Sprouts Farmers Market, Inc. Q3 FY2021 Earnings Call

Good day and thank you for standing by. Welcome to the Sprouts Farmers Markets Third Quarter 2021 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 today, 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 third quarter 2021 earnings call. Jack Sinclair, Chief Executive Officer, and Chip Molloy, Chief Financial Officer, are with me today. The earnings release announcing our third quarter 2021 results, the webcast of this call and quarterly slides 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 expectations for 2021 and beyond. 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 the GAAP figures, please see the tables in our earnings release. In addition, because our results for the third quarter of 2020 were impacted by the COVID-19 pandemic, this presentation will also include certain comparisons to results in the third quarter of 2019. As a reminder, to account for the 53rd week in fiscal 2020, we shifted each week back one week, thereby ignoring the first week of fiscal 2020 to better align holidays for comparison purposes. Because of this, the two years stack comp will not be a simple addition of two periods. For more information can be found at investors.sprouts.com under additional reports as needed. With that, let me hand it over to Jack.

Thank you, Susannah. And good afternoon, everyone. I'd like to start today by first welcoming Chip, as our new Chief Financial Officer. Chip recently made the decision to resign from our Board of Directors after nine years and join us full-time. I'm excited to have him as a partner and key member of our leadership team. During today's call, I'll start with a few highlights. Chip will then provide a review of our financial results and outlook. And then I will return to provide details relating to improved quarter activities and updates on key elements of our strategy. We have the right strategy and are excited about moving it forward piece by piece, making great progress on our supply chain, differentiated merchandise, new format, and real estate selections. However, our initial marketing messages fell short during certain periods. We fully expected to see a positive two-year stack in the back half of this year. And through the third quarter, we did not. With this in mind, we're focused on delivering a clear message that highlights our sharp produce pricing, innovative products, and a farmer's market experience to drive additional transactions in the quarters and years ahead. Taking a step back, if you remember in the middle of 2019, we began a journey of strategic transformation. The catalyst for that journey was recognizing that the efforts to acquire new customers, primarily through an onslaught of aggressive and ever-increasing promotions would result in continued margin and brand erosion, which was not in the best long-term interest of our stakeholders. We immediately pulled back on many of the ineffective and unprofitable promotions and experienced a slight decrease in traffic as expected, but also improvements in our margins. Shortly thereafter, as we all know, COVID became a major factor. It impacted virtually all retailers in a variety of ways. For Sprouts, one of the most important points to understand is that in the second quarter of 2020, we lost approximately 25% of our transactions and to date they have not returned. Certainly, COVID played a significant role in changing the shopping patterns of our customers during the height of the pandemic. Additionally, our changing promotional approach resulted in a loss of coupon clippers. What is encouraging is that those pre-pandemic customers that make up 75% of transactions that stuck with us are putting more units in their basket today than they did in 2019, paying higher average prices via a combination of mix, fewer promotions, and inflation, resulting in record third quarter profits. Our sales in the third quarter of this year were up 5%, and our earnings per share was up 155% when compared to the same period in 2019. The impacts of COVID have also reinforced our strategic direction, which includes the need to win with our target customers, refining our brand and marketing approach with everyday great pricing and unique product offerings, creating a supply chain that provides the freshest produce, while also updating our store prototype, a prototype that continues to provide our customers with a unique experience, with differentiated products yet in a smaller and more efficient store, resulting in higher financial returns and the ability to grow faster in new markets, building density and brand awareness. Before providing more details relating to the quarter's activities, I'd like to turn it over to Chip who will review our financial results and our outlook.

