Sprouts Farmers Market Inc (SFM) 2017 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Sprouts Farmers Market First Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, today's conference call is being recorded.

I would now like to turn the conference 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 our first quarter 2017 earnings call. Amin Maredia, Chief Executive Officer; Jim Nielsen, President and Chief Operating Officer; and Brad Lukow, Chief Financial Officer, are also on the call with me today.

The earnings release announcing our first quarter 2017 results, our 10-Q 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 opening and 2017 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 non-GAAP measures to the GAAP figures, please see the tables in our earnings release.

For the first quarter ended April 2, 2017, diluted earnings per share of $0.33 increased 10% from diluted earnings per share of $0.30 in the same period in 2016.

With that, now let me hand it over to Amin.

Thank you, Susannah. Good morning, everyone, and thanks for joining our call today. Sprout's model of fresh, natural and organic products at prices the everyday shopper can afford, continues to resonate with our customers evidenced by another quarter of positive comp sales and traffic. This is a remarkable accomplishment on the part of our 25,000 team members across the country, considering the ongoing and deep deflationary pressures during the first quarter. We remain focused on delivering innovative products, connecting with our customers both in and out of the store and systems and our team members for scale and long-term growth. This focus continues to produce exceptional customer engagement and service scores, strong operations and solid financial results.

For the first quarter, sales rose to $1.1 billion or a 14% growth, driven by comp sales growth of 1.1% as well as strong new store productivity in the low 80s. While cost deflation of 3% was the highest we have experienced as a public company, we saw modest improvements throughout the first quarter as produce deflation eased towards the end of the quarter.

Sales continued to be bolstered by strong private label sales, which are growing well north of the company average, and continued strength in our nonperishable departments. On the perishable side, despite the deflation, we continue to see strong tonnage growth, which was the strongest increase we have seen since Q4 of 2015. And our fresh team continues to make solid progress in our expanded deli department.

Our focus on the customer is driving positive traffic, which was 0.6% for the first quarter, sequentially increasing since the third quarter of 2016. Cannibalization continues to impact our traffic and is running above the upper end of our customary range. However, we expect that to improve throughout 2017.

The competitive promotion environment was at similar levels to the prior quarter. We are maintaining our competitive position by remaining focus on the customer, offering knowledgeable customer service and fresh healthy products at affordable prices.

Shifting to new store growth. In the first quarter, we opened 8 stores, including our first stores in Florida and North Carolina, which brings our presence to 15 states coast-to-coast. Our 2016 and 2017 vintages continue to open above our expectations. In part, this has been driven by our increased brand awareness activities centered around the communities in which we operate and focused on building our brand affinity and awareness as we enter new and emerging markets. Our pipeline remains strong with 63 approved sites and 43 signed leases for the coming years.

We also opened our new Atlanta produce distribution center in December of 2016. The D.C. is proving to be a tremendous benefit to all of our stores in the Southeast. Most notably, it provides customers fresher and more local produce and allows us to expand our produce vendor relationships.

Let me now turn to our strategic priorities for 2017 focused on sales growth and investments and infrastructure. First, we continue to advance our product offerings centered on health, taste and value to meet our customers' needs. Our private label program continues to be a major focus for new offerings in the store, focused on taste and differentiation of products in key categories. We now offer more than 2,100 private label items across the store, driving 11% of our total revenues. By the end of 2017, we expect our private label program to exceed $500 million in sales. In addition, we continue to work closely with our vendor partners as we jointly focus on new product innovation.

We are well on track to achieve our goal of launching the enhanced deli program in 50 new and existing stores this year, with nearly half implemented in the first quarter. This includes a full service case of freshly prepared protein and sides, a salad bar, fresh juices and soup stations. We continue to drive further innovation in our ready-to-eat offerings and deli to provide a convenient shopping experience for our customers and remain excited about new items going into the stores over the next few months. We are also improving the ingredient standards in our grab-and-go items, always remaining rooted in freshness and quality. We also continue to enhance our meat and seafood department through service, product enhancements and merchandising based on consumer trends and shopping preferences.

Second, we continue to accelerate customer engagement and content across print, digital and in-store to enhance the Sprouts experience and drive increased loyalty with our brand. Our mobile app continues to gain traction, and this year we are focused on improving the user experience. We have begun to leverage affinity-level capabilities to enhance customer offers and loyalty, and look forward to continue to leverage data from mobile customer interaction for increased personalization in the future.

We recognize that the landscape for grocery shopping continues to evolve, and therefore, have expanded our Amazon Prime Now partnership currently in 10 stores with at least 10 more stores to come as the year progresses. By year-end, we plan to be in many of our major markets, allowing Sprouts products to be delivered directly to our customers' doorsteps.

