Earnings Call Transcript - SFM Q2 2021

Operator, Operator

Good day and thank you for standing by. Welcome to the Sprouts second quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Susannah Livingston, Vice President of Investor Relations and Treasury. Please go ahead.

Susannah Livingston, Vice President of Investor Relations and Treasury

Thank you and good afternoon everyone. We are pleased you have taken the time to join Sprouts on our second quarter 2021 earnings call. Jack Sinclair, Chief Executive Officer and Denise Paulonis, Chief Financial Officer, are with me today. The earnings release announcing our second quarter 2021 results, the webcast of this call and quarterly slides can be accessed through the Investor Relations section of our website at investors.sprouts.com. During this call, management may make certain forward-looking statements, including statements regarding our expectations for 2021 and beyond. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information, please refer to the risk factors discussed in our SEC filings, along with the commentary on forward-looking statements at the end of our earnings release issued today. Our remarks today include references to non-GAAP measures. For a reconciliation of our non-GAAP measures to the GAAP figures, please see the tables in our earnings release. In addition, because our results for the second quarter 2020 were significantly impacted by COVID-19, this presentation will also include certain comparisons to results in the second quarter of 2019. With that, let me hand it over to Jack.

Jack Sinclair, CEO

Thank you Susannah and good afternoon everyone. Thank you for joining our call today. In early 2020, we started a new strategy that significantly improved our financial performance, which is now strong and sustainable. Although we still have work to do, I am thrilled with the progress we have made and our continued strong profitability this year. Due to the pandemic, our results are down from last year. However, our year-to-date 2021 sales are up 9.5% and our profit is up 36% compared to the same period in 2019, before the pandemic. We have made significant advancements in executing our strategic priorities. We have a unique model and an excellent team in our stores, which gives me confidence for the future. We are creating innovation centers with dedicated merchandising displays, increasing seasonal and local produce, opening two new fresh distribution centers, and launching our first new format store in July, all of which are driving our strategy forward. We plan to roll out innovation centers in all our new and many existing stores later this year. Monthly, these displays will highlight new market-driven items like Vegan Rob's Butter Popcorn, plant-based Wicked foods, and organic Sacha Inchi seeds. We're also starting an active sampling program, a new initiative for Sprouts, to encourage education, trial, and purchase. We are focused on why customers love Sprouts' produce. Our produce pricing remains extremely competitive, with prices significantly lower than the market average. Our recent cherry season showcased over five varieties from unique family-owned farms, highlighting distinct flavor profiles compared to standard red cherries. We excel in providing great produce deals and are improving further with the addition of two new distribution centers this year. Organic produce now accounts for up to 35% of department sales, one of the highest penetration rates in the industry. Our organic produce prices are very competitive, and we are working to align some organic prices with conventional items to distinguish Sprouts clearly. On the supply side, our Aurora, Colorado distribution center is performing well, and our Florida distribution center just opened in June, enhancing our connection to farmers' markets. We now have over 85% of our stores located within 250 miles of our distribution centers. Our sourcing practices, along with strong relationships with local growers, help us provide the freshest produce to our customers year-round. Since the Colorado distribution center's addition, we have seen increased produce sales in this region due to fresher produce and larger local selections recognized by our customers. Specifically, our ripening rooms for bananas and avocados in Florida and Colorado have significantly