Sprouts Farmers Market Inc (SFM) 2016 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Sprouts Farmers Market third quarter 2016 earnings conference call. (Operator instructions).

I would like to hand it over to Susannah Livingston. Please go ahead.

Thank you and good morning, everyone. We are pleased you have taken the time to join Sprouts on the third quarter 2016 earnings call. Amin Maredia, Chief Executive Officer; Jim Nielsen, President and Chief Operating Officer; and Brad Lukow, Chief Financial Officer, are also not the call with me today.

Sprouts' 10-Q, the earnings release announcing our third quarter 2016 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 forward-looking statements including statements regarding our future performance in growth, product expansion, new store openings and 2016 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 issued today.

In addition, our remarks today include references to non-GAAP measures. For reconciliation of our non-GAAP measures to GAAP figures please see the tables in our earnings release. For 2015 we have presented adjusted net income and adjusted earnings per share and adjusted EBITDA with adjusted measures stated in the reconciliation tables in our earnings release.

For the third quarter of 2016, such adjustments would be immaterial. As such we have presented net income, earnings per share and EBITDA without adjustments. For the third quarter 2016 diluted earnings per share was $0.16.

With that let me hand it over to Amin.

Thank you, Susannah. Good morning, everyone, and thanks for joining us today.

In the third quarter we remain focused on driving top line sales and strategically building our business for long-term growth while managing the current environment. Sprouts net sales grew to $1 billion up 15% compared to the prior year. We are pleased with our 2016 new stores, which are performing well with new store productivity above 80% for the third quarter.

Comparable store sales for the quarter were 1.3% comprised of 1.2% increase in basket and traffic of 0.1%. Comp sales were impacted primarily by cost and retail deflation as well as higher canibalization. Cost deflation was approximately 2% during the quarter and led by protein, dairy, bulk and produce, which also turned deflationary during the quarter..

Nearly 60% of our business is fresh which is on trend, drives frequency and adds strength in our business model, however, today all of these departments are deflationary and impacted our sales and same store sales this quarter. When deflation expands across multiple categories and extends for several quarters it's not uncommon to see higher promotional activity in our industry, which leads to retail deflation higher than cost deflation and this is what we saw during the third quarter. The last time the industry experienced deflation and investments similar to the current environment was in 2009.

Historically we have seen that when deflation turns comp sales, sales and margin follow a similar positive movement. Based on what we are seeing today, we expect the promotional environment to continue in the near term. We continue to remain competitive and invest as appropriated. Based on the slightly better than expected third quarter sales performance we are raising the bottom of the full year same stores sale growth guidance to 2%. Brad will discuss the guidance in detail later.

Outside the impact from the deflationary environment, I remain confident in the core of our business, our business model and bring our ability to continue to bring fresh and healthy foods at value prices to more customers every day. Let me touch on the progress of our key initiatives and why I remain excited about our core business.

First we continue to expand our trusted natural and organic private label program based on strict ingredient standards and a great taste profile. Our private label program now accounts for over 10% of our revenue and continues to significantly outpace our company average in both sales growth and comps. We currently have over 2100 private label items and plan on continued growth in this area for years to come.

Second, our small box format remains an advantage for Sprouts allowing quick in-and-out service, which provides opportunity to expand convenience offering such as our fresh food and deli work. We have implemented food and deli expansion in 73 new and existing stores this year with a few more stores to go during the balance of the year. This expansion includes a freshly prepared protein and sides full service case, a salad bar, fresh juices and soup station.

I recently reviewed the plans for 2017 and I'm excited about adding our food and deli initiative to more existing and new stores and also leveraging this platform to enhance our fresh offering even further. Third, innovating with our vendor partners has enabled us to build and broaden our partnerships and also launch new unique and exciting products and programs like a Hatch Chili program released earlier this summer and new holiday items like chipotle cranberry salsa and dark chocolate drizzled kettle corn.

We look forward to the holiday season and building on our past success. Our sales teams have worked hard to bring forward both branded and private label products that will provide a healthier holiday season for our customers. Fourth, service remains a top priority for our more than 24,000 team members.

We continue to have one of the best customer service (inaudible) in the industry and continue to receive great feedback from our customers every day. Our commitment to increased training investment, has a strategic priority in 2016, was based on feedback from our team members survey.

Our team members in the store desired more product knowledge to better serve our customers as we have recognized this knowledge and service separates us from others in the industry. These training programs are also building our next generation store leader as we continue to grow coast to coast. We are also starting to see the benefits of this program with better customer service numbers today.

On the digital front we have more than 3 million digital customers online and we continue to increase our engagement with them through e-mails and social media and the Sprouts app, which is increasing functionality such as mobile coupons. All of these digital initiatives are focused on driving customer engagement and improving their experience across all touch points.

