Sprouts Farmers Market, Inc. Q3 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Sprouts Farmers Market Third Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. I would now like to turn the call over to Susannah Livingston. You may begin.

Thank you, and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our third quarter 2022 Earnings Call. Jack Sinclair, Chief Executive Officer; and Chip Molloy, Chief Financial Officer are with me today. The earnings release announcing our third quarter 2022 results, the webcast of this call, and quarterly slides can be accessed through the Investor Relations section of our website. 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 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 and the commentary on forward-looking statements at the end of our earnings release. Our remarks today include references to non-GAAP measures. Please see the tables in our earnings release to reconcile our non-GAAP measures to the comparable GAAP figures. With that, let me hand it over to Jack.

Thanks Susannah, and thanks to everyone for joining us today. Despite many of the current challenges in the consumer landscape, we're encouraged by our performance in the third quarter, which included total sales growth of 5%, comparable store sales of 2.4%, and earnings per share growth of 9%. I want to thank our 31,000 team members for their continued dedication and commitment to making Sprouts the ultimate destination for discovering healthy eating and wellness options. Our customers count on us to be a leader in innovative, high-quality and healthy products in a unique and inviting shopping experience. I would also like to highlight the efforts of our operations, supply chain, and human resource teams in supporting our Florida stores and the communities they serve during and after Hurricane Ian. Fortunately, 100% of our team members were safe and all our stores and the Orlando distribution center were up and running within four days of the storm's passing. I would also like to thank all our supply partners who played a vital role in successfully navigating the store. We believe we are making progress in delivering expectations for our customers, team members, and shareholders. We had a solid third quarter and expect continued progress in the quarters ahead. In a few moments, I'll follow up with more details about our recent activities and the remainder of 2022. For now, let me hand it over to Chip to review our financial performance in the third quarter and our current outlook. Chip?

Thanks Jack, and good afternoon everyone. For the third quarter, total sales were $1.6 billion, up $81 million or 5% from the same period in 2021, driven by new stores and comparable store sales growth of 2.4%. Comparable sales were supported by an increase in basket due to retail inflation, partially offset by a slight reduction in items in the basket. Our e-commerce sales grew 19%, representing 11.1% of our total sales for the quarter. Deli continued to be a top performer as customers sought Sprouts as a destination to fulfill their appetite for healthy prepared meals and grab-and-go options such as sandwiches, salads, and snack boxes. The other categories of strength were where we have the most innovation and differentiation, including bakery, grocery, dairy, and frozen. Our third quarter gross margin was 36.7%, an increase of approximately 90 basis points compared to last year's third quarter. The majority of the impact was driven by the fact that we were less promotional this year than last year when we were testing a variety of promotional and pricing tactics. SG&A for the quarter totaled $461 million or $37 million higher when compared to the same period last year. The increase was driven by new stores, higher wages, and additional marketing spend. Last year, we shifted marketing dollars into more promotional activity. E-commerce fees were also higher due to the associated increase in sales, while credit card fees are rising as more customers shift from debit to credit. For the quarter, our earnings before interest and taxes were $90 million. Interest expense was $2 million, and our effective tax rate was 26%. Third quarter net income was $66 million and diluted earnings per share were $0.61, an increase of 9% compared to the same period in the prior year. During the third quarter, we opened one new store in Moreno Valley, California, bringing our total to nine for the year so far. Turning to the balance sheet and cash flow highlights, we ended the quarter with $316 million in cash and cash equivalents, $250 million outstanding on our $700 million revolver and $25 million of outstanding letters of credit. 100% of our $250 million in outstanding debt remains fixed with our interest rate swap through the end of this year. Cash flow generation in the third quarter remained strong. We generated $98 million in operating cash flow and spent $25 million in capital expenditures net of landlord reimbursement in the third quarter. This robust cash flow generation allows us to invest in the growth of our business while also returning cash to our owners through our ongoing share repurchase program. For the quarter, we repurchased 1.6 million shares for an investment of $44 million. For the third quarter, diluted weighted average shares outstanding were down 6% from last year. Turning to our expectations for the year and the fourth quarter. For the full year, we expect total sales growth to be in the range of 4.5% to 5% and comparable sales of approximately 2%. Earnings per share is expected to be between $2.32 and $2.36. We expect capital expenditures for the year, net of landlord reimbursements, to be between $120 million and $135 million. For the fourth quarter, we expect comparable sales of approximately 2% and earnings per share between $0.35 and $0.39. We also expect to open seven new stores during the quarter, bringing our total for the year to 16. Given the current uncertainty in the marketplace, it's a bit early to guide for next year other than the opening of at least 30 new stores. That said, we are committed to controlling what we can control to drive meaningful results. Before turning it over to Jack, I'd like to share an update on the Sprouts Healthy Communities Foundation. I've had the good fortune of serving on the Foundation Board over the last year and have been impressed by the Sprouts' passion for the mission of helping children learn to grow healthy. Through the foundation, Sprouts actively supports 130 nonprofit organizations that operate thousands of vibrant school gardens that provide students with hands-on gardening, cooking, and nutrition education while reinforcing academically what students are learning in the classroom. This year, the foundation has supported programs that benefited an estimated three million students. Our team members also help bring this work to life through their hands-on support, volunteering to help build and maintain many of these garden spaces. This fall, we hosted our annual Sprouts Day of Service where 700 team members donated 3,000 volunteer hours to support the foundation's mission. We want to thank all who took time to participate in these events. And with that, I'll turn it over to Jack.

