Sprouts Farmers Market Inc

NASDAQ:SFM

Earnings Call Transcript 2021-Q2

[Operator]

Good day and thank you for standing by. Welcome to the Sprouts second quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today's conference is being recorded. [Operator Instructions].

I would now like to hand the conference over to your speaker today, Susannah Livingston, Vice President of Investor Relations and Treasury. Please go ahead.

[Susannah Livingston]

Thank you and good afternoon everyone. We are pleased you have taken the time to join Sprouts on our second quarter 2021 earnings call. Jack Sinclair, Chief Executive Officer and Denise Paulonis, Chief Financial Officer, are with me today. The earnings release announcing our second quarter 2021 results, the webcast of this call and quarterly slides can be accessed through the Investor Relations section of our website at investors.sprouts.com.

During this call, management may make certain forward-looking statements, including statements regarding our expectations for 2021 and beyond. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information, please refer to the risk factors discussed in our SEC filings, along with the commentary on forward-looking statements at the end of our earnings release issued today.

Our remarks today include references to non-GAAP measures. For a reconciliation of our non-GAAP measures to the GAAP figures, please see the tables in our earnings release.

In addition, because our results for the second quarter 2020 were significantly impacted by COVID-19, this presentation will also include certain comparisons to results in the second quarter of 2019.

With that, let me hand it over to Jack.

[Jack Sinclair, Chief Executive Officer]

Thank you Susannah and good afternoon everyone. Thank you for joining our call today.

In early 2020, we embarked on a new strategy that led to a positive step change in our financial performance which is strong and sustainable. Well, we have plenty of work ahead. I am excited about the progress we have made and the continuation of our strong profitability this year. Due to the pandemic, results are down compared to last year. Our year-to-date 2021 sales are up 9.5% and our profit is up 36% compared to the pre-pandemic same period in 2019.

We have made great strides in executing against many of our strategic priorities. We have a differentiated model and a great team in our stores, which gives me great confidence for the future. The creation of innovation centers through dedicated merchandising displays, an increase of seasonal and local produce, the opening of two new fresh distribution centers and the opening of our first new format store in July, are among many changes that are driving our strategy forward.

Plans are now in place to rollout our innovation centers to all our new stores and many of our existing stores in the back half of this year. Each month, these displays will showcase new to market attribute-driven items like Vegan Rob's Butter Popcorn, plant-based Wicked foods and grassroots organic Sacha Inchi seeds. And thankfully, the country is in a place where we can start an active sampling program which is a new endeavor for Sprouts and will prompt education, trial and purchase.

We are leaning in to why customers love Sprouts' produce. Our produce pricing remains ultra-competitive with prices significantly lower than the marketplace. We just went through a great cherry season, which showcased more than five different varieties from unique, family-owned farms like Orondo Ruby Cherries and the Skylar Rae Cherries with distinctively different flavor profiles than the common red cherries.

We excel at great produce buy and we are only getting better with our two new DCs added this year. Our organic produce is up to 35% of department sales, which we believe is one of the highest penetration rates in the industry. Our organic produce prices are very competitive and we are now focused on getting some of our organic produce prices in line with conventionally priced items, making it a clear differentiator for Sprouts.

On the supply side, our Aurora, Colorado DC is running strong and the Florida DC just opened in June, getting us back to our farmers' market heritage. We are now at more than 85% of our stores within 250 miles of our DCs. At Sprouts, our sourcing practices, paired with our strong relationships with our local growers, are a part of how we bring the freshest produce to our customers all year long. With the addition of the Colorado DC, we have already noticed an uptick in produce sales in this region as fresher produce and larger local selections are being recognized by our customers.

Specifically, our ripening rooms for bananas and avocados in Florida and Colorado have contributed to significant improvement in sales for these products in these regions. Produce is in peak summer season in Colorado and our local buying has increased substantially and will gradually increase through the growing season up to 20% of the department or up 300% increase versus our past assortment in previous years.

And with the addition of our Florida DC, we will be able to provide an even larger range of affordable local organics and locally grown items during the fall growing season in this region. Creating this advantaged fresh supply chain has provided benefits this year, which will ramp over time as we cycle the regional growing seasons and expand our business. All-in-all, this leg of the strategy is in very good shape as we head into the back half of the year and we begin to leverage the close proximity of our DCs to our stores.