Thanks, Jack, and good afternoon, everyone. For the third quarter, net sales totaled $1.5 billion and comparable store sales were down 5.4% compared to the same period last year. On a two-year basis, net sales increased 5% and our two-year stack comp was down 2.1%. We experienced a slight sequential improvement each month of the quarter in both comp transactions and comp sales. From an e-commerce perspective, sales penetration stayed relatively flat at 10% and appears to be stabilizing at that level. Third quarter gross profit was $540 million and gross margin was 35.8%. The gross profit decline of approximately 130 basis points, which was in line with our expectations, was driven by the anniversary of elevated levels during the height of the pandemic and the balancing of cost inflation and retail pricing. We continually monitor market price points in all departments and are able to pass-through most but not all cost increases. Our margins are still more than 260 basis points higher than during the third quarter of 2019. SG&A costs were $423 million, a decrease of $52 million when compared to the same period last year. The cost decreases were attributed primarily to lower COVID pandemic response costs, incentive compensation, and marketing spend. For the third quarter, our adjusted earnings before interest and taxes was $86 million. Interest expense was $3 million and our effective tax rate was 23%. Our adjusted diluted EPS was $0.56, up 8% compared to 2020. As Jack mentioned earlier, compared to the third quarter of 2019, EPS was up 155% as we continue to maintain our margin structure to a more differentiated customer proposition. During the quarter we opened 3 new stores, relocated 1, and remodeled 1. Both the relocation store and the remodel store are in the new format. Shifting to the balance sheet and liquidity, we continue to generate strong cash flow from operations, $297 million year to date. Through the third quarter, we invested $53 million in capital expenditures, net of landlord reimbursements. During the year, we've also repurchased approximately $137 million in stock and ended the quarter with $250 million outstanding on a revolver and $28 million of outstanding letters of credit, $260 million in cash and cash equivalents and $163 million available under our current $300 million share repurchase authorization. We continue to maintain a low debt position and ended the quarter with a net debt to EBITDA ratio of nearly zero. Now turning to our updated outlook for the year and our outlook for the fourth quarter. Total sales for the year are expected to be between $6.055 billion and $6.085 billion with comp sales down approximately 7% to 7.5%. Adjusted earnings before interest and taxes is expected to be between $325 million to $330 million. Earnings per share is expected to be between $2.04 and $2.08 and capital expenditures of $95 million to $105 million. For the fourth quarter, total sales should be between $1.45 billion and $1.475 billion and comps down between 3% and 5%. Fourth quarter earnings per share is expected to be between $0.26 and $0.30. Lastly, we expect to open 9 new stores in the fourth quarter and 6 new store openings to shift early next year due to difficulties in securing certain equipment from third parties because of supply chain delays. The total new store openings for 2021 is now expected to be 14, including 1 relocation. Before turning to our initial outlook for 2022, I first want to discuss my reasoning for joining the company full-time. Many of you have asked the question why or why now? First and foremost, I love this company, its people and its purpose of providing healthy living options at reasonable prices. Second, I believe the stage has been set for future success. We have a differentiated customer experience with unique product offerings and a new prototype that should allow us to aggressively expand our reach while creating shareholder value along the way. As we continue to learn more about those customers that love us and tell that message to those that don't know us, I believe we will slowly but surely turn the corner on comp store sales, while still maintaining relatively stable margins. Combining a low single-digit comp with our opportunity to grow stores should allow us to consistently produce high single-digit sales growth and high single-digit EBIT growth, while generating sufficient cash for that growth without taking on any more debt. We should still have a significant amount of cash remaining each year returned to our owners. All of this with the backdrop of a current net debt position of essentially zero, while our equity is trading at approximately 5.5 times our current year EBITDA. What does all this mean for 2022? It's a bit early to be definitive regarding expectations. And we know we'll still be navigating some of the lingering challenges of COVID and inflationary pressures on cost and retail prices. That said, for now we're expected to open 25 to 30 new stores, of which approximately 65% will be in the fourth quarter. To be clear, 2022 openings are supported by a very strong pipeline of executed leases and approved sites above this level, but restricted as the aftermath from the pandemic continues to impact supply chains, city approvals and developments. Comps should be relatively flat, total sales growth in the low to mid-single digit range and EBIT growth also flat.

