Grocery Outlet Holding (NASDAQ:GO) Q2 2020 Earnings Call

0:01 Greetings and welcome to Grocery Outlet's Fiscal Second Quarter 2020 Earnings Results Conference Call. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Joseph Pellant, Vice President of Investor Relations. Thank you. You may begin.

0:31 Thank you. Good afternoon, everyone, and thank you for joining us on today's call to discuss grocery outlets second quarter financial results. Participants on this call will make forward-looking statements which are subject to various risks and uncertainties that could cause our actual results to differ materially from these statements. Any such items, including our outlook for fiscal 2020 and future performance, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. A description of these factors can be found in this afternoon's press release, as well as in our latest prospectus and periodic reports we file with the SEC, all of which may be found on our website at investors.groceryoutlet.com or on sec.gov.

1:19 We undertake no obligation to revise or update any forward-looking statements or information. During our call, we may reference certain non-GAAP financial information, including adjusted items. Reconciliations of GAAP to non-GAAP measures, as well as the description, limitations, and rationale for using each measure, may be found in the supplemental financial tables included in this afternoon's press release, in our SEC filings, and in the Investors tab of our website. We reference non-GAAP measures in some of our financial discussions, as we believe they more accurately represent the true operational performance and underlying results of our business. Presenting on today's call will be Grocery Outlet's Chief Executive Officer, Eric Lindberg, President, RJ Sheedy, and Chief Financial Officer, Charles Bracker.

2:06 Following our prepared remarks, we will open the call for questions. With that, I'll turn it over to Eric.

2:13 Thanks, Joe. Good afternoon, everyone. I hope you and your families remain safe and well. Approximately one year ago today, we conducted our first earnings call as a public company. We are very pleased to have delivered strong and consistent financial performance since our IPO. We're equally proud of our ability to navigate the unprecedented challenges and opportunities presented by COVID-19 in recent months. I'm also extremely proud of our hard work, dedication, community support that has been demonstrated across our organization. This includes our IOs and their store associates who have worked tirelessly on the front lines to serve our customers and our communities. Our distribution center teams who went above and beyond to help us keep product flowing.

2:58 Our purchasing teams who leveraged our strong relationships to source both opportunistic and everyday products, enabling us to deliver great values to our customers. I'm so, so grateful for all their commitment. Looking at our second quarter results, our performance reflects this strong execution across our organization. Revenue growth of 24.5% was driven by a 16.7% increase in comparable store sales and sales from 32 new store openings since June of last year. Adjusted EBITDA grew 34.7%, reflecting gross margin expansion slightly offset by modest SG&AD leverage due to higher costs related to protecting our employees and our customers during COVID-19.

3:45 As we move forward, we will continue to reinvest productivity savings and leverage our flexible business model to drive long-term growth. Consistent with that philosophy, we are accelerating our investments in people and capabilities across three areas. First, advancing how we buy as we further develop our infrastructure to drive a wider gap in our leadership position in secondary market. Second, advancing how we sell by improving our ability to attract the very best operator candidates and prepare them for success. and by making our extraordinary network of IOs even better. And third, continuing to scale our business to support 10% annual unit growth. RJ will speak in a moment about the first area of reinvestment, how we buy.

4:30 My discussion today will begin with the second area, how we sell, which is centered all around our IOs. We continue to expand our network of fuel-based educators to more effectively support our existing IOs as well as train and develop our newer operators. In terms of recruiting our new operators to the system, we are utilizing our digital marketing capabilities to more effectively target and recruit new operator candidates. While early, we are pleased to see the quality and the strength of incoming inquiries we receive from both those with traditional retail experience as well as other relevant backgrounds such as hospitality and food service. As we look for new operators, we know that candidates must have both the right mindset and the right skill set to succeed as IOs.

5:18 We aggressively search and screen for entrepreneurs who are smart, independent, hungry, and humble. While we love to find candidates with existing grocery management experience, equally important to us are vital skills such as customer service, labor management, marketing, and leadership. Once identified, these candidates go through an intensive training program, Part of which is an in-store immersion experience with a seasoned operator. In order to make our training program more consistent, scalable, and efficient, we are evolving our training approach to leverage the best of our operator, field, and corporate teams to create a virtual learning environment. We believe the consistency and rigor provided by virtual training workshops and simulations will be an effective supplement to the in-store training environment.

6:05 We expect this hybrid approach will help improve the readiness and effectiveness of new operators when they begin managing their new store. We also believe that it will provide a more consistent and scalable training experience as we continue to grow our store base. Training doesn't stop once the IO first opens their store. Our operators are aggressive and hungry entrepreneurs who are always looking to develop their skills and grow their businesses. To support that, we provide operational and analytical resources through our field management teams, corporate staff, As well as various data and business intelligence tools. To build upon this support, we're developing new educational content designed to help them further grow and develop their skills. For example, sharing of best practices has always played a very important role in our culture. And the emphasis on virtual learning will make it easier for subject matter experts to work with operators across all geographies and easily share video content.

7:03 As our business grows, we will continue to leverage scalable technologies to enhance our ability to support operators. Turning now to new store growth, our retail expansion strategy remains a significant investment priority. We opened seven new stores in the second quarter and now expect to open 30 to 32 new stores for the year. We remain pleased with the performance of our new stores, which, like our broader store base, are benefiting from the elevated customer demand. Looking forward, we remain excited about the availability of attractive real estate sites as we continue to build our store pipeline to support 10% annual growth. In summary, the strong financial results we delivered in the first half of 2020 set us up to accelerate investments in our business to support our long-term growth objectives.