Our 35,000 team members in our stores continue to do a great job. We have restructured our store leadership to reduce the span of control. And in stores, we have restructured to ensure our team members can spend more of their time taking care of the customers. As planned, we opened one store in the second quarter in Reno, Nevada. And continuing with our plan, we have opened two more in the third quarter to-date and remodeled one of our California stores.

Two of those stores were in the new format. These new formats will make it easier for our health-minded and food-centric customers to explore the market's unique and attribute-driven products. Enhancements include all new signage and décor featuring Sprouts' new branding, an expanded frozen department offering easy innovative meal solutions with more than 115 additional new items including meat-alternatives and an expanded refrigerated section highlighting the latest plant-based foods.

As a reminder, this new format will have a smaller footprint, but more selling space per square foot similar to many of our original Southern California stores. The smaller size is very efficient and keeps produce at the heart of the store, while maintaining our familiar open layout and treasure hunt shopping experience. They also cost 20% less to build and we expect to have similar sales to our boxes that we have today, resulted in expected higher returns. Our plan is to open three more of these new format stores across the country this year.

With all this said, sales were slower than we expected in the second quarter. While April experienced strong results both top and bottom line, we were disappointed with May and June. Customers are enjoying travel and dining out again. And against this backdrop, marketing did not drive as much traffic as we would have expected.

To be clear, our brand campaign has reached more target customers, increased awareness and purchase intent, which is a very important first step but more will be needed. We are making next three changes going forward as we continue to update our marketing mix with a test and learn approach. The intent is to convert awareness and to increase traffic. Given the strength of our basket, one will need a modest increase in customers to fulfill our long term strategic goals.

Let me share a bit of what we have underway. In the third quarter, we are focused on refining our marketing to drive traffic with targeted call to action offers, unique partnerships and continuing to push brand awareness. We are connecting with those customers who know us with more touch points to foster more loyalty. With mailed goodness gates, which highlights our seasonal produce offerings, as well as new offerings like our 100% grass-fed Angus steaks and promote those Find a New Favorite items, many of which are exclusive to Sprouts. We continue to offer weekly specials online through a digital ad supported by extensive media, both paid and owned. And we are expanding our full size digital coupon freebies program for Sprouts account holders to encourage trial of new products, drive traffic and grow our database.

We are building an innovation network by cultivating partnerships with up and coming vendors in the food industry. For example, our GloSlim SpiceFruit drove immediate customer interest and traffic to the vitamin department after being featured on the front cover of Women's World. And we are collaborating with many other vendor teams, becoming the destination for their products like [indiscernible] Water, Kettle & Fire's Bone Broth and [indiscernible] popcorn.

Before I hand it off to Denise, I want to acknowledge the credible work the teams at our stores, DCs and in the support office continue to do week-after-week as we expand our business in markets across the country. Our strategic initiatives are laying the foundation to solidify our position as a highly profitable specialty grocer with a strong unit growth story making me confident we are well our way to delivering the growth and returns presented in our five-year strategy.

[Denise Paulonis, Chief Financial Officer]

Good afternoon everyone. For the second quarter, we generated adjusted diluted earnings per share of $0.52 compared to $0.59 in 2020. Compared to the second quarter of 2019, earnings per share was up 73% as we continued to maintain our improved margin structure and make decisions rooted in positioning Sprouts for long term profitable health.

For the second quarter, net sales decreased 7% to $1.5 billion and comparable store sales were down 10% compared to the same period last year. On a two-year basis, our net sales were up 7% compared to the second quarter 2019 and our two-year comp stack was nearly flat at down 0.6%.

As a reminder, to account for the 53rd week in our fiscal 2020, we shifted each week back one week, thereby ignoring the first week of fiscal 2020 to better align holidays for comparison purposes. Because of this, the two-year stack will not be the simple addition of the two periods. More information can be found at investors.sprouts.com under Additional Reports, if needed.

April sales started off strong, in line with our expectations and posting positive traffic. May and June experienced more challenges. As Jeff mentioned, we believe the reopening of restaurants, travel and people going back to the office contributed to the slowdown. Having said this, our basket remains strong, trending down only modestly since the first quarter of 2021, primarily due to lower e-commerce penetration.

Our deli sales were strong in this quarter, partially driven by less buying trends, which nearly doubled and speaks to customers being back at work as well as an increase in prepared meal solutions like one pan meals. Vitamins experienced a marked improvement from the first quarter as our customers got back to basics with added proteins and sports nutrition.

