? And then as a follow-up, looking ahead, what steps you’ve taken to solidify those relationships with those new customers going forward?

Yes. Thanks, Chuck. Because of the trend – the traffic and transaction trends in the second quarter, it’s difficult to break it all down. The whole industry, as you know, is seeing such dramatic reductions in transactions and then such a dramatic increase in baskets. Anecdotally, our stores are seeing a lot of new people that look like the people we’ve been targeting. And that’s quite encouraging. We’re going to do a lot more work to get to the bottom of exactly who is coming and who isn’t coming. And there’s a lot of backup work being done on customer analytics to see if it’s following through on the targeting that we talked about in our last earnings call. So in some ways, that’s a little bit vague, Chuck, but we’re seeing a lot of new customers in our stores, seeing fewer transactions. But we’re seeing customers that we think are very much in line with the new customers that we’re targeting. Sorry, what was your second part of the question, Chuck? Sorry.

Just in terms of productivity opportunities looking ahead and how you can continue to engage with those customers going forward?

Yes. Well, very much, we’ve got a very dramatic change to our marketing positioning going forward in terms of how we’re going to engage that customer. We’ve got a massive branding initiative. We’ve got a new marketing head in the organization, who is changing not only the media, but very much the messaging. We’re going to be telling a lot of stories behind the reality of the products that we have in our stores in terms of differentiation, in terms of our fresh produce offer, and in terms of our bulk offer, along with vitamins and all the exciting things we’ve got in our grocery business that are different. The team will be telling that story in very different ways. And starting actually at the back-end of Q3 and going into Q4 I’m excited about that, and I think you’ll see it will clearly target the kind of customers that we know will respond to our offer when we present it clearly.

That’s great. And then just a follow-up would be performance thus far in July up, I think, you said 9%. I’m curious how the performance has been in some of the markets where you’ve seen a surge in COVID cases, such as your backyard, Arizona, Florida, California?

Well, we see but – basically, you’re right. We’ve got places where the COVID cases are high. So California, Arizona, and Florida have been performing pretty well. But the rest of the country has been performing very well as well. You see little peaks and troughs based on when local ordinances have come out and we watch that pretty closely. When a place shuts down and changes a little bit, it changes a little bit when it opens up and we see that within our categories. But by and large, we’re seeing a pretty consistent pattern across all states and all counties really.

Thank you. Our next question comes from Ken Goldman with JPMorgan. Your line is now open.

Hi, good afternoon, and thank you. I wanted to ask first, one of your larger competitors recently talked about promoting more in June than in April and May. Obviously, you gave us all your numbers. But I’m just curious, did you experience any impact from any of your major competitors shifting a little bit of their priorities in terms of promotions in June? So that’s my first question.

Yes. Well, Ken, I think we talked about how we were changing our promotion emphasis long before the COVID situation hit, and we’re going to promote things that are not quite so deep cut, which was creating a huge margin problem, not driving traffic, and probably deflating some sales as well in some of those categories. So we realigned our promotional focus starting with produce, then meat, then across the store in Q3 and Q4 last year, and that’s what we continue to do. When the pandemic hit in March, we clearly pulled out our flyer and went to digital promotions. We hadn’t seen any impact from the changes in June from everybody else returning to the flyer. Flyers are back in the rest of the industry about where they were before pre-COVID. We’re now in a position where we’re spending zero on it, and it doesn’t seem to have affected us at all, Ken.

Okay. Thank you for that. And then my follow-up. Denise, you talked about funding some of your debt pay down subsequent to the quarter. You don’t have necessarily a high interest rate on your revolver. And you have a lot of potential projects you can spend on. There’s CapEx on new stores and distribution centers, there’s remodels. And, Jack, you talked today about having some more work to do in understanding your customers. So I guess, I’m still a little curious why maybe some more growth-oriented projects are not getting a little bit more of a higher priority from your cash flow at this time, if that’s a fair question? Not – obviously, paying down debt is a very valuable thing too. I’m just trying to get a better sense of as cash flows in where your priorities might be ahead?

Yes. Ken, let me separate out the two different pieces about what our priorities are over the long term versus what we just did as we finished the quarter here. So it’s very real term as we finished the quarter, we are sitting on excess cash. We believe that has been prudent through the pandemic to always have a little bit of excess cash. But just because we had more than we needed, we did want to take some of that off the revolver and get the revolver balance down a bit. That said, first and foremost, if you think about our long-term capital allocation plans right now, we are very focused on investing behind the business. I don’t think that there – you’d be able to say that there’s a shortage of investment that we have done this year. But much of our investment is going to come as we cycle out of 2020 into 2021, both in IT projects in our new stores and putting our two new distribution centers in place. So I will tell you, we are 100% behind investing on what has returns to drive the business moving forward, and that’ll be the first priority. After that, excess cash that’s out there, we’ll continue to come back and reevaluate where we feel like we are with the revolver versus some other return of capital options. But for now, I’d actually just reemphasize that we are focused on investing in the business. It just happens to be that some of those investments are a little bit further out than this particular quarter.