7:50 We look forward to updating you on that progress. Now, before I turn over the call to RJ, I want to discuss a topic of great importance to us. As we've shared with you in the past, our mission of touching lives for the better is deeply rooted in the foundation of grocery outlet. And as part of this, each July for the last 10 years, we have run our Independence from Hunger campaign to address critical food insecurity needs across our communities. We are excited to share that this was a record-breaking year for us, with $3 million raised across our network. Grocery Outlet also donated an additional $1 million, bringing the total raise to $4 million. This brings our total money raised and donated to local communities since the campaign's inception 10 years ago to over $11 million.

8:39 As proud as we are of this accomplishment, recent events have pushed us, as well as many other organizations, to ask ourselves whether there's more that we can be doing to address inequality across our society. Specifically, how can we be more effectively supporting diversity, equity, and inclusion? While we've always served diverse communities and fostered an inclusive workplace, we know that there's more we can do and there's more we will do. We've spent considerable time internally discussing steps we can take to improve going forward, and our efforts will span across our employee base, network of IOs, and other partners. That includes an assessment of our diversity performance and establishing scorecards and measurable goals We're also gathering information through surveys and rolling out listening sessions to gain a deeper understanding of our team's perspectives.

9:29 Lastly, we're providing education modules and resource guidelines to increase awareness and sensitivity across our corporate teams as well as our IOs. With that, I'll turn it over to RJ.

9:41 Thanks, Eric, and good afternoon, everyone. We remain incredibly thankful to our independent operators, our buying and distribution teams, and our valued partners for their outstanding efforts and dedication in helping us to support communities since the start of this pandemic. Our combination of extreme value, unexpected deals, localized assortment and friendly service resonates with customers now more than ever. Over the last several months, we have leaned on our flexible operations to adapt quickly to industry changes. Our inventory management capabilities and supply chain execution enabled us to consistently meet increased consumer demand throughout this period. Our inventory levels remain healthy, depth of value remains strong, and we continue to offer an exciting treasure hunt of wow deals for customers shopping our stores.

10:34 Our execution in the first half of this year was made stronger by prior investments made in strategic business initiatives. For example, consistent reinvestments in purchasing through people, process and systems have enabled us to further strengthen our leadership position in the secondary market and scale our business for growth. These investments help deepen relationships and improve partnerships with existing suppliers. They also help to support new and better ways of pursuing partnerships with both traditional and non-traditional suppliers. We've talked before about greater specialization in our buying organization. Opportunistic supply remains plentiful, and our specialized approach is helping us capture even more of this product.

11:22 Our buying team continues to develop and strengthen supplier partnerships ranging from our largest strategic suppliers down to smaller high growth companies. We also continue to deploy new strategies to identify, establish and develop relationships with new suppliers. Our relationships with many of our largest suppliers go back decades. and we consider them to be an extension of the GEO family. These partnerships are strategic, which means they are broad, long-term relationships that reach well beyond any individual opportunistic deal. Our buyers use a personalized, high-touch approach to engage with each supplier. We interact with each of them at senior levels and communicate regularly to identify a wide range of mutually beneficial opportunities.

12:14 Excess packaging, innovation planning, and reconditioning opportunities are just a few examples of ways we partner with major suppliers. We also look at the total business, both opportunistic and everyday, and manage to shared sales and profit goals. We are equally excited about our potential with smaller high-growth suppliers. These are a combination of suppliers in high-growth categories and those that are on a strong growth trajectory Our objective is to be a valuable solution provider for these partners as well as to help them grow. In some cases, our partnership helps them scale their business by reducing manufacturing costs. In other instances, we help them by driving new customer trials, which increases brand awareness and loyalty.

13:06 We provide an easy, go-to-market retail option for them to grow their business. As with our strategic suppliers, we follow a customized approach and partner with them on long-term, mutually beneficial strategies. We also continue to invest more time and resources in establishing and developing new opportunistic relationships. We are further increasing buyer specialization with a focus on new supplier acquisition. This positions us well to efficiently identify and develop new relationships with suppliers of all sizes. In many cases, new partnerships begin with a smaller initial purchase order. Many initial purchases represent an opportunity to develop new, high-growth, long-lasting supplier partnerships, and we work to nurture these relationships with this in mind.

13:56 Disruption from the pandemic continues to present a number of these new supplier opportunities, including non-traditional suppliers, similar to what we shared last quarter. In addition to investments in opportunistic buying, we are also enhancing our approach to everyday items and category management. This is a combined effort between buying, inventory management, and our strategy teams. Benefits here include more relevant items, higher sales productivity, and better seasonal planning. One recent example is improvements made to our relatively new seafood category. We optimized and focused our assortment according to customer demand which are of higher sales and margin while also streamlining store ordering and execution. Extreme value on quality branded products resonates with customers now more than ever.

14:45 We continue to see strong engagement from existing customers and a healthy flow of new customers shopping Grocery Outlet. These new customers represent a mix of different shopping behaviors and patterns consistent with our overall customer base. We are the primary store for some and secondary or tertiary stores with others. We continue to target bargain-minded customers with value. This approach has served us well and offers ample opportunity for growth. Our marketing strategies are focused on attracting new customers as well as staying top of mind to drive repeat visits with those that already shop us. We continue to evolve our media mix and messaging to capture the attention of our target customer. Our shift from print to digital provides the flexibility to communicate real-time, store-specific information on our ever-changing WOW deals.

15:39 It also helps us address more recent changes in customer behavior and communication preferences. Another initiative within marketing is personalization. Investments made in our email database have enabled the launch of our Welcome Series email campaign. Customers that sign up to receive emails now receive a welcome message followed by a customized program of additional emails and videos that serve as an introduction and education on the unique attributes of grocery outlets. We supplement this brand marketing with regular WOW alerts that communicate the best deals currently available. This is just one part of communicating the WOW beyond the four walls of the store. Customers have responded very well to this outreach and we plan to further increase engagement as we advance our personalization strategies.