The benefit in ease of online shopping has remained relevant for a portion of our customers. For the quarter, e-commerce was 10.1% of sales, settling in the 9.5% range towards the end of the quarter. Compared to the second quarter of 2019, e-commerce sales have increased more than 350%. We have been absorbing additional costs associated with these services for over a year now.

Importantly, for orders placed through the Instacart website, we are seeing about 50% of the transactions are for customers who have opted in to share their data with us. When combined with our own shop.sprouts.com, we are collecting meaningful customer data on around two-thirds of those who shop online. We are also working more closely with Instacart on analytics to support both our e-commerce and brick-and-mortar businesses.

We believe the higher use of e-commerce for grocery isn't the only customer habit that has changed during the pandemic. To make sure we are driving business decisions on recent trends, we are currently performing new safe survey work to evaluate customer's habits in this post-COVID environment.

For the second quarter, gross profit was $550 million and our gross margin was 36.1%, a decrease of 115 basis points versus the second quarter of 2020, in line with our expectations. This decrease was predominantly related to lapping opportunistic produce buys and exceptionally low shrink from elevated demand last year. Our efficient promotions, attractive everyday pricing and differentiated assortment continue to result in superior margins, which are up 330 basis points compared to the second quarter of 2019.

SG&A costs decreased $52 million to $436 million or 28.7% of sales, leveraging 108 basis points compared to the same period last year. The majority of this leverage was attributed to lower COVID pandemic response costs, mainly incentive compensation as well as lower e-commerce expense. This was partially offset by sales deleverage. Compared to the same period in 2019, SG&A increased 14%.

For the quarter, our adjusted earnings before interest and tax were $84 million compared to $96 million in 2020. Compared to the second quarter of 2019, adjusted EBIT increased 63% continuing with the positive step change in financial performance. Our interest expense was $3 million and our effective tax rate was 24%. Even with some sales leverage, we realized an adjusted EBIT margin of 5.5% trending well ahead of our 3.6% margin in the second quarter of 2019. We continue to generate strong cash flow from operations, $177 million year-to-date to fund future expansion and sales initiative. In the quarter, we invested $27 million in capital expenditures, net of landlord reimbursement, primarily for new stores.

Additionally, we repurchased approximately $87 million in stock by the end of the second quarter. We ended the quarter with $250 million outstanding on our revolver, $39 million of outstanding letters of credit, $221 million in cash and cash equivalents and $213 million available under our current $300 million share repurchase authorization. Subsequent to the end of the quarter, we repurchased an additional $25 million in stock for a year-to-date total of $112 million. Reflective with a strong balance sheet, we continue to maintain a low debt position ending the quarter with a net debt to EBITDA ratio of nearly zero.

Now let me provide an update on our 2021 outlook. As a reminder, I am giving these comparisons on a 52 to 52 week basis, as fiscal 2020 was a 53rd week year. The COVID backdrop is resulting in an ongoing flux in customer spending habits and continued consumer hesitation for doing multiple shops. While our basket has remained healthy this year, we haven't realized the growth in transactions that we originally planned. Because of this, we are reducing our topline expectations. We expect net sales to be down low single digits versus 2020 with comparable store sales down 5% to 7%.

Our 20 new store openings for 2021, while inked and signed, may not be completed by year-end due to difficulties in securing certain equipment from third-parties because of supply chain delays that have been complicated by the pandemic. At this time, we have about seven store openings that may be delayed to 2022, although we continue to support options to open these stores by the end of the year. The good news is that our real estate pipeline remains strong and we continue to work towards our 10% unit growth goal in 2022. Similar to 2021, we expect our 2022 new store openings to be weighted more to the back half of the year. With the potential store delays, we now expect 2021 capital expenditures, net of landlord reimbursement, to decrease to the range of $110 million to $125 million.

We continue to expect our corporate tax rate to be approximately 25%. Our scenario based planning, which contemplated potential outsized sales volatility has served us well, resulting in our EBIT range remaining in line with our prior guidance of $305 million to $325 million. Due largely to shares repurchases in the second quarter, we are increasing our adjusted diluted earnings per share to be in the range of $1.90 to $2.02. We continue to expect to maintain a majority of the gross margin rate improvement we realized in 2020 with the next few quarters being slightly pressured as we cycle some COVID benefits we don't expect to repeat. In closing, we continue to remain confident in the strategic changes we began last year, which has structurally changed our financial algorithm for the long term.

At this time, we are happy to take your questions. Operator?

