Vitamin Shoppe, Inc. (NYSE:VSI)
Q2 2017 Results Earnings Conference Call
August 9, 2017 8:30 a.m. ET
Executives
Colin Watts – Chief Executive Officer
Brenda Galgano – Executive Vice President, Chief Financial Officer
Dan Lamadrid – Senior Vice President, Chief Accounting Officer
Analysts
Sean Kras – Barclays Capital
Shane Higgins – Deutsche Bank
Stephen Tanal – Goldman Sachs
Chris Horvers – J.P. Morgan
Peter Benedict – Robert W. Baird
David Schick – Consumer Edge Research
Operator
Good day, ladies and gentlemen, and welcome to the Vitamin Shoppe 2Q ’17 Earnings Results Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to today’s host, Mr. Dan Lamadrid, Chief Accounting Officer. Please go ahead, sir.
Dan Lamadrid
Thank you, and good morning, everyone. Earlier this morning, we released financial results for second quarter of 2017. A copy of our earnings release can be found on our Web site at vitaminshoppe.com in the investor relations section. Making presentations today will be Colin Watts, Chief Executive Officer; and Brenda Galgano, Chief Financial Officer.
Before we begin, I need to remind listeners that remarks made by management during the course of this call may contain forward-looking statements within the meaning of the Private Litigation Reform Act of 1995 about the company’s future results or plans, guidance, strategies and prospects. These are subject to risks and uncertainties that could cause the actual results and the implementation of the company’s plans to differ materially. The words believe, expect, plan, intend, estimate or anticipate and similar expressions, as well as future or conditional verbs, such as should, would and could, identify forward-looking statements. You should not place undue reliance on these forward-looking statements, and we expressly do not undertake any duty to update forward-looking statements whether as a result of new information, future events or otherwise unless required to do so by law.
During the call, we may refer to non-GAAP figures. We have provided a reconciliation for these numbers in tables 4 and 5 in the press release. We refer all of you to our filings with the Securities and Exchange Commission, including our annual report on Form 10-K as well as our quarterly reports on Form 10-Q for more detailed discussion of the risks and uncertainties that may have a direct bearing on our operating results, our performance and our financial condition.
I will now turn over the call to Colin.
Colin Watts
Thank you, Dan. Good morning, everyone and thank you for joining us. I will start by providing my perspective on our second quarter 2017 results, focusing on the drivers of that performance and what our plans are to improve performance going forward. Brenda will then give financial details about the quarter and guidance for the remainder of 2017.
Our guidance will focus on the critical drivers of our business in the context of the day-to-day volatility we expect will continue for the remainder of the year, which has made the challenge of forecasting the broader market very difficult. So to begin with, our second quarter results were below our expectations as sales and particularly customer traffic, worsened, primarily driven by our sports category which accounted for 70% of the comp decline. Our Q2 performance showed an acceleration of some of the price and promotional issues we began to see in late 2016 and early 2017, in particularly sports related categories, which have been exacerbated by historically high level of competitive activity in the category.
Our top line softness is offsetting our achievements on the cost savings improvement front and the progress we continue to make in terms of our reinvention. Needless to say, our entire leadership team is disappointed with our recent business performance. At the same time, we are highly focused on the launching of new programs that have been in development for a while, which we expect will address many of the challenges we have been experiencing. In fact, while early, we are already seeing progress in our Q3 numbers that we are beginning to change the top line momentum of the business, improve our customer acquisition rate and starting to turn around our performance.
During the second quarter, we were impacted by a combination of factors, some internal and largely external, driven by an increased level of competitive spending that have a negative impact on our traffic. As we look at the issues, it became increasingly clear that our level of marketing spend and promotional offers have been insufficient to drive our forecasted rate of customer traffic. Our analysis has shown that our lower traffic was due to lower customer acquisition and retention rates versus prior year. On the pricing front, there were some categories where we were not as competitively priced as required in today’s evolving omni-channel environment.
Finally, we have seen a growing opportunity in our customer base to greatly enhance loyalty and lifetime value of our customers by introducing a major innovation around subscription based fulfillment, which we have now launched across the chain and I will describe in more detail later on this call. As I mentioned earlier, we began to see erosion in both traffic and customer perceptions of our price value, particularly in the sports related categories late in 2016 and accelerating in the early part of 2017. At that time, we launched several pilot programs designed to help us better compete. As we have discussed on earlier calls, these strategies were designed with solid analytical rigor, but also focused on today’s customer requirements and the market. I will provide more detail around three major initiatives that have been rolled out across the chain in the past 30 days.
Let me begin with customer acquisition and traffic. As I said earlier, almost 75% of our sales decline in Q2 was attributable to reduced traffic year-over-year, driven by a historically high level of competitive marketing spending. In response to this competitive surge in spending, we have taken steps in the back half of 2017 to increase our focus on our best customer prospects and plan to increase our marketing spending, both at the grassroots store level as well as online.
