Sprouts Farmers Market Inc (SFM) 2015 Q2 法說會逐字稿

Good day, ladies and welcome to the Sprouts Farmers Market second-quarter 2015 earnings conference call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will be given at that time.

(Operator Instructions)

As a reminder, today's call is being recorded. I would now like to turn the conference over to your host today, Miss Susannah Livingston. Ma'am, you may begin.

Thank you good afternoon, everyone. We're pleased you have taken the time to join Sprouts on our second quarter 2015 earnings call. Doug Sanders, Amin Maredia, and Jim Nielsen are also on the call with me today.

Sprouts' 10-Q the earnings released announcing our second quarter 2015 results and the webcast of this call can be accessed through the Investor Relations section of our website at Sprouts.com. During this call, Management may make certain forward-looking statements including statements regarding our future performance and growth, product expansion, new store openings, and 2015 expectations and guidance. 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 filings with the Securities and Exchange Commission, along with the commentary on forward looking statements at the end of our earnings release filed today.

In addition, our remarks today include references to non-GAAP measures. For reconciliation of our non-GAAP measures to the comparable GAAP figures, please see the tables in our earnings release. We believe these adjusted results provide a good basis to assess the operating and financial results of the Company period over period. For the second quarter ended June 28, 2015, we reported deluding earnings per share of $0.20 and adjusted diluted earnings per share of $0.22. Adjusted diluted earnings per share increased 10% and $0.20 in the same period in 2014. With that, let me now hand it over to Doug.

Thank you Susannah. Good afternoon, everyone, and thanks for joining us today. For the second quarter our net sales grew to $902 million up 21% from the same period in 2014. Driven by the strong performance of our new stores and comp store sales growth of 5.1%. We remain very pleased with our top line revenue growth as we continue to focus on our core principles of health, selection, value, and service to connect with today's growing number of health-conscious consumers.

Our comp growth accelerated to 5.1% from 4.8% in Q1 despite a number of headwinds. During the quarter we saw deflation of approximately 200 basis points compared to Q1. In addition, we continue cycling a strong [produce] season from 2014, the 80 basis points benefit from Sunflower from Q2 of last year, along with higher than normal cannibalization in some of our more mature markets. The swing from 1% inflation in Q1 to 1% deflation in Q2 was driven primarily by significant deflation in produce which, as you know has a greater impact on Sprouts due to the high volume of produce we sell. The strong tonnage growth we achieved during the quarter was offset by the deflation of nearly 10% in April which improves to mid-single digits in the letter weeks of the quarter. We expect the level of produce deflation to begin to settle as we work through the rest of the summer months.

As we've noted in the past the broad appeal of our healthy value focus model allows us to operate a greater number of stores in a trade area than any other natural foods retailer in the industry. Our unique ability to connect with the everyday grocery shopper has been the catalyst for our tremendous growth over the years and continues to fuel our aggressive expansion across the country. Our current growth plan targets 14% annual unit growth with a continued focus on growth in existing markets to offset the investment in our new market expansion strategy. This growth in existing markets has historically led to cannibalization in the 75 to 100 basis points range, however in our second quarter comp was impacted by a higher cannibalization of 175 basis points as we continue to take advantage of infield opportunity in several key markets.

We see this as an effective long-term strategy for several reasons. One, new stores in existing markets open with higher productivity and achieve expected returns much more quickly the new stores in new markets. Two, were able to gain leverage in existing distributions, advertising, and supervision costs which increases the overall profitability of the market. And three, we're able to expand both our market share and brand recognition with a greater number of stores in the trade area. We expect the cannibalization experienced in the second quarter to settle down in the back half of the year as we cycle a greater number of openings over the last 12 months. From an industry perspective we saw increased promotional activity in the second quarter as retailers continue to make price investments in response to consumer and industry change. Based on what we've seen today we would anticipate this level of promotional activity to continue for the remainder of the year.

Now operating in a competitive environment is nothing new to Sprouts and we remain focused on providing our customers on a broad assortment of differentiated products, knowledgeable customer service, and engaging customer experience, and affordable pricing across the store. In doing so we have continued to make price investments in various regions to maintain our competitive positioning and remain focused on our strategy of providing healthy living for less. In strong promotions and solid execution we continue to drive strong top line sales and traffic ending the quarter with improving traffic and comp sales growth that was balanced 50/50 between traffic and ticket.

New store productivity continues to be strong at just over 85% as we've added 8 new stores during the quarter including our first new store in Tennessee. Year to date we've opened 22 new stores in 11 states and are now operating stores from coast to coast. We have an additional 5 stores planned for the remainder of 2015 bringing us to 27 new stores for the year and a total of 217 across the country. Our current real estate pipeline includes 62 approved sites and 47 signed leases for the coming years keeping us well on track to meet our 14% unit growth target. Based on the positive feedback we received at the ICSC real estate convention in May I'm even more confident in our ability to secure great location as we expand healthy living for less into a greater number of markets over the coming years.

We continue to make solid progress on our 2015 strategic initiatives which are focused on broadening our appeal with an even greater number of everyday grocery shopper's across age groups and demographics. This includes growing our social and digital capability, expanding our private-label and specialty product assortment, introducing new and expanded deli offerings, updating our legacy stores with the expanded offerings introduced since 2013, and improving customer engagement through team member training. Engaging with our customer in more meaningful and relevant ways through social and digital marketing continues to be a focus.