16:28 In conclusion, we are extremely pleased with our progress and confident that the investments we continue to make in talent, infrastructure, and operational enhancements will further advance our strategic growth initiatives. I will now turn the call over to Charles.

16:45 Thanks, RJ, and good afternoon, everyone. Our second quarter results reflect the strength of our business model and the outstanding efforts by our team and our independent operators as we continue to operate through this pandemic. Sales for the second quarter increased 24.5% to $803.4 million compared with the same period last year. This growth was driven by a 16.7% increase in comparable store sales as well as the sales contribution from 32 net additional stores since the end of the second quarter last year. Our comp growth in the quarter was a result of an increase in average transaction size partially offset by a decline in traffic. Comp performance was once again broad based with strength across all regions and vintages.

17:34 We opened seven new stores in the quarter ending with 362 locations. We remain pleased with the performance of our newer stores which consistent with our established stores are benefiting from elevated food at home spending. The second quarter gross profit increased 27.7% from prior year to $253.8 million as gross margin performance exceeded our expectations going into the quarter. Our gross margin rate was exceptionally strong, increasing approximately eight basis points from prior year to 31.6%, largely due to reduced markdowns and throwaways as a result of faster inventory turnover. This improvement in inventory efficiency more than offset distribution cost deleverage resulting from enhanced safety measures and higher personnel expense at our warehouses related to COVID-19.

18:29 SG&A expense grew 25.6% to $198 million with the increase largely attributable to higher variable commissions to independent operators resulting from gross margin dollar growth. Higher store occupancy due to unit expansion and continued personnel and infrastructure investment to support the growth of our business. In addition, we incurred incremental COVID-related store and corporate costs as well as public company costs and transaction expenses related to our April secondary offering. These factors resulted in SG&A increasing as a percentage of sales to 24.6% from 24.4% in the same period last year. The stock-based compensation expense for the second quarter was $10.2 million, largely driven by the full vesting of 2014 performance-based stock options in conjunction with our April secondary offering.

19:26 As a result of the tax benefit associated with employee option exercises during the second quarter, we incurred a $2.2 million tax benefit, resulting in an effective tax rate of negative 8.3%. Relative to our normalized tax rate, This option-related tax benefit increased net income by $9.6 million in the quarter, or $0.10 per diluted share. As a result, gap net income for the quarter increased to $29.3 million, or $0.30 per diluted share, compared to a net loss of $10.6 million, or $0.15 per diluted share in the prior year. For the quarter, adjusted net income increased 34.7% to $60.6 million from $45 million last year. Adjusted net income increased 189% to $41.8 million, or 42 cents per diluted share, based on an average of 98.6 million diluted shares in the quarter.

20:29 Turning to our balance sheet and liquidity, due to the sustained momentum in our business and our strong cash flow generation, we elected to repay our $90 million revolver draw in late May. As a result, we ended the second quarter with $79.8 million of cash. As RJ mentioned, we remain pleased with the quantity and composition of our inventory, which increased 13.1% versus the prior year to $229.3 million. Total debt decreased from the first quarter to $460.1 million as a result of our revolver pay down. While we remain confident in our liquidity position, we continue to take the conservative approach of building cash on the balance sheet given COVID-related uncertainty.

21:15 For the quarter, we generated $22.2 million in operating cash flow. It's our strong operating performance more than offset our rebuilding inventory from our March low point. We invested $21.8 million in CapEx in the second quarter as we continue to build new stores and invest back into the existing fleet. Turning to current trends in our outlook for the back half of the year, comp sales growth stands at 10% for the third quarter to date. We continue to see growth in basket size partially offset by lower traffic as customers continue to consolidate their trips. We anticipate that our comp growth will continue to moderate as the economy reopens. With respect to gross margin, we expect that our margin rate in the back half will be roughly in line with prior year quarterly results.

22:06 That expectation is driven by a moderating shrink benefit as inventory turnover normalizes, margin headwinds from commodity cost increases, and the fourth quarter margin dip we typically experience as a result of holiday product mix. With respect to expenses, we continue to prioritize making the right health and safety investments on behalf of our employees, customers, and independent operators. As such, we expect to continue to incur incremental costs in the back half of the year associated with COVID-19, such as cleaning and safety costs, costs for protective equipment and supplies, and higher personnel expense. While the pandemic has been challenging to navigate, It has provided a unique opportunity to bolster talent and infrastructure as we continue to execute against our long-term growth objectives.

22:56 As such, we have increased investments in people, process, and tools to better position us to capitalize on the significant white space in front of us. Those accelerated investments began in the second quarter but will work more meaningful in the third and fourth quarters. The same can be said for public company costs We believe adjusted EBITDA margins for the second half of 2020 will be modestly below prior year levels. In terms of other items on the P&L, with respect to stock-based compensation, we have now incurred substantially all of the expense associated with our time-based and performance-based 2014 employee options. In the second quarter, we implemented a new long-term incentive plan to attract and retain talent.

23:53 At target levels of achievement, we expect that the stock-based comp expense associated with this new plan will ramp over three years to an annualized run rate of approximately $25 million. Following the repayment of our revolver, we expect interest expense to be roughly $6 million on a quarterly basis. We continue to expect a normalized tax rate of approximately 28%, which excludes discreet items. And we expect weighted average diluted share count for the year to be approximately 100 million shares. Based on our current projection of 30 to 32 new store openings in 2020, we now expect the CapEx for the year will be in the range of 95 to $105 million. We do not expect any store closures in 2020 beyond the two we had in the first quarter.