We also continue to expand our partnership with Amazon Prime now with the addition of two more locations capitalizing on Sprouts' strength of fresh and affordable products. On the infrastructure front, our technology and infrastructure priorities for scale are progressing very well. I'm pleased with the foundation our newly formed business intelligence team is building.

We have put some of our best resources at the company in this area and our priorities are fully aligned with our overall business plan and we look forward to leveraging this platform in the future to better understand our customer preferences and enhancing overall customer experience, engagement, and loyalty. Lastly, on the new storefront we added 10 new stores in the third quarter with an additional three in the fourth quarter and remain on track for a total count of 253 stores by year end.

Our 2016 vintage performance reflects our on going efforts to refine our site selections coupled with consistent operational performance. Our pipeline remains strong with 57 approved sites and 38 signed leases for the coming years. Atlanta will be the home to our fourth produce distribution center opening later this quarter.

We also look forward to bringing healthy living to two new states in 2017, Florida and North Carolina, which increases our reach to 15 states. Before I hand it over to Brad, I want to say that I'm extremely proud of our teams in the stores and the office as they continue to manage the near term while staying laser focused on what makes Sprouts Sprouts.

Innovating great tasting, healthy products at valued prices, excellent store locations and knowledgeable and approachable customer service. Our team is more connected and focused than ever before in navigating the current environment while focusing on our strategic initiatives to enhance our healthy living business that will continue to resonate and excite our customers for years to come.

With that let me turn the call over to Brad to speak about our financial results and guidance.

Thank you, Amin.

I'll begin by discussing some of the business drivers for the third quarter and then review our guidance for the remainder of the year. For the third quarter, sales were up 15% with comp sales growth of 1.3%, slightly better than we expected in light of the competitive environment higher cannibalization and the ongoing deflation of nearly 2%, the highest we have experienced all year.

For the third quarter, gross profit increased by 11% to $292 million and our gross margin rate decreased 80 basis points to 28.1% compared to the same period in 2015. 60 basis points of this reduction was due to price investments in certain categories in order to maintain our competitive pricing position along with slightly higher shrink from lower comp sales growth.

In addition, occupancy expense deleveraged 20 basis points, including the negative impact related to a credit received in the prior year period. As we have stated in the past, we will continue to be a sales minded company and we'll be aggressive when necessary to drive our traffic as we look to build this business over the next five to ten years.

For the third quarter, direct store expense was $217 million and as a percentage of sales was 20.9%, an increase of 130 basis points after excluding the pretax loss on disposal of assets in the third quarter of 2015, 30 basis points of this increase related to cycling a lower medical expense from the prior year. The remaining increase was primarily due to deleverage from lower comp sales growth, higher payroll expense from planned increases in wages, and training costs implemented at the beginning of the year and the impact of opening a greater number of new stores in 2016.

SG&A totaled $30 million for the quarter and as a percentage of sales was 2.9%, an improvement of ten basis points compared to the same period last year. This was primarily due to lower bonus expense, partially offset by higher stock-based compensation expense related to executive changes made in the third quarter of 2015.

EBITDA for the third totaled $63 million this was a decrease of 14% when compared to adjusted EBITDA in the same period of last year. This reduction was primarily driven by lower margins as a result of the stepped up promotional environment during the quarter, increased labor costs and higher pre-opening costs driven by additional expenses associated with the Hagen stores that we opened this quarter.

Net income for the third quarter was $24 million a decrease of 27% from the adjusted net income in the same period last year. Diluted earnings per share was $0.16 from the quarter a decrease of 24% from adjusted diluted earnings per share of $0.21 in the same period of last year.

Shifting to the balance sheet and liquidity, we continued to utilize our solid operating cash flows to fund our business and, in combination with our strong balance sheet, return capitol to our shareholders. On a year to date basis we have generated $196 million of cash from operations up 9% from the same period last year and invested $135 million in capital expenditures net of landlord reimbursement primarily for new stores.

Through the third quarter we repurchased $188 million or approximately 8.2 million shares under our share repurchase authorizations. Subsequent to the end of the quarter and through October 31st we repurchased an additional 2.9 million shares for a total investment of $249 million for the year. We ended the quarter with $50 million in cash and cash equivalence and $205 million borrowed on our revolving create facility.

On an LTM basis net debt to EBITDA was 0.9 times at the end of the quarter. With our strong operating cash flows and low debt levels we are well positioned to continue to self-fund our growth plan and maintain our strong liquidity position. Let me now turn to 2016 guidance. Given our third quarter performance we have raised the lower end of the range for full year comp sales growth and we are maintaining our EPS guidance as updated on September seventh.

Guidance for these elements and others are as follows, we expect comp sales growth in the range of 2% to 2.5% for the year. This would imply roughly a flat fourth quarter comp slightly better than we thought back on September seventh.