Thanks Chip. Today, I'd like to highlight progress in those key focus areas that enable our ongoing profitable growth and deepen our relevance with the consumer. After that, I'd like to touch on the here and now, what's happening with our customers during these unprecedented inflationary times and how we responded. First, on the real estate front. A few years ago, we set out to open 10% new stores every year. We've not delivered on that goal given the permitting and supply chain challenges created by the pandemic. This year, we will open 16 new stores, and the trend is improving. We expect to open at least 30 new stores next year on a path to over 40 by 2024. Recently, we completed the implementation of a new real estate tool. This tool provides details of the Sprouts white space for every MSA in the country. Based on the tool, we believe that our brand can support 1,350 total stores in the Continental U.S., an incremental 970 from where we stand today. Second, it identifies the absolute best location for our Sprouts store within a trade area, essentially Main & Main. This enables our real estate team to be more proactive in sourcing the very best sites. Third, it provides a more accurate sales forecast for each location, helping us avoid potential underperforming stores. As we've mentioned many times this year, another area of focus is in-stocks. We expect to complete the implementation of PICAO, or perpetual inventory computer-assisted ordering, by the second quarter of next year. Recently, we also invested in an on-shelf availability solution that provides a single source of truth for product availability as seen from the customers' eyes. The combination of these two tools should support incremental sales, improve margins via the reduction of markdowns and shrink, and free up task-related labor hours in the store so that our team members can spend more time better serving our customers. Moving on. Product innovation and differentiation are critical for Sprouts. It creates an environment of ongoing discovery and helps reinforce customer loyalty. We partner with over 250 local farmers on the produce front to help build strategies around unique varieties. Today, we have over 300 local produce items in our stores, almost double that of last year. And by the end of 2024, we expect 20% of our produce sales to be local. Outside of produce, we're doubling down with our brands. So far this year, we've launched an additional 400 private label products and repackaged more than 450 with an updated design that highlights vital product attributes and is also considered more appealing based on customer surveys. Our brands' non-perishable sales growth during the third quarter was more than double that of branded products. Our merchants also continually seek new and innovative products from the vendor community. In grocery alone this year, we've launched more than 300 first-to-market products, many of which are exclusive to Sprouts for a period of time. Lastly, deli has no shortage of innovation as we curate unique meals and offerings that taste great and are good for you. Deli has been our highest growth category this year. The last key area of focus that I want to highlight is in the customer analytics and loyalty arena. In the previous two years, we've built a true customer analytics team and are working diligently to understand our customers' behaviors and desires better. We have a long way to go, but it's a journey that starts with connecting. During the third quarter, we increased our active e-mail accounts by 19%, our SMS accounts by 42%, and our mobile app downloads increased by 15%. Today, we can link approximately 16% of our total transactions to individual customers compared to just 12% a year ago. Approximately 7.5% of transactions are tied to loyalty customers, up about 50% compared to last year. Our baskets are almost 70% higher than non-loyalty baskets. We've also completed some early testing on targeting and personalization efforts with encouraging results. This will take time to scale, but will provide opportunities for Sprouts in the coming years. Turning to the here-and-now, we all know we live in an inflationary environment not seen for most of our lives. This environment is impacting the consumer and virtually all industries, including retail. Here at Sprouts, we are encouraged by the fact that our traffic has been relatively stable for several quarters. We've experienced some months where it's up slightly and some where it's down a bit. We're not really experiencing a classic trade down. In fact, many of our higher-priced categories are experiencing the most significant growth. We continue to experience that our customers put approximately one less item in the basket. That one less item on average is essentially produce, our lowest price point category. The one with the most items in an average basket and one of our lower-margin categories. Even though we are competitively priced every day in produce, we believe our customer is managing their overall basket spend by eliminating the extra produce item. How are we managing in this environment? Well, we're laser-focused on in-stocks, and our merchants and store operations teams are creating key item promotions that produce a buzz in the stores for our team members to support the drive for that extra item. Our merchants also work diligently with our marketing team to develop and test promotions to drive incremental profit dollars. Our teams have done a phenomenal job managing margin dollars during this volatile period of cost increases. We've also recently announced a partnership with DoorDash. We expect this service to be available in all locations by the end of the year. By partnering with DoorDash, we enter a new marketplace where more customers can access our unique and healthy assortment. DoorDash, along with our long-standing Instacart partnership, should enable ongoing e-commerce growth. We're working now to get ahead of 2023. We believe the average retail increases this year will produce a tailwind for at least a portion of next year. However, we know it is critical to manage all costs including cost of goods, supply chain, and SG&A while progressing in those vital focus areas that I outlined today. With that, I'd like to turn it over for questions. Operator?