[Operator]

[Operator Instructions]. Our first question comes from Krisztina Katai with Deutsche Bank. Your line is open.

[Krisztina Katai, Deutsche Bank]

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

[Jack Sinclair, Chief Executive Officer]

Yes. Krisztina, where we are out at the moment as we are feeling very strong about the strategy in terms of the way it's flowing through in terms of what we have been at, what we have been doing and what we have been making it work. The encouraging thing a little bit is our basket, which we expected to decline a little bit more, hasn't declined. But our traffic hasn't growing.

But make it really clear, that our traffic is kind of stable. Through the pandemic and there's a lot of noise in the pandemic. If you take it back to 2019 and that it today to 2021 on the Q2, our traffic went down through the pandemic as you would expect. Our traffic went down as you would expect because of the change in our promotional position and how we kind of went to market. We expected to lose some of those. As we said pre-pandemic we expected that.

Since the last couple of quarters, we are seeing a pretty static customer base. So it's not like we are losing customers but we are not gaining them as fast as we would like them to do. And that leads on your second kind of point, which is what are we doing to stimulate demand and stimulate that traffic. And we are doing a variety of probably more call to action promotions as opposed to the kind of genetic brand building that we did. We are very pleased with it.

It's giving us good awareness scores, which has always been a problem for this business. And it's also giving us good intent to purchase scores. But what it's not doing is translating itself into more people coming in, which we would have expected to have happened by now. And Krisztina, we don't need that many more customers for the equation of this to work.

And a good thing, from my point of view as we look at different tactics and different call to actions to drive that traffic, because of the financial strength of our model now, we have got a lot of them, if you like, arrows in our quiver that are able to, we can deploy them and we are doing a number of things, testing a number of things in a number of different places, both regionally and different category approaches.

And that's what we are encouraged about going forward that we have got room to play and we have got some options that we are working on that I am feeling pretty confident that the base that we have built in terms of the merchandising changes we have made, the supply chain changes that we have made, the real estate changes that we have made going forward puts in our strong position to position ourselves with the target customers. And as we have said often on these calls, there's enough for those customers.

We don't need many of them for this thing to look very dramatically and are really dramatic way the returns that we can get if we can get a few more customers in this really are exceptional. So thanks for the question.

[Krisztina Katai, Deutsche Bank]

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

[Jack Sinclair, Chief Executive Officer]

Yes. We can't talk specifically about where we are at. You can have look back and see the comparisons change a little bit. So you get some of the comparison triggers mix that's a slightly different number going forward relative to where we have been in Q2. But we can't talk specifically about where we are at in that kind of dynamic.

I think with regard to a return to office, what we saw as people go back to office, we certainly got a benefit on our daily business from that in terms of people being around and going in and buying those kinds of things as Denise alluded to in some of the remarks. What's going to happen, it's certainly an uncertain time for us all. In terms of our own business, what we going to do with the office, we had everybody been coming back in September. But now we are kind of, we think that's what we are going to do and I think that's way the market's going to be.

If it's delayed, then I think there will be a dynamic change in terms of how the customer drove us back to some of the behaviors that happened in pandemic. We are trying our best to not talk about the pandemic going forward, We are trying to talk about, now the COVID's over and we are going to get ourselves into Q3 and Q4 in terms of really getting back to driving the traffic within the strategy that we have outlined. So I don't know what's going to happen with regard to the offices and whether people are going to go back or not. If the offices close down again, then it will make a difference in terms of how traffic and basket get plays into our stores.

[Operator]

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

[Scott Mushkin, R5 Capital]

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

[Jack Sinclair, Chief Executive Officer]

In relative terms, no, there's not a huge difference across the different marketplace. But in absolute terms where you are starting from is different in different marketplaces, as you allude to, Scott, Southern California, Denver, some of the other markets where we are more established in Los Angeles and beyond. We are seeing, as I said, the encouraging thing for us is that the basket holding up in those places or the basket is not going down by as much as we would have expected it to do.

And the traffic dynamic that's happened in those areas isn't really a surprise to us as it went down because in 2019 we were pretty clear, in Q2 2019. But the traffic was there. A lot of that traffic was coming in response to the weekly promotional cadence that we had, very aggressive pricing on the low margin. And changing that, we did see a reduction in traffic that then gets all confused by the noise of COVID, which probably takes it down further.

