Sprouts Farmers Market, Inc. Q2 FY2023 Earnings Call

Thank you for standing by. And welcome to the Sprouts Farmers Market Second Quarter 2023 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speakers' presentation there will be a question-and-answer session. As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Susannah Livingston, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you and good afternoon, everyone. We are pleased you are taking the time to join Sprouts on our second quarter 2023 earnings call. Jack Sinclair, Chief Executive Officer and Chip Molloy, Chief Financial Officer are with me today. The earnings release announcing our second quarter 2023 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 2023 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 good afternoon, everyone. I'm pleased to announce another solid quarter for Sprouts Farmers Market. Our 31,000 team members delivered comparable store sales growth of 3.2%, total sales growth of 6%, and adjusted earnings per share growth of 25% in the second quarter. Their efforts to provide a unique in-store and online experience, differentiated products, and superior customer service will continue to establish Sprouts as a go-to healthy specialty food retailer. During the quarter, we opened six new stores and are on a path to open at least 30 for the full year, allowing us to profitably expand our reach to new health enthusiasts and innovation-seeking customers. During the quarter, we also relocated our Southern California distribution center to a new, larger facility. At the same time, we expanded our Texas distribution center. These distribution centers will allow us to bring fresher products to our customer base while providing capacity for growth in those markets for years to come. In a moment, I'd like to turn it over to Chip, who will provide a closer look at our second quarter financial performance and our outlook for the remainder of the year. Before doing so, I want to take a few moments to thank Chip for his 10-plus years of service to Sprouts. As you may have seen in our release this afternoon, Chip has decided to retire at the end of this year. Chip has been a tremendous asset as a member of our board and executive leadership team, and on a personal basis, I valued and enjoyed our partnership. With that, I'll turn it over to Chip.

Thanks, Jack. And good afternoon, everyone. For the second quarter, total sales were $1.7 billion, up $97 million or 6% from the same period in 2022. This increase was driven by adding new stores combined with comparable store sales growth of 3.2%. We experienced positive comp transactions, a proxy for traffic throughout the quarter, combined with a net increase in basket size. The basket increase was similar to the last several quarters, where the increase in retail inflation was partially offset by a slight decrease in the number of items in the basket from a year-over-year perspective. As expected, moving into the third quarter, we are beginning to see a slight tapering of both the year-over-year price inflation and the unit declines. Our e-commerce sales grew 16% during the quarter, representing 12.1% of our total sales. Our new markets continue to show encouraging trends driven by store density and increased brand awareness. On the product front, our strongest performing categories remain those with the most differentiation, such as grocery bakery, dairy, and proteins, further supporting our strategic decision to focus on these key departments important to the Sprouts customer. Our private label, or Sprouts brand sales, grew 12% and represented 20% of total sales, as innovation seekers value uniqueness and quality only to be found at Sprouts. Turning to gross margin, second quarter gross margin was 37%. Excluding the impact of special items, adjusted gross margin was 37.1%, an increase of approximately 70 basis points compared to last year. Category mix shifts and continued promotional optimization contributed to this accretion. SG&A for the quarter totaled $498 million. Excluding the impact of special items, adjusted SG&A totaled $494 million, an increase of $32 million from the same period in 2022. This increase was primarily driven by the addition of new stores and higher e-commerce fees. Like many other retailers over the last several quarters, we have been experiencing rising labor costs. More recently, we've also invested in a more engaging store bonus program and additional labor hours for sampling to support the long-term growth of the business. To date, our operations and information technology teams have done a remarkable job of offsetting those increases with new processes and technologies while enhancing the customer experience. Examples include the implementation of Fresh Item Management and new labor management systems, installation of self-checkouts, and more efficient sequencing promotional tags. Store closures and other costs totaled approximately $2 million for the quarter. While depreciation and amortization, exclusive of the depreciation included in cost of sales, was $34 million for the quarter. Excluding special items associated with our store closure decision in the prior quarter, the adjusted depreciation and amortization totaled $32 million. For the quarter, our earnings before interest and taxes were $92 million, while interest expense was $2 million, net income was $67 million, and diluted earnings per share was $0.65. Excluding the impact of special items, adjusted earnings before interest and taxes were $100 million, and adjusted net income was $73 million. Adjusted diluted earnings per share was $0.71, an increase of 25% compared to the same quarter in the prior year. Now let's turn to our cash flow and balance sheet, which remains robust and strong. During the second quarter, our cash generation allowed us to first and foremost invest in our business, including opening six new stores, the new distribution center, expanding a distribution center, and investment in convenience meal fixtures. In total, we spent $48 million in capital expenditures, net of landlord reimbursement. We also paid down $50 million of our bank revolver and returned $50 million to our owners by repurchasing 1.4 million shares. We ended the second quarter with $250 million in cash and cash equivalents, $175 million outstanding on our $700 million revolver, and $22 million of outstanding letters of credit. As we evaluate our expectations for the remainder of the year, we continue to monitor consumer spending and behaviors in a dynamic environment and focus on controlling what we can control. For the full year, we continue to expect sales growth in the range of 5% to 6% and comparable sales growth of 2% to 3%. We expect gross margins to be slightly up and a slight deleverage in SG&A due predominantly to the acceleration of new store growth and rising labor costs. The deleverage will be a bit more pronounced in the third quarter, mainly due to timing shifts we mentioned last quarter. We are raising expected adjusted earnings before interest and taxes to be between $378 million and $390 million and adjusted earnings per share to be between $2.68 and $2.76, which assumes no additional share repurchases. That said, we do expect to continue to repurchase shares opportunistically. As Jack mentioned in his opening remarks, we're on track to open at least 30 new stores this year, all of which are in our current prototype. Capital expenditures, net of landlord reimbursements, should be between $190 million and $210 million. For the third quarter, we expect comparable sales growth in the low-single digits and adjusted earnings per share between $0.59 and $0.63.