24:44 In closing, we are incredibly proud of the performance of our team and IOs and the exceptional results we delivered in the first half of 2020. Despite the continued uncertainty surrounding COVID, we remain as excited as ever about our unique positioning in the marketplace and our long runway for growth. We remain committed to managing the business for the long term and making smart investments in pursuit of those objectives. With that, we can turn it back to the operator to begin Q&A. Thank you. Ladies and gentlemen, at this time, we will be conducting a question and answer session. If you'd like to ask a question, you may press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue.

25:31 For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Paul Trussell with Deutsche Bank. Please proceed with your question.

25:45 Yes, good afternoon and congrats on another good quarter. To start, maybe we could touch on the availability of goods as well as the performance kind of breaking down between everyday items as well as opportunistic items.

26:09 Hi, Paul. It's RJ. I can take that one for those two questions. I'll start with availability of opportunistic supply. We continue to see ample supply from our partners, as mentioned in our comments. We're pleased with the health of the inventory and the overall assortment. And I'd point to the great work done by our buying inventory management teams in maintaining the inventory levels that we have. We're in a unique situation for sure, but we've been at this business for a long time and we've been through lots of different cycles. I'd say we keep in very close contact with all of our suppliers. We understand supplier dynamics very well, whether it's changes to assortments being made or innovation or where product may still be on allocation.

26:58 I point to our success right now being the result of the same methods and approach that really we've followed over many, many years. We haven't changed the way that we conduct business, you know, even in this unique situation. We continue to benefit from doing business with lots of different suppliers. You know, we've pointed to the diversified supplier basis of strength on previous calls. Supply does cycle. by item and supplier. And so to be able to balance that across many supplier partnerships, you know, helps at all times. And important to remember here that, you know, this just contributes to the treasure hunt experience in the stores and that customers are, you know, used to changes in items and, you know, they get excited by new and different items showing up with great value on a regular basis. I always come back to the partnerships we have with suppliers, strong, long-lasting partnerships. We're a solutions provider to them.

27:55 We partner strategically on long-term goals. We follow a customized approach. We work creatively. All of these things, you know, they're long-term in nature, so they help, you know, during any short-term fluctuations that we see. And that, again, has been true throughout our history. And I'd also point to focus on new supplier acquisition as a real strength in pre-COVID times with the amount of change in the supplier landscape, but, you know, certainly now. as its benefit of both with traditional and non-traditional suppliers. And we've mentioned previously on the non-traditional side, you'll continue to see opportunities from food service, hospitality, you know, more recently cruises and hotels and, you know, fitness centers and, you know, other opportunities that have come our way.

28:44 Maybe the last point I'll make on opportunistic supply, I continue to be bullish on a long-term opportunity here. Manufacturers have increased production. They don't want to get caught again like what happened back in March and April. You know, I'll say we've already seen some opportunities that have come our way from overproduction. We expect more to come in the future. We continue to benefit from retail closures and slower reopenings and, you know, that time will tell, you know, how quickly others open, but we've been able to help out some suppliers in tight situations there. And, you know, anytime there are changes in assortments, whether it's ski related or category related, packaging related, we see those opportunities.

29:29 And ultimately, any type of supply chain imbalance is a positive thing for us. So, you know, all of those things will continue to be true as we look forward. And then just as quickly in terms of mix, you know, have we, I think your question was, have we seen, you know, any material change in mix? What I'd say here is we don't manage our business to mix. We manage to value, and mix continues just to be the result of where demand is, what we're able to purchase, and ultimately where we can deliver value. As a reminder, customers don't know the difference between everyday and opportunistic. That's all internal speak, but they do recognize value, so we continue to orient around that. That said, everyday has tracked a bit higher in terms of mix as some of the higher demand items and categories do skew more to the everyday side.

30:23 So that's bumped that up a little bit. But, you know, but we're used to short term changes in mix as demand and supply fluctuate. And you always come back to our flexible buying and merchandising model that allows us to adjust and that we don't have set skews or hierarchy or any volume. so perfectly comfortable managing these fluctuations and mix and always maintaining healthy value to drive both sales and margin.

30:52 That's really helpful, Color. Thank you. And just as a follow-up, is there any metrics or color you can share on what you're seeing from a new customer count standpoint or just overall brand awareness? And while food at home is obviously benefiting, you know, all stores. You know, Charles, is there a way that you kind of strip that out and kind of gauge new store productivity that you can speak to? Thank you.

31:21 Yeah, Paul, I'll take the first part and then Charles can pick up on the second. You know, I'd say in regards to new customers, we're pleased with the number of new customers. that continue to come into our stores. New customer levels are tracking at very, very healthy levels, particularly in our developing markets, specifically Los Angeles and Pennsylvania. So seeing really nice new customer account growth there. In terms of metrics, we conduct regular surveys. I would say we look at profile of the customer. We look at shopping behaviors. We look at satisfaction with Grocery Outlet. I'd say a couple things. One, new customers are a mix of those that shop as primary, secondary, and tertiary, very consistent with what we've seen in the past and consistent with the overall mix. And they're having a great experience.

32:15 So satisfaction is high. They're very satisfied with the store experience. We believe there's incredible sickiness. to that experience, and we're seeing it in the metrics from our survey. The treasure hunt resonates with them, the value, the convenience of a small shop, the operator, the connection to community. Health and safety, of course, is critically important to customers now, and they're satisfied with the things that our operators are doing around health and safety and cleaning. And so they're coming in and they're having a good experience, and we think that bodes well for us. looking forward. Charles?

