Sprouts Farmers Market, Inc. (NASDAQ:SFM) Q3 2023 Earnings Call Transcript

Sprouts Farmers Market, Inc. (NASDAQ:SFM) Q3 2023 Earnings Call Transcript October 31, 2023

Operator: Thank you for standing by. Welcome to the Sprouts Farmers Market Third 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. [Operator Instructions]. 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.

Susannah Livingston: Thank you and good morning, everyone. We are pleased you are joining Sprouts on our third quarter 2023 earnings call. Jack Sinclair, Chief Executive Officer; Chip Molloy, Chief Financial Officer; and Curtis Valentine, Senior Vice President of Finance are with me today. The earnings release announcing our third 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.

Jack Sinclair: Thanks, Susannah, and good morning, everyone. I’m pleased to announce another solid quarter for Sprouts Farmers Market. Our 31,000 team members’ commitment to serving our customers, embracing operational excellence and cross-functional teamwork drove comparable store sales growth of 3.9%, total sales growth of 8%, and adjusted earnings per share growth of 7% in the third quarter. Four years ago, we shifted our strategy. We started by defining our target customer segments, health enthusiasts and innovation seekers. Those two segments constituted a $200 billion marketplace in the United States, and we believe we could be the market leader in that space. We then set out to reach more of those customers by providing them with differentiated products and experiences that fulfill their needs and desires.

During our journey, we focused on several critical initiatives, including developing a smaller, more profitable store prototype and accelerating store growth, while evolving an efficient supply chain that provides more freshness. We focused on innovation in our assortment with a strong bias toward our differentiated Sprouts brand portfolio. We expanded our omni-channel strategy and also shifted our marketing approach from weekly unprofitable discounts to messages highlighting our differentiation. Additionally, we focused on implementing systems and processes to improve our operations, better utilizing store labor, and developing talent across the organization. We’re beginning to see the fruits of those investments and they are driving our performance.

However, there is still plenty of work to be done to capture the opportunities in front of us. We remain focused on improving all aspects of our business. In a moment, I’d like to turn it over to Chip, who will provide a closer look at our third quarter financial performance and outlook for the remainder of the year. Before doing so, I want to congratulate Curtis Valentine, our current Senior Vice President of Finance, who will take over as our new Chief Financial Officer on January 1st, 2024. Curtis has been with Sprouts for over eight years and possesses a wealth of retail experience. Our Board of Directors, Leadership team and team members greatly respect and support Curtis, and we all anticipate a seamless transition. I want to congratulate Chip on his upcoming retirement and acknowledge his positive contributions to Sprouts, as a member of our board and executive leadership over the last 10 years.

I am grateful for his partnership as we ushered in a new strategy and more importantly, his friendship. Since I have been at Sprouts, I wish you all the best. With that, I’ll turn it over to Chip Molloy for what he says is his career’s 40th and last earnings call.

Chip Molloy: Thank you, Jack. I appreciate the kind words. For the third quarter, total sales were $1.7 billion, up $122 million or 8% from the same period in 2022. This increase was driven by comparable store sales growth of 3.9% and the addition of new stores. Comp transactions are proxy for traffic for positive every period of the quarter in stores and online. While as expected sequential increases in average unit retails and decreases in units per basket lessened. As we progressed through the quarter, our E-commerce sales grew 16% during the quarter, representing 12.1% of our total sales, and we opened 10 new stores. For the first three quarters of the year, we’ve opened 24 new stores all in a new prototype, acquired two previously licensed stores, and closed 11.

We ended the quarter with 400 in one store. From a category perspective, both perishable and non-perishables produce positive comp sales with particular strength in meat, grocery, dairy, and frozen. The quarter’s performance was also supported by veteran stocks, especially on our Sprouts brand products. Sprouts brand sales grew 14% and represented 20.5% of total sales. As we continue to grow this innovative category of products only found at Sprouts. Unlike traditional grocers’ private labels, our Sprouts brand is positioned as better for you, high-quality, and attribute-friendly. The value of the Sprouts brand resonates with our core customers, as we continue to receive recognition and rave reviews. For example, the Sprouts brand organic vanilla creamer went viral on social media this past quarter for containing only four ingredients all of which are considered clean, which is unheard of in the creamer space.

