BJ's Wholesale Club Holdings Inc

NYSE:BJ

Earnings Call Transcript 2019-Q2

[Operator]

Good morning. My name is Kelly, and I will be your conference operator today. At this time, I'd like to welcome everyone to the BJ's Wholesale Club Second Quarter Fiscal 2018 Earnings Conference Call. [Operator Instructions]

I would now like to turn the call over to Bill Werner, Senior Vice President, Strategic Planning and Investor Relations. You may begin your conference.

[William Werner, executive]

Thank you, Kelly. Good morning, everyone. We appreciate you joining us for BJ's Wholesale Club Second Quarter 2018 Earnings Conference Call and Webcast. Chris Baldwin, our Chairman and CEO; and Bob Eddy, our Chairman -- our Chief Financial and Administrative Officer, will provide you with an overview of our results followed by a Q&A session. Before we begin, please remember that during this call, we may make forward-looking statements within the meaning of the federal securities laws. These statements are based on our current expectations and involve risks and uncertainties that could cause actual results to differ materially from our expectations described on this call and today's press release. Please see the Risk Factors section of our prospectus filed with the SEC on June 28, 2018, for a description of those risks and uncertainties.

Finally, please note that on today's call, we will refer to certain non-GAAP financial measures that we believe will provide useful information to -- for investors. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP.

Please refer to today's press release and the information posted on the Investors section of our website for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP.

With that, I'll turn the call over to Chris.

[Christopher Baldwin, executive]

Good morning. Thank you for joining us for our second quarter earnings call and our first since we've reentered the public markets. In addition to discussing our second quarter results, I'll talk about the company we are today, the key changes we've made over the last few years and our strategies to win going forward.

Our second quarter performance shows that we continue to make progress in our transformation, as we exceeded our internal expectations. Based on our performance, we have increased our internal expectations, which Bob will cover when he provides guidance.

I want to start by thanking our more than 25,000 team members who delivered these results by providing great value and outstanding service to our members. When I joined the team in 2015, we knew we had a great foundation, a strong value proposition, a real estate portfolio that was unmatched on the East Coast, a large and healthy membership base and a key differentiator in our fresh business. But as you all now know, our business at that time was stuck. We lacked the systems and capabilities to support growth, and we had underinvested in key areas of our business.

Our transformation is built on our strong foundation. We are taking a very disciplined approach to investing in these capabilities, systems and people necessary to unlock our true potential.

As a result of this work, BJ's is quite a bit different today than we were even 2 years ago. Our Q2 results show that our transformation is continuing to make progress. This progress is accelerating, but we know we're still in the very early stages. We have much more to do, and importantly, much more opportunity ahead of us.

Today, BJ's Wholesale Club has significant regional scale, with 215 clubs in 16 states up and down the East Coast. We have more than 5 million members. Providing outstanding value and service to these members is core to our strategy. Our success is driven by the outstanding value we deliver to our members, the unique product assortment and the subscription-based membership model that creates dependable and resilient earnings streams for our company and shareholders over time.

Our fresh offering delivers outstanding member value, and we've invested to improve our fresh operations over the past 2 years. As a result, we sell about 50% more fresh food per member per year than our club store competitors.

As a private company, we have made very disciplined investments in systems and technology, including fully installing SAP and improving our omnichannel capabilities. We have also invested in people, marketing and membership to fuel our growth. Our work has been focused on building capabilities in 3 broad areas that are crucial for driving growth.

Those areas are promotional effectiveness, assortment management and pricing capability.

First, I'll talk about promotions. Our investment in SAP and promotion management enabled us to deliver personalized promotions to our members and potential members. This is key to driving member engagement and attracting new members. We've been able to deliver digital coupons and personalized promotion based on shopping habits for the first time in our company's history, delivering tremendous value to our members and, most importantly, driving trips to our clubs.

Second, assortment management. Our investment in the assortment capabilities has given our business more flexibility in delivering the treasure hunt that is crucial to building member engagement and providing value. We are able to turn our assortment and chase new opportunities faster and more efficiently than ever before. Our work in this area also creates the potential for us to enter a number of new categories moving forward.

Third, our pricing capability. We are relentlessly focused on delivering value to our members. Our members save about 25% versus grocery store prices, and we continually compare our prices against competitors to ensure that we are delivering phenomenal value.

Our investment in pricing capabilities is key to our success, and we now have more timely accurate data to maintain this critical component of our strategy.

We have also created a more robust procurement process, instilled SG&A discipline and eliminated unprofitable sales, while simultaneously investing for growth. These investments have set the stage for our growth as we reenter the public markets and have contributed to our recent improvement in comp sales, membership renewal rates, profitability and cash flows.

I am pleased to report that in the second quarter we saw a net sales growth of 4.3% and merchandise comp sales up 2%, our fourth straight quarter of improving merchandise comps. Adjusted EBITDA was $143 million, which was up 5.4% over last year and is an all-time high for our company in the second quarter. We are proud of our progress during the quarter, but more importantly, we see significant opportunities ahead of us.

Let me take a moment to speak about our plan. First, acquiring and retaining members. Membership growth starts with providing outstanding value to retain current members and attract new ones. The average BJ's member can save about 10x their investment in membership fees each year. As we invest in acquiring new members, we work to highlight the value we offer to our members -- to our BJ's members. We are committed to using data to target potential members and consistently reach out to prospective members through both physical and digital channels.

We've made significant progress in acquiring members through digital means. On a year-to-date basis, we've nearly tripled the percentage of members acquired through digital channels, and we see great opportunities in this area moving forward.

We are aggressively testing and using social and digital media to reach younger audience, and we are using mobile technology to target prospective members.