32:57 Yeah, Paul, just to add to RJ's comments on new store productivity, we're really pleased to see performance in new stores. Again, the rising tide is lifting all boats. And so we've seen new stores open this year as well as the ramping vintages for the past several years continue to benefit. Importantly, as RJ mentioned, a big part of that is new customer acquisition. So if you're really good about where we are. It's an important metric for us and one that we track very closely. Our next question comes from the line of Randy Koenig with Jefferies. Please proceed with your question.

33:38 Hey, guys. How are you? Can you hear me? Yeah, we can hear you. Yeah. Oh, yeah. Sorry. So, I guess my first one, maybe back to RJ to kind of follow up on the first question there. So, Can you give us a little bit more background? We talked about expanding the supplier base during the pandemic, cruise lines, hotels, etc. Could you maybe frame out a little bit more quantitatively just how the supplier base has grown maybe in the past six months, past five years, and past ten years? The reason I'm asking is during the Great Recession we saw TJX have a similar The other thing that happened with that particular company was the nature of the relationship or the dynamic of that relationship with those suppliers also changed. And when I'm hearing your comments on the script with the script, with the call, it sounds like the dynamic of the relationship with these suppliers is deepening even further, meaning you're getting even more preferential treatment, seeing, you know, grocery as a preferred partner, getting more, maybe some made-for product or something beyond just opportunistic closeout kind of stuff.

35:05 Maybe just give us some perspective on quantifying that supplier base, and then kind of giving us a little bit more meat around the dynamic of the relationship with the supplier base and how that's been changing over the past three months and the past few years.

35:20 Yeah, thanks for the question, Randy. Yeah, a lot of what you just said there is true and what we've experienced over the years and certainly growth in terms of number of suppliers. We've expanded our supplier base as the assortment has evolved. So you think about categories and We talk a lot about nosh, but I point to natural organic specialty healthy as seeing tremendous growth and the establishment of new supplier partnerships. That's in part because of how we've evolved assortment and of course, what's happening within the supplier landscape with new upstart suppliers and higher growth suppliers coming into the industry and we've been able to establish those relationships and grow with them.

36:05 To your comment about the types of relationships and how that's evolved, we talk a lot about strategic partnerships. And in the comments there, what that means to us is it is much more than a transactional type of relationship. It's much more than an individual opportunistic deal. So we partner with them together for the long term. and so, and we treat the relationship accordingly. So, you think about things like creative solutions to instances where they're stuck, you know, certainly as we think about cost and margin and value and that equation, it's over a longer period of time. We, you know, I think we've evolved into more of a hybrid opportunistic and everyday mix with many of our larger suppliers.

36:56 and that's proven to be mutually beneficial. We're a high growth channel for them and we continue to access more and more of their opportunistic. Specialization within our team is a part of managing these relationships better. So, we think about strategic suppliers and an approach that works well there. We think about smaller high growth suppliers and tailoring our approach needed there. and then this continued focus on new supplier acquisition and development is something that allows us to be more focused. We do believe that we are a preferred partner. We ask suppliers all the time what more we can do to be a better partner and we've gotten better as a result, so we have that type of relationship and communication.

37:45 and for us it's about finding new and helpful ways to partner with them. And so we're constantly working with our points of contact, broadening our reach throughout the organization and exploring opportunities to help them, whether it's specific to innovation or supply chain situations that they're in or on the smaller side and helping them scale to grow. All of these approaches, I'd say, have been part of a longer-term evolution as the company's grown, as we've invested in people and systems to be able to do things better. And I think both we and our supplier partners have benefited as a result. And then just lastly, I think on your question related to nontraditional suppliers, we think of those no different than any other new supplier partnership in that we want to cultivate that relationship and grow with them.

38:39 It has been a smaller part of the mix in terms of PO volume or sales volume, but as with most new supplier partnerships, it starts with an initial PO and then develops into longer, bigger partnerships from there. So we expect many of those opportunities to play out the same way on the non-traditional side.

38:58 Very helpful. And just a real quick follow-up. Just maybe just a progress report on younger market progress, let's say like Pennsylvania, or Southern California and how that compares to mature market performance just so we get a flavor for how the younger markets and the East Coast are doing relative to the historical markets. Thanks. Thanks, guys.

39:25 Hey, Randy. It's Eric. Good to talk to you. You know, we've said it before that the East business is still a very young business. Super, super excited to have Heather back there. She started really in earnest in February. And I'd say great progress this year in terms of comps and sort of her leadership in the market and sort of getting us set up for growth. Transfer out to Southern California. and that market's done really, really well. You know, we really started opening stores there sort of 2014, 2015 and it's taken us a while to get up to what I think is going to be around, you know, 85 to 90 store count by the end of this year and, you know, our market shares are still fairly small but we're doing really well down there.

40:21 I think the brand is growing We've concentrated a lot on supply chain the last few years and making sure we're, you know, buying product, putting it in L.A. and distributing from there. We've also focused our recruiting locally for, you know, placement locally. And so everything's sort of clicking together. And obviously, as we build that market share and build that position, you know, things will continue to get even better. So we're really pleased with both of them.

40:53 Super helpful. Thanks, guys. Really appreciate it. Our next question comes from the line of Robbie Holmes with Bank of America. Please receive your question. Oh, hey, guys. Great quarter, and thanks for taking my question. Actually, just two quick questions. The first was just on the sequential slowdown to the 10% comps. Any color on whether the slowdown is more traffic or ticket-driven? sort of maybe just more color on the slowdown and maybe are there any category things that are, any categories slowing sequentially more than others? And then my other question is just on the incremental COVID-19 costs, can you remind me what the IO cost structure is in terms of how much of the COVID-19, are you guys helping them with the store level COVID-19 costs or are your incremental costs all Your side of the business.

41:50 Thanks.