Got it. Thanks so much.

Thank you. Our next question comes from Chris Mandeville with Jefferies. Your line is now open.

Yes. Hi, thanks. I guess, I was curious if we could maybe dig into your online business a little bit further. Specifically, I’m kind of interested in understanding how the margin profile looks, given presumably some greater basket size, as well as maybe some of the mix shift in delivery versus pickup and anything else that might have influenced channel profitability? Also, I suppose, with e-commerce penetration actually slowing a little bit, now that it’s about 11% of sales in July versus 13% in April, how did that play out on the margin for you? And maybe in light of the fact that you’ve now rolled out pickup nationally. I guess, I’m curious if this reduced penetration might have actually surprised you? And if you can provide any color with respect to the result of pickup?

Yes. Chris, let me take the kind of what’s happening in our e-commerce business, and I’ll let Denise go through the margin profile and the impact of that. In terms of our business, when this all started, we were running at 4%, and it got back up, as you said, to over 13%. It has dipped down a little bit, and it’s tipped back up a little bit. It just kind of goes up and down. But it’s very significantly different than where it was. Our strategy remains the same: we want to provide the option for the customer, particularly within the context of the coronavirus. We want to give them the option to either pick up, have it delivered or use the store. And in that way, we expanded. As we talked last time, we expanded dramatically the pickup capability in our business and the team did a really nice job of making that happen. We’ve seen the customers respond partly in a different way at different times depending on this is very much dependent on local jurisdictions and how people are feeling comfortable with it. It has also helped us deal with the mask issue — allowing people to say look, you don’t have to come into the store if you don’t want to wear a mask; you can use the delivery or the pickup, which has actually helped us a lot in the dialogue and that thorny issue. So I’ll let Denise talk specifically about the margin side of it.

Sure. And just to pick up on that, a couple of things just about what we’re seeing in the overall trends of the basket and how they evolve. Our e-commerce basket is a notably larger basket than the store basket, as you can think about the idea of people consolidating purchases, it’s a bigger basket to start. Generally, the mix of the products in the basket is a little bit more margin-favorable to us. Our business actually is very strong on a profit perspective in areas like grocery and vitamins. Things that are nonperishable for us generally hold a little bit higher margin, and those are mixing a little higher into the basket. So that’s a benefit when we think about the margin and analytics in an e-commerce basket that we have from a mix perspective. Secondly, the other piece is with us having balanced our business to have those delivery and pickup. While pickup still remains a very small part of the business, our margin on that pickup business, we have the ability to leverage a bit more by the use of our own team members in-store to do the picking and the delivery out to vehicles from a pickup perspective. So there’s also a little bit of an arbitrage there as people mix out and have a bit of their business being pickup. Overall, we’re planning e-commerce for margin dollars. Our e-commerce business is profitable, and we really want to serve customers where they want to be served. But the notion of that bigger basket and a little positive mix benefit in terms of the product choices is a benefit to us.

Okay. That’s very helpful. And then my follow-up. I believe you only really have a handful of stores that are exposed to four new ALDI locations that will be opening in the state of Arizona later this year. Can you just give us a quick reminder regarding what initial impact you might have seen, or what you did see for that matter, from that banner when it came to California a few years back and how quickly you were able to recover?

Yes. We’re very intrigued. When ALDI comes next to us, it doesn’t make a lot of difference to our business. If anything, it drives a little bit of traffic to us. It’s such a different proposition that the customer seems to be pretty comfortable using us as a complementary shop in that environment. I’ve competed with ALDI all my career and all sorts of different guises, and they’re a clear competitor in many places. For us, here at Sprouts, I see them less as a competitor. In some ways, the driving of traffic that comes from it might even help us a little bit. You might be surprised to hear me say that, but that’s certainly how we view it.

That was interesting. I do appreciate it. Take care.

Thank you. Our next question comes from Kelly Bania with BMO Capital. Your line is now open.

Hi, thanks for taking our questions. I had two that I really wanted to ask about. First, just on gross margin, obviously, a really big increase there, I think perhaps bigger than you were planning. But I was wondering if you could help us understand and unpack just the shrink, the promotional impact? And what categories are you pulling back on promotions? And just help us think about that kind of gross margin expansion?