We continue to invest in engaging and retaining our current membership base. We use our data to provide personalized promotions based on shopping habits, which improves member value. Programs such as our best-in-class credit card offering and our Easy Renewal program delivered better member value and convenience, while driving retention and engagement for our company. As a result, our membership renewal rates are at all-time highs. This year, we successfully executed a membership fee increase, which has met our very high expectations.

We are pleased with our efforts to attract and retain new members and have a long, long runway ahead of us to continue to drive membership growth.

Second, we intend to deliver value to get members shopping. Our fresh food business is key to delivering member value and driving visits to our club, and we saw the results of our investments in Q2. We saw growth in our dairy, seafood, floral and frozen offerings, driven by new items and a relentless focus on value. We've also been successful in our grocery offerings, seeing growth in salty snacks, water, active nutrition, among many other categories. Our growing general merchandise business is key to creating the treasurer hunt that drives trips and engages members.

Our investment in assortment capabilities let us deliver exciting new products, whether it's the latest fashion trend or the hottest electronics, all at outstanding value.

Apparel was one example of how our investments are helping us drive growth in general merchandise. We continue to invest in assortment, adding new brands and styles at outstanding value while improving our merchandising. This is an important category for our business and for our members.

As a result of investment in systems and execution, we now change our apparel inventory 3 times more often than we did just 2 years ago, providing our members with the latest fashion trends in seasonal apparel. As a result, we saw significant sales growth in apparel in Q2. We have a strong pipeline of new items and look forward to launching exciting new brands at great prices in Q3.

Our investments in merchandising and assortments also drove our TV business growth during the quarter, making it easier for members to shop this very important category. Our seasonal business, including air-conditioners, grilling and garden supplies, also grew in the quarter, driven by new brands exciting products and improvements in how we display our merchandise.

Our private label brands are crucial to providing value to members. These brands, Wellsley Farms and Berkley Jensen, continue to perform well and represented more than 20% of our sales in the quarter. Private label enables us to provide our members with high-quality national brand equivalents and other unique product offerings at roughly 20% to 30% savings to the branded equivalent, while also providing higher margins to our company.

In Q2, our private label seasonal items performed particularly well, with increases in both sales and profitability. Mother's Day was a good example of how we plan to use private label brands to aggressively engage our members. We created outstanding Wellsley Farms floral displays, showcasing our high-quality products at great prices. We have a strong pipeline of new private label items and merchandising plans, including a much better assortment of Wellsley Farms wines and seafood scheduled for Q3.

Third, we aim to make it more convenient to shop at BJ's. We are investing in member value by providing -- by improving our omnichannel capabilities, as we make the club experience easier and more convenient for our members.

We rolled out a brand-new online platform during the quarter, improving the entire portfolio of our technology infrastructure, payment options and online member experience. This is our largest digital upgrade in more than a decade. Our cloud-based platform is scalable for growth and enables us to innovate and quickly launch new services. As a result of our upgrade, we were able to roll out buy-online-pickup-in-club in all 215 clubs in the quarter. Early results indicate that BOPIC is a strong offering. Members using the service tend to be younger and have significantly larger baskets than other shoppers. In addition, we're seeing that about half of BOPIC users make additional purchases once inside the club.

We've also added same-day delivery across the chain for this quarter. Same-day delivery is now available to more than 70% of our members. This service provides great value to members by offering grocery delivery at club prices for members who order on delivery.bjs.com. Members love the convenience of these new offerings. We're still very early -- in the very early stages, and we expect this to see strong growth in Q3 and beyond.

Our tire business is also a good example of how our investments in omnichannel can drive member behavior in existing categories. We recently upgraded our tire website and improved our assortment to make it more convenient for members to take advantage of the outstanding value we provide in this very important category. As a result, we've seen significant year-to-date growth in digital tire sales, feel very good about this area of our business going forward.

The most mature of our omnichannel investments is in our app, which is less than 1 year old. Our app recently reached 1 million downloads, which is well ahead of our expectations. Our app receives higher ratings than many of our competitors, and members love the convenience of downloading digital coupons for their phones. Our omnichannel investments are off to a strong start. Members are responding to the added value and convenience, and we'll update you on these programs as we continue to make progress in the months ahead.

Finally, we plan to expand our strategic footprint. We've reinvented the BJ's Club opening model using a data-driven approach that has yielded much better new club performance. We applied this approach as we planned our newest club and gas station in Roanoke, Virginia, which is on track to open this fall. Membership continues to increase as excitement in the community grows. Looking ahead, we are planning to open 15 to 20 new clubs over the next 5 years, focusing on infill and markets adjacent to our existing locations.

Above all else, the key to our transformation has been our team. We have focused on developing and recruiting outstanding team members at all levels of the company. Over the past 2 years, more than half our senior team are new to BJ's or in new roles. We continued this trend in recent months, adding experienced retail executives to lead our real estate and human resources functions. We've also added a new executive to a senior role in our club operations team. These are crucial areas for us, and I'm thrilled at the level of talent we've been able to attract.

I'm proud of the team in what they have accomplished. I'll reiterate that we're in the very, very early innings of our transformation at BJ's, pleased by the progress we have made and excited about the opportunities that lie ahead. We believe we have the right strategic focus and the initiatives in place to drive further improvement.

And with that, I will turn the call over to Bob, who will review our results and outlook for the year in more detail.

[Robert Eddy, executive]

Thanks, Chris. Good morning, everyone. As Chris mentioned, we are excited to share BJ's story and our second quarter results with you. In the second quarter, we beat our internal expectations for top line, comp sales, margins, membership fees, profitability and cash flow. These gains were driven by our ability to continue the momentum we've built over the past few quarters. Our category profit improvement, or CPI, process and improving private-label execution have yielded great margin gains, allowing us to invest considerably in membership and merchandising initiatives that have fueled our top line growth.