improved sales for these products. During the peak summer season in Colorado, our local sourcing has increased tremendously, expected to reach 20% of the department, a 300% increase over previous assortments. With the addition of the Florida distribution center, we will offer a broader range of affordable local organics and locally grown items during the fall growing season. Building this enhanced fresh supply chain has yielded benefits this year, which will continue to grow as we cycle through regional growing seasons and expand our business. Overall, this segment of the strategy is well-positioned as we move into the latter half of the year and start leveraging the proximity of our distribution centers to our stores. Our 35,000 team members in our stores are doing a commendable job. We have restructured our store leadership to better manage operations. In-store changes ensure that our team members can spend more time serving customers. As planned, we opened one store in the second quarter in Reno, Nevada. In line with our plan, we have opened two more stores in the third quarter so far and remodeled one of our California stores, two of which are in the new format. These new formats will facilitate exploring unique and attribute-driven products for our health-conscious and food-focused customers. Enhancements include new signage and décor reflecting Sprouts' branding, an expanded frozen department with over 115 new easy meal solutions, including meat alternatives, and a larger refrigerated section for the latest plant-based foods. Notably, this new format features a smaller footprint but more selling space per square foot, similar to our original Southern California stores. The smaller size is efficient, keeping produce central to the store while maintaining an open layout and treasure hunt shopping experience. These stores cost 20% less to build and are expected to generate similar sales to our existing stores, leading to higher returns. We plan to open three more of these new format stores nationwide this year. Despite these advancements, sales were slower than anticipated in the second quarter. While April showed strong results, we were disappointed with May and June, as customers returned to traveling and dining out. In this context, our marketing efforts did not drive as much traffic as we hoped. However, our brand campaign successfully reached more target customers and raised awareness and purchase intent, which is a crucial first step, although more work is needed. We are implementing three changes moving forward to refine our marketing mix with a test-and-learn approach aimed at converting awareness into increased traffic. Given our strong basket performance, we only require a modest increase in customers to achieve our long-term strategic goals. Let me share what we have planned. In the third quarter, we are focused on enhancing our marketing to drive traffic through targeted offers, unique partnerships, and continued brand awareness efforts. We are engaging customers who know us through more touchpoints to build loyalty. We are using mail campaigns to highlight our seasonal produce offerings, as well as promoting new products such as our 100% grass-fed Angus steaks and exclusive offerings at Sprouts. We continue to provide weekly specials online through a digital format supported by extensive media campaigns. Additionally, we are expanding our digital coupon program for Sprouts account holders to encourage product trials, drive traffic, and grow our customer database. We are creating an innovation network by partnering with emerging vendors in the food industry, such as GloSlim SpiceFruit, which generated immediate customer interest and traffic in the vitamin department after being featured on a magazine cover. We are also collaborating with other vendor teams to become the primary destination for their products. Before I turn it over to Denise, I want to recognize the remarkable work our teams in stores, distribution centers, and the support office continue to do week after week as we expand our business in markets nationwide. Our strategic initiatives are laying a solid foundation for us to maintain our position as a highly profitable specialty grocer with strong unit growth, making me confident in our ability to deliver the growth and returns outlined in our five-year strategy.