Diluted earnings per share in the range of $0.83 to $0.86 and net sales growth of 14.5% to 15% on a comparable 52 week basis and in line with our September guidance update. EBITDA growth 0% to 2% on a 52 week basis when compared to adjusted EBITDA in the prior year. We remain on track it to open 36 new stores and CapEx will be in the range of $160 million to $165 million, net of landlord reimbursements.

A few additional items to note on the 2016 guidance. As many of you know we will experience a tough compare in the fourth cycling our highest comp quarter for 2015 of 7.4%. The competitive environment has remained consistent over the past few months and we continue to maintain a cautious outlook. We anticipate that the deflationary environment will continue for the balance of 2016 with cost deflation of approximately 1% for the fourth quarter.

As it relates to margins we will continue to make price investments as necessary to drive traffic and to maintain our competitive position. For the full year we would expect gross margins to be flat on a 52-week basis. On the direct store expense line we expect to continue to delever DOC as a percentage of sales through the rest of the year due to higher store payroll expense and deleverage from our expected comp sales growth.

On the SG&A line in the fourth quarter we expect continued leverage similar to the third quarter as many of our investments for this year are now complete. Below the EBIT line we expect interest expense to be approximately $15 million, including interest related to financing and capital leases. We also expect a weighted average and diluted share count of approximately 150 million shares for the year and a corporate tax rate of roughly 38%.

In conclusion, in the face of the current competitive environment, we are pleased with our ability to drive top-line sales growth. We remain steadfast with our strategic initiatives while managing the day-to-day competitive environment to best position Sprouts for long-term growth.

With that, we'd like to open up the call for questions. Operator.

Thank you. (Operator Instructions). Our first question for today comes from the line of Karen Short from Barclays.

Hi. Thanks for taking my question. I guess I want to talk a little bit about this gross margin. I guess maybe, I'm wondering if you'd give us a little color when you became more promotional to drive the comp and obviously pressure gross margin.

And I ask because it helps gauge what to expect for the fourth quarter and I ask also, because given how your stock is acting it would appear expectations are for more much lower growth margins in to perpetuity. So any color there because the other component of that is your implied comp guidance for the fourth quarter obviously still reflects negative comps in the fourth quarter, even though you're going to be more promotional than you were in the third. Does that make sense?

Hi, Karen, it's Brad. Yes, when we set out our guidance on September seventh it was really reflective of what we saw in a stepped up promotional environment at that time. And looking at the results for the third quarter, while margin was down 80 basis points, from a food margin perspective it was down 60 after eliminating the positive impact we had on occupancy in last year's Q3.

Implied in our fourth quarter guidance both back in September and now, we're anticipating a similar competitive promotional environment and looking at roughly flat comps for the fourth quarter as well as similar food margin investments in Q4 relative to Q3.

Yes, Karen, one thing -- I was just going to add one layer a little bit deeper with respect to your timing of the third quarter. We did have higher shrink when we saw sales fall off in the third quarter which we of course corrected, so as we did that in your question for X number of weeks, we were impacted by higher shrink because we had products flow into the stores and that, obviously, we are able to correct for the fourth quarter.

So, and what Brad just said is when you pull that shrink out and based on what we are seeing is we would expect gross margin, the 60 basis points he reference to be similar to maybe slightly better than what we saw in the third quarter. So, I would not -- in short I would not say today that we would expect a much deeper margin investment than what you saw in the third quarter.

Okay, that's helpful. Is there anyway you could give color on comps by geography? Obviously in September you highlighted one market in particular that had become very challenging, but just to get a sense of how broad based the competitive landscaping is.

Yes, I think as far as promotions we're seeing different retailers in different markets. The only structural comment I would make is, in parts of Texas and Oklahoma, the economy has been softer so we're seeing not only pricing competitiveness there but also customer traffic in some cases in certain pockets of Texas and Oklahoma being softer. But outside of that, relatively similar across the board in terms of competition. Jim, I don't know if you want to add anything here.

No, I mean, the geography is, like you said, we're experiencing the unemployment rate for Oklahoma as well as the Houston market, as Amin eluded to, is seeing dramatic uptick, which has obviously impacted our sales in those markets.

Okay. And any reaction from the competition based on your stepped up activity?

We have seen similar actions continue. We've seen -- I call it pauses or accelerators and brakes on and off depending on the week. But I think -- we've not seen incremental activity since we've stepped up. I think everybody was already competitive. In some cases we might have been a little less to the table to get more aggressive. So, it's feeling like it's getting a little bit better but that tends to moving week to week.

Great. Thanks very much.

Thank you. Our next question comes from the line of Chris Mandeville from Jefferies.

Hi. Good morning. Thanks for taking my questions. First off, just a point of clarity really quickly. Did you state that you're expecting a flat comp for Q4 or flat comp for the back half of the year?