41:52 Hey, Robbie, it's Charles. Let me tackle both of those. So first, with respect to the comp flow, I would say that the trend, the enduring trend that we're seeing is that safety is really top of mind for customers. So beginning in the second quarter and continuing now, they continue to consolidate their trips into the store. And so the overall traffic trend has been steady. and I think that's true across our markets. It's really been the average basket size that while it remains elevated, that is starting to moderate as the economy is slowly reopening. So really hard to say how traffic and basket are going to trend as we move into the fall and winter. But I think broadly speaking, this trend of overall moderating comps is one that we would expect as markets continue to reopen.

42:45 That's comp flow. Secondly, your question on COVID costs. Yeah, so we are absorbing some costs and helping support the operators in costs that would normally fall onto their P&L. Things like supply costs in the store for personal protective equipment and safety-related costs, cleaning costs. Again, it's not per the letter of the operator agreement. It wouldn't be a cost of ours, but we think it's the right thing to do. and so we've absorbed those costs in the second quarter and we would anticipate continuing to absorb those costs as we move through the balance of the year here. That's great. That makes a lot of sense and really helpful. Thanks, guys. Our next question comes from the line of Michael Lasser with UBS.

43:34 Please proceed with your question.

43:36 Good afternoon. Thanks a lot for taking my question. If you look at the customer base by for shopping behaviors, so the full shops versus those who are just doing a fill-in, which I think you had some nomenclature in how you referred to those different buckets earlier in the call. How are those two baskets doing quarter to date versus where they were doing in the first two quarters of the year? So my question is basically, are you seeing a slowdown in those fill-in shoppers, or is the slowdown occurring more in those who are doing their main shop at Grocery Outlet.

44:15 Yeah. Hi, Michael. Yeah, I'd say across different shopping behaviors or groups, if you will, we talk about primary, secondary, tertiary. We've seen consistent trends, so no particular trend specific to one versus the other.

44:33 And for those customers who you've been able to attract new into the fold, Have you been able to trade them up from being tertiary or secondary into a primary shopper? How do you do that?

44:50 Yeah, so we, as I said, we have been a healthy mix. They're newer, so there isn't a ton of history there for movement, if you will. and then beyond that, you know, we don't necessarily think of all tertiaries as potential for secondary or secondary to primary all the way up. Customers shop us in different ways. They fit us into shopping patterns, you know, specific to their needs and, you know, how that works for them. So, yeah, certainly to the extent that they have the propensity to become primary, Thank you very much and good luck. Thank you. Our next question comes from the line of Oliver Chen with Talon.

45:59 Please proceed with your question.

46:02 Hi, thank you. Inventory management was tightly managed this quarter. As we look ahead, should we expect inventory growth to underpace sales growth in the back half as well? Do you expect that trend to continue? Also, your comments on buyer specialization, why was now the right time for that to happen, and what do you see happening in terms of timing of impact of that decision?

46:27 Hey Oliver, this is Charles. Let me take the first part and then I'll send it over to RJ. But with respect to inventory, I'm really pleased with the current composition and level of inventory that we have. Of course, you saw a nice rebuild from the end of the first quarter. So as we look towards the back half of the year, I would think in general it's going to trend roughly in line with sales growth. Of course, given the nature of our business, and the opportunistic purchasing, it can fluctuate a bit more than the traditional retail, but I think that general rule of thumb in line with sales growth is pretty safe.

47:09 And in regards to specialization, we've been talking about that for a number of years. Let's say the first piece was when we introduced inventory management back in 2013. Those were tasks handled by the buying team previously. So the first piece there, and then more recently, really two years ago, started the planning and moving people into everyday and opportunistic. And really just a reflection of being able to better manage the business, recognizing that opportunistic and everyday are unique parts to buying. and you know with the change we've been able to go deeper so on the everyday side still growing into better category management and everything involved with that and then on the opportunistic side you know it's been hugely beneficial to have 100% focus from that team as we think about these different tiers and types of suppliers as well as new supplier acquisition.

48:08 Thank you and as you do look ahead of curbside pickup and delivery what are your thoughts about how and many more.

48:46 So, you know, still hard to replicate online and we don't want to sacrifice value for that. So, you know, we'll continue to evaluate e-commerce relative to other long-term priorities. And in the meantime, we continue to do a lot by way of digital marketing, you know, things like personalization and social media and growth of the email database, you know, all of those things. have been impactful for us, and we think that helps us quite a lot in terms of new customers and share of wallet growth.

49:18 Okay. And lastly, on that point you're making about digital marketing and marketing spend, how are you thinking about the incremental dollar and spending at what medium and customer acquisition costs as you look at different options online and you also allocate your dollars from print to media?

49:37 Yeah, it's really been a shift. So we've become more efficient with our marketing spend and a lot of digital has come as we've shifted away from print and traditional, conventional marketing media. Print is still very prominent. And we've just shifted those dollars more efficiently and more effectively. And I've always said it's better for this business, real-time, store-specific items. Digital supports that in a way that print never could. And so, you know, it's been beneficial both from an efficiency standpoint, but also from an effectiveness standpoint and fitting with our model as well. Our next question comes from the line of John Heinbockel with Guggenheim.

50:23 Please proceed with your question.

50:25 And maybe for RJ, I know a lot of the stuff you've done with the procurement department has been With internal folks, have you expanded that group here or intend to as a part of the investment? Thoughts on that? And then secondarily, where do you think you sort of end up here on the private brand journey? Particularly, you know, we're in a downturn and it may last for a while.

