Sprouts Farmers Market, Inc. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion of our financial condition and results of operations together with the consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the 2020 fiscal year, filed on February 25, 2021 (“Form 10-K”) with the Securities and Exchange Commission. All dollar amounts included below are in thousands, unless otherwise noted. Business Overview Sprouts Farmers Market offers a unique grocery experience featuring an open layout with fresh produce at the heart of the store. Sprouts inspires wellness naturally with a carefully curated assortment of better-for-you products paired with purpose-driven people. We continue to bring the latest in wholesome, innovative products made with lifestyle-friendly ingredients such as organic, plant-based and gluten-free. Since our founding in 2002, we have grown rapidly, significantly increasing our sales, store count and profitability. Headquartered in Phoenix with 362 stores in 23 states as of April 4, 2021, we are one of the largest specialty retailers of fresh, natural and organic food, and fastest growing retailers in the United States. Our Heritage In 2002, we opened the first Sprouts Farmers Market store in Chandler, Arizona. From our founding in 2002, we have grown rapidly, significantly increasing our sales, store count and profitability, including successfully rebranding 43 Henry’s Farmers Market and 39 Sunflower Farmers Market stores added in 2011 and 2012, respectively, through acquisitions to the Sprouts banner. These three businesses all trace their lineage back to Henry’s Farmers Market and were built with similar store formats and operations including a strong emphasis on value, produce and service in smaller, convenient locations. The consistency of these formats and operations was an important factor that allowed us to rapidly and successfully rebrand and integrate each of these businesses under the Sprouts banner and on a common platform. Outlook In 2020, we announced the initial steps of our new long-term growth strategy that we believe will transform our company and drive profitable growth. This strategy focuses on the following areas: • Win with Target Customers . We plan to refocus attention on our target customers, where there is ample opportunity to gain share within these customer segments. Our business can grow by leveraging existing strengths in a unique assortment of better-for-you, quality products and by expanding ecommerce capabilities to allow customers easy access to differentiated products through delivery or pickup. • Update Format and Expand in Select Markets . We plan to deliver unique smaller stores with expectations of stronger returns, while maintaining the approachable, fresh-focused farmer’s market heritage Sprouts is known for. Our geographic store expansion and new store placement will intersect where our target customers live, in markets with growth potential and supply chain support, providing a long runway of at least 10% annual unit growth beginning in 2022. • Create an Advantaged Fresh Supply Chain . We believe our network of fresh distribution centers can drive efficiencies across the chain and support growth plans. To further deliver on our fresh commitment and reputation, as well as to improve financial results, we will aspire to ultimately position fresh distribution centers within a 250-mile radius of stores. 21 • Refine Brand and Marketing Approach . We believe we can elevate our national brand recognition and positioning by telling our unique product innovation and differentiation story. Increased customer engagement through digital and social connections will drive additional sales growth and loyalty. • Deliver on Financial Targets and Box Economics . We will measure and report on the success of this strategy against a number of long-term financial and operational targets. Recent Developments – COVID-19 On March 11, 2020, the World Health Organization declared the outbreak of a novel coronavirus (COVID-19) as a pandemic, and on March 13, 2020, the United States declared the pandemic to be a national emergency. As COVID-19 spread throughout the country, the situation has continued to evolve, including, more recently, the increasing adoption of the COVID-19 vaccine and the accelerating reopening of state economies to approach pre-pandemic levels. We continue to make significant investments in compensation, benefits and personal protective equipment for our front-line store team members and incur elevated ecommerce fees as consumers have increasingly used online shopping alternatives to purchase our products during the pandemic. As we begin to cycle periods of 2020 where our results benefited from the initial onset of the pandemic, we are reporting declines in year over year net sales and comparable store sales growth. The ultimate impact of the COVID-19 pandemic on our results of operations for future periods will depend on the length and severity of the pandemic and governmental and consumer actions taken in response, which we cannot predict. These uncertainties make it challenging for our management to estimate our future business performance. See “Item 1A. Risk Factors— The coronavirus (COVID-19) pandemic has disrupted our business and could negatively impact our financial condition.” in our Form 10-K for additional information. 