We would have expected our traffic to have bounced back about harder in those places. And that's back to what is it we need to do in terms of building the clarity of our messaging and then the call to action and the immediacy of the call to action that we need. And that's the things we are testing out at the moment. But to the crust of question, we are not seeing a significant difference across the different marketplaces.

[Denise Paulonis, Chief Financial Officer]

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

[Scott Mushkin, R5 Capital]

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

[Jack Sinclair, Chief Executive Officer]

Tucson was a little bit of a remodel, Scott, as you know. The new one that we have opened in Phoenix, which we are very excited about, we opened 10 days ago or something like that. So it's early days. But we are very encouraged by the customer reaction to the changes that we made in Tucson, We are got a lot of positivity.

The encouraging thing for me, with regard to that is the way customers are saying, well, I thought you were now building smaller stores, but it feels bigger and that's certainly the feedback from the Phoenix store, which we built at 23,000 square feet. And the people in Phoenix know our business well and they actually think the store is bigger. So that's encouraging in terms of doing that. It's too early to say in terms of the absolute level of the numbers.

Call to action, the call to action kind of will be less about very direct product and price high-low kind of drivers. It will be much more about, if you like, driving people to the offer and the proposition that we have whether it be plant-based, whether it be on new meat assortment in terms of our whole Angus and grass-fed beef assortment, whether it will be towards our keto business.

It will be much more about how do you tell the story and give a value against our vitamins and herbals business, give a value to our bulk as we relaunch our bulk. It will be more about category and aggressive, in some ways. As I said, we have got some resources to do that. So it will be aggressive in that. What it won't be is a return to 10 for $1 corn.

[Scott Mushkin, R5 Capital]

Perfect. Thanks guys. I appreciate it..

[Operator]

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

[Tom Palmer, JPMorgan]

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

[Jack Sinclair, Chief Executive Officer]

Yes. I think it's a good question about whether the dynamics have changed. I think the holidays are competitive. In fact, I would want to call them the mainland groceries are certainly going back to more aggressive promotions around the holidays on products that we do in sales. So I think there may be some evidence that that can drive some traffic in the post-COVID world, as a kind of ending of the COVID world.

Could we drive traffic by going back to aggressive pricing? Probably. Would it be the wrong people coming into these doors? Probably. Would it help us? Probably not. So our whole business is about driving the traffic of the target customer base and winning dollars and market share from that target customer base. And that's the call to action that we are putting in place.

The last thing we want to do is drive in very little profitable customers who just come in for the deals, which is where we came in a couple of years ago and that's why the comparison to 2019 Q2 and the Q2 in 2021 works for me in terms of understanding our business. We have reshaped the whole proposition of the business and we reshaped it to target against specific customers who appreciate the differentiation that we have so that we are not going head to head with anybody on pricing or promotions. And we don't actually have to win a trip from anyone, We just need to win some dollars to drive the transactions.

So I think, to answer your question, we probably could get traffic back in, in terms of the wrong traffic. But it doesn't feel like that would be right place because we go back to making a lot less money as well.

[Tom Palmer, JPMorgan]

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

[Denise Paulonis, Chief Financial Officer]

Great question. And we actually keep the two pieces separate. So I would say, we continue to be optimistic about our core 2022 pipeline in terms of deals that we have in the works and getting to that 10% new store growth that we wanted. Any impact that happens with up to these seven stores from 2021 is a separate outcome than what would be in 2022. So if some of them push, that would make the 2022 number bigger, not really be a replacement and then a belief that 2022 would push out.

Just as folks understand, the delay in the stores that we have is really tied to some of the refrigeration equipment and some of the inputs that go into how those get installed into stores. Working hard to find alternatives to just some supply chain constraints in some of that product inputs being able to come through. So we don't expect that this is going to be a long term sustainable issue that we have about our own capacity to build the stores, it is just a near term supply chain constraint.

[Jack Sinclair, Chief Executive Officer]

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

[Tom Palmer, JPMorgan]

Thanks.

[Operator]

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

[Kendall Toscano, Bank of America]

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

[Denise Paulonis, Chief Financial Officer]

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

[Kendall Toscano, Bank of America]

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

[Denise Paulonis, Chief Financial Officer]

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

[Kendall Toscano, Bank of America]

Okay. Great. Thank you.

