Sprouts Farmers Market, Inc. (SFM) Earnings Call Transcript & Summary

Good afternoon. I'm Leah Jordan. I'm the grocery analyst at Goldman. And it's my pleasure to introduce the management team of Sprouts. First, we have Jack Sinclair, the Chief Executive Officer, and then next, we have Chip Molloy, the Chief Financial Officer. Thank you both for joining us today. I'm sure many in this room know Sprouts pretty well, but I'll just give a quick introduction. Sprouts is one of the largest natural and organic focused grocers with 400 stores in 23 states.

So let's just jump right into our chat. I think I just wanted to start off today just if you could describe how 2023 has been so far for Sprouts? What have been some of the bigger wins and what have been some of the bigger challenges this year?

Great. Yes. We're having a good year. We're comfortable where we're at with positive traffic in both our e-com business and in our bricks-and-mortar business, but as well as the kind of the performance this year, which we're comfortable with so far. And we're doing some good things for the long-term for the business. We've put another new distribution center in Fullerton, Southern California on top of the distribution center we did in Denver and the distribution center we've got in Orlando, which is all about creating a short lead time for our fresh foods and improving the importance of produce to our business and investing in that supply chain has been an important thing. We're making some real progress in our store pool. We're going to build 30 stores this year and well on the way to being able to build 40 stores next year. So the 10% store growth that is our aspiration. And those smaller stores, the 23,000 square foot stores that was part of our kind of change in strategy a couple of years ago, they're performing at the level we would like them to perform. So I'm very encouraged that we're putting -- we opened our 400th store last week in Haddon Township, New Jersey. And the week before, we opened one in Rialto, California. So from [ the shining sea were moving ], we're getting stores all over the place, which is exciting to be part of that program. And so -- and the team we're developing, the team, we've got a new President on board. We've got a new Chief Technology Officer on board, developing the marketing team. And we're going to have to get a new Chief Financial Officer as well.

That's a down part of the year.

So we're having a good year...

No, that's great to hear, and thank you for all that color. And I think we're going to delve into a few of those topics more as we go through today. Just wanted to start off on the consumer. Curious what you're seeing in consumer behavior, basket trends, which categories are resonating with your core customers given this macro environment? And then how have volumes trended as we've seen inflation moderate as well?

So the dynamic of inflation has clearly been really important over the last 2 years in the grocery sector, probably lasted longer than we all expected it to last in terms of the level of inflation, what's happened through that inflation as we saw a reduction in units going through the business. So we've been very comfortable with our traffic as I said earlier. So our traffic is performing well. So that's driving the comps that we need to deliver. Inflation, what's going to happen to inflation. Customers have clearly been very sensitive about wastage in their own. So in our business that sells so much produce, less -- more likely to buy one bag of salads than 2 bags of salads, more likely to buy one box of strawberries than 2 because they don't want to waste them, and we've seen that dynamic in our business. As inflation slows down a little bit, and it's not deflation, but the disinflation, we're seeing a trend and a little bit of a trend where the reduction in units is flattening out. So it's playing out kind of the way we thought this mix of what's happening to traffic. And the categories that are working for us are the ones that we're most differentiated. We're now selling a lot more plant-based milk than we are dairy milk. I don't know many grocers in the world are selling more plant-based milk than they are dairy milk. We're selling a lot more organic beef. We're selling a lot more grass-fed beef. We're selling a lot more of items in the grocery, dairy and frozen departments that are keto-based, gluten-free, vegetarian, vegan, plant-based. That whole dynamic as we've evolved our assortment, we're seeing those are the categories that are performing well for us.

I just wanted to touch on something you said. You said traffic kind of returned to growth in the first half of the year, which we've seen. And just curious how you think you're resonating with your core customer? What are you doing differently on brand awareness to kind of attract and retain those customers?

Well, we're working very hard in our marketing team, and we've got a new marketing team in place, again, as I said a little bit earlier, and we're very pleased with the progress we're making there. Our specialty grocery business needs a personalization -- personalized approach to the customer. We're not trying to be all things to all people. We're trying to be very focused on taking care of the health enthusiast customer, who's focused on food being health and that link between what's in the food to what they eat is something that's been very important to try to resonate with these target customers, and that's been very much part of how the marketing -- our marketing will evolve. A lot of the customers that shop with us, they kind of like they like us, in fact, kind of love us, but they forget about us some time, and we're a complementary retailer as opposed to -- we don't need to win traffic from anybody. We just need to win a little bit of share of wallet with those target customers, and we're going to get better at personalizing communication using loyalty programs to be more effective at getting to those customers, and we're doing a lot of work on that.

