Ladies and gentlemen, thank you for standing by and welcome to Sprouts Farmers Market's first quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today's conference is being recorded. [Operator Instructions]. I would now like to hand the conference over to your speaker, Ms. Susannah Livingston, Vice President of Investor Relations and Treasury. Please go ahead.

Thank you and good afternoon, everyone. We are pleased you have taken the time to join Sprouts on our first quarter 2020 earnings and long term growth strategy call. Jack Sinclair, Chief Executive Officer and Denise Paulonis, Chief Financial Officer, are with me today. The earnings release announcing our first quarter 2020 results, our long term growth strategy slides and the webcast of this call can be accessed through the Investor Relations section of our website at investors.sprouts.com. During this call, management may make certain forward-looking statements, including statements regarding our 2020 expectations and outlook as well as our long term growth strategy and financial targets. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. For more information, please refer to the risk factors discussed in our SEC filings, along with the commentary on forward-looking statements at the end of our earnings release issued today. Our remarks today include references to non-GAAP measures. For a reconciliation of our non-GAAP measures to GAAP figures, please see the tables in our earnings release. As well, to accommodate the additional time needed to discuss our long term growth strategy, we have added an extra 15 minutes to the call today. With that, let me hand it over to Jack.

Thank you Susannah and good afternoon everyone. Thank you for joining our call today. We could not have expected the magnitude of change in our business that has occurred due to the COVID-19 pandemic. And I want to start the call by emphasizing how critical our team members, particularly our store team members, have been in this time of crisis. Grocery store workers around the world have become everyday heroes working on the front lines to ensure people have the food and products they need to feed their families and frankly to survive. The more than 32,000 hard-working and profoundly dedicated team members of the Sprouts family have served countless hours under the most difficult of circumstances in order to ensure our customers have healthy food to feed their families. It's extraordinary how people are changing their view of our grocery store workers. Every day, they are rising to the occasion, showing up to their jobs donning masks and gloves, carefully following ever-increasing safety measures and altered operational procedures and taking it in stride as they continue to prioritize customers and their needs. Right now, we are focusing primarily on our people. The entire leadership team is inspired by the amazing work our team members and our partners are doing. It takes a community of dedicated individuals to keep our stores open in a time that none of us has ever experienced. I want to thank not only our dedicated team members at Sprouts but also all parts of our supply chain, our distribution centers, our drivers, our vendors and our farmers and growers, who are all part of keeping the food supply chain running. I am inspired by not only our store team members but by the decisiveness and agility of our leadership team and our management team, who…

Thanks Jack and good afternoon everyone. First, I hope all of you and your families are healthy and safe. I will begin by discussing our business results for the first quarter and then hand it back to Jack to discuss the current environment and strategy. I will join again to discuss the long term financial targets for Sprouts. First quarter profitability was very strong with adjusted earnings before interest and taxes up 61%. The quarter was really a tale of two cities, so to speak. The first few months of the quarter were on track to deliver sales in line with the high end of our expectation and margins above our expectation due to the smarter promotional strategies we implemented late last fall. March followed with a dramatic increase in demand for food from the COVID-19 crisis resulting in additional sale and leverage in the business. First let me review the highlights. In the first quarter, net sales grew 16% to $1.6 billion and comparable store sales were up 10.6% compared to the same period last year. We estimate that COVID-19 positively impacted sales by $146 million and comps by 9.6%. For the first quarter, gross profit increased 23% to $594 million and our gross margin was 36.1%, an increase of 180 basis points compared to the same period last year. SG&A increased 16% to $436 million or 26.5% of sales, flat compared to the same period last year. SG&A included a pretax special charge of $1.2 million related to our ongoing strategic initiatives. As for the story behind the numbers, the quarter started off with January and February on track to post comps at the high end of our outlook with slightly negative traffic. As well, our early efforts to refine and balance our price position, comp and improve…

Thanks Denise. Before I discuss our strategy, I wanted to share a few comments around today's environment. Given the unusual circumstances, I am going to give color on the current trends. Denise's numbers show elevated sales levels that continued into April, though not at the same level as March. We believe the stockpiling is over. More importantly, our observation is the industry is experiencing a significant change in consumer behavior. In order to avoid social contact, customers are consolidating their shopping trips and shifting their visits more throughout the week and less on the weekend. The less trips are resulting in many more items in the basket but at a reduction to traffic. No one knows how long these behaviors will last. Social distancing has changed consumer behavior as well, leading to a significant surge in e-commerce sales. For April, our e-commerce sales increased over 950% from last year. This change in consumer preference prompted us to swiftly roll out our pickup service from 55 stores to all stores. We aggressively implemented this service to Los Angeles and Central California in mid-April and are on target to implement it to all 344 stores in early May. This service in partnership with Instacart utilizes an innovative model with our team members performing the picking and delivery to cars Many of these pickup roles will be filled with existing team members, which has presented even more opportunity for us to bring in new talent. Throughout COVID-19, we have been aggressively hiring creating thousands of new careers at Sprouts. Though it is much too early to define a new normal, COVID-19 has been a catalyst for trial of our e-commerce offerings which could stick with many customers as we exit this pandemic. Though we are keenly focused on the present, COVID-19 has provided…