Thanks, Chip. Let me speak more about the current business and our ongoing strategic initiatives. From a merchandising and innovation standpoint, vitamins, deli, and grocery are some of the highlights during the quarter, boosted by back-to-school seasonal shopping from parents looking for better-for-you options for their children. Allergy-free items, like Healthy Crunch jam and Nut Butter Bars, were popular in school lunch boxes this quarter and were among the unique items we highlighted in our new innovation center merchandising displays. As kids return to school amid the spread of the flu and the COVID Delta variant, sales in our immunity-based vitamin categories increased, and with busy families and more folks returning to work, we saw strong performance in our updated prepared meal solutions, sandwiches and sushi bar, driving growth in deli. For vendors and entrepreneurs, we are becoming the destination to launch new innovative products through our monthly Find a New Favorite program and other campaigns. Good Catch’s innovative plant-based breaded seafood line just launched nationwide with Sprouts. Dr. Bronner's entry into the bars category did an exclusive lunch with Sprouts added San Joaquin almond nut chips. In turn, we were also keeping the innovation train moving and held our first brands vendor summit with over a few hundred participants. We have launched our own brand plant-based oat whipping cream and oat milk, now just in time for the holidays, as well we have included new wood-fired flatbread pizzas from Italy, organical melt, the first of its kind in our deli set and a vast probiotic program in the vitamin department. In the third quarter, we also reset our wine department and created Sprouts seller pits with over 50 plus new wines focused on transparency of ingredients and attributes like organic grapes or sustainably grown. These wines not only taste great, but they have also been beating our expectations. The wines along with the other unique products mentioned are driving home the best part of a farmers market, exploring new and exciting products from people and companies with interesting stories and passions. Moving on to promotions and marketing, our focus remains on adding profitable sales growth, getting more customers in the door, and creating more loyalty with our target customers. Earlier this year, we fell short in communicating our commitment to great prices in our marketing, especially in produce. While it was present in-store, we didn't effectively communicate our value message to our customers. We began to address this imbalance in the third quarter by trying new things. Some worked, and some didn't. For example, those spikes worked and even drew future visits after the second visit. Special events in produce focused on our differentiation, like tropical fruits or varieties of grapes like Moon Drops and Gum Drops drove more excitement in the store and were successful. We leverage embedded calls to action in our branding work, highlighting our competitive advantage in produce, including attractive pricing, which is better than most and differentiated with more local, new varieties, and organic produce. We've been very deliberate, making measured investments in this regard and utilizing more of our owned media to share these messages. Throughout the third quarter, our traffic slightly improved each month, as we believe our customers responded to these new messages. During the fourth quarter, we are continuing many of these tests on a broader scale. We're doing more mass media on Sprouts' strengths like promoting compelling, high-perceived value items that are more relevant to our core customer. As well, we continue to refine our broader brand message and campaign to attract those new customers still unaware of Sprouts differentiated store. Just recently, we expanded the ways we shared our wellness expertise with our customers. In October, we hosted an interactive wellness livestream with industry experts to discuss natural remedies for anxiety, inflammation, and immune health. Led by Maria Menounos in collaboration with partners like Ancient Nutrition, the panel spearheaded topics we're all thinking of today: How do I improve my health and feel better, which is likely why we received 20,000 RSVPs. Turning to operations, no one is immune to ongoing supply issues and rising labor, product, and transportation costs. Throughout supply chains, we are fortunate that we deal with smaller vendors to whom we're a big customer. This advantage allows our teams to continue to manage the health on the shelf, providing a great buying experience for our customers. That said, we are experiencing higher costs, most of which we’re passing through outside of some fresh categories. We're experiencing lower labor applications like others across the US and are working hard to keep our stores staffed by focusing on retaining our team members and making new offers quickly. To ensure team members are rewarded for their work in addition to base pay, our team members have access to incentive plans at every level in the organization. On the transportation side, the strategic change we made this year with the opening of two new distribution centers closer to our stores in Colorado and Florida is mitigating some of the transportation cost pressures experienced in the industry. The addition of the new distribution centers not only helped in costs, but they also helped bring our local produce offering to life in stores. The Colorado growing season just wrapped up. The ability to source from local vendors was prevalent in all the regional stores in that state. During the third quarter, sales penetration of local produce in Colorado reached double digits, a level never before and greatly improved the freshness to our customers. Now that we're in November, the Florida growing season is just kicking off. We're excited to be featuring over 20 local Florida growers and over 100 local items during peak season, supported by the 'meet the grower' marketing in the store, and we have high expectations of replicating the success we had in Colorado. The third quarter marks a significant milestone along our journey with the opening of two new format stores. One was a relocation in Phoenix to a nearby site and the other was a remodel of our Tustin, California store. I'm excited to share some highlights. First and foremost, the Phoenix relocation store is 23% smaller and the sales are up significantly. The Tustin remodel store has not changed in size, but has all the elements of the new format and its performance is encouraging; the new format project remains the highlight, brightly displayed in the center of the store. Unique to Sprouts, we meet with first-flow. We expanded and centralized our frozen department and presented more grab-and-go items in our deli department. The new stores are experiencing an increase in the percent of protein sales and frozen is performing exceptionally well. Despite moving expensive solid bar and pre-piped deli options, deli sales are also performing above the company average. Even though it is early days, these results give us confidence in the new format model. Over the next few months, we will open three more new format stores and it will be the platform for our 2022 openings. We continue to learn from and develop this new format. The simplicity and smaller size of the new format will significantly reduce our cost to build and operate the stores. The cash investment to build is approximately 20% less by taking out the expensive deli fixtures and simplifying other areas like proteins. With smaller square footage come lower costs to operate, whether that be in rent expense, improved string, or other operational efficiencies like self-checkout. By utilizing our space more efficiently without having to reduce our SKU count in most departments, we expect sales to be at least equal to the larger boxes we built in the past, all resulting in improving returns. Before I wrap it up, I'm excited to share some updates on the Sprouts Healthy Communities Foundation. In 2021, we're supporting 150 nonprofit organizations with grants totaling $3 million, continuing our work to support our communities with access to fresh, nutritious food and empowering children with the knowledge and resources to live a healthier life. And this weekend we have a National Day of Service, where over 500 Sprouts volunteers will complete 50 service projects across the country. Through the help of the foundation, we all get our hands dirty by supporting the local school and neighborhood gardens we have helped create over the years, which is a great event to give back to the communities that support us. I emphasize we have work to do, and while we're disappointed in the third quarter top line, the strategic transformation is progressing well. Our journey to improve upon this Sprouts model is well underway from our new innovation centers, our two new distribution centers, our measured promotional approach, and our new format stores. We are confident in the ability of our long-term strategy to create a more profitable and sustainable company for many years to come. At this time, let's open up to questions.