Okay. Just switching gears to probably one of the most popular questions we get around your company, which is gross margin. I think that's one thing that really stands out for Sprouts is how resilient it's been over the last few years, and that's largely been driven by the strategy shift you guys embarked on a couple of years ago. But there's just been some concern around as volumes remain under pressure and maybe pricing tailwinds are fading just across the industry overall that we could see a more promotional environment. So just curious how you view the promotional landscape today, how you think it evolves from here, what degree are vendors a part of this? And then maybe any more detail around what you're doing in the data analytics and targeted promotion?

So in 2019, when Jack came on Board, we chose to get out of the [ high-low game ] specifically around produce. We were chasing margins down, profitability was going backwards, and we made a conscious decision to do that. That would have been a slow bleed of transactions had it not been for COVID. And so in the second quarter of 2020, we actually -- we literally lost 20% of our customers and 20% of our transactions in one quarter. And as we came out of COVID on the next year, the dynamic didn't change. They never came back. So we never got those transactions back. So when we think about gross margin, those very highly price-sensitive customers that we had as we referred to them as coupon clippers as part of our strategy as much as you don't use -- don't use the word, you fired your customers, but we fire 20% of our customers and they're highly price-sensitive ones. And the idea that we would now get promotional, highly promotional again and burn down margins to chase unprofitable customers doesn't -- it's sort of a definition of insanity, if we didn't do it if we did it again. So we're staying away from margins of choice. We feel like we have a differentiated product base. We have a differentiated stores and margin is something that we can manage. And as it relates to the whole marketplace, I'm not even sure the conventionals will get back into that place, but that's a question for a different day. Their margin structure is very different. And they go to market different today with their customers on a more personalized basis. So their need to burn down margins may not be there either.

That's very helpful. Just sticking a little bit with pricing. I know Jack you mentioned salmon, and we touch on it again here. But how do you think about pricing overall versus your natural and organic peers, but as well as conventional grocers? And we talked about the shift in produce, but just how are you thinking about that category overall because it is still a big driver for you guys?

Produce is very important to us. The whole proposition of Sprouts when it started off in San Diego, all those years ago, it was based on farmers market, building using produce as the driver to bring people in with fresh foods, fantastic fresh foods at a great price, and that's very much. We've got a very big substantial number of people who come in, 60% of the people who come into our stores in the basket have got produce in the basket. So that's a significant number of people who are coming because of produce. And part of the reason is our freshness. We've got good DNA in our teams around the country in terms of keeping produce very, very fresh. And the second part of it is having value and price in that context. Organic produce is a very important part. 40% of our produce is organic, which is again a much bigger number than you'd find in conventional grocers. We want to be very, very aggressive on organic pricing. So when I look at the competition in natural and organic, we're very substantially cheaper than anybody in that space, substantially cheaper. And different parts of the country, you see different dynamics, but we're watching produce pricing more than anything else, in fact, almost solely and exclusively as we look at produce pricing. And so in different parts of the country, we have wider gaps than others, but everywhere, we want to be in a very strong position on produce. And when I look at the rest of the store, we don't have enough things that I can compare to. I walk around Walmart and Kroger, and I can't find anything that they sell what we sell. So it's quite difficult to do price checks because we don't sell in the same stuff. So that's part of how we think about it, produce pricing really important to be aggressive on it, the rest of the box, we're kind of positioning it, so that will be giving value, and looking at elasticity when the price goes down, do we get the volume out of it and vice versa.

That's very helpful. Just kind of shifting back to the inflation discussion. You've already mentioned that, I know several times and -- but it's such a popular topic within the grocery landscape. We've seen food inflation meaningfully decelerate this year. Just what level of inflation have you been seeing in your business given there are some differentiated categories? And then how do you think it evolves from here? And then how do you think about the dynamic between units and inflation as we head into next year?