Thanks again Jack. Over the last few months, we have challenged our internal performance expectations, our past practices, our box economics and our expansion plans. We set a high financial bar grounded in long term targets, which we believe we can obtain. While the current environment affects our ability to predict the precise timing of when each of these strategies will impact our results, I am confident the strategies will lead to future earnings growth. Starting on slide 15. The basis of my discussion today is our goal of driving attractive profit growth and expanding ROIC by reducing our cost to build, driving annual 10% plus unit growth and delivering comps in the low single digits while stabilizing or expanding our EBIT margins. Turning to slide 16. As we evaluated our strategy, we realized our box was becoming too large and too expensive to build to maintain the economics we have historically. Jack hit on the benefits of a smaller store earlier. The result is a box that is about 20% smaller in square footage and with a similar reduction in fixture costs, leading to a blended cost to build of approximately $3.2 million, including inventory and pre-opening costs. It's important to note that this cost of our enhanced layout store had reached upwards to $4 million in 2019, so this is a substantial reduction in costs. Moving on to slide 17. The target economics of the new box includes year one sales of approximately $14 million, with sales growing 20% to 25% in four years to annual sales of $16 million to $18 million. As Jack commented, these sales will be roughly flat to our historic trends, though in a much smaller square footage box. We expect that this will result in a blended 8% four-wall EBITDA margin in…

[Operator Instructions]. Our first question will come from Karen Short with Barclays. Please go ahead

Hi. Thanks very much and really appreciate the color on the longer term outlook and focus. I mean I do want to ask some questions about that but obviously things are extremely abnormal now. So wondering if you could just answer a couple of shorter term questions to begin with. Specifically on SG&A, is there any way to give us the actual dollar amount of investments in labor that you had in place for 1Q? I realize that's small but then some color on how to think about that dollar amount in 2Q? And then once things normalize, what the stickiness would be on costs from a cleaning, PPE perspective? Anything you could give on that would be really helpful.

It's difficult to be exact on that, Karen, in terms of how things are evolving and changing. It's difficult to know how much PPE we are going to need going forward. We are clearly going to need some and it's difficult for us to evaluate exactly what that number is going to be. One of the reasons we are a bit reticent to be clear about where it's going to be going forward is some of these pressures going forward. I think the likely impact of a post-COVID world is probably broken into three things for us and costs are certainly part of it. How much impact will it have on our wage rates? How much impact will it have long term on our cost in operating the stores? How much will social distancing impact us going forward? So I think it's difficult for us to put numbers to it. But it's clearly part of our planning going forward and we are doing a lot of work on it at the moment.

And Karen, I think with the math that we gave you specifically as to what impacted Q1, you should be able to back into pretty well what the SG&A weight was in the quarter. But it was all really geared to supporting our team members and PP&E.

Yes. I mean, we were kind of coming up with the incremental SG&A for 2Q of about $60 million. So then I think the question is really, that seems to exceed what the sales number will look like, if we kind of assume April was 7% and then maybe May and June kind of decelerate from there slightly. So I guess it kind of backs into what, obviously you gave some numbers in terms of overall annual guidance being slightly better. But it really comes down to gross margin at that point. So maybe first thing, can you tell me if I am way off on the SG&A on that $60 million for 2Q? And then I guess on the gross margin front, maybe if you could give a little color in terms of how much shrink is benefiting you in terms of like 1Q, I guess, in the COVID period but also in 2Q? Because I assume you have some significant benefits from lack of like low spoilage. I mean that has to be hundreds of basis points. So any color you could give there would be great.

Yes. Karen, what I would say is, I would reiterate what we talked about in the script that we released. So April, we saw our sales up about 7%. That included being closed on Easter Sunday. So that adds back 300 to 400 basis points to what we have seen in the April sales trends. And when we are seeing margin right now, we are still seeing benefits from shrink and we are seeing a little less mix goodness, as you would just assume, as people are back to buying produce and some other things in our store. In SG&A, I think your number is high. So just in terms of the total dollar amount of what we would foresee right now, your number is high. So I wouldn't be expecting that much to be coming through in what you are modeling.

