Sprouts Farmers Market, Inc. Q2 FY2022 Earnings Call

Good day, and welcome to the Sprouts Farmers Market Second Quarter 2022 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Susannah Livingston, Vice President, 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 second quarter 2022 earnings call. Jack Sinclair, Chief Executive Officer; and Chip Molloy, Chief Financial Officer, are with me today. The earnings release announcing our second quarter 2022 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 2022 and beyond. These statements involve several 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. Please see the tables in our earnings release for a reconciliation of our non-GAAP measures to the comparable GAAP figures. With that, let me hand it over to Jack.

Thanks, Susannah, and thanks everyone for joining us today. We are pleased with our performance during the second quarter. We emphasized bringing back a selling culture, improving in-stocks, amping up our merchandising and testing marketing initiatives. This resulted in better-than-expected financial performance including total sales growth of 5%, comparable store sales of 2% and earnings per share growth of 10%. I want to thank our team members for delivering this performance in what continues to be a very difficult environment for them professionally and personally. They live our values every day and bring positive energy to our stores and ultimately, to our customers. One of our key values is love being different, which is ingrained in our DNA and underpins our strategy. It can be seen in the unique products we carry, the layout of our stores and the knowledgeable service provided by our diverse team members. As we move further away from what we all hope was the peak of the pandemic, these differentiations are being recognized by our customers, and we are pleased to see this resulting in positive top line performance. We recognize the well-documented challenges facing the consumer in the months ahead. However, as we celebrate our company's 20th anniversary, we continue to be confident we're headed down the road with the right strategy and the right team in place. In a few moments, I'll follow up with more details relating to our recent activities and focus on the remainder of 2022. For now, let me hand it over to Chip to review our financial performance in the second quarter and our current outlook.

Thanks, Jack, and good afternoon, everyone. For the second quarter, total sales were $1.6 billion, up $74 million or 5% from the same period in 2021, driven by new stores and comparable store sales growth of 2%. We did experience positive comp transactions, which is our proxy for traffic. Both traffic and comp sales steadily improved as we progressed through the quarter. We experienced strength in categories where we are most differentiated such as grocery, dairy and frozen, while deli continues to be a shining star as consumers search for healthy and convenient meal options. Our e-commerce sales grew 15%, representing 11.1% of our total sales for the quarter. Our merchandising and store operations teams are slowly but surely making progress as they partner to bring back the consultative selling culture in our stores by highlighting key items with placement and signage while also supporting them with sampling events. Our goal is to spark interest in purchasing that one extra item for a consumer who we know is having to make difficult spending choices during these highly inflationary times. Our second quarter gross margin was 36.4%, an increase of approximately 30 basis points when compared to the second quarter of last year. The improvement is primarily associated with shrink and decreased warehouse and distribution costs, which continued to benefit from the opening of our two new distribution centers last year. We continue to pass through the increased product cost to retail pricing. SG&A for the quarter totaled $462 million or $26 million higher when compared to the same period last year. Increases were predominantly driven by new stores, rising wage rates, credit card fees and e-commerce fees. For the quarter, our earnings before interest and taxes were $87 million, interest expense was $3 million and our effective tax rate was 26%. Second quarter diluted earnings per share were $0.57, an increase of 10% over the same period last year. During the quarter, we opened two new stores and closed three. The three closed stores had reached the end of their lease, and we believe that most of their respective customers can be better served by nearby stores in the marketplace. There are no further closures planned for this year. And in fact, we are excited that all but one of our new store openings in the back half are in the new format. Turning to the balance sheet and cash flow highlights, we ended the quarter with $289 million in cash and cash equivalents, $250 million outstanding on our $700 million revolver, $25 million of outstanding letters of credit and a net debt-to-EBITDA ratio less than 0. Importantly, during this time of rising interest rates, our interest cost remains relatively flat due to our $250 million swap in place on our outstanding debt. Our ongoing strength of cash generation fully supports capital investments for growth while also allowing us to continually return cash to our shareholders through our share buyback program. For the quarter, we spent $24 million in capital expenditures net of landlord reimbursements and repurchased 2.4 million shares for an investment of $65 million. Our diluted weighted average shares outstanding for the first half of the year were down over 5% when compared to last year, reflective of our sustainable share repurchase program. Turning to our current outlook for the full year. We expect total sales growth for the year to be 4% to 5% and comp sales growth between 1% and 2%. Earnings per share are expected to be between $2.18 and $2.26. We expect to continue to pass through product input costs and expect a slight increase in gross margins for the full year relative to last year. On the SG&A front, the back half growth relative to the front half is slightly higher due to the timing of our new store openings, higher marketing investment in Q3 relative to last year, rising supply costs and increased security measures in a number of our stores. In addition, over the last several quarters, it has been extremely difficult to fully staff our stores, which has offset a rising wage rate environment. The good news is that we feel we are finally making real progress in staffing the stores. However, it results in slightly higher total spend. We expect to open 15 to 17 new stores this year, inclusive of the eight new stores opened year-to-date. We are slowly making progress towards our strategic goal of 10% unit growth a year and currently expect to open at least 30 new stores in 2023. We now expect capital expenditures for this year, net of landlord reimbursements, to be between $130 million to $150 million. For the third quarter, comparable sales are projected to be in the range of 1% to 2% and earnings per share are expected to be between $0.49 and $0.53. With that, I'll turn it over to Jack.