Sure. Yes. So on our last earnings call, it's been, I don't know 6 weeks ago now, for the back half of the year, we expected inflation to be about 4%, 5%, mid-single digits. And that premise was we were already a month into the second half. And the premise was, if prices didn't move at all, and you just did the math and you saw them very flat, we'd still get that kind of pickup with our mix of our business based on price increases that have happened over the course of the last 12 months. That's the way we thought it would happen. We also saw and felt like our units decline was sequentially starting to flow to a place where it's steady state. We expected that to happen as well as we begin to see the quarter started. It started to happen as we saw that. So we're seeing less sequential inflation, and we're seeing less sequential units in the basket being moving out. And so net-net, they're starting to converge, and that's the way we expected the back half of the year to play out, and that's what we foresee happening as we think about it going forward, it's hard to predict next year, I mean, it's really hard. But I don't see -- we don't -- in our business, we don't see deflation. Looking forward, it's probably going to be in the low single digits from an inflation perspective as we move forward.

From a volatility point of view on pricing going forward, when you're so dependent on produce, which we are, it's a more volatile category than you're going to find anywhere else. So if anything, with the weather trends and El Nino and there's probably some pressure on the opposite, will there be more inflation going forward. And that's something you can't really tell you tend from one week to the next. You're kind of looking at what's happening with produce inflation. And as I say, there's probably more trends making it go that way than go down.

Just wanted to switch gears, I know Jack, you said this on the intro, but new store growth is a big piece of the story as well for Sprouts. Just how are you thinking about the long-term store target, where do you see the greatest white space, and how do you select locations in new markets? And it sounds like we're on track to get back to the 10% cadence. But just any risks that you see there?

Well, we're excited about the new format. We've gone down to smaller stores. We've gone from 32,000 square feet to 23,000 square feet as a format. And the fundamentals are if we can sell the same amount in 23,000 square feet that we did in 32,000 square feet, you can make a lot of money relative to the returns that we can get on it. In terms of the pipeline that we've got, we've put a lot of work into making sure that we're -- there's 1,300 what we call seed points around the nation, where there's enough health enthusiasts to support a Sprouts store. And the second -- so the real estate team are looking for stores in all of those sites. If we have a distribution center within 250 miles of those sites, that's what we're prioritizing at the moment. So our store portfolio growth, California, Arizona, Texas, Florida and the Mid-Atlantic are the kind of key big drivers at the moment. And that's well on pace. We had some execution challenges as the whole industry did in terms of building the stores. We've got past licensing and getting access to getting them signed off by the local authorities. That's in good shape. Now we're over about 100 stores that have already been signed off. The challenge is now execution, which over the last couple of years has been difficult for everybody, whether it been getting components for refrigeration or components for air conditioning units, having to get ahead of that has been one of the things that we've been working very hard at in the last year. So we're very confident about the 30 stores this year. We're confident about 40 stores next year, and we're well on track to be confident to get to the 10% number in '24 and '25. Beyond that, we're going to have to go to some other places, which we're in the middle of working at.

Great. Just sticking a little bit with the newer stores. On the last call, you mentioned that you saw some encouraging trends out of these newer markets and the 5 that you just mentioned. So just curious on maybe some specific trends in those key markets of what you've been seeing. What are you doing differently today? And how do you think about marketing in new markets versus your existing markets?

Yes.

Yes. So encouraging trends. We separate our markets in what we call established and non-established markets. So established markets would be where we've been for a long time, Arizona, California, et cetera. Unestablished markets are Florida, Mid-Atlantic. And so we're now in a place where in Florida, Mid-Atlantic, we're starting to see year 2, year 3. And the encouraging part for us is a lot of those stores on the one side, they started out slower because we were in a non-established market and the brand awareness wasn't there. But what we are seeing is we're seeing double-digit comps not only in year 2, but we're also seeing a double-digit in year 3 in those markets. So we're catching up, whereas in the established markets, they start higher and they close -- much closer to maturity. So we're really encouraged by the fact that we're seeing those kinds of comps in those markets as we become more brand aware. So that's probably the biggest plus for us. And then the marketing on -- the marketing and the market versus -- new versus...