To this end it was extremely important to find a talented experienced and innovative Chief Marketing Officer to separate the Sprouts brand into the future. Even though Shawn Gensch has only been with the team for a few weeks, I can already see that his deep retail experience in marketing, loyalty, and digital will have a positive impact on how we engage and support our customers along with their journey to better health. In addition to Shawn we continue to strengthen our Senior Management team with experienced leaders including Dan Sanders who joined the team as Executive Vice President of the store operations in June and Dan Bruni who joined the team as Chief Information Officer earlier this year. Both bring a wealth of knowledge and industry experience to our Company and will play a vital role in our continued success.

As many of the large natural and organic brands become main stream product innovation through Sprouts private-label continues to be a priority. In this year alone we've introduce more than 150 new private-label items and continue to view this as an important growth category for the long-term. Our comp and sales growth in private-label exceeded the Company average for the quarter as we continue to add new and innovative products and categories across the store. Items like our new Sparkling Lemonades for the summer have been a big hit with customers while innovative products like our Sprouts Organic Siracha Lime Kale Chips were recently recognized by a gourmet retailer as a better for you snack and a stepping stone for shoppers of all ages who are trying out a natural and organic lifestyle. As for our attribute driven specialty categories we continue to expand strong sales growth that is outpacing the industry. With our depth of products in these categories we believe Sprouts offering attracts a greater number of customers as we continue to see our sales well outpacing those of our conventional peers.

Following a successful test we are adding our new and expanded deli offerings into four additional stores, this includes features like a new salad bar; stocked with ready to eat, healthy and flavorful salads, prepared proteins, healthy side dishes, and an improved assortment of entree meals and side dishes. Following the rollout of these additional stores we will be looking to incorporate many of these offerings into a greater number of stores in 2016 and beyond. We continue to reinvest in our current stores maintain superior store conditions and have remodeled four stores this year and have completed nearly 100% of our 2015 sales initiative projects. Once done all of our stores will feature some or all of the enhanced product offerings found in our new stores opened since 2013 including expanded offerings in package grocery, and frozen foods, fresh made sushi and Boar's Head among other improvements.

At Sprouts we believe every meal is a choice and our team members play and essential role in educating and inspiring our customers to eat healthy. To that and our investment in team member training is more important today than ever. As one customer recently wrote, good customer service is the life blood of any business, this year we are focusing on improving customer engagement, increasing overall product knowledge, and developing future leaders to support our rapid growth. We continue to reap the benefit of these efforts and one recent online survey showed our customer service ranking as the highest attribute of our stores. I continue to be very optimistic of the future of our Company and tremendous growth still in front of us. Our unique accommodation of health and value with a proven reputable business model continues to make Sprouts one of most dynamic growth companies in grocery today. I'm extremely proud of all of our team members who deliver on our mission to inspire healthy living for all each and every day.

Now before I turn the call over to Amin, I'd like to say a few words about the announcement made today regarding my transition to Executive Chairman of the Sprouts Board of Directors. Sprouts has been part of my life for 13 years during which time I've had the privilege of seeing the Company grow from a single store into one of the largest and fastest growing natural foods retailers in the country. This planned transitional from CEO to Executive Chairman will afford me the opportunity to continue to work with the Board and Management in providing strategic guidance.

We're very fortunate to have an exceptional Management Team and I am honored to be passing CEO leadership to Amin and a President role to Jim. As most of you know Amin I'm sure you would agree that his proven leadership, strategic vision, and strong business skills will successfully carry the Company forward. With Jim stepping up to the President role Sprouts is on solid ground as it continues on its exceptional growth trajectory. It's been a real privilege to have led this vibrant and dynamic company for the past decade and I look forward to the remaining part of its continued success. With that let me turn the call over to Amin, to talk about our financial resulting guidance.

Thank you, Doug and good afternoon. Following Doug's highlights of the business drivers let me cover the operating results and guidance. For the second quarter gross profit increased 18% to $264 million resulting in a gross profit margin of 29.2%, a decrease of 90 basis points compared to the prior-year period. This reduction in gross margin was primarily a result cycling a strong produce season from last year as well as investments and price to maintain our competitive positioning. These were partially offset by leverage in buying costs and continued leverage in occupancy from our pre 2014 vintages.

As Doug mentioned we continue to be aggressive in making smart price investments to bring healthy living for less to our customers every day. We also continue to see good traffic from expansion of differentiated offerings across the store. Direct store expenses were $177 million for the quarter and as a percentage of sales was 19.7%, an increase of 50 basis points compared to the prior year. The leverage from higher sales in our pre-2014 vintage stores was offset by higher expenses from stores open less than 12 months. In the second quarter we also experienced increased healthcare costs as we cycled the lower utilization from last year.

SG&A totaled $23 million for the quarter and as a percentage of sales were up 2.6% an improvement of 50 basis points compared to the same period last year. This improvement was primarily driven by lower bonus expense partially offset by higher advertising expense to support a higher number of new store openings in the second quarter of 2015 compared to the prior year. Adjusted EBITDA for the second quarter totaled $78 million, up 12% for the same period in 2014. Adjusted EBITDA margin rate was a 8.6% a 70 basis point decrease compared to the prior year, driven by the timing of new store openings as well as price investments. Adjusted net income for the second quarter totaled $35 million and improvement a 16% from 2014. This increase was driven by higher sales as well as lower interest expense as a result of additional voluntary pay down on our revolver and a decrease of interest rates from our April 2015 refinancing.