For the quarter, net sales increased by 4.3% to $3.2 billion compared with $3.1 billion last year. Comp sales increased by 5%, which included a 3% favorable impact from the sale of gasoline. As a reminder, our comps are reported on a shifted basis in accordance with the NRF calendar. Merchandise comp sales, which exclude gasoline sales, increased by 2%. We are proud to report that this is our fourth consecutive quarter of merchandise comp sales gains. Our general merchandise business led our merchandise comp sales gains with a 4% comp during the quarter. At this time last year, we were in the final stages of making significant moves within our general merchandise assortment, including largely removing jewelry in favor of apparel.

Our Q2 GM comps reflect the positive impact of these changes. We revamped our summer seasonal and TV assortments as well and saw strong gains in those categories, particularly later in the quarter. Comp sales of our edible and nonedible grocery businesses, respectively, increased by 2% and 1% during the quarter. These gains were driven by more effective promotional tactics as we get smarter about promotional effectiveness and member engagement.

Our perishable business saw a comp sales increase of 1%, owing to our continued improvements in the execution of this part of our offering. For those new to the BJ's story, we have been working hard to make sure that our members experience the best product and presentation whenever they visit us, and we made considerable progress in the second quarter.

You should also know that there were certain unprofitable areas of our business that we strategically chose to exit while we were a private company. Our Café business is one example that we have yet to fully cycle. The result has been an increase in profitability in our fresh business at the expense of some lost sales throughout this year in our fresh business.

Membership fee income grew by approximately 10% versus last year, driven by the increase in our membership fee, which went into effect in January of this year as well as the results of our continued focus on new-member acquisition. Member reaction to our recent fee increase has met our high expectations. We also continued to invest to drive members into our higher-tier memberships, as those offerings create a higher lifetime value for us and the best value for our members.

Gross margin dollars increased by $35 million to $589 million, and gross margin rate increased by 40 basis points to 18.2%. As you know, gasoline is sold at lower margins than much of our other merchandise. Excluding the impact of gas sales, our merchandise gross margin rate increased by approximately 80 basis points over last year, driven by our procurement initiatives.

While driving these margin gains, we effectively managed our distribution costs and invested in member value to maintain our price advantage versus our competition. Since we began our CPI process 2 years ago, we have secured more than $300 million in procurement cost savings. That is more than double our initial savings estimates, and there is definitely more to go. We continue to work with our supplier partners to optimize our inventory assortment and our procurement costs.

SG&A expenses were $549 million compared to $477 million last year. When evaluating this number, you should consider some expenses incurred this year that relate to our IPO. Included within our $52 million total stock compensation expense is a $49 million charge related to certain equity awards that were issued in connection with the company's IPO.

SG&A also included management fees to our private equity sponsors of $1 million. Our quarterly management fee arrangement was terminated in connection with the IPO, and as a result, you will not see this item going forward.

We also incurred approximately $1 million in other IPO-related expenses. We have included adjustments for each of these expenses in arriving at adjusted net income. Excluding these onetime expenses related to our IPO, SG&A for the second quarter was $498 million compared to $473 million in Q2 last year. The increase was driven by continued investments in membership acquisition and talent additions in key growth areas of the business. Operating income was $39 million compared to $75 million last year. Operating income increased by 14%, to $90 million from $79 million in the same period last year, excluding the IPO-related charges I referenced earlier.

Interest expense increased to $60 million from $44 million in last year's second quarter. This year's -- rather, this quarter's expense included a charge of $19 million related to the extinguishment of our second-lien term loan. Assuming the IPO and related second lien payoff took place at the beginning of the quarter and excluding that debt extinguishment charge, interest expense would have been $31 million. For the quarter, we had an income tax benefit of $15 million compared to an income tax expense of $11 million in the prior year. The benefit was driven by 2 things: first, the lower taxable income driven by stock compensation and other charges related to the IPO; and second, by the $9 million windfall tax benefit that occurred as a result of stock option exercises by former executives during the quarter.

We expect to continue to experience windfall tax benefits as stock options are exercised in the future. However, timing and amounts of any windfall benefits are difficult to estimate. For the quarter, we reported a net loss of $5.6 million or $0.05 per diluted share compared to net income of $20 million or $0.22 per diluted share in the second quarter of fiscal 2017. Adjusted net income was $43 million, an increase of 42% from the $31 million in the prior year period. Adjusted net income excludes the after-tax impact of the IPO equity awards, IPO costs, management fees, interest and charges related to the extinguishment of our second-lien term loan, and the windfall tax benefit from option exercises.

For the purposes of calculating adjusted net income, we have used a normalized tax rate of approximately 27%. Our press release includes a table that reconciles GAAP net income to adjusted net income, including on a per share basis. Adjusted EBITDA increased to $143 million from $136 million in the comparable period last year. This is a record level for us in the second quarter, and we are proud of a continued steady increase in profitability we have experienced over the last 10 quarters. For clarity on the adjustments used to arrive at these figures, please see the non-GAAP tables included in our press release.

Moving now to the balance sheet. Total inventory was down 3% over last year's second quarter. We continue to execute on plans to better manage our inventory levels and cash flows. Our AP to inventory ratio, a key measure of our working capital efficiency, came in at 78% versus 73% last year.

Total debt was $1.96 billion at the end of the second year -- end of this year second quarter compared to $2.77 billion at the end of last year's Q2. The reduction in debt was due to the payoff of the second-lien term loan and a partial paydown of the ABL using IPO proceeds and operating cash flows. Our net debt at the end of the second quarter of this year was $1.93 billion. And our net debt to LTM adjusted EBITDA at the end of the second quarter was 3.4x.