Lastly, we are investing in infrastructure to support our store growth and drive productivity improvements. Our technology projects are progressing as planned, focused on driving efficiencies both at the store level and the support office. All of this is key for scale and will enhance the experience of our team members and customers alike, driving retention and improving service in the store.

The team members' training established last year continues to improve our team members' professional growth and strengthen our operational performance scores in the store, creating a team with deep and operational readiness for a continued growth across the country.

Before I hand it over to Brad, I want to say that I'm deeply grateful for the passion and performance that our teams delivered against this dynamic environment during the quarter. We remain confident in our business model and we continue to focus on our customers, our team members and our model of health and value.

Let me turn the call over to Brad to speak about our financial results and 2017 guidance.

Thank you, Amin. I'll begin by discussing some of the business drivers for the first quarter, and then review our guidance for 2017. As Amin mentioned, for the first quarter, sales were up 14% with comp sales growth of 1.1%. Deflation of 3% reached its highest levels since we've been a public company, mainly driven by deepening produce deflation during January and to a lesser extent in the back half of the quarter. By the end of the quarter, many of our categories entered a neutral or slightly positive territory with regards to inflation.

For the first quarter, gross profit increased by 10% to $337 million and our gross margin rate decreased 110 basis points to 29.8% compared to the same period in 2016. The majority of this decrease in margin is from cycling higher margins in 2016 when we experienced deflation without the corresponding promotional environment. In addition, occupancy expense deleveraged due to an increase in average square footage growth in our new stores and higher rent expense, partially attributed to higher real estate taxes.

For the first quarter, direct store expense increased 18% to $229 million, an increase of 75 basis points to 20.3% of sales compared to the same period last year. The increase was primarily due to higher payroll and benefit costs, in part due to deleverage of fixed expenses associated with lower comp sales growth and an increase in depreciation expense from higher unit growth in 2016.

SG&A increased 4% to $32 million for the quarter, a decrease of 30 basis points to 2.8% of sales compared to the same period last year. This primarily reflects timing of our investments associated with our strategic initiatives as well as lowered net marketing and stock-based compensation expenses as compared to the prior year.

EBITDA for the first quarter totaled $95 million, a decrease of 2% when compared to the same period last year. This reduction was primarily driven by lower gross profit margins and increased labor cost.

Net income for the first quarter was $46 million, flat from the same period in 2016. Diluted earnings per share was $0.33 for the quarter, an increase of $0.03 from the same period in 2016. The recognition of excess tax benefits related to the exercise of stock options, now reflected in the income tax provision, lowered our effective tax rate to approximately 32% for the quarter.

Shifting to balance sheet and liquidity. We continue to generate solid operating cash flows from operations, up 17% in the first quarter to $115 million. We also invested $57 million in CapEx, net of landlord reimbursement, primarily for new stores.

During the quarter, we repurchased approximately 4.1 million shares for $80 million, fully utilizing our prior $250 million authorization. We ended the quarter with $21 million in cash and cash equivalents and $285 million borrowed on our $450 million revolving credit facility. On February 23, our board approved a new share repurchase authorization for $250 million to be used through the end of December 2018.

Looking forward, our expectation is for our net debt to EBITDA to be in the range of 1.2 to 1.5x. We believe this range provides an optimal leverage for Sprouts, and combined with our strong operating cash flows, positions us well to self-fund our growth and enhance shareholder returns through our ongoing share repurchase program.

Now let me turn to 2017 guidance. We now expect net sales growth of approximately 12.5% to 13.5%. We are increasing our full year comp sales growth to be in the range of 0.5% to 1.5%. This reflects the ongoing competitive environment that remains at similar levels to the first quarter as well as easier compares in the back half of the year. Our expectation is that Q2 comps will track at similar levels to the first quarter.

Diluted earnings per share are in the range of $0.87 to $0.91 resulting in EPS growth of 5% to 10%. This includes an estimated effective tax rate of approximately 35% for 2017. The lower effective tax rate is due to the change in accounting standard related to the recognition of excess tax benefits for stock-based compensation reflected in the income tax provision for the year.

Consistent with our previous guidance back in February, we plan to open 32 new stores, including stores opened in 2 new states, Florida and North Carolina. And CapEx will be in the range of $155 million to $165 million, net of landlord reimbursements.

A few additional items to note on the 2017 guidance. We expect 2017 to be in the 1% to 2% deflationary range, a slight improvement from what we believed at year-end, mainly attributed to produce. We anticipate that deflation will progressively improve throughout the year with the expectation that we will cycle deflation in most all categories as we enter the third quarter.

As it relates to margins, we continue to make price investments as necessary to drive traffic and to maintain our competitive position. We continue to expect gross margins to be lower than the prior year in the first half of 2017 as we cycle the higher gross margins in 2016. For the full year, we would expect gross margins to be slightly below 2016 levels.