22 Results of Operations for Thirteen Weeks Ended April 4, 2021 and March 29, 2020 The following tables set forth our unaudited results of operations and other operating data for the periods presented. The period-to-period comparison of financial results is not necessarily indicative of financial results to be achieved in future periods. All dollar amounts are in thousands, unless otherwise noted. Thirteen weeks ended April 4, 2021 March 29, 2020 Unaudited Quarterly Consolidated Statement of Income Data: Net sales $ 1,575,447 $ 1,646,539 Cost of sales 989,273 1,052,707 Gross profit 586,174 593,832 Selling, general and administrative expenses 439,662 436,304 Depreciation and amortization (exclusive of depreciation included in cost of sales) 31,229 31,021 Store closure and other costs, net 2,048 (1,082 ) Income from operations 113,235 127,589 Interest expense, net 2,991 4,827 Income before income taxes 110,244 122,762 Income tax provision 27,196 30,952 Net income $ 83,048 $ 91,810 Weighted average shares outstanding - basic 118,044 117,545 Diluted effect of equity-based awards 563 203 Weighted average shares and equivalent shares outstanding 118,607 117,748 Diluted net income per share $ 0.70 $ 0.78 Thirteen weeks ended April 4, 2021 March 29, 2020 Other Operating Data: Comparable store sales growth (9.4 )% 10.6 % Stores at beginning of period 362 340 Closed — — Opened — 4 Stores at end of period 362 344 Comparison of Thirteen Weeks Ended April 4, 2021 to Thirteen Weeks Ended March 29, 2020 Net sales Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Net sales $ 1,575,447 $ 1,646,539 $ (71,092 ) (4 )% Comparable store sales growth (9.4 )% 10.6 % Net sales during the thirteen weeks ended April 4, 2021 totaled $1.6 billion, a decrease of $71.1 million, or 4%, compared to the thirteen weeks ended March 29, 2020. The sales decrease was primarily due to a 9.4% decrease in comparable store sales as a result of cycling the initial impact of the COVID-19 pandemic. Comparable stores contributed approximately 96% of total sales for the thirteen weeks ended April 4, 2021 and approximately 94% for the thirteen weeks ended March 29, 2020. 23 Cost of sales and gross profit Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Net sales $ 1,575,447 $ 1,646,539 $ (71,092 ) (4 )% Cost of sales 989,273 1,052,707 (63,434 ) (6 )% Gross profit 586,174 593,832 (7,658 ) (1 )% Gross margin 37.2 % 36.1 % 1.1 % Gross profit totaled $586.2 million during the thirteen weeks ended April 4, 2021, a decrease of $7.7 million, or 1%, compared to the thirteen weeks ended March 29, 2020, primarily driven by decreased sales volume. Gross margin increased by 1.1% to 37.2%, compared to 36.1% for the thirteen weeks ended April 4, 2021 due to strategic changes in promotional activities and initiatives to decrease shrink. Selling, general and administrative expenses Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Selling, general and administrative expenses $ 439,662 $ 436,304 $ 3,358 1 % Percentage of net sales 27.9 % 26.5 % 1.4 % Selling, general and administrative expenses increased $3.4 million, or 1%, compared to the thirteen weeks ended March 29, 2020. The increase was primarily driven by higher ecommerce fees as more customers have continued to rely on home delivery and curbside pickup during the pandemic and new stores that have opened since the comparable period last year , partially offset by lower bonus expense due to COVID incentives in the prior year. As a result of this increase and sales deleverage, selling, general and administrative expenses as a percentage of net sales increased to 27.9% from 26.5%. Depreciation and amortization Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Depreciation and amortization $ 31,229 $ 31,021 $ 208 1 % Percentage of net sales 2.0 % 1.9 % 0.1 % Depreciation and amortization expenses (exclusive of depreciation included in cost of sales) increased $0.2 million and primarily related to new store growth as well as remodel initiatives in older stores. Store closure and other costs, net Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Store closure and other costs, net $ 2,048 $ (1,082 ) $ 3,130 289 % Percentage of net sales 0.1 % (0.1 )% 0.2 % Store closure and other costs, net increased $3.1 million to $2.0 million, compared to a credit of $1.1 million for the thirteen weeks ended March 29, 2020. The increase was driven by inventory loss and additional expenses related to the impact of winter storms at several of our stores and a fire at one of our stores during the thirteen weeks ended April 4, 2021. Store closure and other costs, net during the thirteen weeks ended March 29, 2020 primarily represented a recognized gain on the assignment of the lease for one of our closed locations. 