Year-to-date free cash flow, which we define as operating cash flow less CapEx, came in very strong at $128 million versus $8 million in the prior year. The prior year included a onetime cash outflow of approximately $73 million for the compensatory payments related to options for our February 2017 recapitalization. Therefore, a more appropriate comparative prior year amount is $81 million. The strength in this year's cash flow is driven by our improved profitability and our strong working capital management.

Before I turn to our outlook for the remainder of the year, I'd like to recap some of the key events and transactions that have taken place recently as we expect them to yield annual interest savings of approximately $75 million. On June 27, we completed our initial public offering. This offering yielded net proceeds of approximately $691 million, which were fully -- we used to fully extinguish our second-lien term loan and to partially pay down our ABL.

Next, shortly after our IPO, we received ratings upgrades from both Moody's and Standard and Poor's.

Our current corporate family ratings are now B1 at Moody's, up from B3; and B at S&P, up from B minus. On August 13th and 17th, respectively, we closed repricing transactions of our first-lien term loan and our ABL facility. Our first-lien term loan is now priced at L plus 300 and includes a step-down to L plus 275 upon reaching 3x leverage.

Our ABL is now priced at L plus 125, with a term loan portion of the facility priced at L plus 200. We also extended the maturity of our ABL for a new 5-year term. Further, we drew $350 million on our ABL and paid down the first-lien term loan to capture even greater interest savings. Note that the results of these repricing transactions have not been included in the Q2 adjustments I discussed earlier.

Assuming LIBOR rates at the end of last fiscal year, the payoff of the second lien will reduce our annual interest expense by $58 million and the repricing of the remaining facilities will reduce our annual interest expense by an incremental $16 million for a total annual interest expense reduction of approximately $75 million.

We have grown the top line and profitability of our business along with free cash flow in both the second quarter and first half of this year. Going forward, we believe the momentum of the first half will continue and our bottom line results will be aided by the deleveraging effects of the transactions I just reviewed.

Based upon our performance to date and the repricing transactions, we have increased our internal expectations for the year and offer you the following outlook.

For the year, we expect net sales to be in a range of $12.6 billion to $12.7 billion, with merchandise comparable store sales, excluding gasoline, at 1.8% to 2.1%. We expect interest expense for the full year, including the anticipated benefit of the August 2018 repricing transactions and excluding interest in the first half of fiscal 2018 related to the second-lien term loan, to be $115 million to $118 million. In other words, we expect interest expense in the back half to be $54 million to $57 million.

We assume a tax rate of 27%. That rate will vary with any discrete items in each period. And as I mentioned earlier, the tax rate will benefit to the extent that there are additional option exercises that generate windfall tax benefits.

For the year, we expect net income to be in a range of $101 million to $111 million or $0.83 to $0.91 per share based on 121.9 million diluted weighted average shares outstanding. We expect adjusted net income in the range of $163 million to $173 million or $1.17 to $1.24 per share, based on 139.2 million adjusted diluted weighted average shares outstanding.

We expect adjusted EBITDA to be between $553 million and $563 million for the year. And finally, for the year, we expect capital expenditures to be in the range of $160 million to $170 million. As I mentioned earlier, we expect to open our new club in Roanoke, Virginia, in the third quarter, and a club in Clearwater, Florida, right around the end of our fiscal year. We have also built a great pipeline for next year that we will discuss with you on future calls.

As we look out beyond this fiscal year, our longer-term financial goals include average annual revenue growth of 2% to 3.5%, driven by new unit growth of 1% to 2%, and merchandise comps, which exclude gasoline, of 1% to 2%. We target long-term adjusted EBITDA growth of 5% to 7% and low double-digit adjusted net income growth. And finally, our net leverage target is less than 3x, as we continue to pay down debt with the substantial free cash flow that this business generates. We anticipate being below 3x net debt-to-adjusted-EBITDA by the end of next year.

In closing, I'm proud that our continuing transformation has yielded Q2 performance that exceeded our internal expectations. I'm also happy to have reported to you an outlook for the remainder of the year that reflects our great performance in Q2, along with a meaningful impact of our debt repricing transactions. I look forward to delivering on our goals for the remainder of the year.

And now I'll turn the call back over to Chris for closing comments before we begin the Q&A session.

[Christopher Baldwin, executive]

Thanks, Bob. We are pleased with our second quarter results, which exceeded our expectations. More importantly, we are still in the very early stages of our transformation. We see significant opportunities ahead of us, as we work to attract and retain members, deliver value to them to get them shopping and make it more convenient to shop at BJ's Wholesale Club. Now let's go to questions.

[Operator]

[Operator Instructions] Your first question comes from the line of Robbie Ohmes from Bank of America Merrill Lynch.

[Robert Ohmes, analyst]

Actually, it's going to be a couple of quick questions. The first is, I was wondering if you could give us some color on the traffic versus ticket break out in the comps? And maybe within that, I know you gave the grocery comp, but maybe discuss the inflation part of your grocery business, and also what the competitive environment looks like on the grocery and fresh side of our business. And then my second question is the -- sorry, the membership fee increase, I think you guys said something like "met our high expectations on renewal rates." Can you maybe, Chris, give us color on -- and maybe remind us what you're doing to keep those renewal rates so high post the membership fee increase? And if you can give us any numbers around that renewal rate that would be terrific?