50:53 Yeah, so we have expanded the group. So one of the best investments we make is in people. And so the group has grown as the business has grown. Part of that related to specialization, part of that is related to a growing business. So we'll continue to invest in people and would expect that to continue to be a very positive return for us. and then for private label, we haven't increased the priority on that. It still remains on the list as far as future roadmap goes. We continue to see plenty of supply from an opportunistic standpoint. So that's always preferred and it's something that we'll keep on the list and we'll determine when or if it becomes a higher priority in terms of assortment strategy.

51:45 and then maybe as a quick follow-up, wow alerts in a consolidating trip environment. I know they were very effective in getting people in more frequently. How effective are they in COVID and then have you changed your approach in COVID?

52:01 Yeah, so very effective, Jon. For one, it's a great way to communicate to customers what we have in the store. So if they're not sure about making a trip or they're trying to decide where to go, We think it's a great, even more relevant now than ever, you know, great way to communicate that to customers. And, you know, when we think about personalization, it's really about expanding wow alerts. So to show them more of the store, you know, take it outside the four walls and make it more specific to the customer for the items or the categories that they're looking for. So, you know, really pleased that we have that and We expect that to be an important part of digital marketing for us ahead. Thanks.

52:49 Our next question comes from the line of Karen Short with Barclays. Please proceed with your question.

52:55 Hi. A couple questions for you, maybe a little more housekeeping-ish, but first would be can you give us a little bit of an update on the promotional environment and whether, you know, say from your conventionals, if you've noticed an uptick, The second is you called out commodity cost increases going forward. So could you just give a little color on what you're seeing on inflation and what your expectations are? And then I just had one question related to the IOs.

53:25 Hey, Karen, Eric. Thanks for the question. Yeah, I would say nothing unique in the promotional environment. that you all haven't seen and read about. I think you paid attention to the, I think Albertson's and Safeway call, they just couldn't rely on suppliers. Inventory was down. It was very difficult to promote. People are starting to get back into the fresh side where control is a little bit better, but We have not seen a whole lot different than what you all write and describe. We're not seeing any new competitive activity or any gimmicks in any of the markets, but I'd say it's pretty much status quo to what we've read as well.

54:11 And Karen, this is Charles.

54:12 Let me address the inflation question. So we didn't feel much inflationary cost pressure in the second quarter. We are now starting to feel that across a number of categories, including meat and deli and produce. So we do expect that's going to be a bit of a gross margin headwind in the back half of the year that we didn't see in the first half. Again, we love the fact that our model allows us to mitigate some of those inflationary pressures because we can We can buy and merchandise flexibly, but we do think, nonetheless, it will be somewhat of an impact in the back half.

54:54 Okay, thanks. And then just a quick question on the IOs. Can you just give us an update, if you did, I missed this, but on the interest rate relief that you had called out in 1Q for the IOs?

55:08 Yeah, so that continues to be the case. We've given... We've given relief to the IOs to the tune of a 50% reduction in their interest rate. And as I mentioned before, it's one of many COVID-related costs that we're absorbing, and we would anticipate to continue to do so as we work our way through the pandemic. Our next question comes from the line of Simon Gutman with Morgan Stanley. Pleased to see you with your question.

55:39 Hey guys, it's Simeon. So my first question is a modeling one with two parts. The first part is, could gross margins be up again in 2021 for any reason? And then related to it is incremental margins in general for this business have been in the mid single digit range. And that's with your normalized comps of let's say four to five or 6%. When we start normalizing to those levels, Should the incremental margins follow, and any reason why they should be stronger or weaker than those historical numbers?

56:14 Yeah, Simeon, this is Charles. Let me try to tackle both of those. So, first of all, with respect to your gross margin question, so you're really pleased with the performance we saw in the first half of the year. Again, shrink was a big benefit just because of the sustained momentum on the top line, so we saw much lower markdowns and throwaways. We've always said that over the long term, we take the view of managing for stable margins. And I'd say that's true both with respect to the gross margin line as well as adjusted EBITDA margin lines. So we're just starting our initial planning for 2021. We very much expect it will be a fluid environment in which we'll be operating.

57:00 But again, what I can tell you is longer term, We manage the business for stable margins and, again, both gross margins and adjusted EBITDA margins. The reason is because of the reinvestment that we've talked about. You will definitely have quarters. You can have quarters like we had in Q2 where really up and down the P&L, the stars aligned, and we saw some nice flow through. But our objective would be to make sure that we're doing the right things to reinvest in talent and in infrastructure and to ensure our success as we continue to grow stores.

57:38 Okay, and then my follow-up is with regard to the IOs and some of the training that was mentioned. First, I don't know if you'd say this, but was the tone that you used this quarter in terms of the script around training, was it with a little bit more urgency or heightened importance? And second of all, if it was, can you talk about Thank you for joining us.

58:19 Reflection that we have 70 to 75 to 80 inbound AOTs per year that we're training and getting ready to go out into the system. I'd say second, if you're your traditional grocery manager that's thinking about another opportunity, this is probably not the year that you're looking. We're dipping our toe into some other candidates from outside of the grocery arena, so it's an opportunity for us to upgrade the training and, you know, both from a forced virtual training to combine with what we're doing in the stores, and then two, to train people on the grocery business that may possess other skills, entrepreneurial or customer service or, you know, back office.

59:06 I would say it's all of those things. And then, you know, I think you've heard themes throughout from us that, you know, if it's working well, that's a good time for us to pick at it and see if we can improve it. So just a thread of continuous improvement would be probably the final.

59:24 Thanks, Eric. Our next question comes from the line of Joe Feldman with Telsey Advisory Group. Please issue with your question.

59:34 Hi, guys. Thanks for taking the question. I wanted to go back to, RJ, you were talking about personalization and in response to Jon about it as well, but how are you tailoring the message on those wild alerts? That's kind of how I think about personalization, or is it just like you're increasing the number of wild alerts sent to people? Like, what is actually happening there?