Shifting to balance sheet and liquidity, our balance sheet remains strong as we continue to generate robust operating cash flows. Year-to-date we generated $121 million of cash flows from operations and invested $61 million in net capital expenditures primarily for new stores. As you are aware during April we secured a new credit facility, a five-year $450 million revolver at attractive rates which will replaced our term loan. As a result of this transaction the Company reported a loss on extinguishment of debt including by $5.5 million related to the write off deferred financing cost and issued discount. During the second quarter we voluntarily paid down an additional $100 million of outstanding debt resulting in a balance of $160 million on this revolver and ended cash and cash equivalents for the quarter and $97 million. As a result of the voluntary pay down the interest rates on the revolver will drop to LIBOR plus 1.25% effective in the middle of August.

Let me now turn to 2015 guidance. Due to the increased competitive environment and an inflation environment close to zero, we are adjusting our guidance for the year to the following, net sales growth change slightly to 19% to 21%, comp sales growth up 4% to 5%, adjusted EBITDA growth of 10% to 12%, adjusted net income growth of 13% to 15% and adjusted diluted earnings per share of $0.80 to $0.82. We expect no change to CapEx which will be in the range of $100 million to $110 million. In addition we are guiding comp store sales growth for the third quarter and the 4% to 5% range.

A few additional items to note on our 2015 guidance. First, comps for the third quarter and full year assume near zero inflation to the Sprouts basket, lower retails from a higher promotional environment, and higher cannibalization through the third quarter. Our full year inflation near 0% to 1% range compares to a 3% inflation rate last year. Keep in mind the 4% to 5% comp from a near zero inflationary environment is above our long-term comp sales target when adjusted for normal inflation. We continue to generate increased traffic and tonnage volume growth, as well as continue to outpace both the conventional and specialty channels in natural and organic product sales which is a clear indication that our value proposition is resonated with our customers.

Second, as it relates to margins we will continue to make price investments during the back half of the year to maintain our pricing strategies. We expect the third quarter gross profit margin to be slightly less compressed than the first half and start to level out in the fourth quarter. The leveling off in the fourth quarter is driven by cycling the significant number of stores open less than 12 months which have a lower gross margins, as well as coming off the exceptional produce season in the first half and early part of the third quarter of last year. Third given the number of new stores opened over the last 12 months, we expect continued pressure in DSE for the third quarter of approximately 50 basis points and expect this trend to normalize in the fourth-quarter.

The above items are expected to yield an overall EBITDA margin for the year of approximately 8.2% to 8.3% bringing our EBITDA margin closer to a 2013 EBITDA margin of 8% and believe this range is appropriate for Sprouts at this point in our growth phase and overall environment. And at EBITDA margin equivalent to our guidance for this year our cash and cash returns by year three to four still remain healthy and consistent at 35% to 40% returns. This is both in line with our long-term economic model and shows that resiliency of the Company to maintain the strong economic model in an competitive environment. Lastly our weighted average share count will be approximately 156 million shares for 2015 and our corporate tax rate will be approximately 38% as we have received enhanced deductions for our food donation initiatives.

In conclusion our focus remains on driving top line sales growth for our broad healthy product offering, affordable prices, and knowledgeable team members providing good customer service. Despite the impact of the inflationary and promotional environment on our guidance we feel confident about our business given the strong customer traffic, comp sales well above sector average, our ongoing strategic initiatives, and continued unit growth across the country. Our balance sheet is healthy, our business model is solid, and we look forward to delivering a great growth opportunity that lies ahead.

Lastly, I'm honored to succeed Doug as CEO of Sprouts and I know we will continue to be nimble, innovative, and customer focused to deliver on our mission of healthy living for less. I'm excited about having Jim as a partner in his new role as President and Chief Operating Officer and to continue to work with Doug in his new role as Executive Chairman of the Board. Over the past few years Doug and I have spent significant time in the field and the office discussing Sprouts mission, strategy, and culture as well as customers evolving expectations of grocery stores and we have great confidence in the future of this Company. I look forward to working with the Board of Directors, Sprouts exceptional leadership team, and our committed 20,000 team members to grow the brand successfully and profitably. With that we would like to open up the call for questions. Operator?

(Operator Instructions)

And our first question comes from the line of Edward Kelly of Credit Suisse. In the interest of time we are asking that we please limit to one question. Mr. Kelly, please go ahead.

Hi. Good afternoon. I guess my one question would be related to competition. Could you maybe provide a little bit more color on what you are exactly seeing from a competitive standpoint. What has changed since Q1? Talk a little bit more about how are you reacting and the thoughts on margins for the business beyond this year?

Hi, this is Jim Nielsen. I'm going to break it into three buckets on the competition front. We will look at new outlets, added assortment, and then where we are seeing investment in promotional pricing. From a new outlet standpoint we're relatively neutral on a sequential and year-over-year basis.

On added assortment we have seen retailers add assortment. We've seen some retailers put natural and organic items into print, however, we cannot connect this to any negative sales impact. In fact, the nonperishable side of the business continues to see uptick in sales throughout the year. And I would attribute a lot of that to the buying team and some of the new promotions and pricing and new products they're delivering.

In terms of promotions, we've seen a little investment in price in the nonperishable side, but nothing that we haven't seen in quarters past. Where we've seen a little bit more aggressive approach on promotions has been in the produce and meat side. And we would anticipate to see that through Q3 and possibly through Q4. Beyond that, I would not like to project.

This is Amin. Just on your latter question about sort of looking out, obviously from a visibility of competition standpoint, we really look and price competitively. As you know, our model is built on health and value and we're positioned to be both every day.