[Christopher Baldwin, executive]

Thanks, Robbie. On traffic and ticket, we saw a balanced contribution between both traffic and ticket in the quarter. We felt very good about both elements of the proposition. While we're not going to get into the specific numbers, we consider it an equal contribution from both. I'm going to combine my answer on the grocery and competition. Over the course of the quarter, Robbie, as you know, we are very disciplined in how we approach our pricing proposition and it's -- as it's fundamental to the model of club stores. And across the quarter, we had no change in our pricing stance relative to our competition overall. Our pricing versus grocery is 25% or more better, and we have 10% to 15% advantage versus mass, and we price equally every day to our club store competitors. That, we feel very good about our competitive position. There are certainly occasional regional dustups in terms of certain key items that get footballed, but we feel very good about our overall pricing proposition to our members. On the renewal rate, overall, we've done a really good job of communicating value to our members and continuing to add value. And we're encouraged by what we're seeing in terms of execution around the pricing change. As you think about the flow through of the renewal price -- excuse me, the membership price change, about half of it comes from new members and about half of it is flow through of the higher fee. And the biggest driver of our ability to keep our renewal rate high is the ability to execute on easy renewal, which we discussed with you for some length and continue to progress in improving our credit card offering, which saw a stronger performance. Lastly, I think the last part of your question was about inflation. We saw inflation to be about flat on the company for the quarter. No real material change, either up or down. Thank you very much for your questions. Hope I hit every point.

[Operator]

Your next question comes from the line of Christopher Horvers from JPMorgan.

[Christopher Horvers, analyst]

Can you talk a little bit about how you think the weather perhaps impacted second quarter comps? I know there were some shift and I think you got some hot weather in there as well. Sam's is talking about -- or Walmart is talking about good beverage sales and so forth. And any thoughts in terms of how you're capitalizing on and quantification of what you're seeing from a Sam's lift perspective?

[Christopher Baldwin, executive]

From a Sam's lift perspective, it's certainly helped our comps overall. But on weather, overall, Chris, the early part of the quarter was really weak. It was a wet cold start for the second quarter, but we feel like we made up for it in the back half with hot, warm weather. And one of the reasons I made some comments on active nutrition and beverage that I did is reflective of that. Our general merchandise proposition also responded very well, with air-conditioner and grilling sales and seasonal garden sales to be -- were very, very strong towards the back half of the quarter. So overall, I would characterize weather as about neutral, with a bad start and a stronger finish. And I would characterize the impact of Sam's to be certainly a contributor, but we feel good about our business overall.

[Christopher Horvers, analyst]

Understood. And then as it relates to the gross margin -- 2 margin follow-ups, as it relates to the CPI benefits, when you were out on the roadshow process, you talked about really not expecting much incremental benefit from new negotiations and with the vendors. Can you talk about how those vendor negotiations have proceeded, and whether or not we're including any incremental benefits in the gross margin outlook? And then lastly, on advertising, can you talk about sort of the amount of pressure that you saw in SG&A from a rate perspective relative to advertising, that would be great?

[Christopher Baldwin, executive]

I'm going to take a broader strategic point. Then I'll ask Bob to follow up. Overall, we feel very good about the procurement capabilities we've built. And one of the things that we think a lot about, as we run our business and speak to you about it, is the discipline with which we approach the delivery of sales, margin and cash flow performance. So with that discipline, we feel really good about where we are and really good about where we're going. So I'll let Bob take the specifics on CPI.

[Robert Eddy, executive]

Chris, so when we were out on the roadshow, I think, we talked to everybody about the fact that we have completely reinvented our procurement processes and had tremendous success doing that. In my prepared remarks, I talked about the fact that we've yielded $300 million in procurement savings program to date, so over a couple of years here, more than double what we thought we would do initially. And that overperformance is the result of the fact that we continue to get better at changing the story in our suppliers' minds in terms of how we can grow together. And it's important to note that, that you're comparing against the S1. We had told you $260 million in the S1; and we are now sitting over $300 million. So we clearly have been getting a little bit more successful at doing it, getting a little bit more sophisticated at this process and adding new wrinkles into it. So you'll see in the future an increasing press forward on private label as part of these discussions on the growth year aspect of our assortment aspirations here. So we've had tremendous success to-date, and we do see continuing success going forward. We -- as we talked about on the roadshow, I think, we certainly hit the majority of our categories once, but every single category we've hit, the second time has yielded more results when we go through it again. And so we certainly feel like there's a whole lot more to go get. It seems to take on a different life every quarter. I would tell you with that color, 80 basis points of merchandise margin growth was really a strong quarter. And if I were to give you a detailed guidance going forward, I probably would not forecast 80 basis points for Q3, for instance, but we absolutely see more here out of our CPI program. And we'll use it as fuel for growth in the merchandising and marketing initiatives that Chris talked about. And we'll obviously use it to make sure that we continue to provide the outstanding value we provide to our members going forward. That is our first commandment. We have to provide that value every single day.

[Christopher Horvers, analyst]

And then on the advertising deleverage?

[Robert Eddy, executive]

Yes, thanks for reminding me. Advertising was about half of the remaining increase after you deduct all the IPO-related stuff. So we have -- we've been investing disproportionately in both promotional advertising as well as even more so in membership acquisition. So if you think back to the story we told you on the roadshow, we have changed our entire membership approach from a periodic membership acquisition campaign that took place in the fall and the spring to always on-campaign. Underlying that is a simple thought of the lifetime value of a member is -- on an average member is about 10x the marginal acquisition cost of that average member, and so we should be disproportionately investing in this all day long. We have certainly done that throughout the first half of the year. We will continue to do that in the future. And that sopped up a meaningful part of that increase in SG&A.

[Operator]

Your next question comes from the line of Mike Baker from Deutsche Bank.

[Michael Baker, analyst]

Just wondering if you could provide -- you provided some color, I suppose, looking back into it, on the monthly trends, but any quantification or additional color on how the comps trended by month? And I guess related to that, your implied back half comp guidance does suggest a pretty big acceleration on a 2-year basis. It's just comps around 2 for the back half against much more difficult comparisons. What gives you that confidence? Is it based on the trend that you're seeing throughout the quarter?