Turning to gross margin. The third quarter gross margin was 36.5%. Excluding the impact of special items, adjusted gross margin was 36.6%, a decrease of approximately 10 basis points compared to last year. Slightly favorable merchandise margins were offset by expected pressure from our new and recently expanded warehouses in California and Texas. SG&A for the quarter totaled $503 million, excluding the impact of special items, adjusted SG&A totaled $502 million, an increase of $41 million, representing approximately 30 basis points of deleverage compared to the same period in 2022. This expected deleverage was predominantly driven by new store openings, wage increases, and labor investments in our Store Sampling program. Like most retailers, we expect wage increases to continue to imply some pressure for a couple more quarters when compared to the previous year.

However, we are beginning to see labor markets loosen and wages stabilizing sequentially. Door closures and other costs totaled approximately $3 million for the quarter, while depreciation and amortization, excluding depreciation included in the cost of sales was $32 million for the quarter. Our earnings before interest and taxes were $88 million for the quarter, while interest expense was $2 million. Net income was $65 million and diluted earnings per share were $0.64. Excluding the impact of special items, adjusted earnings before interest and taxes were $90 million and adjusted net income was $67 million. Adjusted diluted earnings per share were $0.65, an increase of 7% compared to the same quarter in the prior year. Our cash flow and balance sheet remain strong.

During the third quarter cash generation of $114 million allowed us to continue to invest in our business. We spend $64 million in capital expenditures net of landlord reimbursements. We also paid down $25 million of our bank revolver and returned $32 million to our owners by repurchasing 831,000 shares. We ended the third quarter with $252 million in cash and cash equivalents, $150 million outstanding on our $700 million revolver, and $22 million of our outstanding letters of credit. As we evaluate our expectations for the remainder of the year, we continue to monitor customer spending and behaviors in the mixed economic environment. For the full year, we expect total sales growth of approximately 6.5% to 7%. Comp sales growth of approximately 3%, adjusted earnings before interest and taxes between $387 million and $393 million, and adjusted earnings per share of between $2.77 and $2.81, assuming no additional share repurchases.

That said, we do expect to continue repurchase shares opportunistically. We are on-track to open 30 new stores this year, all of which are in our smaller, more cost-effective current prototype. Capital expenditures net of landlord reimbursements is expected to be between $190 million and $210 million. For the year’s fourth quarter we expect comp sales of approximately 3% and adjusted earnings per share between $0.42 and $0.46. But before turning it over to Jack, I too would like to congratulate Curtis. I’ve worked with Curtis for a very long time at multiple retailers and am confident he will serve this company and shareholders well for many years. I also want to thank my 31,000 teammates, our Board of Directors, and Jack for allowing me to play a small role in the Sprouts journey.

With that, let me turn it back to Jack. Jack?

Jack Sinclair: Thanks Chip. Our results signal the alignment of our merchandising, marketing, supply chain, and operational initiatives propelling our strategy forward. The management team we have built up over the past few years is growing together and our efforts are paying off. I’m particularly delighted by our solid traffic growth throughout the year. We are steadily making progress on the unit growth front. In 2021, we opened 12 stores in 2022, 16, and this year we’re on track to open 30 all in the new more cost-effective prototype. Our pipeline remains strong with nearly a hundred approved stores, 60 executed leases, and the expected opening of approximately 35 stores in 2024 with close to 70% in the back half. Our supply chain continues to evolve and improve.

Our new Southern California DC is now fully operational and already improving freshness to our largest market. Our ripening rooms added in Arizona, Texas, and our new California DC this year increased sales and margins in avocados and bananas. Together with the stores, the teams have enhanced their processes with the help of added systems leading to better in stocks and forecasts. As we continue to expand east, we’re closing our Georgia DC, optimizing our Florida DC network for more scale, and ensuring freshness with a new partner in the Northeast. We continue to focus on innovation and differentiation, which sets us apart from other food retailers. As Chip noted, our Sprouts brand grew 14% in the third quarter as we launched new meals, snacks, beverages, and seasonal items.