Thanks, Chip. We recognize the challenges consumers are facing in this fluid environment and are considering this in our strategic decisions. Inflation, high gas prices and the year-on-year effect of the impact of Delta last year all contribute to an uncertain outlook for our stores and our customers. In light of this macro environment, we remain proactive, implementing tactics for Sprout's long-term success and a solid back half of the year. In operations, we're amping up the selling culture and operating a more efficient store with a focus on in-stock. In merchandising, we're highlighting our differentiation and value like the Sprouts brand as well as healthy prepared meals. And in marketing, we are quickly analyzing what works and what doesn't. I'm excited to see the selling culture reignited at Sprouts. It can be witnessed in the energy in the store with seafood road shows, community events and sampling, and yes, team member contests. Nothing brings back that selling culture more than a little healthy competition among stores. The team members owned this one in the second quarter and reached new goals. In June, we returned to an in-person, annual SproutsCon festival with 1,200 team members from grocery, vitamins, produce and store managers in attendance. We were enthused to see more than 1,200 vendor exhibitors, representing more than 500 brands, sharing their unique product attributes firsthand. I left inspired by the energy from the team, and I'm excited to see the impact in our stores and on our performance. As I mentioned on our last call, the operations team continues to improve in-stocks and reduce shrink by leaning on new technology like perpetual inventory computer-assisted ordering or PICAO and F-I-M, FIM, fresh item management. By aligning inventory levels to sales demand, dairy and frozen are seeing meaningful improvements and importantly, this is flowing through to better sales. With the addition of two new distribution centers, we're taking miles off the road and benefiting gross margins. Even more importantly, this better serves our customers who are looking to Sprouts for the best quality and value in fresh and organic produce. While we have lapped most of the new DCs benefit in the second quarter, we look forward to continuing to leverage the Florida DC as we expand in that region as well as expand our supply chain as we grow the Mid-Atlantic and California areas. As we continue to expand our footprint, retaining and developing Sprouts' 31,000 team members is key to our future success. Recognizing this, we've taken measures to improve the onboarding experience, enhance our training and fully staff our stores to support our customers and engage our team members. With this focus, we're seeing turnover stabilize and excitement in the organization around the culture building we are doing. Moving on to merchandising. As the consumer is being pressured by inflation, we are proactively focusing on value across the store. We're driving value through pack and pricing leaning into our great produce pricing emphasizing our large bulk offering where customers can control their costs, expanding our local produce, which provides more attractive pricing and running BOGO and vitamin offers to help customers save. In addition, we continue to move the needle on our Sprouts brand. Differentiation is key to our product selection, and it's rooted in the value we give to our customers. Our Sprouts brand does offer entry-level price points but is more focused on innovation, wellness or health benefits as well as quality. Some recent releases are pasteurized eggs, avocado and asparagus fries, and medicinal gummies with many more to come this year. Deli meals, sandwiches and sushi continue to outperform our expectations as time remains precious for consumers our daily traffic has been up, even after increasing retail prices to keep up with inflation. However, one price that remains fairly constant is our long-standing favorite, our current $5 made-to-order deli sandwich has recently taken off on TikTok, unsolicited, with more than 7.8 million views. Our in-house culinary team is inspiring change with innovative meal options, including penne caprese and nut-free pesto sauce, salmon with béarnaise and roast garlic Brussels, and no-antibiotics-ever chicken, salsa roja with chili, sweet potatoes and many more to come. We've been adding additional prepared meals cases to our existing store base to support this growth, which is now in more than 85% of our stores. In addition, we continue to update and add new one-pan meals to our meat department with our proprietary marinades loved by our customers. Marketing is one area we continue to monitor and pivot more quickly as needed. Data shows that the consistency of our paid media messages focused on great prices on the freshest produce is working in our markets and increasing overall aided awareness. However, our aided awareness is still quite low for our emerging markets. With this in mind, going forward, we're over-indexing our marketing spends in our emerging and expansion markets, especially in digital, streaming TV and radio. When it comes to driving spend, we are growing personalized offers, continuing basket-building initiatives and aligning all our channels, social, digital and in-store, with consistent messaging for all key events. We've begun to test personalized engagement in categories we own like vitamins and organics and are seeing success. On the social side, we continue to actively nurture long-term relationships with micro, macro and mega influencers across the health and wellness space. On the consumer data side, we continue to understand our target customers better. We utilize four key data points: numerator, credit card, customer surveys, and e-commerce. From a digital standpoint, we've increased e-mail subscribers by more than 19%, SMS subscriptions by more than 70% and mobile downloads by more than 30% over last year. Overall, customer counts have been slowly increasing over time, and our customer satisfaction scores remain very high. We also began testing e-commerce campaigns to attract new customers to our shop.sprouts.com site, resulting in high double-digit sales growth. As well, during the second quarter, we began to accept EBT SNAP for same-day delivery and curbside pickup for orders placed on Instacart. This allows all customers to order fresh and nutritious foods online and enjoy greater convenience, accessibility, and affordability. I'm delighted that our new inspiring women's resource group was instrumental in supporting one of Sprouts' new initiatives. We're investing in women's college athletics through the backing of the Big 12 and Pac-12 Conferences, four key universities, and 50 individual collegiate women athletes in partnership with softball icon, Jennie Finch. Being the first grocery retailer to make this commitment to collegiate athletics and coupled with our sponsorship of the Angel City Football Club, we remain invested in growing and changing the landscape of women's sports for years to come. We're proud to sponsor these great female athletes and look forward to many more strong ideas from our inspiring women's resource group to support our business. With that, I want to thank you for your interest in Sprouts. We're confident we are working diligently on controlling what we can control in the current economic environment while not losing sight of the long-term plan to grow this unique brand across the country. At this time, we're happy to take your questions.