On the direct store expense line, we continue to expect to delever DSE as a percent of sales, primarily due to higher wage costs and deleverage from our expected comp sales growth. On the SG&A line, we expect to be relatively flat to slightly leveraged as a percent of sales, mainly attributed to our expected comp sales growth. Below the EBIT line, we expect interest expense to be approximately $20 million including interest related to financing and capital leases.

In conclusion, we are pleased with our financial and operating performance for the first quarter. We remain confident in our business model, our strong free cash flow generation and our strategic priorities to position Sprouts for growth, while driving long-term shareholder value.

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

(Operator Instructions) And our first question comes from Zach Fadem of Wells Fargo.

Can you talk us through some of the puts and takes to the gross margin line in a little more detail. You mentioned the year-ago tailwind from better poultry margin. But with gross margin down 100 bps in Q1, to what extent was the year-over-year compare a factor? And what was the magnitude of the incremental pricing and occupancy?

Zach, this is Jim Nielsen. I think it's -- first of all, it's important to note that gross margins for Q1 2017 were in line with Q1 2015. But part of the pressure we had on gross margin was driven by produce and meat. And as we alluded to, we did catch that tailwind last year in protein relative to the poultry deflation that we didn't have to pass-through.

Yes. And I'd just add to that, the 25 basis points of the decline related to increased occupancy and realty taxes that we experienced in the first quarter. So again, just reiterating, in the first quarter of '16 we were up 80 basis points, which was our strongest quarter of last year from a year-over-year perspective and it was really related to the cost deflation on poultry without the -- any retail deflation. So everyone was experiencing pretty lucrative margins in the first quarter '16.

And Zach, the only thing that I would add, relative to produce, is that we did see significant tonnage growth in produce. So we have great response from our consumers around our promotional plan. So that's increased slightly in terms of penetration, which put us to a slight little pressures on improved margins.

Got it. And can you talk a little about the recent reinflation in produce? Thus far, are you coming across any sourcing or availability issues? And I know, it's early, but has there any been noticeable change in the promotional environment in the category?

Yes. I mean, so as we look at produce, it was kind of the Tale of 2 Halves, right? The first year, we saw deflation in apples and pears and veg. And as we saw the growing regions moved from kind of South America, Mexico, Yuma and the Southern California, Northern California. We did experience some tightness in berries due to some gapping on the import side coming from South America. And then wet veg, we've had some challenges in wet veg due to all rains in California. We like the rain in Northern California. We like the rain in California, but too much rain causes some issues with mold. Had a lot of wind up there, so we had some product damage. So we did experience some inflation on the back half. And actually -- and from a global market, you saw that in Europe as well. So the export market on veg kind of elevated and put some pressure on cost as well, so Tale of 2 Halves. Looking forward, when you think about produce for Q2, we see it being slightly deflationary. Veg is already stabilizing and will continue stabilizing throughout the quarter, but we're anticipating melons, grapes, berries to be slightly deflationary. And looking at cherries and soft fruit, which are big categories for us to be in line with last year, and 2016 was a very solid year. So that's kind of an outlook and a recap of Q1 related to produce.

And our next question comes from Robbie Ohmes from Bank of America.

I was hoping you could maybe give us some color on how to think about the second quarter. And maybe tie into that, you mentioned some expense shifting, is that expenses that will shift into the second quarter? Also, can you give us some color on how the Easter shift affected you guys, if at all? And then just sort of lastly, a follow-up on the gross margin question in the occupancy part of it. As you look out at your signed deals and what you're doing in real estate, are occupancy pressures rising for you guys? Or is the environment getting easier for you to secure the real estate you want at maybe a better lease rate?

Okay. It's Brad. I'll Start with the first few questions. With regards to expenses in the first quarter, as we set out on the SG&A line, a lot of the favorability was timing in nature and that will sequence through the balance of the year. As we indicated in our consistent guidance for SG&A, pretty much flat to only marginally negative for the entire year. With respect to DSE expense, we were down 75 basis points in the first quarter. That is our toughest compare when we look at 2016. And progressively, we would be looking to be improved throughout the balance of the year. I would say with regards to Easter shift, it was completely inconsequential to our overall results. And with regards to occupancy, I think we're seeing some pressures more on the real estate taxes growth in certain pockets throughout the country. But -- and quite frankly, as we've talked about on the February call with regards to slightly slowing our growth this year, we'll open 32 stores, it gives us -- it puts us in a much better position with regards from a negotiating standpoint. So I think we're feeling pretty, pretty confident and like what we're looking at. As a number of retailers continue to shutter, that's only providing us with incremental (inaudible) best sites and the best locations across the country.