Our first question comes from Scott Mushkin with R5 Capital. Your line is open.

Thanks for taking my questions. And thanks also for providing a little bit of thoughts around 2022. So I think, obviously, a lot of questions around the kind of sales performance as the company goes forward into the fourth quarter and into next year. So I was wondering if you can kind of give us some thoughts about what the gross margins you guys think will look like as we go into the fourth quarter and how much investment you think there needs to be to get that traffic and sales line moving. And then, as we think of 2022, which I think you said EBIT was going to be kind of on the flat side, kind of take us through the idea of where we grow, where will margins be, doesn't have the exact guidance, but clearly, there are a lot of people in the market that don't think you guys can do this. And so, I was wondering, if you can maybe tell you why you think you can?

Well, I'll let Chip go through in a bit of detail with some of the margin dialogue that we've been having. Fundamentally, we've reshaped the margin, as you know, Scott, over the last couple of years and we're in a position where there may be some tweaks we need to do to invest in it. But by and large, we've got our margins where we need to get them to be and the focus of the business over the next quarter and next year is how do we get the comp sales to that moderate comp sales that we talked about? And there's kind of three buckets in that. That’s how you grow the basket, which the stores are doing a nice job with invest and chasing after that. That’s how you grow transactions from existing customers. And we've seen some success in some of the marketing activities in that, whether it be the bounce back or 72-hour sales, we've seen something in that. And then the next stage is how we grow new customers. We probably need to think a little bit about how and where we invest in our marketing dollars to drive that going forward. But I'll let Chip talk a little bit about the margins.

Yes, Scott. In the fourth quarter, the gross margin is expected to decrease year-over-year. It won't decline as much as it did in the third quarter, approximately 70 to 80 basis points. Looking ahead to next year, I expect that we will still see a year-over-year decline in the first quarter, but we are aiming for flat gross margins for the year. There are opportunities in the non-merchandise margin areas that could help offset some of the inflationary pressures on margins. Additionally, we will continue to test various promotional strategies to manage margins while driving sales without negatively impacting our bottom line.

Thanks for that guys. And as a follow up we get this question also a lot from people. Around the format itself, do you think it's differentiated enough in the marketplace? Or do you need to do more to bring those people in to have people understand that Sprouts is different? And to kind of draw them in more aggressively? Thank you.

In terms of what sets us apart in our stores, I believe our prominent placement of produce is a key aspect of the Sprouts offering. We need to emphasize this more, especially considering our competitive pricing on produce. Additionally, our vitamin department stands out, particularly in the context of growing health concerns post-COVID. Our knowledgeable staff in that area adds significant value, contributing to our differentiation. Recent changes, including the introduction of innovation centers, have also enhanced our product offerings, providing us with a clear edge over competitors by selling unique items. We are becoming a go-to destination for small brands looking to launch, and our team is effectively integrating these products. I see private branding playing an even larger role in future innovations. Moreover, our unique offerings in specialty diet items like keto, paleo, and gluten-free should be communicated more prominently. Your question implies we might need to do a better job of attracting customers to our stores, and that's something we are actively addressing. We plan to enhance our messaging significantly in the upcoming quarter and beyond.

Thank you. As a reminder, we ask that you please limit yourself to one question and one follow-up. Our next question comes from Matt Fishbein with Jefferies. Your line is open.

As I think about the top-line trajectory from here, I know you've pointed to the past couple of months as sequential improvement. How did October look relative to the previous three months, and related to that – as it relates to marketing dollars, where do we see marketing dollars next year going, is this a case of there not being enough marketing dollars spent? Or is it simply like you were explaining the tactics involved with those marketing dollars? Thanks.