Okay. And then just on the longer term strategy. I know you said that you were not taking out any categories in the new smaller format. But maybe just a little more elaboration on what will be downsized? I know you did call out dairy. But anything else you could call out would be helpful.

Sure. Karen, I think the reality of it is as we went to larger stores, we didn't actually put a lot more SKUs or categories into the store. We did some certain categories and gave it more space and did a better job probably in terms of the customer experience. Going forward, we are certainly going to double down on those categories that are very important to us and very important to that target customer grouping that we were talking about. And that comes down to produce, which is always going to be fundamentally important to us. And we won't be compromising anything on that. If anything, doing a little bit more in that space. Frozen food has come out as a very important category because we are so differentiated in it. The fact that we have got so much plant-based, so much vegetarian, unique brands is really coming through strongly in this customer segment that we are targeting. So we will probably give a little bit more space to frozen foods. And we will probably look quite hard at our, what we call center of plate, whether it be our meat business, whether it be our plant-based business, how do we become more of a destination for center of plate. Those would be the three categories that we are going to give a little bit more emphasis to. The consequential, we think we can do vitamins and supplements really, really well with a little bit less space. We think we can do bulk really quite well, although there's a lot of discussion going on about bulk, as you can imagine, in the current world. We think we can do that in a little bit less space. So we will be flexing our space a little bit. Deli won't be quite as big. But certain categories will get a bit more space, if that gives some color to you, Karen.

Thank you. Our next question will come from Scott Mushkin with R5 Capital. Please go ahead.

Hi guys. So thanks for taking my questions. So I just wanted to get into the April sales a little bit and as far as it does goes with your long term strategy about smaller boxes. It seems with our data that maybe you guys are just a little bit undercomping the industry so far in April. And I was wondering what you think may be driving that? And then forward, does it give you any pause about the strategy at all?

Yes. Scott, I would tell you, when we look at our comp, we have get very significant that we don't have the benefit, if that's the right word, of the volume that has come from consumables in the space that majority of grocers have had a very big uptick on what you would call paper products and bleaches and all the obvious things that have come flowing through in that. We are not really in that space, although we have got some interesting offer in there. It's not something that's at the core of our business and so we are not getting the benefit there. And the other piece of our business is, we have taken out salad bars and we have taken out soup and we have taken out olive bars. And we have restricted our bulk offer because of the amount of utensils that are involved in it. So if you take those categories out of it and you take consumables out of it, we think we are faring pretty well in the market.

Okay. That's really great color. So I have one more short term and then a little bit of a longer term strategy question. Everyone's obsessed with the SG&A and whatnot. But incremental margins have generally been about 15% on extra sales. As we think of you guys going forward, is it going to be way lower than that? Or is it going to be somewhere near that? Or how are you thinking about the incremental margin on extra sales? And then I had just one last one on produce pricing.

Well, the margin really, what's been happening in margin over the last little while, as you know from the pre-COVID world, we were significantly enhancing our margins by being much more thoughtful about our promotion investments. And that continued in the first two months of Q1. And then into P3, we had the COVID dynamic, which changed it a little bit. The COVID dynamic enhanced the margin even more and I think we quoted in our numbers what we thought pre-COVID. Post COVID, we obviously pulled back a lot of advertising because having the inventory to be able to support promotions became a real challenge. That naturally enhanced margins and it will have done for the industry as well. The high topline that we had clearly enhanced shrink, which enhanced margins and that flowed through pretty well. The mix, our mix actually enhanced a little bit and Denise said in her remarks how the mix gets a little bit better because of vitamins and supplements, which has been a real strength for our business, particularly in March. And we have seen our grocery business has been strong as well, which for us, is an enhanced margin mix for us. So we are seeing some positives in that. And I think what's happened, when you are a more fresh-dominated business, when the restaurants kind of pulled back, there was a lot of availability of low-price inventory, which we were helping the farmers move through. And I think we have played a pretty good role in helping the restaurant and helping the inventory that was going to restaurants in fresh foods that we were probably better placed to take advantage of than some of our competitors or some of the retailers that are operating in the grocery space. So those five things, some of them will be real for a long time, some of them won't be real for a long time. So it's difficult, again, for us to predict the margin going forward. But I would be very comfortable that we will be able to deliver on where we were pre-COVID on the margin growth going forward, if not beyond that.

All right. Perfect. You know what, I am going to yield. I appreciate. I will take the pricing question offline. Thanks. Appreciate it.