Robbie, this is Amin. What I would add on the real estate side is that, the last couple of years, we definitely started to see some tightening or upward pressure in real estate. But as Brad said is -- given the number of retailers and the amount of space that's starting to come to market, we are seeing a little bit of easing on that front. There's more space out there today, and we think that that will continue to happen compared to if you were to look a couple of years ago, it's pretty tight or tighter, certainly.

And our next question comes from Chris Mandeville of Jefferies.

I guess just beginning with the full year comp guidance increase and maybe accounting for the quarterly results in Q1 relative to shoot expectations, anyways. I was just wondering, I fully understand why we are seeing the sales range increase a little bit here. Is there anyone thing that you'd point to that drove your decision whether it be actually updated guidance expectations on deflation? Or are you simply seeing stronger trends observed of late and you expect further momentum?

Yes. I think you nailed it. Deflation is the primary driver. We think that deflation will continue to ease. At the beginning of the year, I think we anticipated about a negative 2 deflation for the year. And today, we're -- our range, we think, is negative 1 to negative 2. The other thing I would say, it remains relatively competitive out there. However, we're starting to see some good traction on not only tonnage overall, but also traction on some of our other key initiatives, including private label and the deli program as well as some enhancements we're making and service enhancement in the meat and seafood area. So from a tonnage standpoint, we're seeing good momentum. And we think, as we continue to focus on our key initiatives, that should help with some tailwinds as we work through the year. And so the big question really becomes is, what's the time frame of the lag of retails following cost deflation?

And our next question comes from David Magee of SunTrust.

Actually, just to follow-up to that question. I'm curious, as inflation sort of seeps back into the business now and hopefully, that continues through the year. Has the sector changed at all structurally? Maybe a greater presence of discounters or other that would sort of cause this to be different, this scenario, than maybe in the past when you've had inflation come back into the sector?

Yes. David, that's a good question. I think what we've seen in the past is when we've gone through extended period of deflation, it does take a little bit of time for that reflation to work back into the retails. So we're seeing out there, today, competition levels are similar to Q4. And into Q1, we're at similar levels today. We've not seen any meaningful easing. And so we'll see how the summer work -- how we flow into the summer from a competitive standpoint. And with respect to discounters, what I would sort of reemphasize is, we've got a pretty differentiated model. Our business is really anchored on great-tasting healthy products at value prices, just a breadth of assortment of fresh, natural and organic as well as attribute-based products. And a lot of our unique departments, like vitamins and HBA are expanded. Continuing to expand the private label program and also the high touch service. So we're continuing to see good tailwinds. Our new stores are continuing to open well. The strongest have been -- our 2016 and '17 vintages are the strongest in the history of the company and a lot of this has to do with our better and fuller offering as well as stronger brand recognition. So we don't think that the discounters directly impact us. I do think that there is some level of competition in terms of to the extent that, that discounters impact the conventionals to move whether it's in price or product, then there is an indirect impact. But historically, we've not seen any direct impact or hardly any direct impact from discounters opening near Sprouts.

And our next question comes from Rupesh Parikh of Oppenheimer.

So I also wanted to ask, on the gross margin line, so it sounds like now the expectation is for gross margins to be down for the full year versus flat previously. If you can maybe help me understand why the change in the -- I guess, a slight revision of forecast?

Yes. I would say that our first quarter overall gross margin rate came in line with our expectations, with the exception of the increase in some realty taxes. And we see that continuing to a slight extent over the balance of the year. And just reiterate the fact that, as we said in February, the toughest compares from a margin standpoint is the first quarter and second quarter. We're up 80 bps in Q1 last year, 40 in the second quarter. So I think they're easier compares in the back half. And going into our updated guidance, we continue to remain cautious with regards to the competitive landscape, but at this point in time, we're not seeing any sequential change from a competitive pricing standpoint.

And our next question comes from Vincent Sinisi of Morgan Stanley.

I want to ask actually on your new produce facility in Atlanta. Obviously, now this is the first quarter that it's been fully working. Can you quantify, hopefully, or at least qualify kind of the benefits that you're seeing thus far? What is it doing from a cost perspective? And then also maybe thoughts around, now with that open, for more of a store growth perspective as you go forward?

Vinny, this is Jim. A couple of pieces. Obviously, the Atlanta DC provides us ability to continue to grow in the Southeast as well as into the Florida, up into the Carolinas. And so that was critical for us to get there. And the other part of that was just getting fresher product as we were moving it from Texas into the Atlanta market, where we just put an age on it. So the benefit really becomes not an acquisition cost savings because some of that product is still coming out of Mexico or out of California. We have the opportunity, obviously, to get some stuff out of Florida and Atlanta, but it's really about what are we delivering to the customer and making it easier on our operations team. So we're seeing better quality product in the stores. We're seeing better execution as a result of timely deliveries. It's too early to really be speaking to meaningful P&L benefits, but we can tell you, anecdotally, customer response as well as our team member response for our ability to service that market more efficiently has been extremely favorable.