I would like to discuss our marketing strategy, and Chip can provide insights on October's traffic patterns. We're currently evaluating the appropriate amount to invest in marketing. It's more a matter of tactics rather than simply the budget, as we've traditionally allocated significant resources to aggressive promotions like paper flyers, which we have since discontinued. The COVID pandemic accelerated this change, and it has equipped us with strategies we can utilize in Q3. We're being cautious about how we allocate our marketing funds and are still assessing which strategies are effective and which are not. I believe it is essential to convey the unique advantages of Sprouts more effectively, especially regarding our pricing on produce, where we are 30% to 35% less expensive than our competitors in certain markets. Our customers aren't sufficiently aware of this, particularly since we aren't employing highly aggressive high-low pricing strategies. We need to emphasize our everyday low pricing on produce more strongly. Additionally, we must clarify how our innovations benefit potential customers. While some marketing efforts are necessary for driving sales, I believe we can increase in-store shopping without heavy marketing by introducing innovative products and promoting them effectively in our stores. We have had some success in encouraging existing customers to purchase more through our marketing investments. Ultimately, we need to attract new customers who resemble our current customer base, which will require targeted marketing tactics and resources moving forward. However, this does not suggest we need to increase our marketing budget significantly compared to previous expenditures to enhance traffic.

And Matt, this is Chip. As it relates to October, we will typically provide guidance by the month, but we guided for the quarter minus 3 to minus 5. We feel good about October as it relates to that guidance. November and December, which has been factored into that guidance were pretty good last year, because there was a resurgence of COVID towards the end of the year, which makes it a little bit more difficult in November and December from our year-over-year comparisons. But we feel good and feel confident that we're going to be in that minus 3 to minus 5. And then in a little bit on the marketing spend front too, I think it's good to know that we're continuing to test quarter over quarter. From Q3 sequentially to Q4 we are spending more money in marketing or at least we're anticipating spending more money in marketing, not just to test and learn but also to help us set off the year right for next year. And then year over year, we’ll spend a little bit more in Q4 than we did last year.

That all makes sense. Thanks for the additional information. As a follow-up, I know that cost inflation generally serves as a benefit for traditional grocers, but can you explain why Sprouts and possibly specialty grocers might not benefit in the same way? Additionally, how do you anticipate the overall impact in 2021 will compare to 2022? Thank you.

We've observed an increase in average unit retail prices that aligns with broader market trends influenced by inflation. The products we offer, such as proteins and meats, are experiencing similar inflation levels as seen across traditional grocery stores. As mentioned in the previous call, we carry many unique products that others do not, which may contribute to the differences in our inflation experience. Significant inflationary pressures are evident in our meat, pork, chicken, salmon, and fresh produce, while our grocery business reflects much more tempered inflation. Future developments may alter this situation. As we move into 2022, it's uncertain how this will play out, but we've seen rising levels in our protein categories recently, which may stabilize or even reverse as the economy slows. Overall, we're confident in our ability to pass on the increased costs for most commodities, with a few exceptions in the protein sector.

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

You've given some answers to this already, but I wanted to explore a little bit more on the commentary about flat or flattish comps in 2022. A little bit lower than what the street was expecting, especially if your margins are already where they need to be. So we're just trying to kind of parse out what some of the headwinds are that would hold you back from a positive number or elements of uncertainty here because of the macro trend back to away from home. I just wanted to kind of get a more complete list if I could of what would hold you back from a positive number there?

Ken, this is Chip. What would hold us back as one is early and there's a lot of uncertainty in the marketplace. As Jack has already alluded to inflationary pressures, how does that play out? Where does that go? What does that do to the consumer? As you start to see while it's getting squeezed in the marketplace, what does that do to a secondary or tertiary shop or a secondary or tertiary item? It's just too early to bet on something that's higher. I'd much prefer us plan for something that's lower, plan our cost structure accordingly for that. And then as we get through these tests and learn spaces, the more we can learn about where we can drive traffic through marketing dollars or promotions, then we'll continue to do that profitably going forward. But at this point, I'd rather us plan around the idea that it's going to be closer to zero and we can work our way into something better as we learn more.

And then, you did talk about, again, your margins kind of being in that range you want to be. You talked about the gross margin next quarter. I wanted to get a sense because your SG&A dollars have come down each of the last five quarters, obviously a pretty high number during COVID. Are we at a more of a level, the level 423 or so where that's kind of a run rate going forward? I know it's not going to be exactly the same every quarter, but I'm just trying to get a sense for how low we should think about that going ahead?

Yes, certainly. In the third quarter, similar to the second quarter, we experienced significant SG&A reductions compared to last year, largely due to COVID-related costs. As we move into Q4, we are past that phase, and we're expecting our SG&A to increase year-over-year in Q4. You can calculate the specifics based on the other metrics we’ve shared. Looking ahead to next year, based on our initial outlook, we won’t be reducing costs; instead, we will continue to see cost growth from this point onward. However, we need to be careful and mindful about how we manage this growth moving forward.

Our next question comes from Mark Carden with UBS. Your line is open.