Thanks, Chip. We continue to be encouraged by our performance to date driven by the strategic changes we've made over the past few years. Our differentiated products are resonating with our core customer segments, supply chain continues to get stronger and more efficient, we are accelerating our store growth with our new prototype, we are improving the customer experience both in-store and online, and slowly but surely connecting more effectively with current and potential customers. As I've mentioned many times, we are a specialty food retailer. We curate products that contain attributes appealing to health enthusiasts. For example, in proteins, more than 50% of our beef sales are grass-fed, more than 50% of our chicken sales are organic, and 90% of our grocery sales have specific diet attributes such as vegan and non-GMO. Even in produce, which many consider a commodity, over 40% of our sales are organic. This is a significant difference from other grocers. Our innovation seekers are also finding a treasure trove of products from locally sourced produce to our private label Sprouts brand. In the second quarter, we focused on our seasonal produce assortments in each region, and shared the local grower stories in-store. For the second quarter, approximately 90% of our produce sales are from local farms. As Chip mentioned, the Sprouts brand continues to be a growth driver for us with penetration over 20% this year. We have driven the brand through active sampling, e-commerce, and store merchandising improvements, and redesigned packaging. Our team has released over 200 new Sprouts brand items this year, focusing on relevant test profiles and health attributes. We were honored this year to receive many vertex awards, including Retailer of the Year and several gold, silver and bronze awards for our curated products. With eliminating the guesswork of finding healthy alternatives, because differentiated healthy options are who we are and what we sell. As I mentioned earlier, during the second quarter, we were busy improving our supply chain. We successfully opened our new larger Southern California distribution center in Fullerton in May and closed our Colton, California distribution center that we outgrew in late June. We doubled the size of our Texas distribution center and added ripening capabilities in our Texas and Arizona distribution centers. These expansions grew our distribution center square footage by approximately 40%. Coupled with our recently opened distribution centers in Colorado and Florida, these expansions allow us to support our 10% store growth while improving our produce quality and freshness. As for unit growth, our smaller, most cost-effective format continues to roll out. We opened six new stores in the second quarter, bringing us to 14 new stores year-to-date, all in the new prototype. Our pipeline is also growing, with nearly 100 approved new stores and more than 60 executed leases, helping us gain traction towards our goal of 10% unit growth per year starting in 2024. Our recent vintages continue to perform as expected, as we focus on great store locations, increasing our marketing reach for greater awareness, and highlighting our unique attribute-driven products both in and out of store. We continue to work on our omnichannel experience. As I have mentioned, we rolled out a more active sampling program that helps support trial and basket growth of our unique and healthy offerings, including Sprouts brand products. And while our enhanced customer service program is just off the ground, we're seeing scores for in-store satisfaction improve beyond our early goals. Online, we're pleased with the sales and customer growth in all three of our channels: Instacart, DoorDash, and at our own shop.sprouts.com. Over the last several quarters, we've significantly enhanced our e-commerce platforms, including our site redesign and optimized search functionality to create a more personalized and relevant customer experience within the product shopping, a menu redesign, and rolling out a shoppable flyer. Communicating and connecting with customers more effectively continues to be a top priority and opportunity for Sprouts. Almost 80% of our media is now spent on digital aimed at driving more shopping occasions with our target customers, supported by data-driven plans. Our Find Your Healthy creative campaign is evolving to use more enticing food photography to communicate freshness and move away from the animations. Our new creative approach is designed to work in tandem with our digital media plan that focuses on each stage of the customer journey. As we all know, linking transactions with individual customers provides valuable data and better insights into their needs and wants. We're still in the test-and-learn phase with our personalization efforts. These learnings are helping to guide our thinking, as we build towards a more robust and relevant loyalty program. This is a multi-year journey that we believe could provide significant future benefits. In summary, we believe we're making progress in growing our business and establishing our brand as the healthy specialty retailer of choice in a challenging macro environment. That said, we have more work to do to capture the opportunities in front of us. Fortunately, we have a talented team in place and are well-positioned to succeed and grow. With that, I'd like to turn it over to Chris for questions. Operator?