Thanks.

Thank you. Our next question will come from Rupesh Parikh with Oppenheimer. Please go ahead.

Good afternoon and thanks for taking my questions. So I also have a shorter term and then a longer term. So I know you aren't providing guidance going forward. But if we see a comp similar to the April level, would there be enough leverage to drive positive operating margin expansion even with the higher level of cost?

Yes. I think as I mentioned in my remarks, I think that at the moment, we think that for the full year, we will be able to meet or exceed what we previously guided. And then talking about Q2, I think that, as I said, we believe that we will not see the operating margin improvement that we saw in Q1. If we have elevated sales levels, it's still reasonable to believe that we will see operating margin at or better than last year in Q2.

Okay. Great. That's helpful. And I guess just going back to your addition of store pickup recently. Is there a way to help us understand, if you look at stores that have had store pickup versus stores that haven't, what type of comp difference are you seeing between those two different classes of stores?

Well, the increase in the 55 stores that we had was fairly substantial. The reality of it is, the rollout of programs literally just had. There's some stores, I think we have got 40 more stores to finish, just I am looking at --

Yes.

For a nod on that. We have got about 40 more stores to finish to get to 340. But these have literally just happened inside the stores. It's very clear from the 55 stores that we are seeing an uptick. It was very clear we were seeing an uptick on the delivery program, as we mentioned the numbers on e-commerce going forward. So I think we took the view that it was something that the customer would be wanting from us as part of the challenges on social distancing. And we think it's something that's going to be measurable going forward. Exactly what that number is going to be, I am not sure. But I am sure it's going to be more than what it was before we started.

And in the very immediate term, we have seen generally a leveling out of the delivery portion of the business. We mentioned that it was 13% of the sales in April. With the rollout of the pickup portion of the business, that piece is still increasing in its contribution to the overall sales.

Okay. Great. And my last question, just on the longer term. How are you thinking about price investments in your commentary that you believe you can expand, have stable to expanding EBIT margins?

Yes. I think as I have said in previous calls, I fundamentally believe that our assortment and our products are such that it's very hard for us to have comparative pricing and invest in products because the key to us is differentiation. And as long as we have got value within that product that we are putting in front of the customer, the elasticity of demand will reflect what we need to do in terms of investing or what we need to do with our margin. We are very clear that the important categories for us, we are investing in the right sourcing resource, both in terms of the big plays around how can we work on differentiation around varietal development in produce, breeding development in our meat business and really getting ahead of the plant-based trend that these products will be different for us and we won't be under the kind of -- the focus on pricing will not be the way it would be if I was sitting in another grocery business, looking at other grocery business' comparative pricing. It's hard to compare us. We have got to have great value and we will judge great value by the elasticity of the products that we have. And that was working pretty well for us at the start of Q1. And then the whole kind of world's changed a little bit from March. But that's certainly the program that we will be following going forward.

Great. Thank you.

Thank you. Our next question will come from Ken Goldman with JPMorgan. Please go ahead.

Hi. Good evening. Thank you. I wanted to ask about a couple of areas of your store and whether you are able to either take advantage of some dislocations or whether you find there to be some challenges. And what I am asking about in particular is produce where we are obviously all seeing stories of some produce being unfortunately thrown out rather than sold and then the meat side, where we are all, of course, hearing about some labor issues and plant closures, which are leading to some shortages. So just wondering how you are dealing with those? What some of the headwinds and tailwinds have been along those lines? Thank you.

Yes. Good question, Ken. I know it's kind of very live in terms of how we are thinking about things going forward. And it kind of highlights the reality of the last few weeks for us all, is that things change from one week to the next, from one day to the next. And the meat thing really did kick off dramatically in terms of excess demand in the middle of last week after the executive order was put in place which highlighted the potential shortage of supply in meat. The great thing for our business is we tend to have our own supply base. So we have got a pretty tight supply base that works directly with us. We don't need the extent of pre-packed meat. That is very much a feature of a lot of the grocers where they have deconstructed the meat business in the back of the store. So there's not as much butchery, not as many butchers and not as much, if you like, creation of product within the store. So we are pretty well placed in that we have got a really strong team. We are really proud of the butchers and the way they have operated right the way through this crisis in terms of taking on board some real discipline in terms of how they operate in procedures and giving customers real confidence that there's hygiene in place that needs to be in place. So we have weathered it pretty well, although demand has been pretty dramatic over the last few days. And if demand keeps going at the rate that it's going, you will have shortages in meat. But it's supply, we are not so worried about. It's the level of demand that we have got to kind of manage ourselves. And we think we are well placed to manage that by having our own butchers. With regard to the produce side of things, it's kind of pretty sad. I was listening to a congresswoman from Florida talking about Florida, in Florida with some produce potentially going to be thrown out. And our team really aggressively spoke to the Florida Produce Association and quickly moved that product into the stores. And obviously, at pretty low-cost prices, but we got this thing moved and got it into customers' hands. And we will be aggressively looking for ways to support local farmers as farmer's markets have kind of wound down across the country. We are really well placed to sell a lot of produce. And that's worked well for us being responsive and supportive of the local source of produce supply. I think we are well placed to do that. And we structured ourselves to be able to do that better than we maybe would have been able to do two or three months ago.