[Robert Eddy, executive]

Absolutely, Mike. Thanks for those questions. We certainly did see, as Chris mentioned earlier, better back part of the quarter than the front part. May was pretty slow for us, June was about right on the average for the quarter, and July was, I think, our best comp month of the year so far. So we felt like, coming out of the quarter, we were in great shape. Some of that, as Chris talked about, was the impact of weather. But the underlying businesses all performed very well. You're right on that the guidance for the back half is a pickup from our internal expectations, and that is really the feeling that we have coming out of the second quarter and the momentum provided by that, plus what we view as the contribution from our membership programs going forward and the changes in assortment and other merchandising factors that our merchants are putting together now for the back half. I would tell you that we expect Q4 to be stronger than Q3 from a comp perspective. So as you're tuning in your models, think about that. But overall, we're very comfortable with our momentum coming out of Q2 and foresee a good back half.

[Michael Baker, analyst]

Okay. Well, so I had another follow-up, but with something you just said will lead me to a different follow-up. Why would fourth quarter be better than third quarter? What's behind that comment?

[Robert Eddy, executive]

Well, I think part of it is what's going on in the prior year, and you pointed back to much tougher comparisons. Q3 we had a pretty strong benefit last year from all of the after-hurricane impacts. And so we've got to bump up against that in this fiscal year. So all things equal, that's why we tell you Q3 will be a little lower than Q4. If you want more color, I feel a little bit better about our contribution from omnichannel in the back half and the items that our merchants are cooking up for a holiday season. It looked like they are better than last year as well. So that's what I would tell you on that.

[Operator]

[Operator Instructions] Your next question comes from the line of Matt Fassler from Goldman Sachs.

[Matthew Fassler, analyst]

My primary question, and I'll try to stick to the operator's rule, relates to membership tiers. I know a big part of your story relates to signing people up at higher tiers of memberships, getting people onto the private label credit card, upgrading those who have already been members. Any color as to the progress that you saw on that front during the quarter?

[Robert Eddy, executive]

Sure. We continue to see progress. We continue to make changes to our world here in trying to invite progress. So one thing we are working on is co-brand application at the register. And that will hopefully roll out here in the next few weeks and allow us to really turbocharge that program. For color, we do about 110 million transactions, 10 million at the membership desk and 100 million at the register. So currently, we are only accepting apps at the membership desk and some tabling amount something. So if we can get people going to the register and not meaningfully add to the lines that we have at our registers and turbocharge the program that way, we would consider that a home run. We continue to try and think of ways to tweak the program and build upon the program. The penetration of the car continues to increase, both at the register and the gas pumps. Gas pumps is probably the most meaningful increase. Up over 20% of our transactions at the gas pumps are using the co-brand card. So that $0.10 off a gallon really matters to people. And as Chris mentioned, getting folks into Easy Renewal has been a nice tailwind here as well. We are up around 47% of our members in Easy Renewal at this point. That's up 7 or 8 basis -- or 7 or 8 percentage points from the end of last year and well towards our goal to get to where we want to be at the end of this year. That's providing a nice offset to the fee increase headwind that Chris talked about and will allow us to build from there.

[Matthew Fassler, analyst]

I think this follow-up follows naturally enough from your last answer. I can slip it in. Gas gallon comps versus the merchandise comp average for you?

[Robert Eddy, executive]

Yes. Gas gallon comps were about flat, Matt, quarter-over-quarter.

[Operator]

Your next question comes from the line of Chris Mandeville from Jefferies.

[Chris Mandeville, analyst]

Majority has already been asked. So I guess just focusing in on free cash flow, you obviously alluded to in your preamble that you made some good gains on inventory management, receivables loss was down as well, payables were up low to mid single digit. So can you just speak to the opportunity that remains on improving working capital? Do you have any type of target or goal set that you can share with us over the next 12 to 18 months?

[Robert Eddy, executive]

Sure. So certainly we made some nice progress on inventory, in particular. We look at that inventory to an accounts payable ratio as an important one. Obviously, the club business is special and that it sells most of -- we sell most of our inventory before we have to pay for it. So we sold 78% of our goods before we had to pay for it this quarter. That was pretty strong for us. I would tell you some of the inventory decrease was timing of receipt of goods as we play around with what comes in for the back half. The rest of it was real inventory -- sustainable inventory decreases. We continue to work on that. Our logistics team is pretty special from that perspective, and we will continue to do so. You referenced the accounts receivable in there as well. That tends to be timing of credit card receipts and rebate receipts more than anything. So I wouldn't pay too much attention to that. That's why we stick to AP to inventory ratio. And we'll continue to work on this. The biggest -- the next big chunky opportunity for us is to take advantage of the new generation of logistics systems that are out there, and we will do that in the coming years. It takes a while to put those things in and do it right without disrupting your business. We will do that in the coming years, and that, we think, is worth, call it, another $50-or-so million of inventory savings there, but that's the next leg out. All of these working capital gains we used to delever them, and we'll continue to do that. So nice results. We're proud of them during the quarter. We see a little bit more runway here in the back half, but the next big leg is that systems update.

[Chris Mandeville, analyst]

Okay. And then I know it's only been a few months, but how receptive have your customers have been thus far with Instacart? Can you provide any insights on basket size or the categories that are being shopped versus in-store today? And then can you just remind us of what other digital initiatives we should be looking forward to in the coming year?