And our first question comes from Ken Goldman from JPMorgan. What is your question, please?

Hi, thank you. And Chip, congrats on your pending retirement. I was curious, typically when a retirement is announced, the company will either announce a successor or at least will say that a search is underway. In this case, the release indicated that a search will take place. I just didn't know if that's indicative of any element of suddenness or anything we should think about in terms of the timing. I assume there's nothing there. I just wanted to ask and make sure.

No, absolutely, Ken. The search is underway. We should have been clear. And if we didn't express it like that, because it is a step two underway. And it's not at all sudden. We've been thinking about this for some time, and Chip's been thinking about it for some time. But Chip, do you want to say something on that?

Yeah, this has been planned for a while in my head, and the timing's right. It's been a great run here. I've been here 10-plus years, and I'm just ready to go out to pasture. I've tried to retire a couple of other times but failed miserably. This time, I think I'm good to go.

You've been there during an interesting 10 years, so congrats to you. I just wanted to also ask about the competitive environment. It certainly still seems, from what we can tell, to be rational. Clearly, there's been more promoting going on, seems to be paid for mostly by the vendors, the manufacturers. Just wanted to get a little bit of a broader sense of how you see that for the rest of the year? What you're factoring into your guidance? And if you would agree that it's still within the boundaries of what you might consider rational, if that's the case.

Yeah, I think you're describing exactly right, Ken. The context of the competitive dynamic doesn't seem to be changing dramatically. Certainly, we're in a slightly different place. A lot of the things we sell are very different from what you would describe in that competitive dynamic. So we're watching it closely. We monitor our produce pricing very carefully, and we're in good shape on that. We're not seeing anything that gives us cause for concern in that space.

Great, thank you so much.

Thank you. One moment for our next question. And our next question comes from the line of Leah Jordan from Goldman Sachs. Your question, please.

Good afternoon. Thank you for taking my question. I just want to touch on volumes. You said that they were improving sequentially, but still in declines. Just any color on the magnitude of how that's improving there. And then should we think that it's coming back from the produce side, as that's where the challenge was last year, or can you just talk about how the trends in fresh and produce overall are to the total store decline?

Yeah, Leah, this is Chip. Overall, we're seeing, as expected, and honestly, last year we expected it to happen this way, but when the Ukraine incident happened, we expected at the beginning of the year that as the year progressed, there would be less top-line benefit associated with average unit retail, and that the units per basket would start to stabilize to get less negative effect earlier. We're beginning to see it late in the quarter and beginning to see it into the third quarter where it's happening just as we thought. You're seeing less benefit from average unit retail, and you're starting to see it stabilize sequentially. The same applies to units; you're beginning to see less negatively per units, and it's beginning to stabilize, and it's just starting to get to that number slightly under 10. And that's where we're hanging out units per basket.