Denise Paulonis, CFO

Good afternoon everyone. For the second quarter, we generated adjusted diluted earnings per share of $0.52 compared to $0.59 in 2020. Compared to the second quarter of 2019, earnings per share was up 73% as we continued to maintain our improved margin structure and make decisions rooted in positioning Sprouts for long term profitable health. For the second quarter, net sales decreased 7% to $1.5 billion and comparable store sales were down 10% compared to the same period last year. On a two-year basis, our net sales were up 7% compared to the second quarter 2019 and our two-year comp stack was nearly flat at down 0.6%. As a reminder, to account for the 53rd week in our fiscal 2020, we shifted each week back one week, thereby ignoring the first week of fiscal 2020 to better align holidays for comparison purposes. Because of this, the two-year stack will not be the simple addition of the two periods. More information can be found at investors.sprouts.com under Additional Reports, if needed. April sales started off strong, in line with our expectations and posting positive traffic. May and June experienced more challenges. As Jeff mentioned, we believe the reopening of restaurants, travel and people going back to the office contributed to the slowdown. Having said this, our basket remains strong, trending down only modestly since the first quarter of 2021, primarily due to lower e-commerce penetration. Our deli sales were strong in this quarter, partially driven by less buying trends, which nearly doubled and speaks to customers being back at work as well as an increase in prepared meal solutions like one pan meals. Vitamins experienced a marked improvement from the first quarter as our customers got back to basics with added proteins and sports nutrition. The benefit in ease of online shopping has remained relevant for a portion of our customers. For the quarter, e-commerce was 10.1% of sales, settling in the 9.5% range towards the end of the quarter. Compared to the second quarter of 2019, e-commerce sales have increased more than 350%. We have been absorbing additional costs associated with these services for over a year now. Importantly, for orders placed through the Instacart website, we are seeing about 50% of the transactions are for customers who have opted in to share their data with us. When combined with our own shop.sprouts.com, we are collecting meaningful customer data on around two-thirds of those who shop online. We are also working more closely with Instacart on analytics to support both our e-commerce and brick-and-mortar businesses. We believe the higher use of e-commerce for grocery isn't the only customer habit that has changed during the pandemic. To make sure we are driving business decisions on recent trends, we are currently performing new safe survey work to evaluate customer's habits in this post-COVID environment. For the second quarter, gross profit was $550 million and our gross margin was 36.1%, a decrease of 115 basis points versus the second quarter of 2020, in line with our expectations. This decrease was predominantly related to lapping opportunistic produce buys and exceptionally low shrink from elevated demand last year. Our efficient promotions, attractive everyday pricing and differentiated assortment continue to result in superior margins, which are up 330 basis points compared to the second quarter of 2019. SG&A costs decreased $52 million to $436 million or 28.7% of sales, leveraging 108 basis points compared to the same period last year. The majority of this leverage was attributed to lower COVID pandemic response costs, mainly incentive compensation as well as lower e-commerce expense. This was partially offset by sales deleverage. Compared to the same period in 2019, SG&A increased 14%. For the quarter, our adjusted earnings before interest and tax were $84 million compared to $96 million in 2020. Compared to the second quarter of 2019, adjusted EBIT increased 63% continuing with the positive step change in financial performance. Our interest expense was $3 million and our effective tax rate was 24%. Even with some sales leverage, we realized an adjusted EBIT margin of 5.5% trending well ahead of our 3.6% margin in the second quarter of 2019. We continue to generate strong cash flow from operations, $177 million year-to-date to fund future expansion and sales initiative. In the quarter, we invested $27 million in capital expenditures, net of landlord reimbursement, primarily for new stores. Additionally, we repurchased approximately $87 million in stock by the end of the second quarter. We ended the quarter with $250 million outstanding on our revolver, $39 million of outstanding letters of credit, $221 million in cash and cash equivalents and $213 million available under our current $300 million share repurchase authorization. Subsequent to the end of the quarter, we repurchased an additional $25 million in stock for a year-to-date total of $112 million. Reflective of a strong balance sheet, we continue to maintain a low debt position ending the quarter with a net debt to EBITDA ratio of nearly zero. Now let me provide an update on our 2021 outlook. As a reminder, I am giving these comparisons on a 52 to 52 week basis, as fiscal 2020 was a 53rd week year. The COVID backdrop is resulting in an ongoing flux in customer spending habits and continued consumer hesitation for doing multiple shops. While our basket has remained healthy this year, we haven't realized the growth in transactions that we originally planned. Because of this, we are reducing our topline expectations. We expect net sales to be down low single digits versus 2020 with comparable store sales down 5% to 7%. Our 20 new store openings for 2021, while inked and signed, may not be completed by year-end due to difficulties in securing certain equipment from third-parties because of supply chain delays that have been complicated by the pandemic. At this time, we have about seven store openings that may be delayed to 2022, although we continue to support options to open these stores by the end of the year. The good news is that our real estate pipeline remains strong and we continue to work towards our 10% unit growth goal in 2022. Similar to 2021, we expect our 2022 new store openings to be weighted more to the back half of the year. With the potential store delays, we now expect 2021 capital expenditures, net of landlord reimbursement, to decrease to the range of $110 million to $125 million. We continue to expect our corporate tax rate to be approximately 25%. Our scenario-based planning, which contemplated potential outsized sales volatility has served us well, resulting in our EBIT range remaining in line with our prior guidance of $305 million to $325 million. Due largely to shares repurchases in the second quarter, we are increasing our adjusted diluted earnings per share to be in the range of $1.90 to $2.02. We continue to expect to maintain a majority of the gross margin rate improvement we realized in 2020 with the next few quarters being slightly pressured as we cycle some COVID benefits we don't expect to repeat. In closing, we continue to remain confident in the strategic changes we began last year, which has structurally changed our financial algorithm for the long term. At this time, we are happy to take your questions.

Operator, Operator

Our first question comes from Krisztina Katai with Deutsche Bank. Your line is open.