Sprouts brand seasonal assortment expands yearly, bringing back classics like pumpkin spiced apple cider, and adding new items like our gluten-free mini maple cookies making us more relevant each holiday. Additionally, we’re one of the fastest-growing retailers of grass-fed beef making up over 50% of our beef sales. We continue to expand in categories like frozen with the release of our daily free pros and desserts, and we have revitalized sampling to drive customers to rediscover these items and other gems like our unique chili lime rolled tortilla chips. As well our innovation center is becoming more popular as we highlight new vendors and products. We highlighted mocktails for dry July to great fanfare, taking advantage of this growing trend.

Our merchants are rising to the challenge of bringing these products to life in the store and online. New category management capabilities have helped us analyze more trends and insight data to understand customers’ shopping habits and desires. Our teams are planning earlier and aligning the organization even stronger behind key themes and seasons like Back to School, which was up high single digits this year. These events reflect our unique customer mindset as they think and shop differently when they come to Sprouts. As this quarter progressed, these changes resulted in improved brick-and-mortar traffic. Digital and online marketing have been leaning heavily into video and social, emails and searches, in telling our unique story. Marketing hand in hand with merchandising has been driving our salt to buy Sprouts campaign, which ties into how our products address our discerning customers’ needs.

E-commerce has remained solid at over 12% of our total sales, a dramatic increase from 2% in 2019. Our research shows an online delivery customer is a valuable omni-channel customer, as nearly 80% of our online customers also shop in store. And as a bricks and mortar customer starts using e-commerce, their spending increases more than 30%. Our awareness scores have also seen a 10% lift since the beginning of the year. All these initiatives have resulted in more frequency from our existing customers and growth in new customers. We are in the early days of our digital initiatives, but are encouraged by the initial results. In-store, improved operational systems, aided ordering and planning. As Chip mentioned, our in stocks are improving and our store teams are delivering our objectives.

In stock sampling and service stores were added to the store goals at the start of the year, resulting in the highest customer service stores in our company’s history. Since 2019, we’ve invested almost $400 million in our team members in the form of increased wages, training, and bonuses, resulting in improved retention and enhanced store experience for our customers. We are also in the midst of developing a loyalty plan to further engage our customers. Our initial research told us our customers strongly desire a program from Sprouts. They want a program that helps them live and eat better, while driving our innovation and differentiation for them to explore. We’re working through the structure and expect to release a summer pilot next year.

In the meantime, we continue to build more muscle around personalization with added data and improved knowledge. Overall, our results demonstrate that our strategic initiatives are taking hold as we become a leader in the natural and organic space. When we recently asked why customers shop at Sprouts, they said, we own natural and organic and we carry differentiated products. This sentiment is precisely what we wanted when we started this journey four years ago. We still have a lot of opportunities to grow, but all our combined efforts are beginning to resonate with our customers. With that, I’d like to turn it over for questions. Operator?

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Q&A Session

Operator: [Operator Instructions]. Our first question comes from the line of Ken Goldman from JPMorgan. Your question, please.

Ken Goldman: Thank you. Good morning, everybody. Just curious if we could get a little more detail on how you see the path ahead for your gross margin. This was the first quarter in almost two years in which it didn’t expand year on year. It’s still doing quite well, obviously, but just curious how we think about or should think about modeling into the fourth quarter. And I know it’s a little early to talk about 2024, but any basic thoughts you would have on that line item would be helpful.

Chip Molloy: Yes, Ken. This is Chip. We are really confident that we can manage the gross margin right around flat. This quarter, it was down 10 bps, that was really a drag from the expansion of our distribution centers, both in Texas, as we said on the call of Texas and California. There is a little deleverage there. But our merch margins are hanging in there. In fact, they were up some and steady and traffic is up. So, we feel good about that. And our merchs are really laser focused between mix and pricing, et cetera, that we think will remain flat next year.

Ken Goldman: Thanks. And just a quick follow-up. How is the competitive environment right now within produce? Are you seeing anything unusual in terms of competitors discounting, doing anything to gain customers in a way that might not be rational?

Chip Molloy: We haven’t seen anything irrational so far, Kenneth, and produce has always volatile categories. So, things go up and down in different parts of the category, change at different times. but we have certainly not seen any significant investments from anybody in the produce space.