Regarding the fresh side of the question, Leah, areas like meat, we've seen a slowdown in the rate of inflation. We've also seen an encouraging change in the unit volume that's been going through. The way Chip described it, almost 18 months ago, how that's playing through is how we are expecting it to play through going forward. Again, we're seeing a little bit of reduction in terms of inflation, not going into a negative, but the pace of inflation is slowing down. The fluctuations in units are changing. But in volatile categories like avocados, you're seeing some dramatic changes in that where the pricing changes and you see an immediate change in unit volume. So we will watch it closely. Produce is a big part of our business as you know. So we monitor that, and there's always been volatility in produce, and that remains the case.

Okay, great. Thank you. And just on my follow-up, I wanted to check in on the third quarter comparable sales guidance. The low-single-digit figure is just a bit more vague than you guys typically provide. So I'm curious if you're seeing anything different behavior-wise from the consumer, or is that more just a function of maybe uncertainty on the disinflation outlook? Any color there and maybe some quarter-to-date color as well? Thank you.

Yeah, it's a little less broad, obviously those singles can be one to three-ish. We feel solid about that. And how that unit versus average unit retail and how it transpires through the quarter is, I would say, fragile in how it fundamentally comes out. But right now, I feel really comfortable that we're going to be in that range.

Okay, thank you.

Thank you.

One moment for our next question. And our next question comes from the line of John Heinbockel from Guggenheim. Your question, please.

Hey, Jack. Can you dive into the two target customer segments in terms of growth in new households of that group? Any insight you have on wallet share? I'm just curious how they're performing relative to the overall base in terms of acquisition. How much of their wallet do you think you have today?

We've got a little percentage of the wallet, which we've always had in terms of health enthusiasts and innovation seekers. The encouraging thing that, when I look at data are both natural and organic, which is the kind of which we can get very good data on in terms of our market share. Market shares encouragingly growing within that space and significantly different from the traditional products that we have. Our business is continuing to focus on differentiation so that we can attract and appeal to a small share growth that we need from those target customers. We're seeing some encouraging market share data in the last little while. I'm very encouraged by the traffic that's coming in. The traffic's coming in both digitally, in e-commerce, and in bricks-and-mortar. We're seeing a nice balance of both, and so we're creating this omnichannel customer with the curated assortment that we've got. The data we have gotten will get more data going forward, but the data we have so far suggests that we're growing share with those target customers, which has always been the intent since we really pivoted the strategy around this target customer base.

So when you say low-single digit, that's your share of the market as opposed to your share of individual customers' wallets? I know you don't have a loyalty program, but I'm just curious, with your best customers, what percent of your wallet do you think you're getting in food? Is it 15% or 20% or not that high?

I'd say it's relatively low. I don't have the exact number. And that's why the opportunity is so big in front of us. We don't need much growth to make the numbers really add up over the next few years. That's why we're so confident about where the strategies are. We've got a low share of our customers' wallet, which is the nature of our assortment. We've said all along that we're not going to try and win on conventional products with conventional grocers. We're going to differentiate ourselves based on the assortment we have, and that, based on what we're looking at the moment, is moving in the right direction. We continue to have confidence that the growth and share of wallet that we will get with those target customers is more than enough to fulfill our long-term plans.

All right, and then just lastly, do you think you'll have a loyalty program, and it'll probably be more affinity than loyalty? When do you think you'll have something out there in the next 12 months or longer?

We're working very hard on that. It will evolve and develop. I don't think you're going to wake up one day and have it exactly the way we want it. We will get more data from our customers and increasingly get more data from them. What we then do with that, we're in the process of figuring that one out. Exactly how it manifests itself and how it plays into the marketplace, we should be able to know exactly where we are by next year on this one.

Thank you.

Thanks, John.

Thank you. One moment for our next question. And our next question comes from the line of Mark Carden from UBS. Your question, please.

Good afternoon, and thanks so much for taking the question. And Chip, congratulations on your retirement. So another strong comparable sales number. It seems like you're seeing some nice market share gains. When you think about your store base, are you seeing much of a deviation in results between your newer markets and your legacy markets? You guys talked about improving brand awareness. Are you near where you want to be from a recognition perspective in some of your newer markets, or is there still a lot more runway in that front?