Krisztina Katai, Analyst

Hi. Good afternoon, and thank you for taking the question. So I just wanted to start with the topline. I know you guys have a very different sales mix and a customer profile that you are targeting. But your two-year just turned negative for the first time, but industry data remains strong. So I am just curious if you could just talk about your level of confidence in the strategy that you are in indeed targeting the right customers in the right ways? And then I also wanted to get your thoughts, I believe Jack you talked about just fine-tuning your customer communication. So if you could just talk about what it is that you trying to do to really drive customer traffic?

Jack Sinclair, CEO

Yes. Krisztina, where we are at the moment is we are feeling very strong about the strategy in terms of the way it's flowing through in terms of what we have been at, what we have been doing and what we have been making it work. The encouraging thing a little bit is our basket, which we expected to decline a little bit more, hasn't declined. But our traffic hasn't grown. To be clear, that our traffic is kind of stable through the pandemic and there's a lot of noise in the pandemic. If you take it back to 2019 and that it today to 2021 on the Q2, our traffic went down through the pandemic as you would expect. Our traffic went down as you would expect because of the change in our promotional position and how we kind of went to market. We expected to lose some of those. As we said pre-pandemic we expected that. Since the last couple of quarters, we are seeing a pretty static customer base. So it's not like we are losing customers but we are not gaining them as fast as we would like them to do. And that leads to your second point, which is what are we doing to stimulate demand and stimulate that traffic. We are doing a variety of probably more call to action promotions as opposed to the kind of generic brand building that we did. We are very pleased with it. It's giving us good awareness scores, which has always been a problem for this business. It's also giving us good intent to purchase scores. But what it's not doing is translating itself into more people coming in, which we would have expected to have happened by now. We don't need that many more customers for the equation of this to work. From my point of view, as we look at different tactics and different calls to action to drive that traffic, because of the financial strength of our model now, we have got a lot of arrows in our quiver that are able to, we can deploy them and we are doing a number of things, testing a number of things in a number of different places, both regionally and different category approaches. That's what we are encouraged about going forward that we have got room to play and we are working on that. I am feeling pretty confident that the base that we have built in terms of the merchandising changes we have made, the supply chain changes that we have made, the real estate changes that we have made puts us in a strong position with the target customers. As we have said often on these calls, there are enough of those customers. We don't need many of them for this thing to look very dramatically different; the returns that we can get if we can get a few more customers in this really are exceptional. Thanks for the question.

Krisztina Katai, Analyst

Thank you. And just if I could just squeeze in a quick follow-up. Maybe if you could share what your performance is in recent weeks as we are looking at the third quarter? Your guidance assumes a reacceleration on the two-year stack. So how should we think about the cadence between the third and the fourth quarter there? We are starting to see some companies delaying the return back to office. Some of them are into 2022, which, in theory, could help you guys. I wonder if you could just kind of talk about some of your thoughts there?

Jack Sinclair, CEO

Yes. We can't discuss specifically about where we are at. You can look back and see the comparisons change a little bit. You get some of the comparison triggers mix that's a slightly different number going forward relative to what we have been in Q2. But we can't talk specifically about our current dynamics. With regard to a return to office, what we saw as people went back to the office, we certainly got a benefit on our daily business from that in terms of people being around and going in and buying those kinds of things as Denise alluded to in some of the remarks. What's going to happen, it's an uncertain time for us all. In terms of our own business, we had planned for everybody to be coming back in September. Now we think that's how the market's going to be. If it's delayed, then I think there will be a dynamic change in terms of how the customer reacts. We are trying to focus on driving the traffic within the strategy that we have outlined. I don't know what's going to happen with the offices and whether people will return or not. If the offices close down again, then it will make a difference in terms of how traffic and basket get plays into our stores.

Operator, Operator

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

Scott Mushkin, Analyst

Hi guys. Thanks for taking my questions. So, I guess the first one. I was going to poke at the sales issue because it's the elephant in the room. I wanted to talk about the differences, if there are differences, where you have more density, Jack, like Southern California and Phoenix where the brand is really well known, and compare that to less dense areas. Is there a difference?