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

Good evening. This is Michael Lasser for Mark Carden. If the model is evolving from one that was driven heavily by consumers buying produce and other fresh items, and now it's going to be more deli and prepared oriented. How do you think that's going to change the economics over the long term? And do you think that the fact that customers are adding one less produce item into the basket is more a function of some of the model changes that have occurred? Or is it more a function of the economic environment right now?

Yes. I think, sorry...

It's Michael.

Michael. Sorry, Michael. As I think this one through, our produce business is being affected more by the economic environment than by a change in our model. Product remains at the heart and center of our proposition to the customer, a significant proportion of our sales come in produce. I think what's happening is it's just a little bit easier for the customer to take one item out of the basket in produce; they'll buy one punnet of strawberries instead of two. And that's certainly a trend that we've seen over the last two or three quarters. And regarding the model, I think it's a customer that's taken us to where we need to go in terms of meals and prepared meals. We're seeing strength in that business and the team has done a nice job of developing some great products that fit in with our health and attribute-based assortment. So, I think it's more about the evolution of the customer and how effective we are becoming in our meals space and will become much more effective going forward rather than a significant change in the model, if that kind of answers your question.

Yes. And my follow-up question is you've outlined some parameters around store growth for next year. How should we think about the economic sensitivity overall of Sprouts' same-store sales growth in the event there is a recession? You do over-index to more affluent consumers who would presumably be a little less impacted by some of the challenges than other consumers but still, your prices are a little bit higher than other retailers. So, how do we think about those puts and takes?