Ken Goldman: Thanks, so much.

Chip Molloy: Thanks, Ken.

Operator: [Operator Instructions]. And our next question comes from the line of Leah Jordan from Goldman Sachs. Your question, please.

Leah Jordan: Hi, good morning. Thank you for taking my question. I just wanted to ask a follow-up around gross margin. Understand the pressure from the warehouse expansion. But just curious, what was the biggest surprise since it did come under a little bit to your flat guide? And then how did promotions track to your plan? And I guess when should we start thinking about your ability to leverage the warehouse expansion costs and when store growth support that?

Chip Molloy: Leah, it’s Chip. So, the gross, as it relates to any surprise, we did guide to flat. I mean, it was de minimis plus to flat, could be plus 10 or minus 10, that’s the way we look at it. Any surprise there? Shrink was a little higher, nothing scary. We are a pretty low-shrink business in general. It was a little higher than we expected. But other than that, our — is really solid. As I said, they continue to stay solid. The D&T will continue to be a drag for probably a couple of quarters. And so, we will have to manage through that. The merchants are working hard to try to manage through, and we feel really confident. I suspect Q4 might look similar to Q3. We might be flattish to maybe down a couple of basis points. And then going into next year, we are feeling pretty good that we can manage around that to be really close to flat.

Jack Sinclair: And, Leah, we are very confident in the investment in our distribution centers is going to pay us dividend in the long run in terms of both the capabilities of driving freshness to the customer. And in terms of getting our costs, long-term costs done.

Leah Jordan: Okay. Thank you. And then my follow-up is just on quarter-to-date trends. If you could provide any color there, just as your guide implies some deceleration.

Chip Molloy: So, we are guiding to about a three comp, and so we feel really good. I mean, we are one month in and feel solid around that three comp, and we will keep working towards there.

Operator: [Operator Instructions]. And our next question comes from the line of Rupesh Parikh from Oppenheimer. Your question please.

Rupesh Parikh: Good morning, and thanks for taking my question. So first on new stores, as we look at new store productivity, at least how we calculate, it was above our expectations. So curious how new stores are forming versus your internal expectations? And then what your specific new store productivity calculation is.

Chip Malloy: This is Chip. So, we don’t, there’s a timing if you’re looking at any given quarter and trying to look new store productivity because of the timing of when they open it can throw the numbers off. So, as it relates to us, we’re just looking on average, we look on average how is our sales per square foot averaging, considering that we’re putting new stores in the ground. And we’re doing that, we’re continuing to see that stay relatively flat despite the fact that we’re accelerating our store growth at lower volumes. And we look at how our performance of new stores are relative to our proformas, we feel, that we’re working towards those proformas and they’re on track to deliver the shareholder value that we’ve outlined in our long-term guidance with our store model, new store models.

So, and to sit here, and I apologize, but to go through the new store productivity, we would probably be here 15 minutes trying to go through a spreadsheet that I don’t think would be of a lot of value to any of us. So maybe offline we can walk through it. Yeah, I certainly spent more than 15 minutes talking to Chip about this for a patient.

Jack Sinclair: But I’m really pleased with the new store performance. I mean, there’s ups and downs across the different, across the country in our less established markets and our more established markets. But we’re opening stores right across the country at the moment, and I’m pretty encouraged where we’re at, and the way we set this off a few years ago and moving to smaller stores, I think is definitely de-risked the program going forward. And we’re feeling pretty confident with where we’re at.

Rupesh Parikh: Great. And then maybe just one follow-up question. So, on an almost 4% comp there was de-leverage this quarter. Just any insight, you know, as you look into next year in terms of what type of comp you may need to deliver to leverage expenses.

Chip Molloy: Yeah. Well, as you remember, we did guide to de-leverage for the year, which imply the back off was going to have some de-leverage. The acceleration of new stores combined with just wage pressures, a bubble of wage pressures that we’ve all been working through is probably going to create a need to have a, slightly higher comp for the next couple quarters to deliver some, high single digit earnings growth without share buyback. So, it’s going to take a little bit more, but, I think once we get steady state and get through this timing of going from 16 to 30 to, 35 plus is just getting through that and then these wage pressures, but we’re working hard at it.