[Operator]

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

[Spencer Hanus, Wolfe Research]

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

[Jack Sinclair, Chief Executive Officer]

Yes. That's both good questions. I think ultimately what happens will be driven by COVID and the customer behavior. That customer behavior, I am not sure retailers will be able to influence that because really over the pandemic, it's not really been the retailers behavior that's influenced a lot of what's happened. It's been the customer behavior and how they do view the context that we are in when and which evidence coming out.

It's clearly, we had expected, even a few weeks ago we had expected to be in a different place today relative to where we were then. And now, who knows how people are going to play out with it? Now what will the retailer do to try and attract traffic within that environment. I think probably it will be more about trying to invest, if they need to invest in some kind of promotional techniques to try and get people back, probably using loyalty and data information more effectively than we have had.

And number one, that's certainly something we are thinking about how best we can communicate directly with our target customers and really give them a rationale to come back and probably get you some calls to action, as I just outlined and talked about. The second part of the question, I have kind of lost it.

[Denise Paulonis, Chief Financial Officer]

Just how customers are looking at value?

[Jack Sinclair, Chief Executive Officer]

How the customer is looking at value? We are doing a lot of research on this. I think, Dennis alluded to in our remarks. We are doing a ton of research to understand our target customer. And what the perspective is, the ones that we are targeting are pretty much looking at it as it's the same as it's always been at Sprouts. It's kind of good value on produce. I think people recognize that. I think they recognize the differentiation and they recognize the value behind it.

We are not seeing significant, we are not seeing any score changes in terms of value among our target customers. And that's something we are looking at, because that's important to us. I think that's why we are again pretty static traffic at the moment. The question is, how do we translate, how do we get to translate this awareness that we have got and this growing awareness into transactions. And we think as COVID, it kind of, dilutes and becomes less important, we think that's going to help us as we get these calls to action into the marketplace with our target customers.

[Spencer Hanus, Wolfe Research]

Yes. That's really helpful color. And then I just wanted to ask on inflation. What was that running in the second quarter? And how are you thinking about sort of passing that through sort of over the next, in the back half and then into 2022? Do you think there is an acceleration? Does it remain pretty sticky? Or is this more of a transitory inflationary environment that we are in today?

[Jack Sinclair, Chief Executive Officer]

Well, we are being told that it's a transitory inflation environment. But let's wait and see. I think we will manage it as it goes. Produce has been pretty up and down, but pretty flat in terms of we are not seeing huge problems passing on our pricing changes in produce. The protein side of things, salmon and beef and we have seen significant cost price increases. And we probably haven't been able to pass on quite as much as we would like to, but we do see it. Certainly, we were planning on being transitory and this thing will go back to normal in due course.

[Denise Paulonis, Chief Financial Officer]

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

[Operator]

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

[Mark Carden, UBS]

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

[Jack Sinclair, Chief Executive Officer]

Yes. I see. I don't think we have lost any of those customers who are interested in natural and organic and interested in our proposition or not. The data would suggest our traffic stayed pretty flat with that type of target customer. The customers that we lost, notwithstanding the consolidation part, the customers that we lost were, what we call, the coupon clippers, the people that weren't particularly dynamically interested in our proposition. But they were interested in very low pricing on the fresh foods that we put in front of customers, whether it would be chicken fillets or the corn or the tomatoes or whatever it might have been that we were advertising aggressively.

So the challenge for us going forward is not so much, can we get them back from Kroger? It's, can we get a message out and the call to action with those customers who have an affinity to who we are, but we haven't got them in the store. Now if it's simply COVID has done that, I think that will happen automatically. I think that will happen automatically. If it's not COVID that's done it, I don't perceive that the challenge because the proposition, If you have gone to Kroger, so I say Kroger but anybody in terms of the context of consolidating your shop.

And you have gone and you saw that they have got some and organic thing, I promise you the scale of the differentiation between what we sell, first of all the pricing on produce, the differentiation from vitamins and herbal, the bulks assortment that we have got, the attribute-based products, whether it be keto, paleo is so different. Our frozen food business, 90% of what we sell in frozen foods is different to what I can walk around any supermarket.

So it's differentiation. You cannot access it. And as the people who are not shopping whether it's because of COVID, they will come back on the basis of the differentiation that we have got. And we have got to give them a call to action to do that. And I am very confident that we have not got that underlying challenge that people have gone to the mainline supermarkets and thought I can get everything I need I would have got at Sprouts. It doesn't look like that in the data that we have analyzed.