And our next question comes from Chuck Cerankosky of Northcoast Research.

Going back to the SG&A line, can you talk a little bit about the marketing adjustments or spending if that was a factor in the ratio coming down?

Yes. That was a portion of the SG&A benefit in the first quarter. And that was on a number of factors on the advertising line, which is net of rebates, much of which would be timing in nature in the first quarter.

And our next question comes from Edward Kelly of Credit Suisse.

So I guess, I want to come back to comps. Could you maybe talk about the cadence of comps through the first quarter? How did Easter impact the business? Did weather impact the business? We heard that from Smart & Final yesterday, I don't know if you saw that. And then what are you seeing so far in Q2? And then the second part of my question is related to guidance. And I know you've guided comps up 0.5% to 1.5%. Q1 one was up 1.1%. Comparisons getting easier. The deflation is going away. You've been conservative here. And I'm just wondering if you're just continuing to take a conservative approach or if there's something else out there that you're concerned about?

Yes. I'll reverse that. There's nothing out there that we're concerned about. Our comp adjustment was primarily driven by easing of deflation. I think the only sort of watchout is what happens to retail and the timing of the lag to retail, that's probably as much of a margin question as compared to a comp question. I think, going into the summer, depending on what competition is doing and how others are feeling, we felt that a cautionary stance would be more appropriate in moving it up in a directional manner as opposed to a step-change. But overall, we're good -- seeing good tonnage in the business. And we're seeing good positive traction as we work through it. We expect, as Brad said, the second quarter to be similar, maybe slightly better, but generally similar to the first quarter at this point in time.

The only thing I would add on the comp cadence is, I've alluded to it earlier, it's A Tale of 2 Halves on the deflation. And so we did experience some significant deflation, as you guys saw in the CPI in the first part of the quarter that, obviously, put a little bit of pressure on retails. And we did have some weather in terms of -- and we didn't call it out, but the Southern -- or the California weather did have a slight impact to us in the first part of the quarter, but very, very slightly.

And our next question comes from Kelly Bania of BMO Capital.

I was wondering if you could expand a little bit in terms of what you're expecting during this transition period from deflation to inflation? And particularly, do you expect any categories to be handled differently in terms of the potential lag and how quickly that's passed along? Just curious if maybe produce is any different? And then I just also, as a second question, just wanted to just ask, you mentioned the affinity data that you're starting to use. Just curious if you have any learnings about your customer based on that? Any surprises or anything that you guys feel like you can really start to leverage from that?

Kelly, this is Amin. I'll start and then let Jim add if he's got any anything else. As far as the transition period, I think the competition or the competitive landscape continues to be heavy on ad items. And so as we're moving into the summer, we would expect the level of competition on meat, in particular, as we move into the grilling season, would be one area. As you recall, last year, it was extremely competitive as we got to the middle of the summer and into the fall in the meat category. So at this point, we're expecting for it to remain competitive in that area, so I think that's one transition point. And then other fresh categories, people continue to remain sharp. And again, the biggest changes we're seeing is more on promo and ad items, particularly. Jim, I don't know if you want to add anything else there.

Yes. I mean, you get a bit of a short squeeze when you talk about highly elastic categories at meat and produce, as Amin discussed, especially in a highly competitive market. But we're seeing people start to be a little bit more rational at least on everyday prices. And then other areas where we're starting to pick up a little bit of inflation, still anticipate to be slightly deflationary bulk, is a little bit more inelastic for us so we'll -- pass that through and shouldn't take any margin compression there. As it relates to the affinity question, Kelly, yes we're going to entice our consumer. I wouldn't discuss it on this call. But most importantly, what it's really helping us do is do a much better job of just item selection. And that's not only within categories, but really on the promotional side, is making sure that we're selecting the right items for ad that not only have high velocity, but have high halo rate to drive overall basket.

And then the other piece on the digital side, I would add to, in addition to what Jim just said, on the affinity side. We're able to take some of the uniqueness of the Sprouts business model and attribute-driven categories like natural organic, VMS, vegan and have built out pools of customers who, through their purchasing behaviors from the data we have as well as what they've shared with us in areas that they're interested in, and bringing more relevant content to them as well as the offers that we already have that Jim talked about bringing them out a little bit more. It's early, extremely early to see what kind of direct impact that has into the numbers, but we're pretty excited about the size, the number of customers, we double up into these affinity pools. And as we go over the next 6 months, I think we'll have a better sense of how customers are engaging. Those customers are engaging differently with the Sprouts brand.