Thanks a lot for taking my questions. First, a bit on the comp question that we just had, but are you guys able to measure how far you are today with respect to shedding some of the less profitable coupon clippers? Are we almost past some headwinds? You still think there's a ways to go and then, are you seeing any different customer mixes that your new format stores versus your legacy stores? Thanks.

Yes, both very good questions, Mark. The confusion that's come with COVID, we talked about losing 25% of our customers over the course of the immediate aftermath of the COVID. Since then, has been relatively static at about 25%. We think, and this is an estimate that we got, that 15% of those came from the COVID environment and 10% probably came from the change in the promotional strategy that we fairly aggressively implemented a little while ago. Since then, it's been kind of pretty static Max consistent in terms of the way the customer, some customers have drifted off, but some customers have drifted in as well. So where that will go, I think it will flatten out pretty quickly now that we're in the position where you shouldn't see the promotional impact being a cause of further dilution and traffic. Going forward, we believe it will go in the opposite direction if we can get our marketing right and our execution right. But by and large, we're getting to that flat point as we go into the two new stores that we've reopened. I think we're seeing not just in the junior stores, but across the board, some encouragement in our target customer base, and that they're spending a little bit more with us and putting a little bit more in their basket. So we're seeing some trends to that effect, but it's early days because we only got two of them. And there's a broader context going forward as we move into this. We would expect that to be the case, but I've not got enough data to really back that up right now.

Yes, I think I don't know when we will reach a normal environment. There are certainly many challenges with our inventory. One of the problems we face is having a large number of SKUs. If we don't have a particular item in stock, customers may look to alternatives within our offerings, which helps somewhat with our inventory issues. I would say our inventory situation worsened at the beginning of Q3 but improved slightly towards the end of Q3. However, it remains a continuous struggle to get products through our network. It's not only about the products themselves but also about transportation and drivers and ensuring that people are available in our warehouses and at our third-party distributors. So while it was more difficult at the start of Q3 and improved slightly, it still presents a significant challenge at the moment.

Our next question comes from Krisztina Katai, Deutsche Bank. Your line is open.

Thanks for taking a question. I guess I wanted to go back to your call to action test that you have been doing for the past three months and you did say that the ones that focused on your differentiated produce mixed resonated with customers. So maybe if you could just share a little bit more in terms of how did these translate to potential improve store traffic and what are maybe some of the early learning some customer engagement and loyalty building perspective that you can go forward from here?

We can often revisit our loyalty strategies, especially regarding the activities we engaged in during Q3. When we introduced differentiated grape varietals, they proved very successful for us. The flavors and tasting experiences we offered, particularly through sampling, contributed to this success. In Q3, we managed to bring some sampling back into stores. We believe that offering unique tasting opportunities fosters customer loyalty. We are eager to expand our sampling initiatives around our differentiated products and the innovation centers we’ve established in stores, featuring new items such as chips, health-focused products, and beverages. We've made notable progress in this area and aim to enhance sampling experiences for customers to encourage greater loyalty moving forward. In terms of marketing efforts like our Bounce Back Campaign, which encouraged customers to return with their receipts, we noticed that this increased transaction frequency among our existing customers. Additionally, our 72-hour sales on select products were also successful, although not all campaigns yielded positive results; we experienced a mix of successes and setbacks in our initiatives. Looking ahead, we are focusing on better understanding our target customer base using various data sources. We are exploring the potential of enhancing our email marketing and text marketing, which is becoming an increasingly significant trend in the industry. We see opportunities to grow our text marketing as we gain more customer information in this area. The idea of loyalty cards will also be part of our ongoing discussions as we strategize for the future.

And I wanted to follow-up on some of the inflationary comments that you made. You said that your grocery side is much more manageable, but you're seeing obviously a lot more inflation on the fresh side. How much were you able to pass-through in the third quarter, and have you seen any customer resistance to higher prices in some departments perhaps where the change, change of rate has been more rapid?

I think Chip can add some insights too. However, we have definitely experienced notable cost increases in beef, chicken, pork, and salmon. While we've managed to pass on some of those costs, not all of them have been transferred to consumers, and we've encountered some pushback at the higher price points for meat. We are noticing some customers trading down within the protein category. Protein prices have risen, though not quite reaching double digits, and we've successfully passed on produce price increases without significant resistance. Overall, the rest of the business remains quite manageable, but we are seeing some pushback particularly in the beef and protein segments.

Our next question comes from Edward Kelly, Wells Fargo. Your line is open.

Could you just talk about the store openings continue to get kind of pushed back a little bit. Can you just talk about what you're seeing there? And then, it did sound like in the guidance when you talk to or at least the longer term about the low-single-digit comp and high-single-digit sales, that maybe we're not talking about 10% store growth. Just kind of curious if there was some subtle change there as well.