That would be a flat comp for Q4 is what we're guiding to. If look at the two year, back in Q4 it would imply a similar result to Q3.

Okay. And then I'm just trying to understand your decision to spend another $60 million or so on your buy-back program post Q3 in light of today's results. Can you help us go through the thought process there and the decision to actually use your revolver to finance that. And then I suppose longer term, has there been any change or an increased wellness to actually utilize leverage on a go forward basis?

As you can imagine, we would evaluate our capital structure in the context of our multi-year planning and clearly what we are seeing in the business, notwithstanding we're in a temporary deflationary period, the company continues to generate significant excess free cash flow, it's a very capital efficient model and the cash on cash returns of 35% to 40% within three to four years are absolutely solid.

And so, in the context of our annual review of capital structure we initiated a $250 Million authorization that is in place from the date we implemented it to the end of fiscal 2017. And I think we're being very prudent with our balance sheet. We of a conservative capital structure and we think it's just another opportunity to enhance returns to shareholders and overall value creation.

Great. That's very helpful. And if I could sneak one last one in there. Maybe I missed it. But did you discuss self-cannibalization and then maybe more specifically any initial read on the former Hagen openings.

Yes, I'll answer those in inverse. You know, when Hagen closed last year and we called this out, when those Hagen stores started closing in the fourth quarter that gave us a positive impact in the fourth quarter of 2015 and the first couple of quarters of this year, of 2016. As others -- us and others started opening up in the second quarter, really when we saw a lot of those stores open back up as either conventional or some other operator, that benefit started to go away and we're seeing a little bit of negative impact from those openings.

So while they weren't brand new store openings there is another retailer opening up and we'll cycle that in the second quarter of next year, really at the end of the first quarter. So that's on that component. As far as cannibalization is concerned the one comment I would make is that we've seen -- you know, over the last come of quarters our cannibalization has picked up.

We're above your 150 basis points, high end of our 150 basis points to target. However, when we look at those stores those stores are coming out of the gate strong, even net of cannibalization they have very strong cash on cash returns. So this is one of those decisions as a company that we know in the long term it's the right decision to make, while it hurt short term costs. When I look at both comps and traffic for the stores that are not being cannibalized, and we've had a significant number of stores that were cannibalized over the last couple of quarters, both comps and traffic to non-cannibalized stores look pretty good.

So I think our traffic story is actually quite different in our stores that are not cannibalized. So I view that as a positive. And the last comment I'll make tied to that is our tonnage continues to -- since we started to invest through the middle of the summer, tonnage continues to improve. So pretty positive sign on that front as well. Albeit we've spent a little bit more on margin.

Very helpful. Best of luck in Q4.

Thank you. And our next question comes from the line of Zach Fadem from Wells Fargo.

Hi and good morning. So you've historically talked about a 30% discount on produce relative to competition. I'm curious how that's been trending of late given the current environment. And second, you mentioned 60 BIPS of price investments in the quarter. Were these concentrated primarily in fresh or across the board?

Just with regards to the gross margin investment of 60 basis points, that includes both the promotional investment spend as well as the additional shrink that we experienced because of the lower comp sales growth until we could adjust our operations to respond to our forecasting sales.

With the -- Hello, this is Jim. With the regards to that, we continue to maintain our spread. It's not what you quoted but we continue to maintain our 20% to 25% spread that we have with our competitors across all geographies. And more of the drivers that we had impacted in produce, for us, was deflation, as Amin just mentioned, cannibalization and, to a lesser degree, was the competitive landscape.

Okay. And new store productivity, at least by my calculation, improved quite a bit versus last quarter. Curious if you could comment on the drivers here. Was there a certain region out performing or maybe greater mix of existing versus new market. Any color here?

That's a good question. It's the later of what you said. It is that -- we had talked about it on the last call. We were more existing market heavy towards the back half of the nine months where we opened most of the stores. So, at the beginning of the year we were a lot more stores in new markets, which you as you know take three, four years to mature, whereas the existing markets start off quite well. So, I think given the momentum that we have in our new store productivity I expect our new store productivity to perform well going into the fourth quarter and into early part of next year.

Okay. And finally, did you guys provide a quarter to date comp for Q4?

No, we don't provide quarter to date comps.

Okay. Got you. Thanks so much.

Thank you and our next question comes from the line of Chuck Cerankosky from Northcoast Research.

Good morning, everyone. If you could when you're looking at these new store opening, especially in new markets, how is the opening promotional package compared to a normal deflationary period? Are you forcing to be more aggressive or can you talk about that a little bit, please?

You know, we won't get into specific tactics on pricing in new markets. What I'll say is we obviously spend quite a bit of time doing a couple of things and, obviously, training because we have a lot of new team members. We'll have some people from existing markets transfer over. But predominantly a greater number of team members are new to Sprouts so we spend a lot on that.