Okay. Thank you very much for that. And then a follow-up for me. I may have missed this, forgive me if I did. Did you guys address whether you have gone any further, made any concrete conclusions about what you are going to do with the deli business in your stores? I know there were some debates internally about directions to go there. I just didn't know if you had finalized anything on that side.

Well, specifically on deli, we clearly invested a lot of space and a lot of cost into the deli and what worked in our new format stores. That level of investment, that level of space, we will wind back. And so that will be a big part of the better utilization of space going forward. The deli business and if anything the COVID world has got us thinking very hard about how effectively we are going to provide, if you like, meals-to-go, ready meals, that kind of sector, something that we will be doubling down on how best to achieve that because in the post COVID world, it feels to me like the restaurant businesses are not going to rush back, not going to come back anytime soon, certainly aggressively anytime soon and that there's an opportunity for us to do the right thing in that environment. We might not have thought that so assertively pre-COVID. But post COVID, there is a way of doing this outside the store and creating really good products for customers that allows them to fulfill these needs. So early days, but more to come on that going forward.

Thank you. Our next question will come from Paul Trussell with Deutsche Bank. Please go ahead.

Thank you for taking our question and good afternoon. I know you are not giving forward guidance as it relates to same-store sales. But as we think about the second half of this year, right, I am curious to know if you believe that the right thought process is that the business will be trending back towards a 1% or so kind of comp level, which it sounds like what you were doing kind of pre-COVID? Or is your view that the initiatives and strategy that you have just outlined in terms of marketing and merchandising plans or perhaps what's still going on across the broader environment from a food at home standpoint or as you mentioned, customers being introduced or reintroduced to your stores that you will, going forward, be at a little bit of a higher trajectory or run rate from a topline standpoint, even as this kind of pandemic starts to be behind us?

Paul, I think the simple answer to your question is, I wish we knew, right? I think that we are all watching what's changing in the environment very quickly. And I think that while, whether COVID is in place or not or stay-at-home orders are in place or not, we are seeing some goodness in new customers getting introduced into our stores or customers kind of reintroducing themselves to us. But in terms of where will we even be with stay at home and the volume of demand that will still be not in restaurants and still centering around home is really the part that we just don't know. So I think that we feel good that our strategy is going to keep pushing. If anything, COVID likely accelerated some of our ability to communicate with some of our customers just because they needed another outlet for food. But at the end of the day, it's really, it's a bit of a wait and see right now.

Yes. And just to reinforce that, I think I don't know if we will ever come back to a post-COVID world that looks like a pre-COVID world. So it's difficult for us to envisage that. I do believe the trends on e-commerce and the trends on restaurants will be in a post-COVID world. So what that will mean for our business, we just don't know. And that's the reality of it.

Understood. As it relates to the slide, I think it was 20, in your long term plan, you spoke to stable to expanding EBIT margins and gave a kind of list of items that will contribute to that. I would say that it's very comprehensive and easy to understand what will transpire on the new store front. Just curious if you can get a little bit more detail on the actions taking place and the timetable in which you will impact all the stores as it relates to improved volume, the optimization of the supply chain, labor productivity, et cetera?

Yes. Let me start with a few comments, Paul and then I am sure Jack will jump in with some additional color. When you think about smarter promotions and improved buying, that's the work we have been doing. That is the work that Jack and the team started before I joined last fall. And I think that that will only continue. And as we continue to think differently, in particular with our produce buying, with having both centralized and local resources to really take advantage of the best opportunities, I think that's an ongoing piece of work but one that has certainly already started and we have referenced a number of times as being part of the benefit that we are seeing now. On supply chain optimization, we talked about Florida and Colorado DCs. We hope that we will have both of those in place by early next year. And as those come online, they will very quickly start to help transportation costs, which is really a key part of the benefit that they are going to provide to get much closer to our stores for all the outbound products. So we will get transportation benefit and freshness benefit at the same time. A lot of the labor productivity changes are more likely to come along as we roll out initiatives that will be a little bit longer term in nature. So probably not next week or next quarter, but more out a couple of years in terms of the options we will take there. One example of things that we are testing right now is we are testing self-checkout. We will test and read that. But if that would be an initiative, we would be able to push on that one. So those are probably a little bit longer term in play. We are working on shrink right now with the fresh item management program that we have got as well as a lot of other processes that we are working on in the stores and we are starting to make some improvements there. But once again, a bit of a longer term play. So not next week or next month, but hopefully in the foreseeable future. And then e-commerce and the labor and benefits costs are just real to us now. So that's kind of embedded in the numbers, assuming that they are here and here to stay. Does that help?