This is Chip. First, in the short term, we're excited about our strong pipeline. We are still identifying excellent sites that align with the Sprouts model. However, we are facing challenges with the permitting process, which is a hurdle for anyone trying to construct new buildings across the country. Additionally, completing construction and sourcing the necessary equipment has become increasingly difficult. We experienced a heavily loaded second half of Q4 with several new store openings, and these challenges have created a bit of a domino effect. We believe we can return to a double-digit unit growth profile. However, it's uncertain how COVID and supply chain issues will affect us in 2023 and beyond. Our current optimism is that we can achieve around 10% unit growth by 2023. It's important to note that new units may not deliver and mature immediately, so when calculating, achieving 10% would likely result in slightly less than 10% topline growth. Combining this with a low single-digit growth could reach our target. While there is potential for growth to exceed this, this is our outlook for 2023 and the future.

The lease is progressing well in terms of our needs moving forward. Once we open, the data will come in, but it's been a challenging time for everyone. As Chip mentioned, obtaining permits, managing construction, and sourcing materials has been difficult in reaching our goals. However, we have not changed our direction; it's just a matter of the pace at which we can move forward, and we want to communicate what we can achieve in 2022.

Can you discuss the mix of new stores going forward, particularly in newer markets like Florida compared to existing markets? What are your observations regarding the store ramp in those newer markets, including the time it takes for stores to reach profitability? Additionally, how does the growth of these stores this year and next year affect the P&L?

Yes, certainly. All of our new stores going forward in 2022 and beyond as planned are of the new format. So, they're all the smaller stores new format. Our expectation is that the average unit volume won't be dramatically different than they have been historically and the ramps should not be much different than they have been historically. So, that's the way that I would think about it going forward.

From a geographical perspective, we have different expectations in markets where our brand is less recognized, particularly regarding the timing of our efforts. Consolidating Florida has been an intriguing challenge as we aim to integrate into markets like Tampa. Opening smaller stores enables us to achieve greater market concentration, which allows us to allocate marketing spending more effectively from the outset. Florida is definitely a market we are enthusiastic about moving forward, especially with our distribution center and multiple leases in place, enabling us to establish a strong presence in key areas. We are genuinely excited about how this will all unfold.

And I would add to that is it is very clear to us that density matters. It matters from a brand perspective, it matters from an opening sales volume perspective. The ramp may be a little bit dampened because it's in a market that's established, but the opening volume is higher in established markets and the profitability is higher in established markets. So, as we get into these new emerging markets like Florida, like the Mid-Atlantic, it is really critical for us to get some density in those markets from a brand awareness perspective and get to the volumes that we believe will really drive shareholder value.

Our next question comes from Brandon Fletcher with Bernstein. Your line is open.

My question is pretty simple. I think the strategy makes sense and we track on the differentiation. One of the things that's been odd to us is that some of the other grocers that may have kind of comped, the comp a little bit better. We certainly perceive as having less of a strategic move, meaning the differentiations and their service levels aren't there, but maybe the comps haven't suffered quite as much. And so the puzzle we've been trying to solve through which you gave us a little color on is, you had to let go of some kind of the less profitable coupon clippers, but we're curious if you kind of have a view as to help folks that have less differentiation may have been holding up a little bit better. Kind of on the comp-to-comp battle, because I think that's kind of the weight that hangs on what is otherwise a really positive story in our view?

I think it's a good point. I think when I look at the conventionals who have to come as you're competing the comps to. I do believe that the COVID environment that consolidated clear the number of shops that people need to buy their groceries shopping has gone down through the pandemic from something like five to two. And it has gone from five to two. The consolidation of the shop around the conventional grocers has probably helped that enable them to hold those comps better than ours over that period of time. I think it's beginning to change a little bit and we may get some benefit of that bouncing back the other way. When I look at what's happened in the course of the marketplace, the broader marketplace. The mass channels and the club channels can add on top notch so much for selling the mass channel struggled a little bit to start with. They're bouncing back pretty hard on the numbers at the moment. So the conventional grocers probably suffering a little bit and like going forward, we tend to not focus too much on what other people's comps are we focus very much on being we are a complementary retailer. And we believe our comps are kind of controlled by our own destiny, that if we get this right and do the right thing that we'll be in a position to drive the additional share of wallet that we need from our target customers. And there's plenty of dollars out there for us to get to the kind of modest low single-digit comps that Chip's been talking about that we can get there within our own world, almost irrespective of what happens to the other guys. But in simple answer to your question, I think it's the COVID environment has made that difference.