[Christopher Baldwin, executive]

Sure. Thanks for your question, Chris. A couple -- overall, our intent at a strategic level is to make our club the most convenient club to our members. And over the course of a quarter, we've replatformed our entire omni-portfolio, as I mentioned in my prepared comments, and the 2 big convenience initiatives that launched in the back half of the quarter are same-day delivery and buy-online-pickup-in-club. Both have performed very, very well. On buy-online-pickup-in-club, we see the ring to be higher than our average as much of the, what we are seeing, flow through of that system is general merchandise, as people reserve inventory, pay for it and then come up. And about half of them are shopping the club after they pick up their reserved order. Secondly, on the same-day delivery, the value prop there is really important to us, and we've been really encouraged by what we've seen. And the member there, who is using that service, is a bit younger than our average, and we feel good about that. And the value prop is really simple. We're giving people same-day delivery for club store prices plus a $15 fee. And that value prop has been very clear, transparent and working. As we bring those capabilities up in terms of the experience, we'll begin to market them in the third quarter, and we're encouraged by what we see.

[Operator]

Your next question comes from the line of Simeon Gutman from Morgan Stanley.

[Simeon Gutman, analyst]

I wanted to ask a question about the second quarter. The comps were very fine at 2%. I wanted to ask how you, Chris, can you parse out the environment, which was pretty good? I know you talked about the month a little bit -- versus internal efforts? And then anything around the Sam's Clubs closings, the stores that are benefiting from those?

[Christopher Baldwin, executive]

Yes, I think -- Simeon, thanks for your question. I think that the -- in the macro environment, it is very clear that the value retail works, and when you add convenience on top of it, it works even better. And the environment, I think, overall, on a macro basis is very, very good, but the thing we are pointing to is we are very early in our transformation, and we feel very good about the discipline with which we have approached growing sales, earnings and cash flow. As a private company, we work really hard to completely transform the disciplines and processes within the company in order to be ready to come out to the public markets. And I think the balanced approach we've had is flowing through our P&Ls. And the environment certainly is good. There is no question that a competitor closing some stores is good, but what I -- we point to most is our internal efforts to continue to deliver better value every single day to our more than 5 million members.

[Simeon Gutman, analyst]

If I can ask a quick follow-up, can you remind us why the strategic consulting fee is not excluded from the P&L?

[Robert Eddy, executive]

Simeon, it's excluded from the adjusted EBITDA definition, but not from adjusted net income.

[Operator]

Your next question comes from the line of Kate McShane from Citigroup.

[Kate McShane, analyst]

In the prepared comments you mentioned more new categories moving forward. Would you be able to disclose what you're thinking in the timing of that? And with regards to private label, were there any specific changes made to private label in Q2 that yielded the better results?

[Christopher Baldwin, executive]

Couple of things. Let me take the second one first, Kate, and thank you for your question. The private label business continues to be a terrific source of both sales and profit growth for us. So we feel very good about that. And the big thing that I tried to highlight in my prepared comments was a more integrated approach to how we merchandise and market, an example was Mother's Day, as we did private label floral, and we felt very good about the in-store presentation. Our clubs executed very, very well and the results were terrific. So as we thought -- as we think about it over time, we've gone from a series of items that we've added in order to compete more effectively in categories and create leverage with our suppliers to a much more integrated sales and marketing approach, which will drive our business going forward. So that, while sounding simple, has yielded better results. Secondly, on new categories, I'll go back to my comments that I made in response to my question that Simeon asked. In that, the company has worked really hard to create more and more discipline on how we approach things, and there is no better example than the approach we have to managing our categories. Apparel is the most recent addition where we've taken out jewelry and replaced it with apparel to significant benefit. And as we go forward, things like outdoor categories and tools are places where we believe our core member will see great value, and we expect one of the reasons why we're encouraged by our back half, particularly Q4, is our entry into some of those categories in a more meaningful way will create significant opportunity for us going forward. Those are 2 ones I would spotlight at this point. Sporting goods is another one that we will do a much better job at.

[Operator]

Your next question comes from the line of Edward Kelly from Wells Fargo.

Your next question comes from the line of Peter Benedict from Baird.

[Peter Benedict, analyst]

First, just looking at the perishables and the nonedible grocery comps in the quarter, they did slow a little bit from 1Q. So I'm not sure how the compares set up from a year ago, but can you just talk about those 2 categories? Maybe what drove the slowdown and how you're thinking about them within your back half guidance?

[Robert Eddy, executive]

Peter, so we think about those categories, obviously, against the compares that are out there. The perishable business, we think, did okay during the quarter when you consider the compare. And the nonedible business could do a little bit better, but generally has been right around the company's comp or at least around the company's traffic trend. And so we feel like that's, in view of the entirety of that business, an acceptable result as well. We're playing around a lot in perishables, as you know, given our story. We're spending a lot of time and resources and effort to try and make sure that our members have the best experience whenever they visit us, and we made considerable progress on that in Q2. So that was an upside to perishables. The downside, you've got to remember, is the effective discontinuing businesses there as well. So in my prepared remarks I talked about Café. There are couple businesses throughout, but Café, it's the perishable business, in particular, that we've discontinued. So all told, we feel like we're doing fine in both of those businesses. And as we continue to work on the perishables business, as we continue to get smarter about member engagement and promotional effectiveness, the nonedible business will respond as well.

[Peter Benedict, analyst]

Okay. That's helpful, Bob. And then just from a higher-level perspective, Chris, just how are you guys thinking about the CPI initiative? Obviously, it's given you guys a lot of profits to work with. Just your thoughts about booking those gains going forward versus reinvesting into price and to drive the top line, drive membership. Where do you sit with that as we look out over the next couple of years?