59:57 Yeah, so personalization, we're in the very early and end Phil Joe of you know planning how we can become more customized and personalized mentioned in the comments this welcome series email campaign that we put out to new customers so specific to them they're new to the model so it is about introducing and educating them because it is a different kind of shop and we want customers to understand that the the Wow Alerts are still now not personalized to customers they're specific as they've always been specific to stores and items. So they're local and they're real time and they reflect some of our best value, highest velocity items. The next phase then with WOW Alerts, once we start tracking more customer specific information, would be to have that specific to you, Joe, versus someone else based on what you like, what you buy, and other suggestions of things that you'd find interesting.

1:00:55 We have super high engagement from these Wow Alert emails that go out. Customers look for them. They open them. They react to them. And we think we can increase that engagement further still when it becomes even more relevant to you and your specific needs.

1:01:12 Great. Thank you for that. And then I guess a follow-up maybe also for you, RJ, was the opportunistic buys that you're seeing out there, are there any categories – Thank you for joining us.

1:01:37 Yeah, it's really broad-based, and to the extent that there ever are situations where it's too heavy or lighter, so to speak, I mean, I'd say those are, for a long history of this company operating with this model, it's just part of normal fluctuations and cycles that happen. And so, but yeah, on the whole and over a reasonable period of time, It's healthy. Nothing specific to categories. It's ample really across all and things move around but not of any significance to point to that it would call out one category versus another. Our last question comes from the line of Jeremy Hamblin with Doherty & Company.

1:02:26 Please proceed with your question.

1:02:29 Thanks and congrats on the strong results. I wanted to start with a question on store openings. You increased your guidance by a couple of units. In terms of as we look forward into 2021, can you provide any commentary on the quality of the real estate opportunities you're seeing, the quantity of real estate opportunities, and whether or not kind of what's transpired here in 2020 makes you think a little differently about the types of locations that you might look at going forward. And then I had a follow-up question.

1:03:05 Hey, Jeremy, Eric, I'll take the latter part of the question. No change in direction in terms of the types of sites that we're going to consider. We're always looking for, you know, great real estate, you know, whether it's a dense market or rural market, we want to be sort of where people are and they're used to shopping. So I'd say that would be an overarching for us. Relative to long-term, the target, we think the 10% unit growth works really well. The pipeline for 2021 is very strong. We've continued having our real estate meetings monthly, approving sites, getting leases signed. We continue to go out and look into markets and we're excited about both the finish of this year and the prospects for next year.

1:03:51 I think relative to the big question that we've gotten from A number of people is what do we think is going to happen in years 21 and 22 relative to supply. I would say the markets that we operate in for many years have been pretty competitive. Lots of people looking in the 15,000 square feet, you know, up to 30,000 square feet. We've been able to be really flexible, split up boxes like Kmart's and Sears and other, you know, retailers that are giving up sites and get into 10,000 square feet all the way up to 30,000, 35,000 square feet. I think what is going to happen is this greater real estate market sort of gives back square footage. We're going to have more opportunities versus less. And if we have more opportunities, I think we'll have a good focus on quality.

1:04:36 But at the same time, I think there could be some opportunities relative to, you know, what we have to pay to get into those sites.

1:04:43 Okay. That's great. And then just in terms of I wanted to ask a follow-up question actually on PPE costs. In terms of now we're many months into the pandemic, it seems as though there's been some efficiency gains in terms of managing simply because we have better visibility on what needs to be done and there's less of a scramble in terms of getting PPE to the team. Can you give a sense on whether or not the impact of those costs Is that starting to diminish, you know, as it relates to, you know, the overall total cost, you know, percent cost of sales, but just any color you might be able to provide on that, you know, would be helpful.

1:05:35 Yeah, Jeremy, this is Charles. Let me try to provide a little bit of insight there. You know, I would say, and I should emphasize, everything we're seeing for COVID costs for us, given our model, it's It's across a number of areas and it's several different lines in the P&L. Some of that's expense, some of it's capital, but everything from our distribution centers to costs in our corporate office for the staff that remains and all the work from home costs. Everything I talked about that we're doing at stores, both from a support standpoint for IOs as well as incremental capital that we put into the stores. So It's a number of things. It was a significant impact to us in Q2 and really was one of the key drivers as to why we delevered SG&A in the quarter. I do think that while there may be some efficiencies we're seeing, it's going to continue to be a significant cost for us until we get on the backside of COVID.

1:06:40 So from a modeling standpoint, it's really one of the reasons why We're trying to orient folks towards the back half of the year and adjusted EBITDA margins again being slightly lower than prior year.

1:06:55 Okay, great guys. One last question maybe on your debt and you kind of briefly pulled that debt down. In terms of thinking on a go-forward basis, you're generating a lot of cash. Is that a priority to potentially reduce the overall debt levels here as we move into 2021 or into 2022?

1:07:23 Yeah, the way we're thinking about it, Jeremy, is that until we get, again, on the backside of COVID, let's just take the conservative approach and continue to put excess cash back on the balance sheet. We feel great about the liquidity position. As you point out, we've got plenty of internal cash flow to fund our investments and growth as a result of how good we felt we did take the opportunity to repay the revolver in May. But I think what we've done is decided to table the longer-term discussion around what's the right leverage ratio ultimately for this business and then what do we want to do with excess cash after that. I think that'll be a conversation we can revisit once we get some more Clarity around COVID.

1:08:11 This concludes our question and answer session. I'd like to hand the call back to Eric Lindberg for closing remarks.

1:08:19 Hey, thanks everyone for joining us. Appreciate all your questions and we look forward to catching up with you individually after this call. Thanks so much. Take care. Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.