And our next question comes from Ryan Domyancic of William Blair.

On the call you talked about the doubling of the number of stores with the Amazon Prime Now partnership. Would you say with adding the more stores that the program has kind of exited this pilot phase and is becoming more strategically important to the model?

Yes. I think, from a model perspective, the one thing I would start with is when we approve new stores, we don't include the Amazon Prime Now sales into our model when we approve the sites. Now with respect to the productivity of what we're seeing, we're pretty excited about the uplifts that -- lifts we're seeing in the stores where we're rolling this program out. Some of the -- we want to roll it out to make sure that the stores are able to execute it well as well as we're trying to gain some more efficiency out of the process and really manage the cost for the collective Sprouts and Amazon partnership. So I would say, yes, we're now exiting the pilot phase and we're ready to ramp into -- accelerate into more of our markets. By year-end, we would expect to have at least a couple of stores in most of our major markets as well as build out a more robust plan for 2018.

And our next question comes from Shane Higgins of Deutsche Bank.

Actually, just -- I had a follow-up on the Amazon Prime partnership. What do you guys know kind of about the demographics of this Amazon prime customer that you have relative to your average customer? Is this wealthier customer? Is it a younger customer? What kind of insights you guys have?

Yes. We work pretty closely with the Amazon team. And what we do know is that the overlay of that, the broad -- as you know, that the Sprouts shopper is pretty wide from 30% of median income all the way up to 90-plus percent of income in the trade area. So for us, in each of our markets we are able to look at all of our stores and the network of stores as well as where Amazon Prime Now members are. Now obviously, that data is not shared with us, but we can conclude through our relationship with Amazon on which stores would be most productive. So that's the approach we're taking is, how can we service the maximum number of customers as we start with 1 store then 2 then 3 then 4 in a particular market. So that's the approach we're taking. And from a demographic standpoint, it fits very well with the overall Prime Now network.

The next question comes from Mark Carden of UBS.

My question is related to your deli and prepared food initiative. So in stores where we've expanded this offering, how much of a pickup in incremental shoppers maybe of shop (inaudible)? And then also, Amin, are you also seeing simply an increased new share of overall food shopping (inaudible)?

Sorry, Mark, you were cutting out there, but we'll try answer the deli question. We're looking at it in sort of -- we're seeing 2 things is the stores where we're expanding and putting in incremental deli initiatives, we're starting to see good volumes. And those volumes are continuing to ramp. And in the first quarter we continue to see meaningful increases sequentially quarter-over-quarter in that area. So what we've learned is it's a business that builds over time because customers are getting used to now you have expended that product into your stores. What I would say is that for stores where we're starting out with deli day 1, we're seeing a -- in some cases, meaningful higher lift as a mix and that excites us a lot. And now we have a full 2016 and going into 2017, we're seeing much stronger volumes in that deli department and the mix for stores which start out with the deli program. So we'll continue to adjust our approach to which stores, new stores we're are putting deli in and are pretty bullish on the new stores and what we're doing there. I think as we continue to get more customer data, it will also be interesting to see how the deli program is impacting other areas of the business positively. And not only traffic counts, but also what it does to basket and net overall halo into the store.

Mark, this is Jim. The only thing I would add is it's a really nice balance of basket and transactions. So the growth we're seeing in deli is not only in the number of new customers, but also a nice growth in basket as well. The only other thing is we're going to -- we get good consumer data, our customer service data, the responses we're seeing there. The customers listing us as a primary grocer for deli has improved 700 basis points from just March of -- or excuse me, May of 2016 to March of 2017. So not only is it being reflected in sales growth, tonnage growth, but we're getting favorable consumer response from our customer service data standpoint.

And our next question comes from Karen Short of Barclays.

I had 2 questions. One is just on produce. I guess there's a fear that the fact that California is flush with the water may lead to persistent deflation in produce with more planting, growing, et cetera. So can you talk to that. And then I just had a totally unrelated follow-up question.

Karen, this is Jim. Again, I kind of alluded to it earlier. We need the right balance of Mother Nature between rainfall as well as heat and certain temperatures in the evening. So the excessive rainfall in Northern California is going to be great for future crops and the water table. But the heavy rains did put a little bit of pressure on the veg category, so we did see some, as I mentioned, some inflation there. But looking forward, it's going to benefit us on the berry category, which I alluded to. So we would anticipate grapes and berries to benefit from some of that rainfall. But as I mentioned, we had a negative impact from too much rainfall on the veg category. So just looking out through the entire year, again, we're slightly deflationary on produce, but much improved from the beginning of the first quarter, which was significantly deflationary.