[Christopher Baldwin, executive]

Yes. As we think about -- I'll make a macro point, and then I'll ask Bob to make a specific comment if he chooses to. But, Peter, our primary focus is reinvesting in those savings in member value. The most important takeaway is that our CPI work has allowed us to deliver pricing to the consumer that's equal to every one of our club store competitors, better than grocers and better than mass merchants and to expand our margins. We've also, in that same bucket, have invested substantially in the member experience, omni-experience and in membership marketing overall. And we feel very good about our ability to continue to do that going forward. It gets to my earlier answer on the balance and discipline we've tried to run the company with, that is not only has been an important part of the most recent periods but will be an important part of how we run the company going forward. Bob, do you have anything to add to that.

[Robert Eddy, executive]

No. I think, Chris, you hit the highlights. Pricing is -- member value is the most important thing we do, and CPI has allowed us to do that first and foremost and maintain the pricing gaps that we have as well as to invest in all the membership and assortment and other initiatives that we are working on.

[Operator]

Your next question comes from the line of Simeon Siegel from Nomura Instinet.

[Simeon Siegel, analyst]

Bob, to your earlier point, nice merch margin improvement, and understanding you don't expect the same in Q3, but what do you see as a long-term gross margin potential? And then as you guys -- Chris, as you guys think about traffic opportunities, understand the current, but also thinking about longer term, how do you think about new customer traffic versus greater frequency of existing shoppers?

[Robert Eddy, executive]

Simeon, so your margin question is a good one. While we were very impressed with 80 basis points improvement on merchandise margin -- and we hope to replicate that, but that's not how I would plan the business. And yet I think the thing you need to remember is, we are approaching these assortment discussions with our suppliers in waves, and so the results come in waves as well. So Q1 and Q2 had pretty spectacular results in that view. Q3 and Q4 have a little less from what we know today. I sort of think if you're asking a longer-term question, I think there's probably another -- as much as another point of merchandise margin to go get over the next couple of years, and we're actively after that. At some point and the point is probably approaching pretty quickly. These discussions are going to stop being about just acquisition cost and becoming more about what products are actually on the shelves and what categories are on the shelves and how can we better balance the margin, the actual acquisition cost with the growth side of the business and get a little bit more focus on what's the right stuff to excite our members and provide that treasurer hunt when they walk in the door. So we absolutely think that there is more to go get here. We absolutely think that the P&L will benefit from that, but we would look to move this program towards the growth side over time.

[Christopher Baldwin, executive]

And, Simeon, to your question on traffic, the new-member marketing work that our team has been working on is really focused on teaching people how to use the club. And as we continue to mature new members, we feel good about the future of our company. I will also point to some of my comments on using digital acquisition tools to access younger members, particularly newly forming families, which are a great target for the club store industry, and we feel very good about our efforts there. So our membership acquisition work has been fruitful. And we continue to market to those members, trying to focus on value and convenience. And we feel pretty good about what we have done and the opportunities that lie ahead of us in both areas.

[Operator]

Your next question comes from the line of Ryan Domyancic from William Blair.

[Ryan Domyancic, analyst]

So just a follow-up on the digital side of things. Is the cost of acquiring those digital members less than the cost of acquiring a member through a direct mail channel? And then what percent of members today are acquired through digital channels? And where do you hope to get that percentage to in the next 2 or 3 years?

[Robert Eddy, executive]

It's a great question, Ryan. So certainly digital acquisition is an evolving thing for us. We, for the longest time, have been almost fully denominated in direct mail acquisition efforts, with some contribution of radio and, some years, television, but the vast majority has been in direct mail. We've seen -- our team has made tremendous progress in the last few quarters, trying to figure out how to do this more effectively first. So Chris mentioned in his prepared remarks that we had about a threefold increase in the number of members acquired digitally. The cost per acquisition, we are still working out. So the charge we gave to our team was, go figure out how do to it first and then let's figure out how to scale it at an appropriate cost. So I would tell you that it's still more expensive to acquire a member digitally than it is in direct mail, but the trend is getting to where digital will become a much more palatable cost going forward. So we're making very good progress on it, and we'll look for that to continue to scale going forward.

[Operator]

Well, we have time for one more question. Your next question comes from the line of Edward Kelly from Wells Fargo.

[Edward Kelly, analyst]

Sorry for the technical difficulties. My question to you is really related to fresh, and what I'm trying to understand is the true underlying momentum of the business. So have you fully cycled the disruption that you saw last year in the business? Is it possible to quantify what the exit of the Café business means here? And then just as it relates to this category overall, can you give us an update on just the in-store execution of the category and where you are today versus where you think you can be over time and the bigger picture upside here?

[Robert Eddy, executive]

Sure, I can certainly think about that. So we are, I would say not fully cycled with the disruption. We continue to work to improve our execution in the field, and we will continue to do so. We have stored investment dollars that way. We have begun our process to really fully rebuild the operations capability in the company starting from the top of the house all the way down. As Chris mentioned in his prepared remarks, we welcome this week new executive to our operations team that will run the northern part of our operations team. And so we are working on the team. We're working on the training of that team. Chris also mentioned a new executive running our Human Resources team. We have charged him with fully rebuilding the learning and development curriculum for the company throughout, but with a particular focus on the operations team. There's a tremendous amount of work going on to make sure the labor model is right so that we take the considerable amount of money that we spent on our team members every year and make sure it's applied at -- in the right places at the right times. So while we've made tremendous progress and the conditions that our members see are better than where they were a year ago, they are still not to our high standards. And we will continue to work diligently to make sure they are at that standard and they stay at that standard going forward. You bring up the Café business, that while small, I would tell you it absolutely impacted the comps of that business. So I think a few tenths worth of comp for the continuing exit of Café, that will be fully exited by the end of fiscal year. And so we feel like the underlying business approaches the comp for the whole company, but it's not quite there yet, and we will continue to work to get it there over time.

[Operator]

And this concludes today's conference call. Thank you for joining. You may now disconnect.