Jack Sinclair, CEO

In relative terms, no, there's not a huge difference across the different marketplace. But in absolute terms, where you are starting from is different in different marketplaces, as you allude to, Scott, Southern California, Denver, some of the other markets where we are more established in Los Angeles and beyond. We are seeing, as I said, the encouraging thing for us is that the basket is holding up in those places or the basket is not going down by as much as we would have expected it to do. The traffic dynamic that's happened in those areas isn't really a surprise to us as it went down because in 2019 we were pretty clear during Q2 2019. That traffic was there. A lot of that traffic was coming in response to the weekly promotional cadence that we had, very aggressive pricing on the low margin. Changing that, we did see a reduction in traffic that gets all confused by the noise of COVID, which probably takes it down further. We expected our traffic to have bounced back harder in those places. That's back to what we need to do in terms of building the clarity of our messaging and the immediacy of what's required. We are not seeing a significant difference across the different marketplaces.

Denise Paulonis, CFO

I would just add the point. What we do know is, we just started at different water levels. Some of our California stores are just much higher volume starting stores than perhaps our Florida stores. But to Jack's point, the relative change is not materially different across the regions.

Scott Mushkin, Analyst

And as a follow-up question, when you say call to action, Jack, that's just getting a little bit more promotional? Or how do we think about it? And any thoughts on how this Tucson store is doing so far? I know it's only been a month or so, but I’d love to understand how the new formats, even though it's a remodel performing?

Jack Sinclair, CEO

Tucson was a little bit of a remodel, Scott, as you know. The new one that we have opened in Phoenix, which we are very excited about, we opened 10 days ago or something like that. So it's early days. We are very encouraged by the customer reaction to the changes that we made in Tucson. We got a lot of positivity. The encouraging thing for me with regard to that is the way customers are saying, well, I thought you were now building smaller stores, but it feels bigger and that's certainly the feedback from the Phoenix store, which we built at 23,000 square feet. People in Phoenix know our business well and they actually think the store is bigger. So that's encouraging in terms of doing that. It's too early in the absolute level of the numbers. Call to action will be less about very direct product and price high-low kind of drivers. It will be much more about driving people to the offer and the proposition that we have whether it be plant-based, whether it be on our new meat assortment in terms of our whole Angus and grass-fed beef assortment. It will be much more about how do you tell the story and give value against our vitamins and herbal business, and give value to our bulk as we relaunch our bulk. It will be more about category and aggressive, in some ways. And we’ve got some resources to do that. So it will be aggressive there. What it won't be is a return to 10 for $1 corn.

Scott Mushkin, Analyst

Perfect. Thanks guys. I appreciate it.

Operator, Operator

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

Tom Palmer, Analyst

Hi. It's Tom Palmer, on for Ken. Thanks for the question. I just wanted to follow up on the promotional discussion. Do you think if you chose to, you could drive traffic with heavier promotions? Just in the current environment, are promotions as effective than they have been in more normal periods? Just trying to understand how you think about that potential lever as you reach out to customers?

Jack Sinclair, CEO

Yes. I think it's a good question about whether the dynamics have changed. I think the holidays are competitive. I would want to call them the mainland groceries are certainly going back to more aggressive promotions around the holidays on products that we do in sales. I think there may be some evidence that that can drive some traffic in the post-COVID world, as a kind of ending of the COVID world. Could we drive traffic by going back to aggressive pricing? Probably. Would it be the wrong people coming into these doors? Probably. Would it help us? Probably not. So our whole business is about driving the traffic of the target customer base and winning dollars and market share from that target customer base. That's the call to action that we are putting in place. The last thing we want to do is drive in very little profitable customers who just come in for the deals, which is where we came in a couple of years ago and that's why the comparison to 2019 Q2 and the Q2 in 2021 works for me in terms of understanding our business. We have reshaped the whole proposition and targeted against specific customers who appreciate the differentiation that we have so that we are not going head to head with anybody on pricing or promotions. We just need to win some dollars to drive the transactions. To answer your question, we could probably get traffic back in, in terms of the wrong traffic. But it doesn't feel like that would be the right place because we go back to making a lot less money as well.

Tom Palmer, Analyst

Okay. Understood. And then just on the store delays. So with some of the 2021 openings pushed to 2022, you indicated that 2022 could be back-end loaded. Could we expect some of these stores to then just get pushed into 2023, given the bandwidth constraints? Or if those stores get pushed, should we think about 2022 being 10% unit growth plus whichever portion of the seven stores get delayed?