From a marketing perspective, we spend a lot of time on grassroots and community engagement and typically six months ahead of opening the first store we start to go into the market and we pick up the activity three months in. The comment I would make with respect to your specific question is we tend to be -- we tend to hold our pricing strategy for new markets for a longer period of time than existing markets because in existing markets we're branded, customers know us so the ability it attract traffic is a lot faster.

So we tend to hold pricing for a longer period of time. But that's not new today. That's been consistent with the program for years. Whether we entered in Dallas 2005 or Colorado 2008 or northern California in 2012.

What it does do when we go to new markets is, because we're holding the price longer, when those stores first start comping we tend to have a slight adverse impact on comps early on, after 60 weeks because we're holding the pricing longer it takes a lot more than 60 weeks for that cycle to turn. But that's just a short term phenomenon, no impact on the long term pattern on the stores.

And, Chuck, the only thing I would add is that our investments spent, in terms of promotions for existing, emerging in to new markets is exactly in line with what we spent in prior years.

Okay, that's very helpful. And then on this new DC that'll be opening up in Atlanta, do you expect any drag from that and when will it start to contribute to reduced costs of goods?

In the very, very beginning it's going to be neutral and as we progress we'll see positive leverage to the DC. More importantly we'll get fresher product for our stores in Atlanta that have better life as well as the ability to buy more local products and provide those to our consumers so we see it as a strong upside in sales.

And we always look for a base level of volume movement before we open a DC. That's why what Jim just said, is it doesn't create a drag because we don't open the DC too early out of the gates. We ensure more costs shipping longer prior to opening that DC but now that we have a good amount of volume and tonnage going through the stores in the southeast it's, sort of, the appropriate time for us to open a DC there.

With the fresher product any help on the shrink ratio that we would notice?

Yes, we should see a benefit from shrink as well as a better positive consumer response. And it helps us get a little more entrenched in the local environment there as opposed to having to back haul something to Dallas and all the way back out to Atlanta, so multiple positives by opening up our DC in Atlanta the back half of this year.

Thank you. And our next question comes from the line of Ken Goldman from JPMorgan.

Hi. Good morning, everyone. I know this isn't exactly on topic today but we've seen a lot of news about pricing pressure across the supplement category. And, I think, and please correct me if I'm wrong, that supplements are maybe a little bit under 10% of your sales. So, I'm just curious, as you look across the competitive environment in this space, do you think going forward you may need to invest a little more in price and supplements than expected or do you think your value proposition in customer service and so forth provides a little bit of cushion for you.

Every one of our departments has a pricing strategy and we continue to refine those but today we feel extremely good about where we are from a pricing position and our non-perishable departments continue to perform extremely well. And I give a lot of credit to the team for strong promotions, relevant items that are on trend and, as you mentioned, our strongest point of difference that we have is our people that are knowledgeable as well as extremely engaging.

One thing I would add to what Jim said is what we've seen, even in our early Amazon Prime now test stores, we see a lower penetration in vitamins and that just speaks to the importance of some of the flow items you might see moved through there. But most of the items that are strong value adds customers are still coming to the stores because they tend to change their regiments and engage and ask a lot of questions around them. So that's also just another data point showing it's the customer service element, it's yet another (inaudible) to us that it's so important in that part of the store.

Okay. And then just going back to the discounting question. Obviously, a lot of what you're doing, in terms of promotions, not just supplements but, really, across the stores, is more tactical in nature. I'm just curious what the plan is for pulling back on some of these promotions once we get a less deflationary environment. And the reason I'm asking is I know that PPDs are less sticky by nature than list price reductions. But a lot of grocers and retailers in general find them harder to, sort of, wean off than feared. So I'm just curious what the strategy is for preventing customers from getting used to buying on deal and eventually you pull back on that a little bit.

Yes, I think we've gone through the cycle several times and what tends to happen is when the deflation pulls back and we're back into an inflationary environment you just see the promotion level tends to settle down across. That's been our experience, across the channel.

And the second element I would say, is the reason we sort of think about it as temporary, is we've not seen a lot of reduction at shelf. Most of the reduction that we have seen or increasing competition that we have seeing is promotional activities so that also speaks to little bit of intent on the part of retailers of temporary versus long term. So hopefully that answers your question. Jim, I don't know if you want to add anything else here.

Yes, I think while we are a promotional company our every day pricing is extremely strong. As we mentioned we do full book checks on a quarterly basis and recently just got one back and we're in a favorable position. So it's not just our promotions that makes us unique and a value brand, it's our every day pricing as well. So we think we have struck the right balance between promotions and every day pricing.

Thank you. Our next question comes from the line of Scott Mushkin from Wolfe Research.

Hi, guys. Thanks for taking my question. So, I can't remember, do you guys give us transactions and, I didn't think I saw it in the press release. I was wondering if you do and how that trended sequentially between second and third quarter?