24 Interest expense , net Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Long-term debt $ 1,181 $ 4,047 $ (2,866 ) (71 )% Capital and financing leases 235 243 (8 ) (3 )% Deferred financing costs 141 141 — 0 % Interest rate hedge and other 1,434 396 1,038 262 % Total interest expense, net $ 2,991 $ 4,827 $ (1,836 ) (38 )% The decrease in interest expense, net was primarily due to the decrease in the average balance outstanding under the Amended and Restated Credit Agreement. This was partially offset by the interest expense paid as a result of an unfavorable interest rate swap. Income tax provision Income tax provision differed from the amounts computed by applying the U.S. federal income tax rate to pretax income as a result of the following: Thirteen weeks ended April 4, 2021 March 29, 2020 Federal statutory rate 21.0 % 21.0 % Change in income taxes resulting from: State income taxes, net of federal benefit 4.8 % 4.7 % Enhanced charitable contributions (1.2 )% (0.8 )% Federal credits (0.4 )% (0.5 )% Share-based payment awards (0.1 )% 0.4 % Other, net 0.6 % 0.4 % Effective tax rate 24.7 % 25.2 % The effective tax rate decreased to 24.7% in the first quarter of 2021 from 25.2% in the same period last year. The decrease in the effective tax rate was primarily due to an increase in enhanced charitable contributions and a benefit for stock-based compensation in the current period, partially offset by a decrease in federal tax credits. Net income Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Net income $ 83,048 $ 91,810 $ (8,762 ) (10 )% Percentage of net sales 5.3 % 5.6 % (0.3 )% Net income decreased $8.8 million primarily due to decreased net sales and higher selling, general and administrative expenses, partially offset by favorable margin impact. Diluted earnings per share Thirteen weeks ended April 4, 2021 March 29, 2020 Change % Change Diluted earnings per share $ 0.70 $ 0.78 $ (0.08 ) (10 )% Diluted weighted average shares outstanding 118,607 117,748 859 The decrease in diluted earnings per share of $0.08 was driven by lower net income. 25 Return on Invested Capital In addition to reporting financial results in accordance with generally accepted accounting principles, or GAAP, we provide information regarding Return on Invested Capital (referred to as “ROIC”) as additional information about our operating results. ROIC is a non-GAAP financial measure and should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital and provides a meaningful measure of the effectiveness of our capital allocation over time. We define ROIC as net operating profit after tax (referred to as “NOPAT”), including the effect of capitalized operating leases, divided by average invested capital. Operating lease interest r epresents the add-back to operating income driven by the hypothetical interest expense we would incur if the property under our operating leases were owned or accounted for as a finance lease (capital lease prior to adoption of ASC 842). The assumed ownership and associated interest expense are calculated using the discount rate for each lease as recorded as a component of rent expense within selling, general and administrative expenses. Invested capital reflects a trailing twelve-month average. As numerous methods exist for calculating ROIC, our method may differ from methods used by other companies to calculate their ROIC. It is important to understand the methods and the differences in those methods used by other companies to calculate their ROIC before comparing our ROIC to that of other companies. Our calculation of ROIC for the fiscal periods indicated was as follows: Rolling Four Quarters Ended April 4. 2021 (1) March 29, 2020 (dollars in thousands) Net Income (2) $ 278,688 $ 185,046 Special items, net of tax (3), (4) 5,673 892 Interest Expense, net of tax (4) 9,900 15,914 Net operating profit after tax (NOPAT) $ 294,261 $ 201,852 Total rent expense, net of tax (4) 149,343 132,002 Estimated depreciation on operating leases, net of tax (4) (83,212 ) (65,473 ) Estimated interest on operating leases, net of tax (4), (5) 66,131 66,529 NOPAT, including effect of operating leases $ 360,392 $ 268,381 Average working capital 130,779 49,290 Average property and equipment 728,757 730,643 Average other assets 567,932 565,510 Average other liabilities (102,618 ) (99,964 ) Average invested capital $ 1,324,850 $ 1,245,479 Average operating leases (6) 1,201,545 1,171,563 Average invested capital, including operating leases $ 2,526,395 $ 2,417,042 ROIC, including operating leases 14.3 % 11.1 % ( 1 ) Fiscal 2020 included 53 weeks. (2) Net income amounts represent total net income for the past four trailing quarters. ( 3 ) Special items include professional fees related to strategic initiatives. 