From a marketing point of view, it just takes a bit longer. One of the things that's important is density. When I joined the company, we had 2 stores in Tampa, we've now got 10 stores in Tampa. It just gives you a better opportunity to recruit, develop, create opportunities for people when you've got 10 stores. So we're finding as we gradually evolve through this. First of all, you've got density, then the marketing becomes easier when you get more of a -- before I got here, we were kind of building stores, one in Seattle and one in Philadelphia and one in Naples, and I figured out that they weren't close together, and it's quite difficult to kind of get the momentum behind those things. And so that's been an important part of how to make this work, how do we build density. Stores just take a bit longer. So I'm not sure marketing can fix a different approach. It just takes longer. People want -- people always drive by a new Sprouts and they go in. And if you go and talk to the people, some people say, well, this isn't for me, where's my Frosted Flakes, where's my Coca-Cola. And the fact that it takes a little while for people to get used to it, but it's not a problem in San Diego, where everyone knows who we are. It's not a problem for us in Arizona, [ where I believe it was ]. I'm not sure marketing is the answer. We're flexing the approach a little bit. But ultimately, it just takes a little bit longer for the non-established markets. And we're working about -- going forward, it's going to be roughly -- it will vary from one year to the next 50-50 non-established and established markets.

That's great. Just wanted to go back to your comment around digital that you mentioned earlier, that's something that's really stood out is how strong your digital channel has been. So very curious if you could share how many of your customers are omnichannel versus in-store only? How do these shoppers spend differently? And then where do you think your sales penetration of e-commerce could ultimately go over the long-term?

I'll take the last, the last question is a really good one. When I joined the company, we were 2% of our sales was e-commerce between 30 stores that pick up and all the stores doing delivery. We at one point during the pandemic, we got to 14%. I think we were the fastest-growing e-commerce business in grocery in the United States for a while there. It's settling down a little bit. It's down to about [ 12% ] now in terms of the mix of our business and 2% of that is pickup. People don't -- if you go into a Sprouts small store, it's not pick up the way you would find out a mass channel where people are buying a lot of diapers and big bulky pet foods and things like that. Our business tends to be if you're going to drive to the store, you'll go in and you won't wait to get picked up. So the delivery is working well. We've got great partners with Instacart and DoorDash, they do a nice job for us. And we're encouraged the way that's working. A lot of our customers, I can't give you a number, but a lot of our customers are omnichannel customers who are floating between the 2. Have you got numbers, okay, will you tell them the numbers?

So if they're shopping online, about 80% are omnichannel.

Yes.

80% more were omnichannel customers, whether they found us first online or where they found us in the store, but they are omni. And of those, they drive about a 2.5x basket size. So it's -- the economics are quite -- if we can get them to shop with us omnichannel, that's quite beneficial for us.

And ultimately, the success of our -- one of the things that through the pandemic, a lot of people were reluctant to shop in lots of different places. They were consolidating and I don't think that benefited us from a bricks-and-mortar. But one of the reasons the e-com grew so fast was because our proposition is so different that if you're going to buy grocery online, you might as well go to anybody. But the fact that ours is different, I think showed that the fact that it grew so much give me some confidence that our proposition is relevant for our target customers.

That's very helpful. And...

Where will it end up, you asked a question, where will it end up, I honestly don't believe it will get to in the United States much beyond the very most 15%. But there's people who would say it's going to get to 50% in 10 years' time. I just don't see it. I think there's a magic about fresh foods. There's a magic about what it looks, what it smells like, what it feels like. And the magic of shopping, particularly you go to the fruit markets of Guatemala and you walk on, you see fruit coming at you. I think people appreciate the feeling of great fresh foods. And so maybe I'm living in another world.

We'll hold you to that prediction. We'll have you back in a [indiscernible]. But I think given the strength of the digital engagement with your core customers, very high at 80%, something that you guys have talked about from time to time is loyalty. And so I think the question has always been, what are the puts and takes of a bigger effort maybe in loyalty because there is such a tremendous wallet share to gain from your core customer. So how do you think about that? Maybe where is engagement today and where can it go?

Sure. Do you want to talk about that?

Yes. So today, we can track about 13% of our customers, some is through the -- I'll say, the light loyalty program that we have today, about 8% or 9% of that, and the rest is just matching the data with [ Fiserv ]. So we can track that. As I said, that's where we get the information. We understand, our omnichannel customer will understand how much they spend in the box, where can we go with the loyalty. Certainly, we have -- I would tell you that back in 2019 on Jack's first week, I had been -- I had stepped in his interim for a brief period of time, I think in the first week, we were there. There was a conversation around loyalty in that meeting. And it was a huge program, what's going to cost $1 billion. And we chose at that point to not do it. We've struggled internally. We've struggled with what it is, what it should be, how much we want to spend and we're getting closer. So I think we are aligning much more so. And we want to get the information. There are ways to get the information. We're going to work really hard in the next 6 months to 12 months. I think by the end of next year, we'll have a real loyalty program up and running. We'll have one where we can track a ton of the data, and we can provide offers at that point. And we can do a lot of other things with data from moving all the way upstream to supply chain and understand what products and what attributes, et cetera, I think the program will be really good for us. But we're getting much closer. I just told you [ breath ] a little bit longer, but I'm pretty sure by the end of next year, we'll have something up and running that will be meaningful.