There's certainly runway on newer markets. We have a very clear position. It takes a little bit longer in Florida and in the mid-Atlantic and certain parts of the country to get the stores up and running and moving the way we want them to. I've been very encouraged by Florida, though, in terms of where we've been, because those stores are newly built, and we're now getting some critical mass in places like Tampa. We're seeing some encouraging two-year numbers out of our Florida business, which suggests it's kind of how we thought about this; it takes a little bit longer, and you need critical mass from a marketing point of view. We still have a bit of work to do to build on that in the mid-Atlantic market. But our plans in terms of the stores that we talked about are very much about consolidating the store base around tighter markets to gain the effects of marketing in place. It takes a lot longer when we're not known, and it goes a bit faster in places where we are known. We're flexing our marketing communication a little bit as we go forward.

Great. And then you said you remain on track to reach your 30-store target for this year. Any update on how you're thinking about unit growth next year? Would you still expect to return to your algorithm, or are some of the headwinds that have been impacting it?

Yes, Mark. We're comfortable with the 30 number, and maybe a couple more than that this year. But in 2024, we will be on track for 10%.

Thanks so much, and good luck.

We have the sites approved on that as well, Mark. So we have a lot of confidence in that.

Thank you. One moment for our next question. And our next question comes from the line of Karen Short from Credit Suisse. Your question, please.

Hey, thanks very much. And I echo my congratulations to Chip for his retirement. I wanted to just ask two things. Looking at the second half sales growth versus EBIT growth, compared to what you just did in Q2, there's a significant divergence, I guess, in those numbers. I know there's a lot of moving parts, but wondering if you could just parse out what those two components would be for that delta. And then, specifically, put some tape on gross margin and SG&A. What specific inflation number are you thinking about for the second half?

Karen, this is Chip. First, thanks for the congratulations. As it relates to the second half, really, nothing has changed since our guidance in the year and even last quarter. I think we gave enough details to suggest that in the back half, we wouldn't see the same kind of profitability gains predominantly because, number one, I think our gross margins are going to be—our gross margins are generally going to be flat in the back half of the year. On the SG&A front, we're going to have some deleverage, specifically in the third quarter. The pieces of that are a couple: one is there's a little bit of timing in the third quarter that we talked about last quarter. Secondly, as we start to accelerate the store growth, that will put a strain on the P&L. Thirdly, as labor costs have been going up for everyone for a long time, as I said on the call, we take labor costs and the store growth piece. Our teams have done a great job of mitigating that transition through that, but as we start to lap some things we did last year, it becomes a little more difficult to mitigate those cost increases. That said, the good news is, at least on the labor front, labor rates are beginning to stabilize, so it won't be as difficult next year, but for the back half of the year, it's a bit of a strain. As we accelerate the store growth, you know how that math works. Again, mid-next year, we should start to be in that stable place.

Okay, and inflation?

So, on the inflation front, our thought at the beginning of the year was always going to be in double digits in the beginning of the year, from a year-over-year perspective. Then, as you migrate through the year, you'd be then, call it, by the third-fourth quarter in mid-single digits, year-over-year. That seems to be starting to play out.

Thank you. One moment for our next question. And our next question comes from the line of Krisztina Katai from Deutsche Bank. Your question, please.

Hi, good afternoon. I want to add my congratulations to Chip on the retirement as well. I have a follow-up question on gross margin, which obviously was quite strong in the second quarter. I think, despite some rising promotions throughout the period. Can you talk about the drivers behind the gross margin? I know you mentioned better promotional leverage, but what are some of the other offsets that you're finding to drive that performance, such as Sprout-funded promotions like last week's sale and private label items? How do you view your current price gaps, and just how willing is Sprouts to retain traffic and market share in exchange for managing margins at these levels?

Thanks, Krisztina. I'll talk about the margin, and then Jack will talk about the gaps. From a margin perspective, we didn't come into the quarter expecting some margin accretion. We did, however, overperform on that line. It is partially driven by mix, both within the categories and overall for the company. Higher-margin businesses are growing faster than lower-margin ones within the categories. Also, as we talked about promo effectiveness, we're continuing to see ourselves more on the ELP and less on the promotional front. Thirdly, we probably overperformed a little bit this time around. About five or six quarters ago, as we saw costs rising, we got behind it a bit. We got a teeny bit ahead this time, and that's sort of transitory. I wouldn't count on that going forward. Looking for the rest of the year, we'll really get into that place where we think the margins will become more and more stable year-over-year.