Our first question comes from Scott Mushkin with R5 Capital.

Jack, thank you for the details. My question relates to what you mentioned towards the end. You spoke about the returning sampling, the marketing campaigns, and the situation with the sandwich. I believe you mentioned that the $5 sandwich became popular on TikTok. When reviewing the quarter, were you able to observe any momentum in traffic? Did you notice these efforts having an effect? It would be great if you could indicate yes or no, and explain your reasoning for either outcome.

In our previous discussion, we noted a quarter-on-quarter increase in traffic, which is a positive development for us. In Q2, we experienced another slight increase in traffic, which aligns with our expectations. We also addressed the units added to the basket and the initiatives we are implementing to enhance that metric. The deli section has shown promise, particularly with the deli meals we've introduced, and the sandwiches have contributed to business growth. Additionally, we've invested in equipment to support our sushi and meal offerings, which are coming together nicely. Our efforts to improve in-stock levels are ongoing, and while we've made some progress, there is still work to be done, especially regarding the systems we've discussed for enhancing backroom processes throughout the day. We've also made strides in our marketing initiatives, though there is still more to learn and accomplish. One of the most exciting developments is that we have resumed product sampling post-COVID. Reintroducing sampling for new products, fresh produce, and innovative items is gradually reintegrating into our operations, which has always been a core aspect of Sprouts. While there is still work ahead, I am pleased with the progress we've made in Q2.