I think transactions have been definitely been softer in the third quarter compared to the previous quarter. What I would say is on a 2-year stack basis they're exactly the same or very similar levels in first quarter, second quarter, third quarter. Couple of additional points around transactions is we've about it, Jim, and I've talked about it before, is when it's highly promotional it's harder to gain traffic and drive more traffic into the stores because everyone is being promotional, and as well, the cannibalization I mentioned earlier.

Probably not to be understated is when you have more cannibalization that's all traffic. And so when we look at the traffic in the non-cannibalized stores they -- certainly we want to see them even higher, but it doesn't -- those numbers are much stronger than our overall traffic numbers. And that's -- we're using that sort of data -- a lot of these data points to determine where we need to invest which markets we need to invest, which departments and how deep so we're trying to be surgical and not splattered across the board in our investments.

And are you still positive though? I would assume you are, right?

Yes. Both tonnage and traffic is positive, even with the high cannibalization.

So this gets to a strategy question for you guys and clearly you're being, the stock was a lot in this report, but you're being punished today. You're obviously making a decision as a management team to take your pricing down, invest gross margin, make sure to let those sales and traffic numbers remain positive, or at least traffic numbers to remain positive.

We had a competitor of yours report yesterday they're kind of taking the opposite view, right? They haven't done much on pricing. Their transactions are hugely negative. Yet their stock is up today. So I was wondering, do you think you're pursuing the right strategy and if so why? And then I have one more question for you.

Yes, you know, I'll just start with the, (inaudible) answer this, there's lots of ways to run a business and Sprouts has always been a top line and traffic driven company. That's our life blood. And we're pretty blessed to have a business model which is highly accretive from a cash on cash return perspective. That's why we don't feel like we need to be super defensive or need to be defensive in any manner to drive the business.

Because even when we talked about this in the past, even when you -- even if needed to adjust our EBITDA margins business down for the mid to long-term in the business, this is just a very, very solid cash flowing business. So you've got a 35% to 40% cash on crash return which might dip by a few points but that's not a reason not to drive traffic, drive tonnage and top line sales.

For us we feel that's the absolute right strategy. Health on trend, fresh is on trend it's 60% of our business and at the same time we know we have a long runway of growth ahead of us. So to take a posture of keep hanging on to margins or trying to -- which would then impact traffic -- we don't believe, for Sprouts today or in the midterm, is the right strategy.

And Scott, the only thing I would add is, again, as Amin mentioned, traffic is critical for us. As you well know, as we've, talked about this in the past and we have that trial and then our consumer moves into that transitional state where they start to buy into the non-perishable departments and then, kind of that lifestyle, when they move over to vitamins. So it's critical for us to continue to keep attracting new customers which in the future will help us leverage a bigger basket and a more profitable basket.

Thank you. And our next question is from the line of Vincent Sinisi from Morgan Stanley.

Hi, this is Andrew [Ruben] on for Vinny. I was just wondering, from a competitive perspective, it seems like a lot of changes on the promotional environment. But any color you can provide on competitive openings and whether there's any certain types of formats that you're seeing to create the competition from today?

We're not going to disclose in terms of specific retailers, but in terms of number of outlets, it was in line with Q2, on a year-over-year basis it is up slightly. We can only look probably three, four months out with any level of confidence and we're anticipating the same level over of competitive intrusion over the next quarter and a half.

Thank you. And our next question comes from the line of Rupesh Parikh from Oppenheimer.

Good morning. This is actually Erica Eiler on for Rupesh. Thanks for taking our question. So I wanted to dive a little deeper into SG&A, kind of a two part question here. So, first, I mean, clearly this year has been an investment year. As we look into next year do you expect to see any relief on the SG&A line or should we expect to see a level of elevated spending that we have seen in the past few quarters?

And then the second part is, as we look at next year, should comps remain below your longer term target of the 4% to 6% range, what are the opportunities to cut costs or maybe you could talk about any other actions that you might be able to take to minimize the impact of a softer top line. Thanks.

Yes, it's Brad. As we've discussed all year long this was an investment year with us with regards to DSE. We've made both strategic increases at the beginning of the year for wages in certain markets and positions as well as stepped up the training initiative, which Amin spoke about earlier. When we look at the performance through the first half of the year, DSE had been deleveraged roughly 50 basis points primarily as a result of these initiatives.

In the third quart are we saw a step up to 100 basis points, excluding the 30 basis points win we had in Q3 last year. And so that 100 basis points really included about ten to 15 impacted for the one time step up in the net new stores that we opened, which will be similar next year and the rest is really deleverage from the lower comp sales growth that we experience in the quarter.