Denise Paulonis, CFO

Great question. We actually keep the two pieces separate. We continue to be optimistic about our core 2022 pipeline in terms of deals that we have in the works and getting to that 10% new store growth that we wanted. Any impact that happens with up to these seven stores from 2021 is a separate outcome than what would be in 2022. So if some of them push, that would make the 2022 number bigger, not really be a replacement and then a belief that 2022 would push out. Just as folks understand, the delay in the stores that we have is really tied to some of the refrigeration equipment and some of the inputs that go into how those get installed into stores. We are working hard to find alternatives to just some supply chain constraints in some of that product inputs being able to come through. We don't expect that this is going to be a long-term sustainable issue for our own capacity to build the stores; it's just a near-term supply chain constraint.

Jack Sinclair, CEO

With some of these, I think we could have done differently if we had known. So we have not given up on those seven stores yet. So we will see where that plays over the next few weeks.

Operator, Operator

Our next question comes from Robbie Ohmes with Bank of America. Your line is open.

Kendall Toscano, Analyst

Hi. This is Kendall Toscano. I am on for Robbie. Thanks for taking my question. I was just wondering if you guys could give us any color on how SG&A performed during the quarter versus maybe what you were expecting? I guess as a percent of sales, were you expecting it to be down as much as it was? Or should we still be thinking about a flat rate of sales for the year?

Denise Paulonis, CFO

Yes. So in reverse order there, we are still expecting to have a flattish rate of sales for SG&A for the year, as we had expected throughout the year. The quarter did come in as we expected. The two main drivers of the health in the quarter were the lapping of a number of the COVID-related compensation and incentive items that were in place last year that we knew would come away and come out of the model this year. Secondarily, as we were expecting, we saw a little bit of a trickle down in e-commerce penetration, which then reduced some of the e-commerce fees in the model as well. So very much in line with expectations and do expect the full year to be flattish as we look to the close of 2021.

Kendall Toscano, Analyst

Got it. That's helpful. Thanks. And then just kind of as a follow-up on the two-year same-store sales trends. Apologies if I missed this. But should we still be thinking about an improvement on a two-year stack each quarter, moving past 2Q?

Denise Paulonis, CFO

Yes. I would say the way that we really are thinking about it right now is what we gave in the minus 5% to minus 7% comp. We are going to come up on an easier comparison to last year as we work through Q3 and Q4. So that's really what's factored into the baseline that gets us for the minus 5% to minus 7% for the year.

Operator, Operator

Thank you. Our next question comes from Greg Badishkanian with Wolfe Research. Your line is open.

Spencer Hanus, Analyst

Hi. This is Spencer Hanus, on for Greg. Can you just comment on personal basket shopping? When do you think that's going to get back to pre-COVID levels? You guys aren't the only retailers that have experienced some loss of shoppers as people consolidated trips. Walmart comes to mind as another big one that's faced some challenges there. What do you think is a strategy that the industry uses to sort of get those shoppers back? Is it price driven? Is it more focused on advertising? Just how are you thinking about that? And then in terms of your value scores with your core customers, how has that sort of changed over the last few quarters?

Jack Sinclair, CEO

Yes. That's both good questions. I think what happens will be driven by COVID and the customer behavior. That customer behavior, I am not sure retailers will influence that because really over the pandemic. It's not really been the retailers behavior that's influenced a lot of what's happened. It's been the customer behavior and how they do view the context that we are in. It's clearly, we had expected, a few weeks ago we had expected to be in a different place today relative to where we were then. Who knows how people are going to play out with it? Now what will the retailer do to try and attract traffic within that environment? I think it will be about trying to invest in some kind of promotional techniques to try and get people back, probably using loyalty and data information more effectively than we have had.

Denise Paulonis, CFO

The fresh side of the business, we have really not seen anything material on the non-perishable side of the business to date.

Operator, Operator

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

Mark Carden, Analyst

Good afternoon. Thanks a lot for taking my questions. So last quarter you noted that you are starting to see some customers trickle back in that may have been consolidating their trips with the Kroger's and Albertsons' of the world during peak COVID. It sounds like some of this has stagnated a bit with the Delta variant. Does it become harder to get these customers back as they become more used to shopping for natural organic at the competitors, maybe get more from their loyalty programs? And does it change your strategy at all for getting them back?