Well, I think the important thing about our business is our proposition is different from other retailers. So, if you're focused on a vegetarian diet or a vegan diet or keto diet or paleo diet, you're likely to stay that way irrespective of the economic conditions surrounding you. So, we feel we've got some stickiness in our proposition in terms of what we offer so that regardless of the context of what's happening in the marketplace, our proposition is differentiated and often appeals to a group of people who are aligned with what we are putting in front of them. I think we've seen this through the stickiness in our traffic over the last couple of years. And I've been encouraged by the fact that almost irrespective of the ups and downs surrounding inflation and pricing, we've got a sticky customer, and I think that will continue irrespective of what happens, and who knows what's going to happen over the next year or so going forward. We've got a sticky consumer who has bought into who we are. As we evolve and develop our loyalty and communicate the right engagement with those customers, I think we're well-placed to compete almost in whatever circumstances come our way.

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

Hi, thank you. Jack, you said last quarter, I believe that e-commerce perhaps will settle in at maybe 8%, 10% of sales post-pandemic and then grow off that. We're pretty far past hopefully, the bulk of the pandemic now, but your e-commerce is still growing nearly 20%. It's over 10% of your total, as you mentioned. Why would it, at this point, go back toward a high single-digit number if it's growing so fast in this kind of environment today?

Ken, I think that's a really good point. As we've evolved and seen what's happened, our customers have bought into that space. The fact that they're able to access our brand and the products that fit in with the health attributes and the kind of diet-focused process. Our customers have clearly voted with their feet around e-commerce and as I said, you're right, I expect it to maybe settle down a little bit more, but it continues to grow. In support of that, one of the reasons we put the DoorDash process in place, which has given more access for people to choose in an omnichannel way how to access our products and our brands. So, I think you've appropriately challenged what I said the last time. This thing is continuing to grow, and we expect it possibly to continue to grow further.

Thank you for that. I would like to follow up regarding capital expenditures. You lowered your CapEx guidance for this year. Although you are not discussing 2023, you previously indicated a range of 2.5% to 3.5% for next year. Was the CapEx number decreased because it is being deferred to next year, or were there other reasons for this year's adjustment?

No, it's being reduced as we approach the end of the year, Ken. We're spending a bit less on some projects than we initially planned. For next year, we're looking at approximately 3% to 3.5% of sales. Store growth will be greater next year, which includes a few projects we intend to undertake. We have a new distribution center coming online, so it will be closer to 3.5% next year.

Thank you. Our next question comes from Rupesh Parikh with Oppenheimer. Your line is open.

We are spending a bit less on some projects than we initially planned. For next year, we anticipate spending around 3% to 3.5% of sales. Store growth will be larger next year, which includes a few projects we hope to initiate. A new distribution center will become operational, so we expect the spending to be closer to 3.5% next year.

Hey Rupesh, you are not coming through.

Can you hear me now?

No. It sounds like you're underwater; I apologize.

Sorry, Rupesh, we can't hear you.

Our next question comes from Chuck Cerankosky with Northcoast Research. Your line is open.

Good evening everyone. A quick question on inflation. What kind of inflation did you see in cost of goods in the third quarter?

Yes, Chuck, we don't give out the actual numbers, but you can see it throughout the industry, it's pretty steady; pretty high inflation has been flowing through for the last several quarters now.

Okay. And then looking at the inventory level for going into this fourth quarter, how do you feel about that? How are the other stocks? And how much of a seasonal effect are we looking at for the holiday selling program, realizing that Sprouts isn't as strong in those categories typically as conventional supermarkets?

I'd just say, Chuck, we don't sell anything like as much in the seasonal. But January is our big month as we prepare as people get focused on their diet specifically going into the holiday period. Generally, we're trying to focus on our stocks, which we talked about, and there's a lot of work going on in the stores in terms of working that. Very importantly to us are things like organic turkeys and some of the attribute-based products we've got around vegan and vegetarian for the holidays. We're well placed for that. We feel we're in good shape. Clearly, it's a volatile world that we're living in, but we feel we're in good shape. We've put a pretty good holiday program together. I'm pleased with the marketing we're putting behind the holidays; we're doubling down a little bit on it. So we feel we're pretty well placed going into the holiday, given the context for our business, which you appropriately identified.