When we think about the SG&A side, again, we spoke in February, and the results have proven out through the first three quarters in terms of front end. We're investing in infrastructure projects. We successfully implemented a HRIS system, which is critical for us as we're growing 14% plus per year, as well a labor scheduling system that is implemented in the non-production departments in the stores. So really settling up the company for scalability and growth.

I would characterize 2016 as a step up in investments. We're not anticipating a similar step up next year, it's sort of like run rate for us. We'll be back to, obviously, in February and Q4 call with regards to guidance for 2017, but just -- with regards to your question on comp and our midterm guidance that we set out about a year ago, that was clearly set out in the context of what our normal operating environment has been with inflation in the 0% to 2% range.

Clearly over the last ten months or so where we have seen prolonged inflation, across many of our categories, which is almost 60% of our category sales are impacted by this deflation, we don't anticipate that continuing over the long term as history has shown. So, again, we're sticking with our strategic focus on building the company for scale and profitable growth.

Thank you. Our next question comes from the line of Stephen Tanal from Goldman Sachs.

Thanks, guys, for taking the question. I just have to dig deeper into traffic disparities, you know, this store is cannibalized versus not. If you could give us some color there and as well as the deltas between mature stores with no cannibalization and, potentially, mature stores with cannibalization or how you just color it around the point one traffic increase this quarter.

Yes, you know, I think what I would say is over the last coupe of quarters is the delta between -- in comps on cannibalized stores has continued to widen as cannibalization has gone up. We have certainly seen a little bit of moderation on traffic, even in the core stores and we reacted to that and we're starting to see good traffic and tonnage movement, we're call it back in the game so to speak, but it remains competitive out there.

And I think the key fundamental for us is when it's this promotional or for us and consumer, actually, when things are highly promotional the ability to draw or uphold customers just becomes harder because it ends up being a net neutral for everybody which I've always said that. But when it gets in a deflationary environments the super promotional activity is not really benefiting anybody except the customer, in our minds. But it just becomes harder to pull more customers into your stores.

Got it. Understood. And I guess, maybe two follow-ups on the same point. If you could help us think about the mix of new markets versus existing markets or even more specifically the mix of the store, the percentage of stores maybe being cannibalized as we kind of try to think through the traffic trend. And then the second question would be, do you have a feel for comps by income bracket as we think about the chains that might be seeing some better traffic trends or maybe less bad traffic trends as we try to figure out what's really going on out there?

Yes. So, couple of questions in there that I'll try to pick them off and if I miss something just restate it. In terms of cannibalization, clearly it's most prevalent in our existing markets where we're deeply penetrated and many times we open stores near just to peel traffic off because the volume of other stores are just at such high levels that on peak times and days, on the weekends and on certain other days, probably on the weekends, it just becomes a more difficult shopping experience -- it's not the optimum experience for the customers in the stores.

So we decided that -- and typically what we have seen, when we do that and even if they drop 10%, 15% or 20% we've seen in sales, just about every time the sales come back and those stores build back up. In fact I can think of at least three or four stores in one of our markets where we've hit three times, and we're going to be making a decision at the next meeting to hit it again. Because that store that is that tight again for a customers ability to get in and out.

I think that's one element. In terms of geographic -- from a vintage standpoint our comps look good, when I look at our 2014 and 2013. We had a really good 2013 comp, 2013 vintage that started off strong so comps there break away from the pattern, they were more front loaded. But the 2015, 2014, 2012, when I look at all those vintages they're following our historical patterns as far as markets. We're continuing to see X just the deflation, both the cost and retail deflation. Once you adjust for the deflation, the pattern is holding very similar.

A lot of the fundamentals of the business we feel good about. We want to do more work on traffic. But I think the key for us both cost deflation and retail deflation is having a big impact on business. When we talk about four to six comps that's on a base of 0% to 2% inflation. And so when you're at a negative inflation you're starting point is at 2% and then when you have competitive activity you have got to hurdle that as well on top of your cost deflation.

So that's how we're thinking about the business and how we're looking at the business. And when we make investments we always think about whether these are rational investment decisions are not. And we're trying to pull customers with this irrational margin of investments is not something that we like doing. But in environment it's something that the industry forces in different markets at different times.

And, Stephen, the only thing I would add is, again, point one traffic is not in language history. But we're on a 4.9 traffic, on a stacked basis five and as Amin mentioned earlier in the call, it's 5.1 in the year. So we're up against some real strong numbers and you did kind of call out is there -- the demographics do they change in terms of the consumer potential leakage.

The only thing that happens in a highly competitive marketplace, like we see today with deflation, is that ad shopper has a tendency to sometimes benefit and moves back and forth to different consumer. But the core customer is -- which is evident by our non-perishable growth and sales and continues to be loyal Sprout shopper.

Thank you. And our next question comes from Robby Ohmes from Bank of America Merrill Lynch.