Sure. Kelly, I’ll start, and then Jack can jump in if he sees fit. First, you mentioned the idea of did it come in a bit stronger than we might have anticipated earlier in the quarter? I would say it actually did come in a bit stronger. Two drivers to it coming in stronger. One was, shrink improvement was better than we originally expected. Part of that is sales velocity remaining high. We were not necessarily betting it would remain as high as it did, which helped shrink. But we also saw good traction on some of our own operating initiatives in store that drove that shrink improvement. So that was one item. The second, as we came into the quarter, I think we were cautiously optimistic that our ability to pull back and stick with digital ads versus print ads would be able to continue. But when we were able to continue that through the quarter, we saw a little bit more outsized benefit than we initially anticipated coming into the quarter. More broadly, unpacking the items that are there. From a promotion perspective, Jack has talked about this quite a bit. We’re leveraging a couple of different tools and approaches. One is really understanding what’s an elastic promotion and what is an efficient promotion, sticking with those and pulling back in places where those don’t make sense. I think the second is really the shift between a print ad to a digital ad and being able to come much more targeted to what we’re promoting each week. The third, tied to that, is what we’re able to do to marry up the way we think about, in particular, our produce buying and then what we promote. Having moved to a digital ad, we’re actually able to leverage much closer to what our produce buying team is able to do and get good deals on short notice and take advantage of getting those to the customer in the marketplace. We’re really able to work through those levers in a bit of a different way than we would have been if we were only doing a print ad. On shrink, as I mentioned, one portion of this is we just have great sales velocity. With things like deli and salad bars being closed down during COVID, some high shrink areas, by default, have lower sales and, thus, lower shrink coming through. The second part, though, is all the operational efficiencies we’re doing. Whether that's part of our fresh item management program and better managing what produced items are coming out in what quantities and reordering appropriately, our team members are watching turns of products in the store, it shows the impact of what we're trying to do. We’ve started to see the goodness of that shrink program come to fruition as well. The third part I’d add is that last year in the second quarter, we were very deep in our promotional intensity. The combination of the number of items promoted and how deep we were going. So we also happened to be lapping just a very deep cycle from last year.

Yes. The key takeaway is the change in the approach to produce. Last year, we were doing a lot of very aggressive commodity promotions at very low prices compared to anyone in the marketplace, which were being planned three to four weeks out to support that flyer. We’re now being much more thoughtful about what we’re putting out there. Produce is still promoting fairly aggressively, but we’re being more thoughtful about the items we’re putting in it and making changes right up to the last day in terms of planning this because our distribution centers are there to flow through quickly. The flexibility and nimbleness of our new team in the produce department makes us very encouraged by the progress they’re making. That’s probably why the results in Q2 were better than we expected, and that will moderate in Q3 and Q4.

Okay. Thank you. That’s very helpful. I guess, Jack, just one other big picture question. Obviously, when you laid out your strategy in early – in the early stages when COVID kind of hit. So I’m curious, as you analyze the results and look at the business, what metrics are you using to discern how much is COVID versus the core underlying strategy and sustainable? It’s obviously hard to separate those. But what gives you comfort that you’re on the right track with this strategy?

Well, first of all, clearly, it’s difficult. We’ve tried to break it down in the numbers that we’ve communicated and try to say this is COVID and this is non-COVID, and I think we’ve done fairly well. The thing that gives me confidence in the strategy is the question just asked around the fact that our numbers are staying strong even when other guys are promoting aggressively. The data point as we’re looking to our real estate portfolio shows that we can tell the stores that are performing really well and this is very clear when looking back on the stores that we had. We can see stores that are working well that are focused on our targeted customers. We’re doing customer research and analytics to clarify how we are targeting the customer base. That keeps us focused on the right customers and honing in on our strategy. So we feel like despite having COVID confusion the entire picture is encouraging.

Hi, thanks very much. A couple – actually, since we were just talking about SG&A broadly. When you back out COVID and obviously the strategic expenses, SG&A was still up 14%. So I guess, I know you’ve commented that e-com costs were offset by the shift in digital or media to digital. But is 14% the right way to think about SG&A growth going forward ex-COVID, because that just seems like a high number?

Yes. Karen, I really think about the incremental SG&A that we will have going forward will be tied to new stores coming online and the cost of operating those stores, as all of our costs of operating the stores hit within our SG&A. We would also see some SG&A costs as we’re investing in the business, including IT. The comment of the 14% in specific, I’m not going to give a prediction on that specific number. Overall, we’re monitoring SG&A very closely, and in total, wouldn’t consider it to be an outsized area of growth beyond what’s happening with new stores and some basic inflation.