And just to clear, oh, hey, Chip.

Yes, this is Chip. Sequentially, we did see some improvements, both slight improvements in traffic; we did see some slight improvements in comps. Obviously, when we talked in April, April wasn't the greatest of the month. So it got better as the quarter went on. The decline in units per basket sequentially in the quarter was slightly better. So we're encouraged by that, but we still have work to do there, but we're encouraged.

You must be a mind reader because that was what I was going to follow up with. My second question, Chip, is probably directed at you. We discussed what level of comps you need to leverage your expenses over time. This obviously is a short-term issue. Is that changing, particularly with rising labor costs? I believe you mentioned a 3% increase. Are we significantly above that at this stage?

As costs increase, a higher comp is necessary to effectively leverage. Ideally, you need a comp that's around 100 basis points above your cost growth to achieve meaningful earnings growth, particularly without new stores. The challenging aspect is that prices are indeed rising, with labor costs and supply costs both increasing. We're putting in significant effort to manage these changes and feel we're in a solid position to navigate through the remainder of this year. Looking ahead, we have several months to explore what this means for next year, identifying areas where we can find opportunities to alleviate some of these rising costs. We're actively starting this process now to stay proactive.

The next question comes from John Heinbockel with Guggenheim.

Jack, to start, you mentioned the issue of unnecessary brand awareness. Can you share your thoughts on the emerging markets with unaided awareness and your target for where you want it to be? How significant is the gap compared to the current situation? Let's avoid talking about Phoenix and focus on more mature markets. Is the most effective strategy to densify the store network rather than rely on marketing, or will that simply take time?

Yes, it will take some time. Let me explain where we stand regarding emerging and established markets. In California, Colorado, and Arizona, the stores we opened have shown strong performance and a good level of awareness, allowing us to start gaining traction more quickly. We're actively working on awareness initiatives in Florida, the Mid-Atlantic, and particularly in Dallas, Texas. Growing awareness is vital, and while marketing plays a role, densification is also important. We're currently opening many new stores in Florida, building on last year's investment in DC, which is enhancing our visibility in the market. It's a combination of both strategies; increased densification allows our marketing efforts to be more effective. The awareness levels in California compared to Florida are notably different, possibly by 20 to 30 points.

How many points?

20 to 30 points would be off the top of my head a number that I would kind of quote.

Okay. And then maybe following on that, maybe talk about Florida in particular, right, the opportunity there, right? Everyone seems to be comping extraordinarily well in Florida, right, if you look at the Publix' results. When you think about your ultimate opportunity, right, to store out the state, yes, how would you size that up, right? Tripling, quadrupling in store count, is that too optimistic?

We won't be tripling our store count in the near future, but we will definitely double it in a relatively short time. As you know, there's a lot of movement to Florida, which means an influx of people, particularly those who fit our target demographic—individuals interested in healthy products, nutrition, and fresh foods. This new population aligns well with our customer base. We're very confident and encouraged by the opening of the new distribution center in Orlando, as it enhances our ability to offer great fresh foods. Our sourcing of products in Florida is allowing us to engage effectively with the local community, and we've seen positive results in the seafood sector there, which I'm pleased with. Overall, we are very optimistic about Florida, and it is likely to be our fastest-growing market in the next two to three years.

Our next question comes from Kelly Bania with BMO Capital.

Just I guess a quick question is on inflation. Is it fair to assume that your inflation is kind of similar to the industry food at home CPI numbers that we're seeing? Or could it be above or below? And then just had a couple of follow-ups.