Thank you. Our next question comes from Spencer Hanus with Wolfe Research. Your line is open.

Great. Thanks for the question. Could you guys just provide a little bit more context on what's driving the acceleration in your comps in Q4? And then relative to Q3, are you expecting a more balanced contribution from units in price next quarter?

Hey Spencer, we're not thinking about three-year comps, and we're so messy. So, we're really starting to settle in more on a two-year. So I could go back and do the math or one of us could. But we really focus on where we are now. As it relates to the acceleration, we're still in this place where we see inflation. We see traffic pretty steady. We see some inflation on cost of goods and subsequent price with a little bit less on the units. When we came in at the beginning of the year, we thought that would dissipate in both directions as the year transpired. It didn't happen because inflation was continuing, and it's going to continue now at least through the first half of next year, and then we'll wait and see at that point. But, we're hopeful that as we get through, we'll not only comp the fewer units in the basket as we get later into the year, but at the same time, we'll probably lose a little AUR and pick up a little bit on the units.

Got it. That's helpful. And then with the pending consolidation in the industry, how do you think that will impact the competitive dynamics in some of your core markets like California and Arizona? I understand you don't compete directly in a lot of the categories, but just curious how you think that impacts price in the industry?

Well, Spencer, it certainly creates a lot of dialogue in the industry, that's for sure. I think we're in a position where we do see ourselves as very differentiated. We've got a very clear strategy in terms of where we're going forward in terms of our assortment and differentiation. If consolidation leads to a lot of price investment, it won't be on the things that we sell. So, we kind of see that we're shielded from almost anything that might happen. Whether it's really successful mergers or whether they're not successful, we think our destiny is in our own hands, which is not in the destiny of what might happen in the marketplace. So we're going to carry on plowing our own canoe, if that's the right expression. We're going to keep doing what we're doing, developing innovative and differentiated products that fit in with the healthy lifestyle that our customers have. We think that wouldn't be affected by the kind of merger conversations that have been happening in the industry over the last little while and particularly to that would apply anywhere in the country where this operates.

Thank you. Our next question comes from Robert Moskow with Credit Suisse. Your line is open.

Hi, thank you for the question. I understand that Californians are receiving government stimulus checks in October. I want to know if you thought that would be a positive for your business, and maybe you could remind us what percent of your business is in California? And then secondly, I wanted to know how much visibility do you have into the 30 new store openings? I mean, there are delays in all kinds of projects for all kinds of reasons. And I know you've already pushed back that target once. How solid is the 30?

We're feeling pretty solid about the 30 stores. We have a strong pipeline of stores that exceeds our needs for this year. So we are comfortable with the target of 30. Although we only opened 16 this year, we understand the context much better going into 2023 and 2024 compared to 2022 due to the supply chain volatility. All things considered, we're optimistic about reaching the goal of 30 stores. California is a significant part of our business.

It's about 40%, Rob?

While we don't benefit as much from government checks as others do, it certainly won't negatively impact us.

One interesting aspect is that we don't perform as well in brick-and-mortar regarding EBT, but we've observed that since introducing it on our e-commerce platform, we are actually seeing higher engagement there than in our stores. This has provided access to customers through e-commerce that we did not anticipate, but it has occurred.

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

Hi guys. Good afternoon. It seems like the gross margin this year is maybe coming in a little better than what you talked about. Can you maybe just provide a little bit of color on that? And then as we think about 2023, and I know it's early, but can you just kind of talk about what your expectation is there, the impact of the new distribution center, that type of stuff?

For this year, we saw an increase of about 90 basis points. More than half of that is due to last year's third quarter when we ran several promotional tests extensively. We had multiple promotions layered on top of each other, but we didn't repeat that this year after learning from the experience. That accounts for approximately half of the year-over-year improvement. Early this year, we fell slightly behind as our merchants dealt with rising costs, particularly in the fourth quarter. However, this quarter, we managed to get ahead a bit. Overall, we achieved a net gain of 90 basis points. Looking ahead to next year, our goal is to keep our margins largely unchanged. There is a slight challenge as we transition our Southern California distribution center, but there are also opportunities to improve our product mix and potentially gain a small margin increase. Overall, we are targeting flat margins for next year.