Okay. And then I wanted to just ask about gross margin kind of more broadly. So obviously, Jack, before you arrived, there was conversation around Sprouts where the focus was on the fact that merchandise margins had remained remarkably stable over time. And that was generally true, as we can all look at the model. But when you arrived, that conversation shifted to the fact that produce merchandise margins had obviously been coming down and had been a big headwind for a while. So I guess my question is, how can you help us – and again, it’s hard with COVID – but can you help us think about what gross margins could look like more sustainably longer-term if we kind of get back to a more normalized environment?

Yes, and you’re right, Karen, it’s very difficult because of COVID to be very explicit about this. But let’s take it back to the pre-COVID world. What we were facing – this is my first call after arriving here. When you look at the business, it was seeing a very significant margin investment to deal with poor sales and negative profitability. Our heritage of produce in this organization is second to none, being able to maintain that DNA while managing those dynamics is critical. So very specifically, it’s about being smarter moving forward. That’s what’s sustainable: positioning our business with a focus on product and varied promotions. We’re going to be looking to turn the promotional cycles around to generate sustainable long-term margin enhancements as we improve our business. I’m becoming more confident, rather than less, that these margins can be maintained and improved as we build better data and target promotions, even absent COVID.

Well, hey, guys. Thanks for taking my question. I actually wanted to follow up on Karen’s question. I know you and most others are not giving any guidance. But your gross margins are going up a lot right now and you’re telling us to expect it to be up in the back half, and we do have to think about next year and the cost of you guys shifting more into e-commerce, etc. When you look to next year, I mean, should – is Sprouts going to a significantly higher gross margin place in a normalized environment? And do you think some of the things you’re doing already are things you were going to do pre-COVID that are getting you there and you see a way to maintain a much higher gross margin level than historically? And then do we need to think differently about the SG&A as you’re doing more pickup? I mean, can you give us any kind of thoughts on could gross margin stay at this level or should we think it’s going to be somewhere between what you’re doing now and what you used to do? Any thoughts on structural changes?

There are a number of things longer-term that should – I’ll let you talk of the SG&A, Denise. But in terms of specifically around the margin, there are three key dynamics that could potentially make a significant difference to next year’s margin. One, we’ve talked about, which is the promotional investment and the changes to promotional strategy should enable us to have a more consistent pattern of product gross margins. Our shrink improvements are key as our strategies mature. The investment in our fresh item management can lead to further efficiencies. Overall, transportation costs will also factor in as we build new distribution centers closer to stores. These changes should lead to significant cost savings. So those factors are right in front of us and, irrespective of COVID, they should enhance margins going forward. Overall, I believe we have a more sustainable long-term margin enhancement trajectory ahead. The COVID environment likely accelerated some of these changes, but we’re on a path that will help maintain that going forward.

Yes. I think from the SG&A side, there is some room for both positives and negatives in that scenario, right? On one hand, while e-commerce penetration comes with a little less margin than our core store business, offsetting that we have some factors that will help as we grow. We’re testing self-checkout in some stores, and we’re looking into better ways to manage labor, especially for our new pickup business. So we’re monitoring those economic factors alongside of traditional fixed operating costs, but there may be puts and takes where we can stay competitive on SG&A while looking at the growth of the e-commerce model. We believe we are in a good position to continue to manage effectively going into the future.

Thank you. Our final question comes from Edward Kelly with Wells Fargo. Your line is now open.

Yes, hi, good morning, everyone. I just – I wanted to ask really just one question. How difficult is it to definitively say that the strategy is working when looking at the business today, given that we’re in a COVID environment? I ask this because your comps aren’t up as much as peers. I know there are reasons for that. But gross margins are up a lot, and I’m wondering if absent COVID, we’d be looking at a flat comp with gross margins up a lot or if they would be better than that. I know it’s hard for us to draw definitive conclusions from what we’re seeing; I’m just kind of curious how you’re doing that and what you would say to support the fact that things are moving in the right direction?

Well, traffic is very difficult to read because of COVID. It’s difficult to know. I wouldn’t have expected by, let’s assume COVID hadn’t intervened, I wouldn’t have expected sitting here looking at Q2 numbers, trying to see a meaningful impact from the strategy we implemented in place. I would similarly represent we would see some margin enhancement but perhaps not as much as we had realized; that’s been augmented by broader customer-focused efforts. Despite the challenges presented by COVID, consumers are slowly shifting to shopping patterns that align with our strategy for targeting customers. There is still work to be done, but certainly, we’ve seen tailwinds driving people to our stores as well.

Thank you. Ladies and gentlemen, this concludes our question-and-answer session. I would now like to turn the call back over to Jack Sinclair, Chief Executive Officer, for any closing remarks.

Thank you ever so much for taking the time to listen to us and show interest in our company. We’re very excited about the prospects. And I really appreciate you all, and I hope you all stay safe and look out for yourself. Thanks so much.

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.