So yeah, Krisztina, the margins are in good shape, and we're comfortable with the way it's being managed. Price gaps play a key role, particularly in our produce business, where we spend a lot of time looking at where we are. We're very aggressive on organic produce, and we've talked a little about how successful that has been for us. The whole context of our produce price gaps is in good shape. We're comfortable with our approach, and we continue to look at it. The other things that will look on pricing, I'm very pleased to win with bulk pricing, given that not a lot of other people sell bulk foods. The fact that we are able to sell loose bulk on commodity items for customers, allowing them to control the volume they purchase and portion control, we're about 20% cheaper than our packaged goods on equivalent items. So that's been an important part of our pricing mechanism going forward. On our base business—our grocery business, our daily business, our frozen business—sell such a different assortment that we look alike elasticity on pricing as opposed to gaps, and we spend a lot of time working out the right price to maximize volume. This aligns well with how we've worked our pricing all the way through. As Chip said, we made some progress on margins and continue to monitor our pricing.

Thank you for that. Just as a follow-up on e-commerce, which was strong again—I think you said it grew 16% in the quarter. Can you talk about the impact the extended partnership has had with DoorDash on your same-store sales? And then just generally, how are you thinking about the sustainability of that e-com momentum once you really start to lap the DoorDash expansion?

As I said, we're very focused on being an omnichannel retailer. The customer will take us where they want to go regarding our offerings based on our differentiated curated assortment. I think it's encouraging for us that we're seeing traffic growth in both e-commerce and in our brick-and-mortar business, and it's kind of equal between the two. DoorDash has enhanced our growth a little bit and traffic slightly. We're pleased with the partnerships with both Instacart and DoorDash. Again, it allows the customer to choose how they want to engage with us. The DoorDash business is a little bit more immediate, as people are looking for faster delivery compared to the Instacart business, but both of them are performing well for us.

I would add DoorDash is helping, but it's still less than 1% of the contribution of our cart.

Okay, that's great. Thank you so much, and best of luck.

Thanks.

Thank you. One moment for our next question. Our next question comes from the line of Michael Montani from Evercore ISI. Your question, please.

Hey, good evening. Thanks for taking the question. I want to ask first off, if you could provide some additional color on what drove the comps this quarter. Was it more transaction size or transaction counts? Also, intra-quarter trends and geographic trends, if there's anything additional you could share on the color front there.

This is Chip. Thanks again. For the quarter, it was a pretty stable quarter period-over-period. We had positive comp transactions throughout the quarter every single period slightly up. We again saw average unit retail benefit from inflation, and we saw a little bit of unit decline, similar to what we've seen. As you got later in the quarter, we started to see that tapering of both the average unit retail and the unit decline. So that's kind of a mix of the transactions, but a mix of the comp. As it relates to geography-wise, again, we find it's been pretty stable across the geography. I will say that we're getting comps like Florida and the mid-Atlantic, where we have a higher mix of newer stores, yielding a little extra comp. Generally, we feel really good about those specific markets. Those less dense markets have been a little bit of a challenge for us—one store in Louisiana or a couple in Oklahoma. They're just sort of onesies-twosies. Those aren't performing as well since we don't have enough brand density. That plays into the story of why we want to densify our markets.

Got you. And then if I could just follow up on SG&A front, I wanted to see basically, what you would need to see in terms of a leverage point from the comps in order to get natural leverage, given the accelerated store growth and the wage inflation you're seeing. Has there been any deceleration to start the quarter, or was the low-single-digit guide looking at what's possibly to come, but you haven't seen it yet?

I'll address the first part. When we're growing at this rate where we're going to be growing 10% a year, you really do need, if your gross margins are stable, to keep your operating margin generally flat. To achieve leverage, you need a three comp to be able to do that over the long haul. Any given quarter, you could have some puts and takes. We have a little bit of call to take in the third quarter that we talked about. Outside of that, you need about a three comp to be able to do that. As to the second question, we feel solid about the quarter feel good about the guide. We're just tracking what we said last call about being essentially a three comp for the year. We said we would be a two to three for the year, so here we are in the back half. We're just tracking for that. So that's where we think we'll be.

Thank you.

Thank you. One moment for our next question. And our next question comes from the line of Rupesh Parikh from Oppenheimer. Your question, please.

Good afternoon. Thanks for taking my question. Also, Chip, congrats on your pending retirement. I want to go back to the traffic, and you mentioned that it is positive year-to-date. So just curious, as you look at your initiatives in-stores, what do you think has been key in driving that positive traffic that you continue to see?