And really our focus is on continuing to drive the sales on new initiatives in some of the departments like deli, and private label, et cetera, which gives us both incremental sales and also higher margin sales in some of those departments which then provides us even more flexibility to the extent that we need to reinvest in price to provide value to our customers.

Can I just maybe ask one quick follow-up here? Your model, I think, is historically right as the way you talked about it is this stable sort of gross margins and you get leverage, right, because you're [growing] and then I guess you have the opportunity to invest that leverage back within pricing and sort of continual improvement.

Can you maybe put into perspective how much you would typically invest in the model? How different it is today and how you need to sort of react to the market?

Yes, I think based on some of the other gross margins lines like occupancy and utilities and buying costs, it's a natural flow-through as maybe 10, 20 basis points of investment. I think the couple of things that are really driving the compression in gross margin this year is we're just giving back a great produce season from last year where we had some exceptional margins.

If you look from 2013 to 2014, if you look in the first half of the year, we had huge margin expansions. In addition, we obviously have a greater number of new stores which are less than 12 months old this year. As an example, at the end of Q2 of 2015 we had 32 stores which are open less than 12 months. At the end of Q2 of 2014, we had only 18 stores which were open less than 12 months.

As you know, our newer stores start off with lower margins from promotions as well as the mixes, higher produce in the store. It's just not investment in price or competition, it's really more about the produce season that we saw last year and then also the new stores less than 12 months old.

Okay. Great. Thank you.

Thank you. Our next question comes from the line of Meredith Adler of Barclays. Your line is open. Please go ahead.

I guess I'd like, since Ed already asked questions about competition and pricing, I will ask about inflation. Why is it that you're still seeing as much deflation as you are? I thought I had spoken to Amin and said that it had sort of flattened out in June, but were still seeing it and can you talk about the dynamics that are causing that?

Meredith, I think in the last earnings call we projected it to kind of subside throughout the quarter. And we did not see that. Obviously you can look at the CPI and the PPI indexes and I think they're both, I think CPI's about negative 5%. We sell a disproportionate amount of fruit and that's really the categories we're seeing a lot of pressure in. Also what you are starting to see a little bit of pressure in, is meat on a year-over-year basis because chicken and pork have become very deflationary over the course of the last two periods.

Meredith, if you recall, just so we can touch on that a little bit more, just monthly as we saw, as Doug said, about 10% deflation in produce in April and then subsiding to mid single digits. At the time, based on the patterns we were seeing, we were thinking inflation would be flat to 1% inflation. Where we ended up in the quarter was basis points in sort of May and June as we sort of ended the quarter and as that deflation continues to sort of level off and get back into a flat to inflationary environment, that should start bringing the comps back up.

And I'll just go back to what Ed was asking about. Maybe I didn't understand, but were you saying that competition is not really the biggest driver of the decline in the gross margin? That it's the comparison with last year and the opening of new stores?

I think there is definitely some increased promotional activity we're seeing on the perishable sides of the business. But it's not the only factor is what I wanted to point out, so based on what we're seeing right now, we're going to start lapping the strong produce season here in the next few weeks from last year and then also the new stores start lapping. When we see gross margin in the third quarter and into the fourth quarter, in the third quarter we will see compression.

We expect lower compression then what we saw in the first and second quarter of 90 basis points. And then right now we're -- in the fourth quarter we see it really subsiding to close to flat, probably slightly negative, but much closer to flat. That sort of proves out that the point that it's combination of the produce season as well as the new stores open less than 12 months as we cycle those.

Okay. Thank you.

Thank you. Our next question comes from the line of Stephen Grambling of Goldman Sachs. Your line is open. Please go ahead.

Hey, good afternoon. I guess I have two clarifications on still the competition inflation. I'm sorry to beat a dead horse here.

Can you help us parse out maybe even how much of a deflation you are seeing in produce as being driven by cyclical supply demand issues versus by competition and as it relates to that, is there a philosophy on your end to maintain a certain price [gap] relative to these peers?

Hi, Stephen, this is Jim Nielsen. We definitely have a price strategy for produce. Obviously we are not going to disclose it on the call. We also have target margins for ad retailers. And when you look at the overall market, and I'm looking at the tightness, yes, there's a little bit of pressure due to demand from potentially some of the conventionals being a little bit more aggressive on the produce side. But some of it is just relative to a flesh market on the fruit side, the stone-fruit side, the grapes, apples, and cherries, the Southern California cherries.

Okay. And then maybe a follow-up question on -- just given the solid free cash flow generation and now the low levels of debt, maybe how do you prioritize redeploying that in terms of either accelerating square footage growth or even thinking about redistribution of shareholders at some point? Thanks.

I think that at this point, as you know, we saw in the second quarter we paid down voluntarily another $100 million of debt and as we move through probably over the next 12 months, we are now beginning the dialogue with our Board about alternatives. We're continuing to work hard and building out the infrastructure from a growth standpoint as we're expanding across the country and into the Southeast and start moving into other states in the Southeast and up.

We will revisit the growth rate, but we want to always make sure that our teams are consistent out there in the field and we're able to execute before we would consider accelerating the growth rate. And lastly as far as redistribution, we would not build a policy on that at this point in time, Stephen.

Thanks so much. I will jump back in the queue. Best of luck in the new roles.

Thank you.

Thank you. Our next call comes from the line Robbie Ohmes of Bank of America Merrill Lynch. Your line is open. Please go ahead.