It's generally in line with what we're seeing from the CPI. We have a slightly different mix, and the volatility in produce pricing can fluctuate significantly. This volatility is likely more pronounced in our business compared to others. Additionally, for categories like vitamins and HABA, which make up a smaller proportion, the mix will differ. Overall, it’s reasonable to assume that we are mostly in line with the trends.

Okay. And I guess just a follow-up, I mean, it sounds like the traffic is turning positive. But how are you looking at or thinking about market share? I mean some of the data we're looking at is natural sales kind of in the high single-digit range at least. Is that at all concerning to you? Are there still customers that you think you're just shedding as a result of the strategy? Or just how do you think about kind of market share? Or is that really not important as you kind of analyze the business?

Let me share my perspective on market share. We offer very distinct products compared to our competitors. Therefore, when I evaluate our market share against the grocery sector, the changes in traditional grocery market share are largely irrelevant to us. Whether they perform well or poorly does not affect us significantly. The key metric for us is whether we are increasing our share of spending among our target customers, and we aim to improve our measurement of that. The market share data that we examine often includes products we either don’t carry or don’t want to offer. The only products that we can directly compare are in our produce category, which we monitor closely. We're assessing whether our produce business is growing as expected, and we’ve made some progress in Q2, but there's still more work ahead. We also sell a variety of bulk items that aren’t part of what others offer, as well as vitamins and health and beauty aids that many competitors don’t sell. To conclude, we don’t focus too heavily on market share; our priority is ensuring we're serving our customers well and increasing our share with them.

Okay. Fair enough. And if I can squeeze one in on unit growth, I guess. It looks like you said about 30, I think, for next year. So that 10% growth target, I guess, is getting pushed out until '24. But is that the right way to think about it, like 7% to 8% unit growth? Or are there any more store closures planned? Could you help us just kind of understand the total picture there?

Yes, Kelly, this is Chip. As mentioned in the script, we are targeting at least 30 for next year and will strive to increase that number. However, we have been reducing the number over the past year, so we want to avoid overpromising and underdelivering, both for ourselves and for the investment community. We are confident we can achieve at least 30 next year and aim for a higher figure. For now, consider it as being around 30. Looking ahead to 2024, we are working hard to reach a 10% unit growth by then, and ideally, we would like to achieve that next year, but for the moment, we are focused on that 30-ish target.

Our next question comes from Ken Goldman with JPMorgan.

I wanted to ask one of the questions I have about Sprouts is when the company will demonstrate more consistency in its earnings and overall performance. This quarter might be better than your expectations, while others have been inconsistent. Every company's goal is to achieve consistency, but is it a high priority for you right now, or is your focus just on the business without worrying too much about the outcomes? Are we at a stage where investors can start to feel some reliability in the numbers being reported rather than the fluctuations we've seen? I hope that makes sense.

Sure. And we certainly would be aspiring to be more consistent than we've been in the last couple of years. Having said all of that, there's been an unprecedented level of volatility, not just in our business but maybe across the marketplace. Now I don't know what's going to happen going forward, Ken. We're certainly very clear about what we are aspiring to do and what we're trying to do. And we want to get to that consistent measure of new store growth and comp growth that we've talked about. And that will deliver the kind of numbers. The one consistency we've got is our margin within that context. So we're feeling that we've put the building blocks in place and the performance of the business, I would expect as in a normalized environment to have been and will be much more consistent going forward.

Okay. As a follow-up, you mentioned how your portfolio stands out compared to some competitors. Clearly, it does. This might not relate directly, but I'm curious about your thoughts on the pricing and promotions strategies of nearby food retailers, which you may not view as direct competitors. Are you observing a generally sensible market, considering the need to pass on higher inflation and the somewhat strained consumer situation?

Yes. What we've observed so far is that there is a significant level of volatility in cost prices, prompting food retailers to pass on these costs at an unprecedented pace, which we haven't seen since the 1980s. I might be one of the few who remembers how to handle these situations. Retailers are transferring the increased costs to consumers, and we haven't witnessed any irrational behavior in this regard. The supply chain continues to present challenges, making aggressive promotions unlikely. Looking ahead, it's uncertain what will happen when consumers start to feel the pinch, particularly if a recession materializes as many expect. My intuition is that there will be a rational approach moving forward. We are committed to planning our business without sacrificing margins for promotions or fearing the competition. Our focus is on delivering the right value for our customers, which entails being proactive with our pricing in produce and ensuring we consider price elasticity. We will monitor volume changes as we adjust prices and respond appropriately as circumstances evolve.