Okay. And then just a follow-up on something unrelated. So you talked about, Brad, your goal on leverage 1.2 to 1.5x. And obviously, we were assuming buybacks in the first quarter. But based on your Q this morning, it doesn't look like you bought back more stock in the second quarter. So just any updates there. I'm assuming we should expect that throughout the year?

Yes. I think you'll find that we ended the first quarter at the same leverage level as we ended the year at, which is 1.3x EBITDA, which is right in the midst of our guidance range in terms of where we want to be, 1.2 to 1.5x EBITDA. So you can do the math on it, but it does imply further share repurchases for the balance of the year.

And our next question comes from Ken Goldman of JPMorgan.

Quick question for me. You talked about maybe expecting a competitive environment for the growing season again. We're seeing cattle and beef prices really rise very quickly. I know it's only one commodity, but is the assumption in your guidance for gross margin deterioration and maybe you won't be able to pass some of that on as much as you would normally would?

Ken, this is Jim. And just to echo what Amin said earlier in terms of the promotional environment. Again, we mentioned that Q1 was in line with Q4 and then we anticipate that at the back half of the year. So that being said, what it relates to, meat. And as I mentioned before, that is a highly elastic category. So what we're seeing is middles. We always have pressure on middles during Mother's Day, Father's Day, Memorial Day. So your growing time, but we're getting some relief on the ends. So on the ends we're able to pick it up all ground beef and you talk about chucks and rumps and those types of things. So we would anticipate a little bit of pressure, again, on middles but hopefully offset by the ends.

And the next question comes from Stephen Tanal of Goldman Sachs.

I wanted to ask one on SG&A. I guess the question would be, I'm a little surprised by the lower incentive comp. What element of this quarter was below plan if that's the driver? Secondarily, just on timing of investments associated with the initiatives and then the ramp of marketing, like how should that play out over the year? And then unrelated, but if you could just comment a little bit on some way on sort of the margin difference on sales that are coming through Amazon Prime, that would be helpful as well.

So on the SG&A front, as we spoke about earlier, there was some timing differences relative to the sequencing throughout the year of our strategic initiatives in terms of when those OpEx items are going to hit the P&L. And there's really no change in our guidance with regards to the full year on SG&A.

I was just going to say with respect to Amazon Prime Now, we want to carry out the same brand promise of health and value onto the platform as we do in the stores. So we're quite -- we look very similar in terms of our ads and overall product set that we carry. So the margin differences is not meaningfully different online versus in the store.

And then, Stephen, the third question you had, what's the relation to the sales initiatives. Amin called it out in the script, we had 50 new stores and existing stores this year. And half were done in the first quarter and the other half will be done in the second quarter with few new stores coming in at Q3, which will bring the portfolio up to around 40% of the portfolio having a compliment of the new deli initiatives by year-end.

The next question comes from Alvin Concepcion of Citi.

Just 2 questions for you. One, what kind of comp growth -- I'm just wondering if you could give us an update on what kind of comp growth do you need to see to see better operating leverage and other opportunities? The follow-up to that, deflation related. What are you seeing in second quarter to date? Sounds like you've seen some inflation probably coming through in the third quarter. So would you expect pass-through from competitors? Are you seeing that now? And are seeing pass-through of minimum wages as well?

So on your first question, operating leverage is -- 3% is sort of the mark when we start seeing any type of meaningful operating leverage. On your second question was around deflation. Most categories are nicely working their way towards flat, as we sit here today. So for the second quarter, we believe we'll still be deflationary overall for the quarter, but they're continuing to work their way towards 0, as Jim pointed -- made some commentary early on produce, on a mixed bag, on the different categories with inflation and deflation, but overall still remaining deflationary. And as we work into the back half of the year, we would expect that inflation would continue to work its way back towards 0. A little early to see if we'll be in the positive category, but I think we could see that by the back half of the year -- in the back half of the year to be back in positive inflation territory in the entire portfolio, unless we see some surprise in produce given our heavy produce-centric model.

And then last question as it relates to minimum wage and the pass-through. There's been a handful of markets we've been able to pass it through, and that's just where there's been significant increases. And again, it's all based on our pricing model that we create, so we don't necessarily just pass-through just because there's is at minimum wage increase. We continue to steadfast and follow our pricing strategies that we have by department and by category and move those prices accordingly with our competition and in line with the strategies that we've developed that have proven to be successful for us.

And our next question comes from Scott Mushkin of Wolfe Research.

I just wanted to take a step back and kind of just get your kind of state of the industry thoughts here. I mean, we're well over a year into, I guess, more difficult operating environment. And it looks like the outlook for the rest of the year, it remains pretty subdued. So I just wanted to get your guys opinion on deflation versus competition. Is this the new normal? So just kind of broadly get your thoughts as we're well into a long period of just tough time for the industry, you guys slowed down and like you said the outlook is, while smidge better, kind of remain flat.