And certainly, the challenge for us is to do it in such a way that's appropriate for a specialized, personalized offer and communicate effectively. There's one thing about getting the data from a lot of customers, second thing is what you do with it and how you effectively navigate your way through making sure that the appropriate communication. And there's something about Sprouts that's people like being associated with. And is there a kind of feeling of specialty, a club feeling that we can create in the back of it as opposed to just taking vendors' money to get more targeted promotions. That's not the way I want to see this one going, and we're in the middle of getting that right over the course of the next little while.

It won't be a high-low program that just give us your data or put in your phone number and you get free money because there's coupons all over the store, that it won't be.

Great. We'll look forward to more details over the coming year, for sure. I think we're getting to the point of our conversation to maybe hit the quick hit questions that we're kind of asking all companies. So these could be just fairly quick. First, on the health of the consumer, do you see the consumer facing more or less headwinds next year compared to '23? And then how are you thinking about the potential impact from trade up or down next year as well?

I think our customer is going to be pretty stable going forward. The people that we talk to are very focused on food as a source of health. And the whole dynamic of health, I think is a really important one. You're seeing it in some of the drugs that are getting sold, way -- the whole dynamic, I think our customers -- I think there'll be more people interested in what we do 5 years from now than there are today. So next year, I think there'll be more trends towards that. In terms of the health of the consumer, I think when you see what's happening with applications for jobs in our world, I think the U.S. is in a better place than most in terms of being stronger next year than it is this year. So I think it might be a little bit better across the board, and I certainly think our customers will be in good shape next year. I'm pretty optimistic.

Yes.

Great. Next, on pricing. We touched on that a little bit. But now that inflation has peaked, how are you thinking about pricing in '24? Do you currently anticipate to raise lower or maintain pricing next year?

Do you want to answer that?

I mean I'll answer the question. That's a crystal ball. Well, we don't anticipate deflation. I suspect in the space we're in, I think that it will probably be low single-digit inflation in our space. It will get to something that's what we would characterize as more normal. And I think if that's the case, it will be really healthy for our consumer. The only risk -- it's actually a risk if it goes the other way, and it's hyperinflation. Again, I think that would be a risk to the economy and a risk to our consumer as well.

And the last one we'll touch on is wallet share. We've seen a big shift of normalization in the consumer wallet share towards services and the like. Looking to next year, what is the one most important factor that would drive higher spending within your business, understanding it's grocery, but maybe along the more premium offering that you sell?

Well, fundamentally for us as we've got a very small share of wallet of our existing customers. We don't need much. We need a few crumbs at the table, they just grow a little bit to where we need to get our business going. What are the things that we are doing to drive that. Our innovation centers that we put into the store where we put a range of products in there that you cannot buy anywhere else. And it's -- America is a major place for innovative entrepreneurial food people, and we want to be the destination for that. And we're beginning to see that innovation center that we've done really driving some really interesting products coming in that space. We would always want to be the leading edge of innovation. We're doing a lot of work. I think there'll be a bit of a trend as restaurants -- having the cost of restaurants, pricing for customers going to restaurants is going to restrict our thing out of home spend. So I think there's a benefit for us, and we're putting a lot of money into putting cabinets into our stores and very specific meal development that's relevant for our target customer. So that's going to be another growth -- that will be a growth -- growth category for us going forward. And we actually think the whole produce space as people get -- we work pretty hard at produce. I think that's going to bounce back a little bit from where it's been for us over the last little while. So we're confident that the different category work that's going on at the same time, marketing that effectively and communicating it effectively, we think that's going to help us grow our business pretty strong next year.

Thank you. That was great. Thank you both for joining us today, Jack and Chip. And this concludes our chat. Thank you.

Thank you.

Thanks very much.