Our next question comes from Edward Kelly with Wells Fargo.

I wanted to inquire about the acceleration in store growth that begins in 2023. How much does the current trend of fewer items in baskets and the elasticity challenges related to a more cautious consumer and inflation impact the timeline for when new stores are expected to contribute to earnings? Additionally, as we consider store openings next year, what are your expectations regarding the productivity of these new locations?

So Ed, this is Chip. In our investor relations presentation today, we included a store profile that has a few slight differences compared to previous versions. We're targeting around $13 million in sales in the first year, and we anticipate that will grow by 20% to 25% over the next five years. Generally, these stores break even in the first year, and by year five, they are expected to achieve an 8% EBITDA margin and 30% to 35% cash on cash returns. This projection includes the latest costs associated with building, which have increased to about $3.8 million per store despite our efforts to reduce square footage and overall costs. Nevertheless, the returns remain strong, surpassing our weighted average cost of capital, which is in the single digits. We are confident in our ability to sustain these returns and remain aggressive in our store growth strategy.

Thank you. I have a follow-up regarding expenses. I'm interested in two things. First, how does the SG&A pattern look for the remainder of the year? Historically, Q3 tends to be higher than Q2, and Q4 is usually lower than Q3. Is that correct? Secondly, as we look at 2023, considering a projected unit growth of around 7% to 8%, I understand you're exploring ways to increase efficiency in terms of costs. However, it seems there's potential for actual dollar growth to exceed that expectation. I'm not sure how much detail you can provide at this point, but any insights would be appreciated.

Yes. For this year, we anticipate that the dollar growth in the second half will exceed year-over-year figures from the first half. A significant part of this is due to our underinvestment in marketing last year during the third quarter. Additionally, we experienced a slight shift in marketing efforts from the second quarter to the third quarter. Looking ahead to next year, we are committed to focusing on new stores and managing associated costs. Our goal is to achieve earnings growth in the high single digits, and we believe we can do this with cost management in the low to mid-single digits. We have tasks ahead of us, but we are dedicated to making progress on this before the new year begins.

The next question comes from Rupesh Parikh with Oppenheimer.

This is actually Erica Eiler on for Rupesh. So I wanted to touch on traffic as well. So I guess, first, just curious if you're seeing broad-based traffic improvements throughout the chain? Or if there are specific geographies of note? And then second, with gas prices easing here, just curious if you think that's helping the business at all here lately.

I think it's too early to assess the impact of gas prices. Currently, we're not observing a direct effect. However, as gas prices decrease, it should benefit everyone. When examining different regions, areas where we have many long-established stores performed well in Q2, aligning with company expectations. In emerging markets, particularly in Florida and the Mid-Atlantic, we see above-average performance due to newer stores that are ramping up. Conversely, we are underperforming in regions where we have fewer stores and limited brand presence, such as the Northwest, Alabama, and Louisiana, where our brand awareness is low and we haven't invested in building it.

Okay. That's helpful. And then just on the decline in units per basket, so you talked about that getting slightly better sequentially. Are there any efforts that you can highlight for us where you feel like you're really starting to see traction as it pertains to driving those increased units?

Well, the only thing I'd repeat, Erica, is what I said a little bit earlier: I think our deli business, we're seeing a strength in that as it comes through. Our bakery business, we've been encouraged by some of the work that's coming through on that. And our underlying dairy business has been pretty strong relative to that. But it's within the context of an industry that's seeing a reduction in units per basket. And we talked about it in the last quarter, we're just looking to try and get 1 or 2 units extra in the basket. And the places that we're seeing the biggest traction is probably our deli business.

Our next question comes from Krisztina Katai with Deutsche Bank.