Yes. Scott, I think the headline is that, we said it earlier, is that retailers they're working through still being in negative comp land. For most of the conventional retailers, they're continuing to be aggressive in ad. And so really where it's playing out is in promotions and ad. And I think what we're seeing is some good discipline being maintained in everyday price as we're working through this deflationary period and back to 0 and hopefully, an inflationary period in the back half of the year. So that's how I would sort of characterize the immediate. With respect to the broader landscape, what I would say is that the fresh areas people are continuing -- I would say that, I think, people will continue to remain fairly competitive in the ad world and so that may be a new norm. But what we see is, for Sprouts, is in that new world, is exactly why over a year ago or almost 2 years ago now, we kind of looked out and said where is it that we need to round out our business better? And so what's exciting for us is expanding private label, expanding deli, doing more meat and seafood where we can add more value and drive sales. And those sales in some of those departments are higher-margin departments. And as we continue to do that, we can continue to invest and have a great cash-on-cash business model. And then during this entire deflationary time over the last 2 years, even though for Sprouts our margins are compressed, our cash on cash return model hasn't changed. And if you recall a couple of years ago, we set out that by 2020 we wanted to get to $20 million per store per year, we're well on our path. And we, in fact, we think that we'll be well ahead of that because of all the great work we're doing in these other departments like deli, meat and seafood, private label, vitamins and HBA. So that's pretty exciting for us is, this competition may be the norm, this is a competitive industry, but we're continuing to build the brand on a full shop and a differentiated shop, and then that's what exciting for us.

And Scott, the only thing I would add is, and the wind here, as Amin alluded to, the bump was related to a better outlook in terms of deflation pressure. And so when you look at the competitive landscape and I hope the deflationary period, it does become more competitive as everybody chases more items and has to go through a lot more tonnage in order to capture the sales. So we do see deflation improving throughout the year. We still have a plan to have the competitive activity to be in line with what we saw in Q1. But as you move into an inflationary environment, you could see retailers become a little less promotional. And the only other thing that I would add is when you look at new outlets and kind of look out, it's definitely flattening in terms of new store growth. We've seen some people come out with some adjustments in new store growth and capital investments. So that slowed a bit and should benefit us in the long term.

(Operator Instructions) And our next question comes from John Heinbockel of Guggenheim.

Guys, just 2 questions. When you think about the vintages exceeding expectations and ramping, what impact does that have on the comp waterfall when you think out over the next -- as those stores mature? And then what impact does that have on the comp that you need to leverage expenses? Is it possible that if they're starting stronger, maybe the comps a little less? But also you don't need as much to leverage expenses. And then also just touch on sort of the balance between cannibalization and brand building. So I think you took on some cannibalization in the past in markets like Phoenix and San Diego, but it was good for the brand building effort and helped the entire market. So has that balance changed at all?

Sure. So on your first question in terms of the new stores, what we see is that with the overall recent vintages starting up stronger is, we think that in new markets that will continue to get the ramp in comp sales. In existing markets, because our brand is so strong, perhaps you have a slightly lower ramp in year 2, 3, 4. But with that said, what you've really done is accelerate the cash-on-cash return model instead of hitting 40% in year 3 or 4, now you're hitting it in year 2. So in terms of expense leverage, to your second question of leverage, that leverage just starts much earlier so those stores are actually much more productive than the 40% cash-on-cash return much earlier. So from a pure profitability standpoint and a business standpoint, to the extent that that's driving the comps to be slightly lower in the future, we actually think that's a good thing because you're just -- you're driving more profitability sooner. And your last question with respect to balance, we continue to be 2/3, 1/3, and have that discipline of opening at least 2/3 of our store in our existing and recent markets. And 1/3 to continue to lead for future growth. And what we're seeing, looking at '17 and '18, is our cannibalization in '17 will continue to moderate as we work through the year. As you guys know that we have a 125 to 150 basis points of cannibalization range in our model. We're going to be, for the full year, below that 150. And as we go into 2018, we will continue to be -- we expect to be maintained below the 150. We had a higher 2016 than normal and coming into early part of '17, but that will abate in back work. Its laid back into our historical range. So hopefully, I captured all 3 of your questions there.

And that concludes our question-and-answer session for today. I'd like to turn the conference back over to Amin Maredia for closing remarks.

As we conclude, I just want to make 2 comments. I want to, once again, thank all of our 25,000 team members in the field for their incredible passion and work as well as our team in the support office here for the effort that were put together in growing the brand. And for everybody who's in the call today, thanks for your time. And we look forward to speaking with many of you in person in the coming weeks. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program you may all disconnect. Everyone, have a great day.