Thanks, guys, and congrats to all of you on your promotions. And I mean being promoted as a person, not promotions that cause deflation. A couple -- I was hoping to get some clarification on just the comp guidance. If I understand the comp guidance for the year, you're guiding to a lower comp for the back half than the [five] you just put up. So you had 200 basis points more deflation in this quarter you just reported. You had very high cannibalization.

What's incrementally getting worse to make the comps slow more in the back half from the [five] that you just put up? And maybe in the context of I think you should have more comp support from year-one stores coming into the comp base in the back half supporting comps as well? So if you could just help me work through all of the variables? And is cannibalization getting worse? What should we think normal cannibalization should be for the back half and then as you look over the next couple of years?

Sure. Robbie, it's a couple of things. One, as you may recall, is last year we actually saw inflation tick up in the back half of the year. So for the quarters, the inflation numbers are 1%, 3%, 4%, 4% as we went through last year in our basket. We're calling for sort of a flat inflation at this point. Maybe even slightly down for the third quarter. So you've got a pretty wide lack of inflation, if you will.

I think the second -- so I think that was the inflation element in it. And the other piece is we're also seeing some -- early in the third quarter last year we were still in a very, very -- we were in a fantastic produce season. In fact, all of July we were running $0.99 cherries, which just drove tremendous amount of traffic throughout the system. We just didn't have that availability this year.

So we were lapping fairly significant, near 20% produce comps in early part of the third quarter last year, which we are now starting to lap. Certainly the cycle here that we see and as we get to the fourth quarter, we think to the extent that inflation is back in normal swings, then I think that we could see that number be above kind of that full-year range.

And have you seen competition focus more on being promotional with the perishables versus center store in the past? And if so, how did it normally play out? Was it just sort of lasts for about a year and then you cycle and then the conventionals go back to focusing on non-perishables? Any sort of insight would be great.

Yes, I think that if you look at the past history, there's a couple of cycles we can look to in 2009 and 2012 where deflation in 2009 lasted for about 12, 13, 14 months. And so you saw things normalize again. And in 2012 it was slightly less than that, Jim, if I recall, it was about 8 to 10 months that deflation lasted.

And so as we sort of come back to normal, I think the competition also starts settling down and we're not calling for that in our guidance at this point, but to the extent that happens, then perhaps that would suggest we're conservative in our model.

Great. Thanks very much.

Thank you. Our next question comes from the line of Karen Short of Deutsche Bank. Your line is open. Please go ahead.

Hi, thanks for taking my question. Just a question on the increase in produce and meat promotional activity. Can you clarify, was that coming from all forms of competition or is it isolated to conventional competitors, isolated to specialty? Any color you can give there?

Hi, Karen, it's Jim Nielsen. It's primarily coming from our conventional competitors within each geography. We are seeing some specialty retailers do some in-store, but we haven't seen any negative impacts of that, so as you look at each geography, it's primarily conventional.

And it is across all geographies?

It's not all geographies, but it's probably half the geographies.

Okay. Then just curious, in terms of your pipeline for next year, I don't know if you could maybe give some early thoughts on split between existing and new markets and how we should think about cannibalization into FY16?

Yes, Karen, couple of things. As you know, Doug mentioned we had 62 approved sites and 47 signed leases. We're still kind of focused on that 70/30 mix. One of the things that we've done, based on what we saw -- and from a cannibalization standpoint, I think Q2 and Q3 of this year, coming up this quarter that we are in, we will see cannibalization peak and then we think that will start subsiding.

One of the things that we have started to do is that as our data has gotten better and better, we have started to, I call it a running meter on cannibalization, so that we know at all times as we are approving sites what type of cannibalization that we would expect. Now with that said, we're not going to pass on great sites in existing markets. But we just want to be aware of what level of -- be more aware of what level of cannibalization that we might expect.

But I think in short, 70/30 is still a good mix and our goal would be to perhaps, from the number that Doug talked about, 175 basis points that we saw this quarter, to start bringing that cannibalization back down, not -- but at the same time not passing on great sites where you would cannibalize a store.

Is there any sense of what a normalized cannibalization rate will be going forward? I mean, obviously you're understanding there will be ebbs and flows?

I think there will be ebbs and flows, but we have historically seen about 100 basis points. And so as we look to that 70/30 mix, of course, as we get into Georgia, we will be in the third year in Atlanta of our stores there, so we're really starting to see some -- a good number of stores there. And a lot of times we see that delayed effect of benefit on comps and leverage and distribution and those types of markets when we do that. But that's generally the cycle we see.

Thanks. And congratulations in all your new roles.

Thank you, Karen.

Thank you. Our next question comes from the line of Scott Mushkin of Wolfe Research. Your line is open. Please go ahead.

Hey, guys. Thanks for taking my questions. It seems like, to summarize a little bit, you're cannibalizing a little bit more, competition is a little greater. I guess with the new companies like the Harvest Market coming to Houston, do you feel -- my first part of a two-part question, do you feel like the competition in cannibalization, you can really say have stabilized?

And then the second question, and I think I heard you right about the EBITDA margin, Amin, it's going to be 8.2% to 8.3%, is kind of what you were implying in your comments. I guess the second part of the two-part question is your thoughts, not on this quarter or next quarter, but what you think normalized comp and a normalized inflation environment would be and normalized EBITDA margin? That would be really great just to understand where the model is, where you think it is right now.

I'll let Jim answer the first question and then I'll pick up the second half of your questions.

Scott, in terms of stabilization and looking at competition, are they being more aggressive, less aggressive, it's been fairly consistent over the last 12 to 16 weeks. We haven't seen any material change in the markets where people have heated up. I think one point just to note that we really haven't talked about here is our overall items per basket are the highest we've seen in two years.