I guess I wanted to follow up to some of the store dynamics that you have highlighted. Last quarter, you talked about softer performance in fresh. I think today, you said frozen dairy are better; you're seeing good traction in deli. So maybe if you could just talk about how the various departments are performing now that traffic has started to come back. And then how are you planning on capitalizing on this to essentially ensure that you will continue to see traffic improvement?

We are optimistic about our fresh business recently, with some improvement in our produce sector, which is crucial for us. Our vitamins and HABA department had a strong performance at the start of Q2, which is encouraging, though I'm unsure how that will develop moving forward. In our deli business, we are doing well, and both deli and frozen departments have benefited from better in-stock levels. This gives us hope that the implementation of PICAO across other categories will lead to uniform improvements. Overall, categories like frozen, dairy, and deli have performed well, and vitamins also had a good showing, although future outcomes are uncertain. Our bulk business, which struggled during COVID, is seeing a positive shift now, allowing consumers better portion control and value management. I am hopeful this will promote business growth as we move into Q3 and Q4. We are focused on marketing initiatives to maintain the momentum in traffic that we've experienced over the last three quarters, and overall, traffic remains slightly positive, which is key for us moving forward.

Got it. As a follow-up, considering inflation, we heard from Costco that July inflation was similar to June, but we've also seen a significant drop. Is this a concern for you from a sourcing perspective, especially since you work with smaller farmers who might be facing more challenges with their operating costs compared to larger food manufacturers?

It doesn't particularly concern us more than our general worries about the pressures on the economy going forward. We are working closely with our produce growers and providing them with long-term commitments. We are taking cost increases and passing those on, which should give us confidence in our ability to source what we need to supply. It’s not something that is troubling us too much at the moment; we're in pretty good shape. There are one or two categories in the more commoditized space where we're facing some challenges due to competition, but not so much in our produce space.

Our next question comes from Robby Ohmes with Bank of America.

This is Kendall Toscano on behalf of Robby. I wanted to check if you have any updates regarding your thoughts on inflation as we progress through the year. Last quarter, you mentioned that you expected some of it to ease as we approached the latter half of the year. Now that we are in that period, have you noticed any product cost increases that might suggest inflation is starting to moderate?

I haven't seen anything yet. There's a lot of volatility in the fresh produce space where it goes up and down and up and down, given the nature of supply in that space. You would have expected inflation maybe to come down given how much work the Fed has been doing on interest rates, but we haven't seen it. And we continue to see a level of inflation that's pretty unprecedented, and we're not expecting that to change anytime soon. But who knows?

We might experience some relief on costs as oil prices decrease, but I don't believe this will affect product input costs in the near future.

Got it. That's helpful. And then my other question was just on the traffic trends. I know you said that there was a sequential improvement from the first to the second quarter. I was just curious if you could give any color on a 3-year basis, looking at a more normalized year just given last year, 2Q was an easier comparison than the first quarter was. I guess, yes, was there still a sequential improvement if you looked at traffic on a 3-year basis?

When we discussed the sequential improvement, we were referring to the changes throughout the quarter, comparing one period to the next. We don't disclose the specific numbers, and we do not analyze a three-year period anymore. We believe we are in a very stable position going forward, and our guidance suggests that our traffic remains quite stable year-over-year.

Our next question comes from Mark Carden with UBS.

So to start another question on unit growth. What are the biggest factors driving the slower-than-expected expansion in 2023? Is it primarily supply chain-driven? Is it getting tougher to find locations you want to be in? Or real estate costs just higher than planned? Any extra color there would be great.

One of the reasons we haven't opened as many stores in 2022 as we wanted is not due to a lack of sites, but rather the speed at which we can develop them, partly because of supply chain challenges. We have faced notable supply chain issues with components necessary for air conditioning and refrigeration. Additionally, the planning and acquiring licenses from various authorities has slowed us down, as those offices were not fully staffed. These constraints on licensing, permits, and supply chain have limited us to 15 to 17 openings in 2022. However, we are sitting on 80 to 85 signed leases, so we have the locations ready. You might wonder why we're not planning for more than 30 in 2023; we are being cautious considering the current supply chain situation. While it hasn't significantly improved, it also hasn't worsened. We are confident in achieving the 30 planned stores for 2023, but we still have work to do on our pipeline for 2024. There are plenty of opportunities to build stores in areas with our target customers, allowing for a 10% increase in new stores by the end of 2023 and into 2024. The primary challenge has been execution, particularly related to legitimate federal hurdles. I hope this provides some insight, and while I'd like to think we could do a few more in 2023, we are currently committed to the 30.