Rupesh, what we've been trying to do is increase customer engagement, both in-store and online. The customer's in-store experience was impacted by COVID, but we've been able to talk to and guide customers. A lot of our customers come into our store looking for dietary advice, so we are trying to engage much more directly. Our sampling programs have significantly ramped up, and I think the fact that we have many new innovative items has helped us. We're doing a lot of sampling on drinks and snacks and seeing much success. We've also been focused on improving customer service, including faster checkout services. We're very pleased with our customer service scores, which we've measured significantly. We know while modestly rewarding the store, part of the bonus program includes measuring customer service metrics that are ahead of where we expected them to be, so there's a lot happening in that area.

And then maybe just one follow-up question. So just on the consumer, are you seeing any shifts in consumer behavior, whether trade down or anything different versus what you saw last quarter?

I think that trend continues a little bit. There's a little bit of trading down across the marketplace and a little bit within our business. People are opting for slightly cheaper options and purchasing slightly fewer items as they go through the store. So there's that trend. However, our customer base tends to stay loyal to our unique assortment, whether dietary-based or otherwise. They might trade around a bit, but the behavior hasn't changed dramatically from Q2 to Q1, and we're not seeing a lot of significant changes in that dynamic.

Great, thank you. I'll pass it along.

Thank you.

Thank you. One moment for our next question. And our next question comes from the line of Kelly Bania from BMO Capital Markets. Your question, please.

Hi, good evening and congrats as well to you, Chip, on your retirement. I was hoping we could go back a little bit to gross margin. I think Chip, if I heard you correctly, you said you're expecting flat in the second half. I think that means flat on a year-over-year basis for the second half. Could you talk about the factors supporting that? And given other grocers, a lot of other retailers are talking about shrink, maybe you can just update us on where you are concerning the various buckets of shrink. And especially, as you mentioned, you are rolling out more self-checkouts.

Kelly, so as it relates to gross margins, I did mean flat from a year-over-year perspective. We expect it to be stable in both Q3 and Q4 year-over-year. As it relates to shrink, Jack will address that.

The dynamic in retail presents a lot of challenges currently regarding some ongoing theft. However, we haven't seen that same dynamic to the extent reported by other retailers, primarily due to our products being niche and differentiated—less appealing for resale. We do have a couple of stores that we're monitoring regarding vitamins and supplements, but we're still managing shrink effectively. Our strength in perishables is also critical; we're focused on ensuring proper product amounts are in-store. We know we have room to improve on that, but the recent investments in our systems are enhancing collection efficiency as well.

That's helpful. I think you addressed a favorable product mix shift. However, I don't think I heard just about vitamins and supplements in particular; how is that category doing? Any color you can share on just the trends in that category?

We've been encouraged in that area. There are a lot of upsides post-COVID with individuals purchasing products for immunity. We continue to see demand here. Cold and flu season significantly impacts adjacent quarters. However, we are quite pleased with that. The teams that are working in our vitamins and supplements department are providing a lot of guidance and advice to our customers when they come in. We are seeing impressive results with vitamins and supplements, which has outpaced that of the overall company comp.

Thank you. One moment for our next question. And our next question comes from the line of Robbie Ohmes from Bank of America. Your question, please.

Hey, thanks for taking my question. And Chip, congrats on the retirement. My question is just when I listen to the thoughts on gross margin and labor and the new stores hitting the P&L, can you give us any sort of ways to think about whether you can keep the gross margin and EBIT margin in similar ranges for 2024 versus what you've achieved in 2023?

Yeah, Robbie. First, thank you for the congrats. When thinking ahead, it is still early to decide for next year. We have a multiyear plan to work from and are just beginning to consider. Our goal is to keep gross margins flat, and we will continue to work to maintain our operating margins close to flat. This means, in the SG&A front, we will constantly look for improvement. Some quarters can be dilutive; we mentioned a little bit more strain in the third quarter. Nonetheless, I believe our teams are rallied around finding leverage opportunities.

Terrific. That's really helpful. Thanks.

Thank you. One moment for our next question. And our next question comes from the line of Chuck Cerankosky from North Research. Your question, please.

Good evening, everyone. Can either of you comment on the inflation you're seeing in the cost of private-label merchandise? Could you please give me your outlook on where you think that growth rate is headed as the economy normalizes? There's been a very strong growth, and do your customers stay with it and keep buying, or do they migrate back to branded products?