Our tonnage in produce is the highest we've seen in five quarters. As we continue to go back to competition, the pressures of competition, I understand that, but there is a lot of pressure from deflation in the produce side of the business. In terms of your first one, last 12 to 16 weeks pretty consistent, Scott.

And then sort of overall model, Scott, as you have probably heard us talk about this before, that this year, with that 8.2%, 8.3% EBITDA margin, we still expect, from a DSE perspective, our most significant compression is actually going to happen in Q3 from the new stores that are open less than 12 months.

And then gross margin, as I said earlier, we expect it to -- compression to be slightly less than what it's been in the first half of the year and then really settling down to a 20, 30 basis points compression in margin, so to round out the year at that 8.2% to 8.3% based on our visibility now.

And as we move forward, I think it's really going to depend on what inflation is doing, what competition is doing, do we need to reinvest in price? We had a pretty rough first half of the year in produce this year. I think that the marketplace will dictate how much we need to invest. Investments, promotions have been heavier in perishables this year. If we have a decent season going forward, then you sort of stick to that 8% to 8.5% model.

But what excites us, Doug, Jim, and I about the model is that even at 8%, 8.5% margin business if you're driving that top line sales, which we have, in the last three years have gone from $14 million to $17 million a store. And with some of our initiatives continuing to drive that number up, it just gives us more flexibility to invest if we need to. But the marketplace will dictate the amount of investment that we make. Our job here is to keep building that flexibility.

That maintains that 35% to 40% cash return as well.

That's right. And even at that 8.2%, 8.3%, we're still running in the range in some regions above that 35% to 40% cash-on-cash return.

So not to put words in and not to try to interpret what you say, Amin, is that the comp may be at 6% when you guys went up through your IPO is kind of where you had it pegged, but you did think you could lever a little bit, you may want the flexibility to reinvest that in price depending on what competition is and that may hold EBITDA margins a little bit more flat. Is that fair?

Yes, and as we've always been consistent with this is, we would never hesitate to invest in margin to drive sales. We're a very top line focused company.

Perfect. Thank you for taking my questions and everyone has been saying congratulations, so congratulations.

Thank you.

Thank you. Our next question comes from the line of Rupesh Parikh of Oppenheimer. Your line is open. Please go ahead.

Thanks for taking my question. I just wanted to touch on the marketing front. I know you appointed a new marketing officer recently. Just want to get a sense of how you guys are thinking about some of the opportunities going forward on the marketing side?

This is Doug. We were extremely excited to have Shawn join the team. It was probably about five weeks ago, so he's still obviously getting his feet on the ground and brings a wealth of knowledge and experience when it comes to the digital and loyalty side. Obviously there's not a lot to share at this time. Obviously we have a lot of things that we're working on and Shawn's expertise is going to take us in some new directions.

But again, not a lot to report at this time just yet. We will be reporting more as he gets in the saddle and we start looking at some of our strategic initiatives and where we're going to take those.

Okay. And if I could sneak in one more question. Just on the real estate front, there's been some noise out there that real estate costs continue to escalate. I just want to get a sense, as you guys are looking in your markets for growth, mainly the Southeast, are you seeing any pressures right now on rental rates?

Not primarily in the southeast. There have been some increases in certain markets, but they have been market by market, so it hasn't been across the board across the country, but there are certain markets. Los Angeles is a perfect example of where market rates have been pretty high and pretty volatile, but we haven't necessarily seen that across the southeast.

Okay. Thank you.

Thank you. Our next question comes from the line of Sean Naughton of Piper Jaffrey. Your line is open. Please go ahead.

Thanks for taking the question. If we look at the overall space just of the food at Whole Market, we're obviously seeing a lot of square footage growth in specialty and I guess on the value side and the [mass in club], and then obviously you have some channel shift with online delivery.

Do you think that the overall sector may be growing too quickly in terms of square footage at this particular point in time? When was the last time that you guys maybe went back and thought about your overall addressable market of 1,200 stores?

Sure. I think there's a couple of pieces there. I think from a new outlets prospective, we obviously keep track of new competition and potential competition that's looking in our trade areas.

Over the last couple of years, that's been relatively flat, as Jim eluded to earlier. So we're not seeing any additional impact on comps from new competition. In terms of specialty, I think there's a combination of things going on as you're seeing food and the consumer kind of redefining food and how they shop, you are seeing more specialty stores open.

But on the other hand, are also seeing consolidation and shuttering of some of the smaller regional players, the traditional players who are struggling for bringing dollars back to the market. And we feel like we're pretty well-positioned in the health and value proposition, particularly the value side of the equation puts us right square peg in where customers are headed today and we think tomorrow.

So it feels like there's enough displacement at this point to support the square footage growth we are seeing in some of these -- ?

We're not seeing -- Sean, at this point, we are not seeing anything in any of our markets that would suggest that you've got new capacity coming, which is at such a high pace that it's starting to hurt the overall market there. We're not seeing anything there right now.

Okay. And then just quickly on the performance of categories across the store, and maybe specifically looking at the nonperishable categories? It sounds like those are performing a little bit better for you. Any comments on food, VMS, or health and beauty on how those performed in the quarter?

We generally don't get into category specific but, as Jim alluded to, is our nonperishables have been performing quite well. The perishables, for all the reasons we've talked about on this call, deflation, as well as some increase in promotional activity, have impacted comps to some degree on that side. But overall we feel the perishables are performing pretty well. I don't know, Jim, you were about to add something.