And just to reinforce that, the supply chain optimization will help us both in terms of shrink as well because the product, fresh product taking less time to get there, we will be able to get a much better flow-through of the product, not throw so much away. And I think that's something that we can see potentially already some benefits coming through in the way we are thinking about it. But once we get shorter distribution channels, I think this will dramatically help our business toward the end of the year, beginning of next year.

[Operator Instructions]. Our next question will come from Judah Frommer with Credit Suisse. Please go ahead.

Hi. Thanks for taking my question and for all the color. First, I just have kind of a high level question, kind of squaring some of the COVID-related comments with the longer term plan. It does sound, as you kind of reset your sights on a new target customer, that maybe you are more focused on a specialty type store customer when historically the Sprouts story has been, our key competition is the conventional grocer. So how do I think about kind of that potentially narrower customer building as big a basket going forward as maybe they are during COVID, given your limited SKU offering and kind of, like you said, the fact that you don't offer those national brands?

Yes. I think if you really look at the segmentation, first of all, I believe there's going to be more customers like the customers we are targeting because of a post-COVID world. People are more interested in healthy eating. People are more interested in -- we are seeing it in our grass-fed beef sales, we are seeing it in our antibiotic-free chicken thing. Things that are perceived as healthier, more people are going to be interested in that in the post-COVID world. And our vitamins and supplements business is performing very well which, again, I think with immunity and people thinking more about these things, I think there will be more people within it. But in the slides that we went through, we need a very small number of people extra and there's plenty of them out there. If you can see that slide, it shows a sliver of market share that we need to grow the business going forward. I wouldn't describe it as specialty. I would actually describe it as complementary. I don't see it as directly competing. Maybe that's the difference, directly competing with the grocers for traffic. We are directly competing with people for their food spend and I am very confident that there's enough people there for us to more than achieve our ambitions. Whether we are defined as a specialty grocer or a grocer, I am not sure what we are, but I am very clear that the target customers are there for healthier and very bespoke products that are created for the benefit of those, that target customer base.

Okay. That's helpful. And just changing gears for a second. Given the ramp in e-commerce activity, to the extent you can, can you help us with kind of pre-COVID and maybe during COVID, the profitability on your online baskets? Obviously, they are dilutive to margin, but have you been making money on your home delivery baskets? And does that change with pickup? And then separately, how much customer data are you capturing, dependent on how you access the customer, right? If it comes through Instacart's app, what are you getting versus how many are coming through your owned website and app properties?

Yes. Overall, when we saw the uptick in e-commerce demand, I think the first thing that we would reach out and say is, we are so proud of our team members. We are so proud of our Instacart team members who are really stepping up and being able to try to chase this demand that was coming through to serve the customers that we needed to serve. Almost overnight, you start to see those orders increase. And to get capacity to service those is no small feat that is out there. The majority of our sales still come directly through the Instacart platform. So while we have some visibility to information on those shoppers, we don't have the visibility as much as it came directly through us, which is an opportunity that we will always continue to look at for the future. So I think from that bigger strategic point of view, we are working on that piece. More broadly on the profitability, we definitely make money on our e-commerce business, both pickup and delivery. So it is a slightly lower-margin business because there are some additional costs that are paid through the system for that, but it is a profitable business. And we are really pleased that with our pickup business, we are really doing this hybrid structure that is letting us leverage our own team members that, if anything, because of their knowledge of the stores, should be that much more efficient at picking orders than what our Instacart partners would be. So really leveraging the best of both worlds of getting capacity and some additional expertise in the store.

Yes. And the baskets are much, much bigger with those customers. That's one of the things that is pretty encouraging in terms of that, in terms of we have the assortment and the product mix and the product range that really does attract that can attract big baskets, which is pretty encouraging as we look to the numbers going forward. But we have got more work to do in terms of understanding our customer. And we will be doing a lot of work over the next few months and years about how we can better really understand the customers that we have. Not having a loyalty card means we don't have as much data as I would want us to have going forward.