Let me start, Chuck, with your second point. Our Sprouts brand product does not operate like typical private labels across traditional grocery spaces. We're focused on ensuring that everything we're putting in behind that is differentiated and has a unique value proposition with no commodity aspects. I believe the growth in Sprouts brand, which is over 20% now, will continue as our team sees success introducing unique products targeted to our customer base's needs. We're doing well across health enthusiasts and innovation seekers, introducing items you can't easily find elsewhere. In terms of cost, we face some volatility in commodity prices, and the impact on the cost side of the Sprouts brand is closely related to that. How the commodities play out can be uncertain. However, we are confident we can manage our product costs effectively, and our team remains focused on ensuring we buy these products at the best possible pricing.

Thank you for that. And Chip, good luck to you.

Thanks, Chuck.

Thank you. One moment for our next question. And our next question comes from the line of Edward Kelly from Wells Fargo. Your question, please.

Hi, guys. Good afternoon. Congrats again, Chip. I want to ask about inflation—a follow-up to Karen's question. I thought I heard you say that you expect inflation to be in mid-single digits in the back half of the year. I just wanted to clarify that. If so, can you talk about the drivers of that level?

Yeah. The drivers of that would just be the prices that are already in place today. As they play out year-over-year, that's how it is going to unfold.

Okay. And then a follow-up is related to your promotional strategy. There's a dynamic of promotional intensity versus engagement. We've heard some talk in the marketplace about increased promotional engagement through things like email, for instance, with customers that may be attached to certain stores that make it look like intensity is growing, but I don't know; it might just be engagement's growing. I don't know how dialed in you want to be.

We can—

Yeah, just kind of curious about how your strategy is evolving? Obviously, your margin does not suggest intensity is picking up, so it seems like it might be engagement.

We are getting better engagement certainly. We're improving in sending the right emails to the right people so that we don't dilute the effect. We're becoming much better at as we get more data from our customers and increasingly personalize our marketing. The nature of our proposition relies on being personalized in our approach. We want relationships; we don't want to be sending random offers to anyone that contradicts their needs.

Great. Thank you.

Thanks.

Thank you. One moment for our final question for today. And our final question for today comes from the line of Scott Mushkin from R5 Capital. Your question please.

Hey, guys. Thanks for taking my questions. And Chip, I think we're all going to miss you. So—. But not yet, because you're going to be around for a little bit longer.

I will.

So my first question is more housekeeping. I know you guys said you were going to close, I think you said, 11 stores this year. It looks like a bunch of those were in the second quarter. How do we—how should we look at net new openings as we move forward? What's your expectation for net openings this year? And how do we think about next?

If you think about it, we will have close to 11 this year, and we will open at least 30. So just doing the math, that's 30—I'm a finance guy, so I can get that—that's a net of 19-plus—. So a net 19-ish or a little bit more this year. As we think of next year, next year we’re targeting 10% unit growth with minimal closures occurring as leases expire.

Okay. That's it. Thanks for the clarification. So then my next question, and I think it's kind of been touched on a little bit, but I just wanted to get out of maybe a little more context around the glide path in earnings as we progress forward. Thinking about the comps, I think it's going to come in this year right in the middle of your range of 2.5%. Without a big acceleration next year, it just seems like the earnings growth could be more muted? Or am I thinking about things wrong?

Well, if you think about it, we're driving towards a three-ish comp, and we're trying to keep our gross margins flat, and if our SG&A grows in line with the top line, it would be high singles on top line—call it 10-ish. That gives you an operating margin that's flat, and you get earnings growth in the high singles pre-share buyback. Can we do that? I think we have confidence, perhaps more than some of your peers, that we can keep our gross margin stable. We have confidence thanks to our differentiated product and how we go to market with our differentiated customer base. As for costs, the recent labor cost increases have begun to stabilize, putting us in a better position for managing these factors next year. Our aligned team is motivated to control costs; we are proactively finding ways to cut expenses where appropriate—many of our investments in store offices will not need as much growth going forward.

All right, great. Thank you for taking the question.

Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Jack Sinclair for any further remarks.

Thanks very much, everyone, for all the questions and your attention. Thanks again to Chip, and congratulations on his retirement. But as Scott just said, he's still around for a bit longer because he's not going until the end of the year. We look forward to working through the next few months together. Thanks again for your attention, take care.

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.