No, I mean, it's the same categories. They're just not the uptick in the attribute categories that we saw last year and we talked about this in the last call. Organic, non-GMO, gluten free, all of which were outpaced in the sector and north of 20% topline growth. It's obviously good growth, but relative to last year was in excess of 30%, and so were not keeping pace with that.

There's other attributes and things that are driving the business and they're just a little bit smaller in terms of overall impact of sales; grass feds, on fire; vegan; probiotics; snacking; alternative protein. There's a lot of little tailwinds in there. The big tailwinds are still strong, just not as strong as prior year.

Great. Thanks for taking the questions and best of luck in the back half.

Thank you. Our next question comes from the line of Charles Grom of Sterne Agee.

Thanks. Good afternoon. Just on the price investments that you're making, I'm just wondering if you could just discuss the degrees of success that you're having. From an elasticity standpoint, unit increases on those price increases across categories. Where have you found success and where have you not?

This is Jim. And like I said before, we're seeing a great increases in terms of overall produce tonnage; in terms of just growth in the overall business, which is helping us drive that traffic. It drove it from 60/40 to a 50/50 in this quarter versus prior quarter, so we're starting to see that.

The nonperishable side of the business, we're just seeing the overall penetration of the ads go up in traffic and some of our new promotions that we have launched here in the third quarter provided even more tailwinds in that area and really helped in terms of overall brand awareness and brand awareness for our partners that we have that are supporting our promotions.

Okay. Fair enough. And then just philosophically, when you see your traffic starting to slow and you weigh that relative to where your gross margins are, how willing are you guys to sacrifice gross margin compression to get traffic back? And I guess alongside that, when you look at your cost structure, do you find that there's opportunities outside of the buying leverage that you have to fund those price investments to get the traffic back in your store?

You know, Charles, we've got a number of pricing zones, over 15 pricing zones in the Company, and so when we see any sort of traffic movement, we're pretty quick to try to pinpoint what's driving it. Obviously we're watching competitor pricing. We price very frequently on the perishable side and then on a regular basis on the nonperishable side. We feel like we're pretty intuitive, we've got a pretty good process of understanding the dynamics of what's happening in each of the local markets.

And the teams do a phenomenal job by category watching movement on the ground and seeing what type of investments we may or may not need to make. If your question is are we going to -- the good news is we're not seeing -- as you heard, we're 50/50 traffic even this quarter. We are not seeing traffic degradation. A lot of our challenges are being caused by deflation, as well as a couple other things we've talked about here. It's not been a concern.

A couple of markets have been a little bit more competitive from a promotional activity standpoint. That's where we don't hesitate to make the price investments in. As Jim said, it's been in about half of our markets. It's not in all of our markets.

And, Charles, this is Jim. The other thing is there's some offsets to gross margins that we have started to do of late and it will continue to give us more pricing powers so we can go out and be more aggressive.

And obviously improving supply chain, keeping our trucks, we're actually just starting with some self-distribution on some key items that will improve the [landed] cost of the store. Some of those promotional partnerships that I talked about earlier. We are getting strong partnerships from our vendor community and that is just obviously related to how great our stores execute and how good our buying team does here of developing those promotions.

The deli mix, deli has been a leading comp driver for us, so we continue to get some improvements there, especially in 2016 when we roll out a lot of the new enhancements that we've done over here at our [Port Cypital] store. And then this continued growth of our private label, that this quarter saw 30% topline growth and continues to be very favorable for us and drive our overall sales.

Thanks very much.

Thank you. Our next question comes from the line of Joseph Edelstein of Stephens. Your line is open. Please go ahead.

Hi. Good afternoon, everyone.

Good afternoon, Joe.

You had a store closure this quarter. We haven't seen you do that before. I was hoping you could add some color around that. Where was the store located? Was it a lease that was getting towards the end of life? Just any comments there would be helpful.

Yes, Joe, that is exactly right. We had a lease that was at the end of life and we had a store -- as part of our acquisitions in 2011 and 2012, we had acquired stores which were fairly close to each other. They were both profitable and making money and when it came to end of life, we felt like consolidating the traffic into one store. We remodeled the store and had good movement to the consolidated store. So it was just a market consolidation opportunity for as.

And the good news, we were able to move half of that business to the two stores within the city.

Okay. Thanks. And also you spoke about doing some fill-ins on existing markets. I was hoping you could maybe speak a little more directly to the Atlanta area, the plans that you have in terms of looking to set up a distribution center for that region. And also is that then something that we would be expecting to step up in expenses as we look into 2016?

I think in the Atlanta area generally we were looking for 2-million-plus cases in our produce to be able to look to set up a DC for getting that efficiency. At this point, it will be sometime in 2016, perhaps late 2016, and we will likely look to lean towards a third-party logistics, a 3PL. That just gives as more flexibility and doesn't require us to go and get a massive warehouse which sits empty for several years for growth and we can really grow into with a partner.

We've had good successes on that front in California, so we're leaning in that direction. And even where we are not leaning that way, but even to the extent that we were to do our own DCs, because it's produce only, it generally costs $2 million to $3 million of CapEx and not a significant CapEx investment and proportionately not a significant P&L investment. It would be all relative.

When we're looking at the DCs that we'll put in the Atlanta area, it is more to support growth and expand our reach so we can continue our growth. 70% of our products are going to be coming from California, potentially Mexico. Still your inbound costs are going to go up. You're going to offset some of that with reduced transportation costs. So it's going to be somewhat of a net neutral. But it's really going to give us the opportunity to have a fresher product, do a much better job at the local programs there and the local markets.