Jack Sinclair, CEO

I don't think we have lost any of those customers who are interested in natural and organic and interested in our proposition or not. The data would suggest our traffic stayed pretty flat with that type of target customer. The customers that we lost, notwithstanding the consolidation part, the customers that we lost were what we call the coupon clippers, the people who weren't particularly dynamically interested in our proposition. The challenge for us going forward is not so much, can we get them back from Kroger? It's how we can get a message out to those customers who have an affinity to who we are but we haven't got them in the store. If it's simply COVID that has done that, I think that will happen automatically. If it's not COVID that has done it, I don't perceive that the challenge because the proposition, if you have gone to Kroger and you saw that they have got some organic things, our pricing on produce, the differentiation from vitamins and herbal, our bulk assortment, the attribute-based products, our frozen food business, 90% of what we sell in frozen foods is different to what I can walk around any supermarket. We couldn't access it. As the people who are not shopping, whether it's because of COVID, they will come back on the basis of the differentiation that we have got. We have to give them a call to action to do that.

Mark Carden, Analyst

Got it. That's really helpful. And then on your digital customers. What's the breakdown between delivery and curbside? Is it still skewing really primarily towards delivery? Any major differences in shopping habits between the two? What are you seeing in spend per customer? I am curious what you have seen on that front?

Denise Paulonis, CFO

Yes. Overall it still skews very heavily towards delivery. We just have a nature of a different product that comes in. People aren't coming to us for curbside, for the convenience of not carrying out 24 packs of water and huge packs of toilet paper. Delivery resonates better with our customers. A nice portion comes through our owned website versus through the Instacart marketplace. In terms of the overall difference of the customer, the e-commerce basket remained significantly higher than an in-store basket, which makes a lot of sense. When people are paying for that delivery process, they want to take advantage of it. The basket is almost double what an in-store basket would be. Very healthy business there. E-commerce stays pretty sticky. We talked about 10% for the quarter, only trending down to about 9.5% by the end of the quarter. We will watch the volatility that might come with the Delta variant over the coming weeks and see if we see any change in trend, but it seems to be well embedded into the shopping habits of our customers right now.

Operator, Operator

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

Erica Eiler, Analyst

Good afternoon. This is actually Erica Eiler, on for Rupesh. Thanks for taking our questions. I wanted to switch back to your new unit growth here. Clearly the team is very focused on opening new stores. But on the flip side of that, comps clearly remain challenged. Can you talk a little bit about why you are still being fairly aggressive on the new store front when the core business remains challenged? At what point do you say, hey, let's put on the brakes and maybe focus a bit more on driving comps and turning around that core business?

Jack Sinclair, CEO

We have been pretty clear about why we are in that place strategy-wise. What we had as a business, we have lost some traffic in the course of the two years on the back of the change in strategy. We have identified the target customer base that we need and it's a pretty small number. We have been pretty modest in our comp expectations going forward. We didn't need crazy comps for the economics of this thing to work as you can see from the earnings we are delivering. If you can deliver superior returns on a relatively modest comp base, then the opportunity for us comes with building a lot of stores in places where we don't exist. There are many of those and we are trying to ensure that our distribution centers will support that program of growth. The opportunity is that we can build the stores much cheaper, get them in front of customers in a smaller footprint, and drive pretty significant returns. When we look at the pipeline for 2022, 2023, all kind of smaller stores relative to where we have been and the returns we can get on relatively modest topline give us a growth potential that is unique. I am not sure that going back to try and chase the wrong customers to get comp in our existing store base and abandoning the program of new stores would generate the returns or cash returns we can get going forward. It’s based on the premise that the customer is more interested in healthy options and diets than they have been. They will be more interested in that going forward. We have a unique proposition that nobody else can or would want to do because we are narrow in what we do. That narrowness allows us to target and build stores smaller in the right places.

Erica Eiler, Analyst

Okay. I appreciate all that color. Just clearly a lot of pressure points out there on the cost side. Can you maybe talk about some of the cost pressures you are seeing in your business right now? Labor, transportation? And how you are thinking about the levers you have to pull on to manage through them?