Over the past year, when we have combined our customer acquisition efforts online in both paid search and social media with efforts driven by our store teams at local market events, we realized growth in new customer acquisition, up 25% in our most successful quarter in 2016. We are also making key upgrades to our Web site to boost both traffic and conversion and we are already seeing improvement in relevant customer acquisition metrics, which support our decisions to continue to fund increases in our marketing spending through the back half.
Let me move on to price value and empowering store selling. We mentioned on our last earnings call, that we were in market with a sizable pricing test based on our broader view of the competitive market both at retail and online, to help the Vitamin Shoppe better address price value concerns of our target customers. Our analysis showed that we were seeing slippage in our price value customer perceptions against other specialty competitors, and even more significantly against online competition over the recent period. There were three significant strategies that were tested in the pricing area across multiple stores and online that had strong traction and performance impact over the past two quarters in the pilot test.
The first was a new key value item or KVI pricing strategy, where we reduced prices across the most penetrated and the most price elastic SKUs in our portfolio to bring us into better alignment with market pricing. These SKUs were across multiple categories, but weighted toward the sports category. The KVI pricing strategy has resulted in a realigning of our price value to a more competitive level in today’s market. We also saw during the test, that better traffic and broader basket purchases with our customers helped us build back margin dollars over the four months of the test so far. In addition to KVI pricing, we introduced two new pricing programs in our stores with strong customer benefits as well as stronger sales support for our Vitamin Shoppe health enthusiasts.
The first of these was a competitive price match that empowers our health enthusiasts to be flexible to work with customers, to ensure that any concerns that our customers may have about retail price comparisons to other retailers, whether online or in bricks and mortar, would not be a barrier to completing a sale on any customer visit. The second change is a hassle free return guarantee that will make it easier than ever for our customers to return a purchase that they have made at our stores or on our Web site. We are encouraged by the results of the overall test program versus controlled stores.
During the four month test period, unit sales were up 5%, transactions were up 2%, comp dollar sales were up 2%, and importantly, the margin dollar impact of the entire program was positive. We also found that customers in the test stores were more likely to progress to a higher engagement state, meaning they’d spend more and visit more and were much less likely to attrite. This entire bundle of new services has been launched across the chain and is being marketed to our customers under our brand new, shop with confidence, banner campaign. I can tell you that the announcement of this new program to over 800 store managers and field leaders at our annual national conference in July was greeted with enthusiasm. Our front line leaders recognize that this new program empowers them with more tools to deal with the new competitive landscape and build and maintain their relationships with their customers.
Moving on to the area of customer retention and Auto-Delivery innovation. The final area that we are addressing is long-term customer retention. Over the past year, there has been a steady upward trend in interest from our wellness customers for better value and convenience for the supplement brands and related items that they regularly purchase. Our recent market research, particularly with our younger customers, showed a strong uptick in interest in subscription based fulfillment in our category, offering better convenience and savings to our loyal customers.
Capitalizing on this new insight, over the past several months we have designed a differentiated subscription service called SPARK Auto-Delivery, that we are rolling out to our customers both in store and online as we speak. The program fuses the best of the Vitamin Shoppe customer experience with the convenient benefits of delivery to home. SPARK Auto-Delivery offers a 10% discount to customers off our best price, double our Healthy Awards loyalty points, a free quarterly discovery box that offers personalized sampling and unique content benefits. The program also features a highly flexible sign up and adjustment capability that allows customers to tailor the subscription on the fly via Smartphone, online or in store.
Over the course of our pilot program, we saw a rapid uptake from customers of SPARK Auto-Delivery with strong metrics. On average, sales behind the program were 60% incremental in the first three months, and for those customers on the program for six months or more, we have seen that number increase to 90%. At the same time, we are introducing a new omni-channel incentive program for our store health enthusiasts, whereby our store managers will be incented based off of all sales attached to their customers regardless of channels.
Finally, I want to provide an update on a few other key aspects of our reinvention progress that we’re going to be leveraging over the coming months. On the cost front, I want to point out that across our entire organization, we have continued to step up our focus on cost reductions. We are seeing the benefits from these initiatives, although slower inventory turns have delayed the full realization in our 2017 P&L. We have made significant improvements in key areas, such as sourcing, Nutri-Force restructuring and our supply chain, that are critical as we align our cost structure with our business requirement. Brenda will go into more detail about this in just a minute.
In addition, we’ve been focusing on strengthening our share of wallet. By the first half of 2018, we will be bringing online several key elements geared towards further strengthening our relationship with our customers and driving greater share of wallet. The first is our new customer relationship management platform taking advantage of our six million active loyalty members who drive 90% of our revenue. The second is a major upgrade to our Healthy Awards loyalty program in early 2018. And finally, we will take full advantage of our new east coast, west coast distribution presence with our new DC, which will provide a significant improvement in delivery times and expenses to our customer’s homes. Each of these programs will continue to help us drive toward a stronger omni-channel retail presence with our target customers.