26 ( 4 ) Net of tax amounts are calculated using the normalized effective tax rate for the periods presented. ( 5 ) 2021 and 2020 estimated interest on operating leases is calculated by multiplying operating leases by the 7.2% and 7.5% discount rate, respectively, for each lease recorded as rent expense within direct store expense. ( 6 ) Average operating leases represents the average net present value of outstanding lease obligations over the past four trailing quarters. Liquidity and Capital Resources The following table sets forth the major sources and uses of cash for each of the periods set forth below, as well as our cash, cash equivalents and restricted cash at the end of each period (in thousands): Thirteen weeks ended April 4, 2021 March 29, 2020 Cash, cash equivalents and restricted cash at end of period $ 257,783 $ 248,667 Cash flows from operating activities $ 105,438 $ 277,072 Cash flows used in investing activities $ (16,605 ) $ (28,036 ) Cash flows used in financing activities $ (2,491 ) $ (87,154 ) We have generally financed our operations principally through cash generated from operations and borrowings under our credit facilities. Our primary uses of cash are for purchases of inventory, operating expenses, capital expenditures primarily for opening new stores, remodels and maintenance, repurchases of our common stock and debt service. We believe that our existing cash, cash equivalents and restricted cash, and cash anticipated to be generated from operations will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors, including the impact of the COVID-19 pandemic on our operations, new store openings, remodel and maintenance capital expenditures at existing stores, store initiatives and other corporate capital expenditures and activities. Our cash, cash equivalents and restricted cash position benefits from the fact that we generally collect cash from sales to customers the same day or, in the case of credit or debit card transactions, within days from the related sale. Operating Activities Cash flows from operating activities decreased $171.6 million to $105.4 million for the thirteen weeks ended April 4, 2021 compared to $277.1 million for the thirteen weeks ended March 29, 2020. The decrease in cash flows from operating activities was primarily a result of changes in working capital. Cash flows provided by/(used in) operating activities from changes in working capital were ($16.0) million in the thirteen weeks ended April 4, 2021 compared to $155.8 million in the thirteen weeks ended March 29, 2020 . The decrease was primarily driven by elevated accounts payable and accrual balances in the prior year period. Investing Activities Cash flows used in investing activities consist primarily of capital expenditures in new stores, including leasehold improvements and store equipment, capital expenditures to maintain the appearance of our stores, sales enhancing initiatives and other corporate investments. Cash flows used in investing activities were $16.6 million and $28.0 million, for the thirteen weeks ended April 4, 2021 and March 29, 2020, respectively. We expect capital expenditures to be in the range of $140 - $160 million in 2021, including expenditures incurred to date, net of estimated landlord tenant improvement allowances, primarily to fund investments in new stores, remodels, maintenance capital expenditures and corporate capital expenditures. We expect to fund our capital expenditures with cash on hand and cash generated from operating activities. 27 Financing Activities Cash flows used in financing activities were $2.5 million for the thirteen weeks ended April 4, 2021 compared to $87.2 million for the thirteen weeks ended March 29, 2020. During the thirteen weeks ended April 4, 2021, cash flows used in financing activities primarily consisted of $3.2 million for stock repurchases, partially offset by $0.9 million in proceeds from the exercise of stock options. During the thirteen weeks ended March 29, 2020, cash flows used in financing activities primarily consisted of $87.0 million in payments on our credit facilities. Long-Term Debt and Credit Facilities Long-term debt outstanding was $250.0 million as of April 4, 2021 and January 3, 2021. See Note 4, “Long-Term Debt and Finance Lease Liabilities” of our unaudited consolidated financial statements for a description of our Amended and Restated Credit Agreement and our Former Credit Facility (each as defined therein). Share Repurchase Program Our board of directors from time to time authorizes share repurchase programs for our common stock. The following table outlines the share repurchase programs authorized by our board, and the related repurchase activity and available authorization as of April 4, 2021. Effective date Expiration date Amount authorized Cost of repurchases Authorization available February 20, 2018 December 31, 2019 $ 350,000 $ 308,017 $ — March 3, 2021 March 3, 2024 $ 300,000 $ 3,209 $ 296,791 The shares under our current repurchase program may be purchased on a discretionary basis from time to time through March 3, 2024, subject to general business and market conditions and other investment opportunities, through open market purchases, privately negotiated transactions, or other means, including through Rule 10b5-1 trading plans. Our board’s authorization of the share repurchase program does not obligate our Company to acquire any particular amount of common stock, and the repurchase program may be commenced, suspended, or discontinued at any time. Share repurchase activity under our repurchase program for the periods indicated was as follows (total cost in thousands): Thirteen weeks ended April 4, 2021 March 29, 2020 Number of common shares acquired 129,968 — Average price per common share acquired $ 24.69 $ — Total cost of common shares acquired $ 3,209 $ — Shares purchased under our repurchase programs were subsequently retired. Subsequent to April 4, 2021 and through May 6, 2021, we repurchased an additional 75,000 shares of common stock for $1.9 million. 