Okay. And then just a quick follow-up. On SG&A, obviously, with an acceleration in store growth, you'll see an accompaniment in SG&A, but you did mention looking to be tight on expenses. I'm just curious what some of the things are that could potentially help you on that line item.

Yes, we still have some items in the stores and are reviewing supplies closely. We are examining every detail to ensure we can manage effectively. Wage increases are forthcoming, but supplies represent a greater opportunity for us. We have some updates related to pricing as we implement changes in stores, and we began this process earlier this year. We anticipate further adjustments next year. We need to be cautious about adding new staff or incurring additional costs. We will consider marketing options, aiming to prioritize that when feasible. Overall, we need to navigate these challenges effectively, and we will identify solutions to ensure we succeed.

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

Hi, thanks for taking our questions. I was wondering if we could just talk a little bit about the new store economic model. I think last quarter, you made some tweaks to that. I was just curious if you could provide an update on how you estimate your year one new store productivity is coming in? And how many stores do you have that are really tracking towards that year one $13 million sales target?

Currently, we're anticipating that year one will reach $13 million. We've opened a total of nine stores this year, with one additional store just recently. We still believe that by year five, we will achieve 16 stores and break even in year one, while aiming for an 8% EBITDA by year five. We're putting in effort to control costs, but since we haven't established a large number of stores yet, and since those we've opened haven’t matured enough, we can't fully validate our projections. However, we're optimistic. Our findings indicate that markets where our brand is well established tend to perform better initially, while in areas with less brand presence, the initial performance may be lighter, but growth accelerates over time.

And Kelly, I think we've been quite encouraged by some of the stores in year two, year three, and some of the less established marketplaces. We're seeing some strength in some of those stores now, which is very encouraging. I think the economics of what we're building in terms of smaller stores, we've only got a few on the ground there, but all of them next year will be that, and so that we're getting the benefit of that into the economics. I think we're feeling pretty good about the ramp-up.

Thank you. I wanted to ask about the categories you mentioned, specifically deli and prepared, which seem to be leading categories. I thought those were somewhat de-emphasized in the new store model. Are you reconsidering that? Are those categories still performing well in the smaller stores? Could you clarify the deli and prepared strategy moving forward?

Go ahead.

Yes, Kelly, when we started on that path, our last prototype focused heavily on the deli area, and we approached it in a very grand manner. We enlarged the store and created an expensive deli section where customers could see the food being prepared. I would describe that as excessive. We don’t need such elaborate fixtures, labor, or space to excel in the deli sector. We are continuing to assess this. We feel confident with our current fixtures, including self-serve options. The previous setup was too costly and excessive, yet we can still pursue our goals with what we have in our new prototype.

Yes, in the deli space in our V5, which is the version before the one we're working on now, it was very grand but didn't really add a lot of assortment. The pandemic kind of took us there is what an opportunity there is for us as far as prepared meals within that deli environment. So, we've added cabinets being down and invested in products, and we'll continue to do that. I think that's come along from the pandemic as much as anything else, what an opportunity there is for us. So we're probably a little bit late to the party, but it's certainly working for us at the moment.

Thank you. Our next question comes from Robby Ohmes with Bank of America. Your line is open.

Hi, this is Kendall Toscano on for Robby. Thanks for taking my question. So, to start if I could get a little bit more detail on the speed traffic trends. You said this quarter was more of a steady trend versus the last two quarters. You called out hogging traffic. In Q2, you said that there was like a quarter-over-quarter improvement and talk some about the marketing initiatives you're doing and some progress on that. I guess just what's obviously hard in a very inflationary environment. But what are you looking at to measure the progress of marketing and things like that? Would you hope to kind of have like a reacceleration in traffic?

Yes, it's Kendall, right?

Yes.