Good morning. I had a follow-up question for Amin and Jim. I wanted to see if I could get you guys to focus on produce deflation a little bit and it coming back. And, sort of, the question is, is the deflation at retail, in your view, in line with the cost deflation or are you seeing a strategy adjustment from the competition.

Maybe you could speak to us about as you get beyond the deflationary environment, which we're all waiting for and I hope it happens tomorrow, but is there a scenario where the competitive aggressiveness in produce continues. Are you seeing anything that may imply that the strategy from some of your larger competitors in the produce category has changed even beyond what you would assume from cost deflation in produce?

And if that is true you can help us think about how your model could adjust for that so that you could return to those sort of 4% or better comps? Thanks.

Yes, I think part of what you said is exactly where we're sitting. Deflation Is a big part of the -- as far as overall market standpoint, clearly fresh is on trend, but when we look at our numbers, we're competitive in price as well as keeping our spreads and keeping our basket mixed, so if you look today our produce is at a very similar level of sales -- at exactly the same level of sales as it was three years ago from a mixed perspective.

The other piece that we're trying to do is become a company that has multiple traffic drivers. I think some of the work we've done around deli and some of the gains we're starting to see in traffic -- foot traffic in our deli department, although deli is not a business that you build overnight. But what we are doing in deli, what we are doing in private label, from a stickiness perspective, as well as more engagement with our digital work to make us more -- to bring more touch points, more top of mind, more relevant advertising, the idea really is to bolster our core of our business around perishables and health and add more reasons for customers to come to Sprouts and stay at Sprouts and from where we sit today we feel pretty good about how we've seen the marketplace behave in the produce environment.

And I can tell you that potentially any retailers who've seen gains in produce it's not come from Sprouts. So, I can tell you because I see that in the numbers. If it's coming from other specialty or other conventionals, that's more likely to be happening than coming from Sprouts. Jim, I don't know if you want to add anything else here

Yes, I mean, again, as I mentioned before, our pricing spreads have been consistent. I actually view them every week in every market by every retailer. So it's been consistent week to week. If there is any variability we, obviously, quickly react to that to get back in line with our strategies. But the investments that we are seeing are really being made on a promotional front, which we called out earlier in the call. And you know, we have seen that starting in the fourth quarter and we anticipate it and that's been laid out in our guidance today.

Thank you. And our next question comes from the line of Bill [Kirk[ from RBC Capital Market.

Hi, guys. Just one question from me. So you stepped up price investment in the quarter yet beat your own internal comp expectations. So, I'm wondering what was the elasticity on that 60 basis points of gross margin investment in order to pull that off?

Yes, you know, we -- we're able to generate traffic pretty quickly with our model, so the elasticity is quite strong. At the same time I would also tell you that -- I don't want to say a good part but a part of that 60 basis points was shrink for a period of time until we readjusted, as Brad said, our ordering.

So you know we've made investments but we make investments very, not to repeat the word again, but surgically and look at every market and competitor, department and not just throw it out there -- the prices out there and we see, when we make those tactical adjustments, we see traffic shift fairly well. We've seen that in the last six to eight weeks. Actually more than that now. It's in the last ten weeks.

Thank you. Our next question comes from the line of John Heinbockel from Guggenheim.

So, maybe this is more for Jim. But just drilling on private brand strategically and tactically. When you think about where we go over the next couple of years and your satisfaction with private brand placement and space allocation, what do you think happens going forward to that, the space that you give to it? And then with regard to pricing, what's happening to the price spreads between private brand and national brand, do you pay a lot attention to that, I imagine you would? And lastly, do customers have any bearing on private brand to private brand from you to another retailer or are they kind of blind to that?

All right. John, lots of questions there. I'll step back and say, look, we're going to deliver what the customer wants and strike the right balance of that for our customers. As we look at private label, this year was last year and the out years, we're looking at more implementality of products we launched 138 items this last quarter and over 60% of those we believe were truly incremental products (inaudible) based or seasonal or just unique formulations.

So, we're trying to strike that right balance in terms of the price spreads that we have against our -- the inline sets and manufacturers, those have consistent spreads that we had for the last three, four years. And our consumers are just getting more confidence with our brand. And part of that, I think is driven by the quality of the experience, eating experience and then the ability to try new and exciting items could make us unique and you can only find them at Sprouts.

Thank you. This concludes our question-and-answer session. I would like to turn the conference back over to Amin for any closing comments.

I want to thank everybody for joining us on the call. We know this is a tough deflationary environment, we're working through it and I just want to give a call out to all of our team members in our office and the stores, the lights have been one a lot longer every night around here working through the environment, but we feel pretty excited about the mid and long-term as this deflation period adjusts itself.

As somebody said it on the call, we hope it is tomorrow but it doesn't look like it's going to be tomorrow but we hope it's soon and we look forward to speaking to you on the road. Thanks.

Thank you. Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect. Everyone have a good day.