[Mark Carden, UBS]

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

[Denise Paulonis, Chief Financial Officer]

Yes. Overall it still skews very heavily towards delivery. We just have a nature of a different product that comes in. So people aren't coming to us for curbside, for the convenience of not carrying out 24 packs of water and huge packs of toilet paper. So it seems to be delivery really does resonate better with our customers. And we continue to have a nice portion of our business come through our owned website versus through the Instacart marketplace. And so we are pleased with that as well as that adoption continues.

In terms of overall difference of the customer, the e-commerce basket remained significantly higher than an in-store basket, which makes a lot of sense. When people are paying for that delivery process, they definitely want to take advantage of it. And so that basket is almost double what an in-store basket would be. So very healthy business there.

And overall we have really seen e-commerce stay pretty sticky. So as we talked about on the call, 10% for the quarter, kind of only trending down to about 9.5% by the end of the quarter. Now we will watch the volatility that might come with the Delta variant over the coming weeks and see if we see any change in trend, but it seems to be well embedded into the shopping habits of our customers right now.

[Operator]

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

[Erica Eiler, Oppenheimer]

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

[Jack Sinclair, Chief Executive Officer]

Well, I think we have been pretty clear about why we are in that place strategy-wise. What we had as a business, we have lost some traffic over the course of those two years on the back of the change in strategy. Notwithstanding COVID, we have lost some traffic on the back of our promotional strategy. And that's why you look at 2019 and you take it forward to 2021, you can see that. And we have identified the target customer base that we need and it's a pretty small number and we have been pretty modest in our comp expectations going forward.

We don't need crazy comps for the economics of this thing to work as you can see from the earnings that we are delivering. So if you can deliver superior returns on a relatively modest comp base then the opportunity for us to grow comes with building a lot of stores in places where we don't exist. And there's so many of those and we are trying to make sure that our distribution centers will support that program of growth. And the opportunity for us, as we have identified, this is part of the new format that we have opened a couple of them in the last few weeks.

We can build the stores much cheaper. We can get them in front of customers in a smaller footprint. And we can drive pretty significant returns on that. When we look at, when I go through the pipeline of what we have got for 2022, 2023, all kind of smaller stores relative to where we have been and the returns that we can get on relatively modest topline gives us a growth potential that I think is pretty unique. So I am not sure that going back to trying to chase the wrong customers to get comp in our existing store base and abandoning the program of new stores would generate that kind of returns or the kind of cash returns that we can get going forward.

And it's based on the premise of a couple of things. One is, the customer is more interested in healthy options and healthy eating and focused diets than they have been. And they will be more interested in that going forward than they will be less interested in that. We have got a unique proposition that nobody else can or would even want to do, because we are narrow in what we do. And that narrowness allows us to target and allows us to build stores smaller in the right places. And the numbers we are looking at, I don't think the modules demonstrate that over the last few quarters even through the strange world we have been in, gives us a lot of confidence there is returns in a modest comp in our existing store base and our real opportunity for us to build 10% new stores, every year and deliver significant returns.

[Erica Eiler, Oppenheimer]

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

[Jack Sinclair, Chief Executive Officer]

Yes. First of all, let's talk about the labor and stores. I think one of the things I have said in previous calls here is, we are relatively amateur in our use of labor in the stores. So those things we are doing and have done that will mitigate some of the labor pressures, we start from a higher base than most any way in terms of wages. So we are in a good place. It's not going to go up quite as much, I don't think, as some others.

We have introduced self-checkouts and a lot of our stores are now rolling that out fast. We didn't have any of that. So that's significant given the labor hours associated with that. Our replenishment in terms of getting product from the back door to the shelf, a lot of systems in place to reduce the costs that hours that we need to run our stores. So filling the shelves and taking the money through the register, we are relatively inefficient in the hours that we use. So there's opportunities for us to mitigate some of the pressures that are coming on labor on that basis.

And with regards to transportation, I am really pleased that we have built the distribution center in Colorado so we didn't have to drive from Arizona to Denver for the product. I am really pleased with our distribution center in Orlando. So the product is driving from Orlando to Naples rather than Atlanta to Naples. So our transportation pressures are clearly real. We have actually mitigated then by bringing them and we said all along, that a bit less miles would save us some cost. So we have kind of mitigated that. But those are real pressures and we think we are mitigating them pretty well.

I don't know, Denise, if you want to add to that.

[Denise Paulonis, Chief Financial Officer]

No. I think you said it well, Jack. And I think for all those pressures coming forward, you can still see the profit that we are delivering through the company. So I think the realization that we do have the cost saves to offset some of those pressures is evident in the results.