Kendall, we've seen net positive traffic for the last three quarters. In every one of those quarters, we had some months that were maybe slightly down and slightly up net-net, we were up. This past quarter, we had the same phenomenon, but net-net, we were down just a hair for the quarter in Q3. As we rolled into October, October was flat. It's a really steady number. It just moves a bit up and down from a comp perspective. As it relates to marketing, our teams are from a promotions perspective; they play with promotions every day, every week, and they measure them from a traffic perspective, from a sales perspective, and from a profitability perspective. We're finding, as we've said in the past, some things work a little bit. But there's no panacea out there that says this is the perfect thing we need to do to go drive traffic. It's just a continuing and overall marketing message.

Yes, we plan to increase our marketing spend. Our focus is on investing in personalization and loyalty. We aim to be more precise with our new media model, ensuring that our spending generates better returns for each dollar spent. This remains an area of experimentation, where we are successfully raising awareness among our customers. The next step is to enhance engagement, which is a priority for us. Increasing our email communication and direct interactions will help foster loyalty and generate more transactions, both from existing and new customers. We are actively working on this across our organization. However, as Chip mentioned, there is no perfect solution. While we have made significant progress and established strong foundations for loyalty and personalization moving forward, the journey continues.

Thanks. That's very helpful. And then just as a quick follow-up. If you could just talk a little bit more about the trends you're seeing with new and existing customers?

We've got some very sticky customers, which is why we get a consistent level of part on the traffic that Chip was talking about a little while ago. In our new markets, new customers take a little longer. When we open a new store in less established markets on the East Coast and in parts of Florida, many customers come in to have a look. The real target customers are the ones that stick around, and they are the ones that we grow from. You get an interesting mix when you open a new store where a lot of people come in, and then it takes a little while for that customer to really get who we are because they often think we're a grocery store. We're a specialty grocery store, which changes that dynamic a little. We're getting better awareness across the customer base. Our existing customers aim to get them to spend a little more. We've been doing a lot of activity in that space. We're seeing a balance of both new customers coming into our business.

Thank you. Our next question comes from Scott Mushkin with R5 Capital. Your line is open.

Hey everyone. Thank you for taking my question. I want to reference slide seven from the presentation, where you showed that the EBIT margin is increasing to just over 6%. If this margin were to remain in the low single-digit range, would you be able to sustain this level of EBIT? That's my first question; I have a follow-up after you respond.

Yes, I think we can maintain it. With a 10% growth in square footage, we will need to achieve comparable sales that are likely above 2% to keep our performance stable, and we do have some costs to manage. However, we believe we are in a position where we will not see any deterioration in gross margins. We have fundamentally transformed our business and altered its composition, and we do not anticipate a decline in gross margins at this time. Our focus is to keep the EBIT margin steady while investing in new stores and managing our costs effectively to ensure that our EBIT margin remains relatively flat.

So, then the second follow-up question to that is obviously the negative side. The positive side, I get this from clients quite a bit is what can we do more aggressively to get that comp moving higher? I know you guys are working on some stuff because clearly, it's almost like a coiled spring, the equity itself, if you can get that comp moving higher. I know, again, we've talked about that before, but it comes up with a lot of clients as the stock is pretty cheap if you can get that comp moving.

Yes, I certainly agree, Scott, that the stock is cheap. The opportunity going forward for us is how do we sustainably build a comp and a customer loyalty base going forward. We can do these pulses of comp by investing margin and thinking that's going to build long-term sustainable profitable customers. That's what the strategy entails, slow, confident driving of a customer base who loves what we do. We continue to see the broader trend in the industry towards health and wellness. We're well placed to take advantage of that. We're positioning our infrastructure to run efficiently going forward. A specialty retailer should be operating at a significantly increased relative to the conventional industry. We now have the opportunity to build long-term customer loyalty, which builds long-term customer profitability without being these pulses of in-and-out; that’s the direction we are going.

Thank you. Our next question comes from Krisztina Katai with Deutsche Bank. Your line is open.