Jack Sinclair, CEO

Yes. First of all, let's talk about the labor and stores. I think one of the things I have said in previous calls is that we are relatively inefficient in our use of labor. The things we are doing will mitigate some of the labor pressures. We start from a higher base than most. We have introduced self-checkouts and a lot of our stores are now rolling that out fast. Our replenishment in terms of getting product from the back door to the shelf has a lot of systems in place to reduce the costs that hours we need to run our stores. Filling shelves and taking the money through the register— we are inefficient in the hours we use. There are opportunities for us to mitigate some of the pressures that are coming on labor. Regarding transportation, I am pleased that we have built the distribution center in Colorado so we didn't have to drive from Arizona to Denver for the product. I am also pleased with our distribution center in Orlando. Our transportation pressures are real, and we think we are mitigating them pretty well. Denise, do you want to add to that?

Denise Paulonis, CFO

Jack said it well, and I think for all those pressures coming forward, you can still see the profit that we are delivering through the company. The realization we have the cost saves to offset some of those pressures is evident in the results.

Operator, Operator

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

Renato Basanta, Analyst

Hi. Good evening. This is actually Renato Basanta, on for Karen. Thanks for taking my questions. My first question is on gross margin. This year, it looks like you have been able to hold on to much of the increases you saw in 2020 versus 2019, which is in line with what you have guided to. But in the second half, it looks like your guidance implies much less of an improvement on a two-year basis. I wonder if there's anything unique to the second half in terms of pressure that you may be expecting? Any color there would be helpful.

Denise Paulonis, CFO

I would reinforce that we do believe we will hold the vast majority of the gross margin gains that we had over the two-year cycle. The one thing that you might think about on the two-year basis is that, remember, some of the improvements in margin actually started in the fourth quarter of 2019. Jack joined us just before that at the beginning of the third quarter and started rolling some of the changes. The fourth quarter was the first quarter where you would see some of the pullback of the very inefficient promotions. That’s why you will just see a little bit less of a full two-year stack gain in the fourth quarter than the balance of the year, only because we captured it a quarter earlier.

Operator, Operator

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

Chuck Cerankosky, Analyst

Good afternoon everyone. First question, if we are looking at customers who might have reduced their visits to Sprouts, do you see any demographic reasons, income reasons that they might be the same customers who were dining out more?

Jack Sinclair, CEO

I don't think I really know the answer to that, if I’m honest. The way we look at what's happened are two things—the consolidation from COVID and the reduction on traffic over two years from the change in strategy. The customers we lost were those who were interested in low pricing on fresh foods we were advertising aggressively. The challenge for us going forward isn’t can we get them back from Kroger; it’s how we can get a message out to those customers who have an affinity to who we are, but aren’t in the store. I think that will happen automatically if it’s simply COVID. If it’s not COVID, the challenge isn’t that those customers have gone to mainline supermarkets; it’s in the value we provide. Our basket has held up when customers do come in, whether from a little bit of baking or cooking or meals. We are seeing strength in our dairy business which suggests the value proposition.

Denise Paulonis, CFO

And the one thing to consider is knowing that we have seen some strength in April and that was the beginning of the reopening, but May and June, I think we would all say whether we experienced it or read about it, restaurants became busy again and travel increased significantly. I have to believe that was relevant to our customer base.

Operator, Operator

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

Kelly Bania, Analyst

Hi, thanks for taking our questions. First, I just want to be clear and I apologize if I missed this, but just want to make sure we understand exactly what is coming in better on the margin front for you to maintain your EPS range despite the lower comp outlook? I just want to be clear on that.

Denise Paulonis, CFO

When we planned at the beginning of the year, we had different levers that we would pull. You can look and say which projects and how fast might they move, how fast can we move on shrink, where can we drive efficiencies and labor in stores. What we're really doing is pulling levers available to us. We are not stopping progress on anything that is core to the strategy. But we are really prudent throughout the P&L in terms of maintaining the gross margin gains from last year and in the way that we wanted to do. We're managing distribution costs and taking advantage of the fact that we have the two new DCs and transportation costs off the road.

Operator, Operator

And this concludes the question-and-answer session. I would now like to turn the call back over to Jack Sinclair for closing remarks.

Jack Sinclair, CEO

Yes. Thanks everybody for taking the time to listen to us. We are excited about our business. We appreciate you taking the time to spend some time listening to us today. So take care, everybody. Appreciate your time.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.