28 Contractual Obligations We are committed under certain operating and finance leases for the rental of land, buildings, and for rental of facilities and equipment. These leases expire or become subject to renewal clauses at various dates through 2040. The following table summarizes our contractual obligations as of April 4, 2021, and the effect such obligations are expected to have on our liquidity and cash flow in future periods: Payments Due by Period Total Less Than 1 Year 1-3 Years 3-5 Years More Than 5 Years (in thousands) $700.0 million Credit Agreement (1) $ 250,000 $ — $ 250,000 $ — $ — Interest payments on $700.0 million Credit Agreement (2) 19,276 7,680 11,596 — — Finance lease obligations (3) 24,562 1,778 4,348 4,468 13,968 Operating lease obligations (3) 1,818,596 209,925 403,624 342,255 862,792 Totals $ 2,112,434 $ 219,383 $ 669,568 $ 346,723 $ 876,760 (1) T he Amended and Restated Credit Agreement is scheduled to mature, and the commitments thereunder will terminate on March 27, 2023, subject to extensions as set forth therein. These borrowings are reflected in the “1-3 Years” column and discussed in the financing activities section above. See Note 4, “Long-Term Debt and Finance Lease Liabilities” to our unaudited consolidated financial statements located elsewhere in this Quarterly Report on Form 10-Q. (2) Represents estimated interest payments through the March 27, 2023 maturity date of our Amended and Restated Credit Agreement based on the outstanding amounts as of April 4, 2021 and based on LIBOR rates in effect at the time of this report, net of interest rate swaps. (3) Represents estimated payments for finance and operating lease obligations as of April 4, 2021. Lease obligations are presented gross without offset for subtenant rentals. We have subtenant agreements under which we will receive $1.1 million for the period of less than one year, $1.9 million for years one to three, $1.7 million for years three to five, and $1.4 million for the period beyond five years. We have other contractual commitments which were presented under Contractual Obligations in our Annual Report on Form 10-K for the fiscal year ended January 3, 2021, and for which there have not been material changes since that filing through April 4, 2021. Off-Balance Sheet Arrangements We do not engage in any off-balance sheet financing activities, nor do we have any interest in entities referred to as variable interest entities. Impact of Deflation and Inflation Deflation and inflation in the prices of food and other products we sell may periodically affect our sales, gross profit and gross margin. Food deflation across multiple categories, particularly in produce, could reduce sales growth and earnings if our competitors react by lowering their retail pricing and expanding their promotional activities, which can lead to retail deflation higher than cost deflation that could reduce our sales, gross profit margins and comparable store sales. Food inflation, when combined with reduced consumer spending, could also reduce sales, gross profit margins and comparable store sales. The short-term impact of deflation and inflation is largely dependent on whether or not the effects are passed through to our customers, which is subject to competitive market conditions. 29 Food deflation and inflation is affected by a variety of factors and our determination of whether to pass on the effects of deflation or inflation to our customers is made in conjunction with our overall pricing and marketing strategies, as well as our competitors’ responses. Although we may experience periodic effects on sales, gross profit, gross margins and cash flows as a result of changing prices, we do not expect the effect of deflation or inflation to have a material impact on our ability to execute our long-term business strategy. Critical Accounting Estimates Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with GAAP. These principles require us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses, cash flow and related disclosure of contingent assets and liabilities. Our critical accounting estimates include inventory valuations, lease assumptions, self-insurance reserves, impairment of long-lived assets, fair values of share-based awards, and income taxes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. To the extent that there are material differences between these estimates and our actual results, our future financial statements will be affected. There have been no substantial changes to these estimates, or the policies related to them during the thirteen weeks ended April 4, 2021. For a full discussion of these estimates and policies, see “Critical Accounting Estimates” in Item 7 of our Annual Report on Form 10-K for the fiscal year ended January 3, 2021. Recently Issued Accounting Pronouncements See Note 2, “Summary of Significant Accounting Policies” to our accompanying unaudited consolidated financial statements contained in this Quarterly Report on Form 10-Q.