Okay. Thanks, and good luck.

Thank you.

Thank you. Our next question comes from the line of John Heinbockel of Guggenheim Securities. Your line is open. Please go ahead.

I have one for Jim and then one for Amin. For Jim, if you think about the step-up in promotional intensity, it sounds like that is more cyclical than secular, driven by deflation, right, and people have all this money to play with. Is that fair?

And then your response, as a merchant, do you sort of have to go with it when it's cyclical like this and maybe analytics go a little bit out the window in terms of not losing mind share traffic with customers versus if it had been more secular? That's sort of for you.

And then for Amin, if you think about the long-term growth algorithm, it sounds from a lot of what you've said that really hasn't changed. This notion of high teens EBITDA growth hasn't really changed in a normal inflation environment. Is that fair?

Hi, John. This is Jim. Relative to investment, I think if you look back -- we talked about 12 to 16 weeks. Scott had asked the question is it getting hotter, is it getting lighter in terms of competition? I said it's been pretty consistent. But beyond that, the uptick past the 16 weeks it's been there, I don't see a change, really, in competition. That's what we've built in the model as being relatively neutral where we're at today.

In terms of how do we price against it, we have a model. We have a price image to protect and we will stick to our competitive pricing and it's been extremely successful for us in the past. I think as we continue to go back, I think it's important for everyone to remember that we're running, again, the highest tonnage numbers that we've seen in five quarters.

We're moving a ton of produce, no pun intended there. And we are seeing a basket size in terms of number of items grow at the highest level in two years.

I don't anticipate the conventionals backing off in terms of their investment. If they do, there's going to be upside for us. If they don't, it's built into our guidance.

Great. Thanks, Jim. John, to your second question, I think that mid to high teens, that 16% to 18% that we have guided to, if you look over a multi year basis, we're not seeing anything in our business model, assuming all the inner comps and inflation in a normalized setting, we're not seeing anything in the business that structurally changes that growth rate.

As you've seen this year, when we have tough deflation or tough produce cycle, or inverse of last year which was a great produce cycle, it allows you to capture dollars at some point and give back in other years. If you look on over a two- or three-year basis, I think that our model is performing very consistent with what we've always seen in the business.

Okay. Thank you.

Thank you. Our next question comes from the line of Vincent Sinisi of Morgan Stanley. Your line is open. Please go ahead.

Hey, great, thanks very much for taking my question. Best of luck, everyone, with the upcoming position changes. I don't want to beat the horse a little bit more here, but I do just want to be clear. With your second half outlook, it sounds like certainly from what you said so far during the call, the deflation, the competitions, obviously the two greatest factors.

It sounds like you're expecting generally kind of maybe late year improvement as both of those factors hopefully kind of moderate. In terms of what's officially baked into your guidance, are you running at -- is it basically you're running within the comp ranges, what you're seeing from a competition standpoint, what you're seeing right now is factored into that?

I guess another way to ask it is, do you think that you've reset expectations low enough now where, even if there is some back-and-forth, you still have given yourselves some room in the back half?

Yes, I think we're making an assumption of zero inflation in the back half of the year. Trends that we're seeing where competition is today, and I think that the other thing I would point out is also taking into account the inflation from last year and having a relatively flat inflation expectation for the back half of the year.

I think the last thing I would say is if you look at the timing of the new stores, our EBITDA margin rate sort of compression kind of peaks in the third quarter and that rate probably looks very similar to the first quarter, the EBITDA margin compression in the third quarter, which is going to give us a very modest EBITDA growth in the third quarter and a relatively flat EPS growth in the third quarter. That really starts picking back up as the DSEs normalize as we lap the DSE expense from recent new stores, as well as the gross margins start to normalize again as we expect.

Okay. That's helpful. And if I could just slide one more question in, if you don't mind. In regard to the comment earlier on your seeing some of the greatest growth in terms of the number of items that is going into the basket.

Can you give any more color? Are the incremental items that are going in, are a good portion of those related to your current in-store initiatives? I know you said four additional deli this year. And then maybe just any other updates on some of the rollout plans for those in-store initiatives?

Yes, I think that we gradually, over the program, as we put the three companies together as well as the initiatives that we've done in 2013 and 2014, if you look at the average items in a basket, that has grown very nicely and very consistently. It's grown slowly over time. We've not seen any spikes up or down, so it's nicely growing. And I think that as we move forward, the deli initiative, we think is a big one.

And I think that private label continues -- and continue to go deep into specialty items and drive more consumers for more destination type of shopping. The one area that I think, over time, we also as a company need to explore is more basket-building initiatives and those are some things that we are going to be talking about as a leadership over the coming months.

And when you look over the nonperishable, when you look at the mix in that basket, what's growing -- and I mentioned it before and there has been some reports out on some specialty retailers and reported comps and we're beating those in the non-perishable side of the business. It's a combination of the nonperishables.

And I give a lot of credit to the group here in the [Vinter] community for coming up with some fantastic promotions. But a lot of it, the majority of that, in addition to those two departments, is coming out of produce.

Okay. Great. Thanks very much. Good luck on (inaudible).

Thank you. And, ladies and gentlemen, this does conclude our question-and- answer period. I'd like to hand the conference back over to Mr. Doug Sanders for any closing remarks.

Thanks for joining us today, everyone, and we look forward to talking to you again on an upcoming call. Have a great evening.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may all disconnect. Have a great rest of your day.