Hi, good afternoon, and congrats on a nice quarter. I wanted to follow-up on the personalized offers. You currently know about 16% of transactions. It seems like it's a pretty good opportunity. If you could talk a bit more about some of the metrics you mentioned; I think you said the basket of a loyal shopper is 70% larger. How are you approaching the analytics side of things to ensure this customer continues to increase their spend with you and also get them to come into the store more frequently?

First of all, we've invested in a customer analytics team, which we've talked about. We're putting resources into this to mine that data and information about the customer. Trying to understand what motivates that customer to spend more money with us. We’ve done very specific tests in areas like vitamins, bulk, where we can see who that customer is and how we can increase their share of wallet going forward. We get a pretty small share. Even though our customers love us, we have a small share of the dollars simply because of the nature of our proposition. So, just mining that data, understanding it, and putting offers in front of them that allow us to grow is critical. We're very early in this process, but we’ve certainly got the infrastructure in place. We're getting some partners on board to help us. This has been done by a lot of people and a lot of different industries. So, we see great opportunity in front of us to personalize offers and drive loyalty from customers who want to give us their information. I think that's going to continue to grow going forward.

Great. And then a follow-up. Could you talk about some of the tailwinds you’re seeing from the clustering of stores around distribution centers? How has that helped with sales as you're now putting fresher items on the shelves? Can you also quantify what the tailwind has been on gross margin, distribution efficiency, and cost reduction, especially with the elevated transportation costs that we have in this environment?

I'll let Chip maybe go into more detail. But specifically, if you're driving fewer distances, and we’re pleased, especially when diesel prices were so high, the fact that we're traveling significantly fewer millions of miles, I can't remember the exact number, three million, I'm getting signals here. Three million miles less on the road to get the same deliveries to the same number of stores is significant saving. That offsets what costs would have come through. That’s encouraging. There will be some doubling-up costs for a while as we get our Southern California in place, but long-term, that will drive us efficiency going forward. Chip, do you want to add anything?

Krisztina, just the first half of the year, we got some benefits from the fewer miles. Once we got into the back half of the year, we are now in a place where we're comping those benefits. So, the back half of the year hasn't been a margin or wasn't in the third quarter, nor do we expect it to be a margin enhancement in the fourth quarter. We're trying to manage that line at this point as a push.

Thank you. Our next question comes from Rupesh Parikh with Oppenheimer. Your line is open.

Good afternoon. Thanks for taking my question. Hopefully, you can hear me now.

We can hear you, Rupesh.

Okay, great. Regarding the new store prototype in Phoenix, I'm interested in how that store is performing now that it’s in its second year. Also, as you continue to launch the new store prototype, have there been any unexpected developments, whether good or bad?

It's nearly been a year. I'm checking if that site has indeed reached a year mark, and it has. We're pleased with the underlying performance of that store, which is exceeding our expectations, and we're very optimistic about the returns. The other new stores we've opened, albeit a small number, are also doing quite well overall, which is encouraging. The economics are significantly better than before due to lower rent and reduced operating costs. Looking ahead, I appreciate that we're establishing smaller stores since they help manage potential construction costs. We're optimistic that our focus on smaller stores will support favorable economics. The business mix is aligning with our expectations, and we did see some unexpected strength in the deli segment, which is performing well. Additionally, frozen foods have shown promising results in these new stores, and I believe we can further invest in that area moving forward.

Great. And then maybe one quick follow-up question for Chip. Just as we look at Q4, is there any more color you can provide in the interplay of gross and SG&A margins for the quarter?

Yes, in Q4 we expect margins to be around 36%. I anticipate that costs will likely increase year-over-year in the SG&A line, approximately 7%, and we have indicated that we would compare it to about 2%.

And I'm not showing any further questions at this time. I'd like to turn the call back over to Jack Sinclair, CEO, for any closing remarks.

Well, thank you, everybody, for your attention today. We appreciate your interest in our business, and I wish you all a very good holiday season. Thanks a lot.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.