And I would also add, Brandon, I think, we've made it in an opening comment, but it is encouraging when you think about, I mean, when we lost 25% of transactions in the second quarter of 2020 certainly that's a challenge, and the fact that they haven't come back is a challenge, but the idea that those 75% as Jack mentioned, they're putting more units in the basket today than they were in the third quarter of 2019. And they're paying significantly higher prices both through mix as well as inflation today than they were in 2019 and we need more of those customers and drive those customers. And then the icing on the cake is if we can get those 15% that left because of COVID who maybe for variety reasons. It's a secondary shop. It's a tertiary shop, inflation is squeezing their basket, whatever, if we can get some of those back as well, we can win.

Yes, that makes a lot of sense. So when you go from five to two and then eventually back to three, because we're not going back to five, the idea would be that those customers will have a reason to add you as the trip and if you message that right, then you get the magic of a little bit of extra comp flowing through so beautifully through the P&L. And so I think that makes sense to us. And as long as you guys think about it that way, I think we understand it well. Our next question comes from Rupesh Parikh with Oppenheimer. Your line is open.

Thanks for taking my questions. So two related questions, just capital allocation. So just given some of the changes in new store growth, at least for next year. I'm just curious how you think about CapEx as a percent of sales going forward? And then also I guess just related to that given where your share prices today in the multiple widget trades, does anything change in terms of how you guys approach share buyback? I know the pace of recent quarters hasn't necessarily been not aggressive.

Hi, Rupesh. As it relates to CapEx. We haven't provided a number but I think honestly I think it’s safe to say what about 3 to 3.5 a year.

Yes, it's probably call it 3% a year. We'll give you more specifics for next year but it should be about 3% of sales from a go-forward perspective. And then as CapEx, which obviously that leaves a lot of excess cash, coming out of the business. Our capital allocation, you know, we're going to continue to evaluate our options. We will continue to, you know, we want to give money back to our owners in some form of fashion a piece of that. We'll just, you know, we're going to play it by year-end. We'll opportunistically buy.

Okay. Great. Maybe just one follow-up question. So if you look at SG&A, you know, same thing in FY 2022 and beyond like, you know, what type of leverage point what type of comp do you need to leverage SG&A, do you think going forward in the current cost backdrop?

Well that's a question that everyone asks and has for 20 years, but it always depends on what you're managing year-over-year. So right now for next year. Our expectation is that our SGA we're going to try to manage at least going in and that call it six maybe 7% growth somewhere in there five to 7% growth, and we're not going to get earnings growth on that number. So if you really want to leverage SG&A consistently as pretty much any retailer, I think you needed two to three comp if your margins are stable.

Our next question comes from Karen Short with Barclays. Your line is open.

Thanks very much. I just a couple of questions on next year in terms of the comps. Can you maybe just give me a little color on how you think that the comp composition will be with respect to traffic versus basket versus inflation? Because I don't know that. I've heard that clearly from you. And then I had another follow-up.

Well, Karen, we haven't actually said it. Let's – you did hear that. Yes, that's too high. Probably have heard it. Gets really early for us to and there are so many it's like a lifetime away 2022 right now, that said, how are we thinking about it? We really want to get our traffic back to at least neutral. And so if you think about that, you got to get traffic back to neutral right now. I don't see that it's quite back to neutral. And right now, I think that will be we'll get some EUR with inflation. I'm not so sure the units in the basket especially when you're looking at where you're comping, I don't think the number of units per basket will increase. I think there'll be flat to down and then you did a math and you kind of get zero-ish comp. Can we do better than that? If we can get traffic going, if we can get traffic positive, we'll have positive comps next year.

So there’ll be three things behind the things that drive our comp if we get it right, Roger said earlier one will going to basket for people that are in the stores, which is going to be part of our comp drive. Both basket, both units and AUR grow transactions from our existing customers. So the customers that come with us come more often because there's a reason to do that. Because there's something new all the time, because the fresh foods is developed, new products, new varietals, new products coming in the innovation center sampling. There'll be people coming on that basis. And then the third bucket is growing your customers from an effective marketing campaign. All of that should add up to having a thought in terms of transactions or pretty flat transactions number going forward. That would be our aspiration.

If we get to the ramp, yes, if we get to the ramp. If we're doing 10% square footage growth, we're probably getting a one-ish comp out of that on a 10% square footage growth. So next year, we're not we're going to be I think around 7% square footage growth. So we might get a little bit less than one on that.

That's helpful because I do think there was an issue where some of the stores you opened at a certain point in time were actually much higher volume stores so you may have been negatively impacted by higher volumes cycling in but I just wanted to clarify that.

We certainly used to open stores with more aggression in terms of promotion and took a lot more time to get back to kind of pin back investment. So I think that's probably what you're alluding to in our previous dialogues.

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