[Operator]

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

[Renato Basanta, Barclays]

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

[Denise Paulonis, Chief Financial Officer]

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

[Operator]

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

[Chuck Cerankosky, Northcoast Research]

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

[Jack Sinclair, Chief Executive Officer]

I don't think I really know the answer to that, if I am honest, Chuck. But clearly that's a possibility. I think the way we look at what's happened, Chuck, are, there has been two things, the consolidation from COVID and then there has been the reduction from less, I am talking two years, the two-year stack, in terms of traffic. There has been those two things, consolidation plus less stimulus in terms of very aggressive promotions.

With regard to restaurants, I think we saw a little bit of a peak at certain times, up and down, in this. But there are some behaviors of the customers have stayed kept going, which is I think why the basket has kind of held out when they do come in, whether it would be a little bit of baking and a little of bit cooking, a little bit of meals. We are seeing our strength in our dairy business which would suggest opposite to the question.

But I don't know that I have really got the answer, Denise, to that.

[Denise Paulonis, Chief Financial Officer]

Yes. And the one thing that I would consider is knowing that we have seen some strength in April and that was the beginning of the reopening, but then May and June, I think we would all say whether we experienced it personally or in the public or press, truly restaurants becoming busy again, travel ticking up quite a bit. I have to believe that that's relevant for our customer base, more or less than someone else's customer base, I don't know. But it feels as though it was real that people were making choices to get out of their homes and to take advantage of what felt like the COVID glory days, for lack of a better way to put it, before the Delta variant really ramped up.

[Chuck Cerankosky, Northcoast Research]

Great. And then when you are talking about calls to action or promotions, could you talk, tell us philosophically how that differs from attracting a new customer or a lapsed customer into your stores versus getting an existing customer to spend a little bit more and increase their basket size?

[Jack Sinclair, Chief Executive Officer]

Yes. I think there are definitely two types of promotions that we are working on. In terms of driving the basket in the store when the customer comes in, there are some very specific activity that we are putting in place, a combination of bringing very exciting. new varieties of product, innovation centers where we have got products that people haven't seen before and that drives it through and very and probably more assertive displays of our produce business, more assertive displays of local produce, which we have just kicked off in Colorado right now, which I am excited about. So local, seasonal, innovation centers, there's a number of things that we are doing to drive basket with the existing customer base.

The secondary, the other side of that equation is how do we drive the traffic to the store. And that tends to be more holistic promotions that would cover across, if you think what, we have got to communicate we have got good everyday prices, we have got great produce prices, we have got unique promotions and we have got specific traffic driving events. And that's what we are going through at the moment in terms of the number of call to actions.

For example, we run 25% of all vitamins and herbal promotion, communicated it very effectively for the direct customer. That's the kind of thing that can drive some traffic and drive some specifics. So we are going to be running at 25% of both promotion, which again, other people aren't going to run about after. And it allows us to communicate the differentiation of our business.

Organic produce, we can use that very effectively. Our organic produce makes us up to 35% of our sales. I don't know anyone that's selling 35% of their produce business that's organic. We are driving those kind of messages in our digital way as opposed to using some of the techniques of being some mass media that we haven't used in the past. We are on TV, trying to do some of those things in some targeted markets.

So it's both sides of the equation. And actually, we are really pleased the way stores again behind the basket driving work as they can do a lot to help that. And I am pleased with the restructure. The way the stores are getting behind it. We are seeing some progress on that. And then we are excited about the work that we are doing in terms of traffic building on those calls to action.

[Operator]

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

[Kelly Bania, BMO Capital Markets]

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

[Denise Paulonis, Chief Financial Officer]

When we planed at the beginning of the year, we had different levers that we would pull. You can look and say which projects and how fast might they move, how fast can we move on shrink, where can we drive efficiencies and labor in our stores and how quickly can we adjust to those types of activities. So what we are really doing is, we are really pulling those levers that were available to us.

We are not stopping progress on anything that is core to the strategy. But what we are really doing is being prudent throughout the P&L in terms of maintaining the gross margin gains from last year and in the way that we wanted to do. Managing distribution costs and taking advantage of the fact that we have the two new DCs and taking transportation cost off the road. And then really working on our in-store productivity initiatives to be able to realize the savings that we need to keep the P&L strong.

[Operator]

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

[Jack Sinclair, Chief Executive Officer]

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

[Operator]

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