Thank you. Our next question will come from Chuck Grom with Gordon Haskett. Please go ahead.

Hi. Thanks and good afternoon. I hope you guys are well. Can you speak to the cost to build out the three new DCs over the next few years? And then as a follow-up, can you remind us on how many of the smaller store concepts that you have tested in? You are expressing a lot of confidence that you can hold sales on a store that's going to be about 20% smaller. Just wondering if you can speak to any test concepts that you have done so far?

Well, we have got some test concepts written down on a bit of paper. We haven't opened any specific ones. But the great confidence we have is, we have got stores that are that size all through our fleet that are doing higher sales than the bigger stores. So the economics are kind of already in our business. It's not like we are reinventing the wheel here. We will do some things that are going to make it more appropriate and better at maybe handling the pickup in e-commerce side of the business. We will probably do a better job in terms of making our meat business come alive. But in essence, we have got the stores in our population. So it's not that I need to go and test anything dramatically. We just need to make sure we go back to where we were. It's going back to the future, if you like, going back to what we have done in the past. And those numbers are more than enough. What we have got in our existing fleet are more than enough to what we need to do and that's encouraging going forward.

And on the DC side of things, the opportunity for us to expand and put the two DCs out there in Florida and Colorado comes with a very high ROI. And what's unique about these DCs is they are primarily produce-oriented. So they are not incredibly high cost to build. Think millions of dollars, not tens of millions of dollars to put in place what we would need for these DCs. And the benefit that we get in transportation, because of how inefficient our supply chain has been, quickly returns the cost that it will take to build these out and get them stood up. So definitely think about this as a nice, simple, fresh DC. This is definitely not a high-tech complex DC to put boots on the ground.

And just from a timing point of view, Florida and Colorado will come before the mid, we have not nailed exactly what we are going to do in the Mid-Atlantic yet, but we are very clear about Florida and Colorado. And hopefully, that will be up and running start of next year.

Okay. Great. And then just one near term for me. Just wondering if you guys could just unpack the components of the gross profit margin performance in the quarter between better promotion, efficiency in mix and then shrink? And then I guess, looking ahead, would you expect that level of performance to continue into the second quarter and likely to offset some of the increased costs that were asked about earlier?

Yes. So let me address Q1 first. So we talked about on the call, we were doing well pre-COVID with really doing smarter promotions and in the way we were doing our buying, driving the vast majority of our gross margin improvement. And we mentioned on the call that that was upwards of 100 basis points of improvement in gross margin. So think about that as the normalized improvement we were seeing from promotion and product buying as we were working through those early parts of the quarter. On top of that, then when you layer to where we ended the quarter, the big drivers that we had there were we did see lower shrink. We had higher sales, faster turning sales and, in turn, lower shrink as we saw elevated volume. We were and needed to, reduce some promotional intensity during those peak stock up weeks because, at the end of the day, we couldn't go out there with a promotion that we didn't know that we would be in stock on to be able to service the customer throughout our stores and throughout our network. So in some cases, we very much simplified the promotional offering to what we knew we would be able to deliver to our customers. And then as we mentioned, there was a bit of mix favorability for us during that stock up in COVID because of grocery, vitamins and frozen, which for us are more profitable categories. And sprinkle into that a little bit of leverage that comes with an almost 11% comp and that really got the incremental 80 basis points or so in terms of getting gross margin to 180 basis points up year-over-year. When you turn to the second quarter, I think the color of a lot of the levers is still real. We are going to continue to work smarter promotions. We are going to continue to leverage the produce buying that we can do. And with the supply that is out there, leverage that locally where we can so that foundation remains. If we continue to see elevated sales, we would expect that shrink would still be a bit of a help as well. And then other things will start to balance themselves out, right? We have shifted our mix back to a bit more produce, a bit more meat, which are a little bit lower margin, so you probably won't see a mix gain, but you wouldn't have seen a mix loss. So net net, I think that we believe that some of the trends will continue. But I would argue that in Q1, that COVID impact was just a very outsized impact, particularly in the last three weeks of the quarter.

Thank you. Our next question will come from Greg Badishkanian with Wolfe Research. Please go ahead.

Good afternoon. This is actually Spencer Hanus, on for Greg. My first question is just for the stores you have in markets that have already started to reopen, think states like Georgia, can you talk about the sales trends that you are seeing there?