Got it. That's helpful. And then with inflation staying as high as it's been, are you seeing any changes in trade down? I know your private label isn't necessarily opening price point like this for others. Are you seeing movement in fresh categories or anywhere else?

We're noticing some trade down, as we discussed in the last meeting. Consumers are moderating the quantity of items like avocados and grapes they purchase at one time, resulting in fewer cherries being bought. Produce continues to be a significant part of our business, and while people are still buying a lot of it from us, the total weight of their purchases is likely decreasing somewhat in the future. We are also observing a trade down in our health and beauty segment, where customers are opting for cheaper products. However, this isn't a major concern for us. I mentioned bulk purchases because our bulk business has improved a bit in the past few weeks. It seems people are taking advantage of buying the right amount they need, allowing them to opt for smaller sizes. We're also working on some of our products to reduce the price shock that comes with changes in size. So, if that provides clarity, we are monitoring the situation and noticing some trade down like many others, but it's manifesting differently in our business.

Our next question comes from Robert Moskow with Credit Suisse.

In the last earnings call, you talked about a downturn in traffic at the very end of the quarter. If you had to just kind of like summarize like what went right to turn that around, was it execution? Or do you think there was other macro factors that help things get better?

There may have been some macro factors at play as people left and then returned. Upon reflection, there could have been several contributing elements. However, our focus remains on what we can control. We believe we've made several improvements that can positively impact our business as we progress through Q2. These include enhancing our in-stock levels, encouraging store competition to boost sales, introducing daily equipment, new cabinets, and additional areas for selling meat products, along with our seafood road shows. We can identify various actions we've taken to improve units per basket. Regarding traffic, I believe macro factors influence that as well, and some of it relates to our marketing tactics. We are continually evaluating our marketing strategies to find the best approaches and enhance our efforts. Overall, we are learning and adapting as we advance with our marketing initiatives.

And how do you think of the macro environment just from here? Because I think the pushback on your stock is that people doubt whether consumers will go to a second grocery store for their weekly shop or a third grocery store like Sprouts, given gas prices are still high, maybe fading a little bit. Like do you think that it's getting easier for you? Or is it getting harder? Or how much of an uphill climb is it?

I think, to be honest, it's difficult to predict what will happen with claims in the next six months due to the uncertainty surrounding it all. However, I believe the challenges we face are not as significant as those others may experience. For example, someone committed to a vegan diet is unlikely to change their eating habits just because of inflation or fluctuating gas prices. Our unique product offerings ensure that those concerned about their dietary choices will continue to shop with us, as many of the items we carry aren't available in traditional grocery stores. This is what allows us to exist as a complementary retailer. Regarding your question about whether customers will shop at a second store, they will only do so if that store offers products they can't find at our store. This highlights the importance of our differentiation. It's evident that customers who choose us do so for specific diet preferences such as keto, paleo, plant-based, vegan, vegetarian, or flexitarian, primarily because they can't find these options elsewhere. They may still get popular items like Tide and Coca-Cola from larger retailers, but they come to us for unique offerings. While I acknowledge that there are macroeconomic challenges for everyone in the upcoming months as the economy stabilizes, I remain confident that our distinctiveness supports our value proposition. Ultimately, people need to eat, and those who are mindful of their food choices will find their way to Sprouts.

This concludes our question-and-answer session. I would like to turn the conference back over to Jack Sinclair for any closing remarks.

Well, thanks very much for your attention and listening to us. We really appreciate your interest in our business, and we look forward to further updates as we go through the year. Thanks ever so much. Take care.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.