It's an interesting question, Spencer. We have been watching it really closely in terms of the dynamics. The two places that we have got a decent store base where things have changed a little bit in the last week or so are Texas and Georgia. If anything and it's so early to say that I am hesitating to be too bold about it, but in Georgia, we have not seen really any difference in customer behavior. There's still a lot of reluctance to kind of go into the stores have not changed. The traffic trends haven't changed. The basket trends haven't changed. Maybe in a little bit to Texas, we have seen a little bit of a difference but not much. And even different jurisdictions, it's interesting how different jurisdictions are doing different things at the moment. There's one county in Texas that said they are not going to go back until May 15, what does it say, May 15?

End of May.

End of May. So I think it's too early to say. But my gut feel is that the customer isn't moving as fast with the changed orders.

Got it. That's really helpful. And then switching to online, how sticky do you think the incremental customers that you are getting in that channel will be going forward?

I am sorry, could you repeat that? You kind of broke up a bit.

Yes. For the online customers, how sticky do you think they will be going forward?

So I think we don't know what we don't know. We know that folks early on are online ordering. As people were ramping up capacity, were ordering out of necessity that they didn't want to leave their homes. We are hoping that they have had a good experience and they want to think about sticking with us to do that. Not enough data behind us yet to really have a good sense of what that looks like for now.

But we are hopeful that as people experience the products that we have got and the brands that we have got, they are going to be sticky. That would certainly be, the implication of what's happening is the people that are accessing our brand in that way are in that bracket of customers that we are targeting. So they are likely to stay with it, provided we continue to do a good job for them.

Okay. Thank you.

Thank you. And our final question would come from Mark Carden with UBS. Please go ahead

Good afternoon and thanks a lot for taking the questions and thanks for squeezing me in. So how do you guys think about SKU substitution in this environment? Would you consider stocking more conventional items in this environment, if it's particularly challenging to keep up in stocks in any categories? And have you seen any major changes to your private label penetration since the virus broke out? Thanks.

Yes. Again, good questions, Mark. In terms of would we go to a lot of the more conventional products? Probably not. We haven't had to at that point. If we had nothing in the store, I suppose we would have to think about that. But just at the moment, I think we talked about in our remarks, because our assortment is a little bit different, we are not battling against the big guys, the big club channels or the big mass channels in trying to access branded inventory that the other grocers are chasing after. We have got our own bespoke product assortment, which I think has stood us in good stead for a little while. The private brand side of it has been a little bit more challenging as some of the private brand manufacturers coped okay to start with and then started to come under pressure, which has caused us to go and look for other alternative brands but very much in our type of space, the organic, very natural and organic space as opposed to mainstream conventional products. So we are having to do some substitution. We are under pressure in a few categories, as you can imagine. And private brands, we are having to be more flexible than probably we would like to be. So that's the nature of just supply chains at the moment across all sorts of different categories and products and industries.

Great. That's helpful. And then you mentioned e-commerce penetration reached 13% in April. Does the virus outbreak change your thoughts on where online grocery penetration could ultimately be for Sprouts? And would you expect to ultimately have to take on any major upticks in CapEx down the road for things like micro fulfillment or really any other capacity enhancing options? Thanks.

Again, good questions. Yes, we do believe e-commerce is going to be bigger than it would have been. In my mind, it's bigger than it would have been. I think e-commerce generally has accelerated across the United States for grocery. I think they have probably gone forward four years in four weeks. And that, whether I think it will stabilize though, looking at some of the data coming out of China, what happened was there was a peak. They were operating at a level. They went off to a dramatic peak and it's actually come back down again to a more measured level. What will exactly happen in the industry or in our business, I am not quite sure. But we will have to make sure that we are capable of effectively servicing a bigger e-commerce business going forward. And that will involve us looking at all the different strategic options around how you fulfill, how you deliver, how you pick, how you handle the last mile. And we are in the middle of doing some work on that at the moment. But having said that, I was really pleased. I would reinforce what Denise said. I was pleased at the way we were able to jump on the pickup thing and move from 55 stores to 344, literally in the space of a few weeks. And the team did a good job on that and the customers are reacting, at very early days seem to be reacting well to that.

Great. Thanks again guys

Thanks Mark.

Ladies and gentlemen, thank you for participating in today's question-and-answer session. I would now like to turn the call back over to management for any further remarks.

Hi. Thanks so much for just taking time to listen to us today. I know there's a lot going on and a lot of you are in the East Coast. And I really appreciate you taking the time and showing some interest in our company. It's a very unusual time for us all in terms of the way we are working and the way things are going. So I really want to thank. I want to thank you for doing that and taking the time to do that. I want to take the opportunity of thanking our own team for all their hard work and all the things that came together on that. And stay safe guys, look after yourselves and look after your families. Thanks ever so much.

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.