On the storefront, it’s been almost a year since the first brand defining store opened in August of last year. During the second quarter, we had an additional ten stores operating in this format. While still early, for the first BDS stores that have been opened for six months or more, we are seeing a 500 basis point lift to comps relative to the rest of the chain. New customer acquisition in these stores is up significantly compared to the rest of the chain as is our customer satisfaction. Some of the big category wins in these stores are in the on-the-go category, weight management category and protein, categories that have not been performing as well across the balance of the chain. Additionally, as we’ve flowed an improved assortment set in several brand defining stores in Q2, we saw a further improvement to margins against the control group.
We are also seeing higher growth and penetration of private brands and improved margins in our VMS products in the brand defining stores. Some of the key new elements in these stores are having a positive impact to performance including our Kombucha bar on tap, our fit freezer and cooler section, our SPARK workshops and nutritionist consultations, as well as these new assortment changes that run across roughly 60% of our major categories. With the good results that we have been seeing on these key elements, we are rapidly expanding them to over 80 stores by the end of this year. And for the stores where we have already introduced these elements, we are already seeing positive results. So in sum, although still early, we are pleased with pilot brand defining store results. We are working to optimize some other items in these stores such as labor and the capital investment behind the stores and we plan to provide a broader BDS refresh strategy tied to our 2018 plan.
Lastly, on the business development front, I’m pleased to welcome Bill Wafford, as our new SVP of Strategy and Business Development, who joined us from KPMG. Previous to that time, Bill worked at both Walgreens and Target. Business development is a major area of focus for us as we position ourselves to be relevant to consumers in the rapidly changing retail environment. To that end, we recently formed an exclusive brand incubation partnership with healthy natural solutions starting with their new line of supplements from Canada. HNS is the first company in our new platinum vendor program, but we expect to see several more in the coming year. You can expect to see partnerships, licenses and strategic integrations as a larger area of focus for us in the coming year.
So let me sum up before I hand it over to Brenda. Our Q2 results were disappointing and my team and I understand that we need to move even faster to change the trajectory of the business. We are making smart, strategic and measured investments in the business that we expect to improve top line performance, but in the short term some are expected to have a negative impact to margins, which Brenda will discuss in her presentation so you can better understand the impact. These are necessary investments to win back customers and ensure future growth and to continue to adapt our business model to our changing consumer behavior.
I’ll now turn the call over to Brenda to take you through the second quarter financial results.
Brenda Galgano
Thank you, Colin, and good morning, everyone. I’d like to review our financial results for our most recent quarter and then cover our latest outlook for the full year of 2017.
Let me start with a quick overview of earnings. On a GAAP basis, the loss per share in the quarter was $6.73, driven by goodwill and store impairment charges totaling $168 million. These two items accounted for $6.61 loss per share. Adjusting for those items as well as the restructuring costs for Nutri-Force, EPS in the quarter was a positive $0.23. The second quarter 2017 EPS was also negatively impacted by $1.2 million from a discrete tax charge relating to changes in accounting for stock compensation and other permanent tax differences, which was not included in our guidance last quarter. The reconciliation for these items is shown in table 4 in our earnings release.
As Colin already expressed, our overall results and more specifically sales, were a disappointment. Comparable sales were down 8.3% predominantly driven by a reduction in traffic. An estimated 1.6% of this decline is due to the cycling of last year’s storewide buy-one, get-one, 50% off promotion in late May, which helped sales but not profit. Adjusting for this program, sports was down 10% and VMS was down 1%. Our vitaminshoppe.com sales were down 20% in the quarter also due to traffic issues tied to challenges with both SEO, search engine optimization, as well as a pull-back in our promotional spending. In addition, approximately 8% of the orders generated from our Web site were picked up in-store, negatively impacting vs.com year-over-year sales by 2%, as those sales are credited to the stores.
The quarter began weak with April comps down 6% and then further declined in May, down almost 11%, before we saw a lessening of the decline in June. As the new sales driving program Colin described has moved from pilot to companywide launch, we are realizing better comps early in the third quarter. Our private label brand penetration is up 95 basis points in the quarter to 23.5% with particular strength in categories like True Athlete and ProBioCare. Our new product pipeline is robust. We’ve been working on several new SKUs and product line extensions that will be flowing into our system beginning this month, which we believe will be well received by our customers.
Moving on to Nutri-Force. We continue to make progress to stabilize this business and we are meeting our time lines to do so. We’ve installed new productivity measures, have finished our customer review and are working to align overheads. Total sales were up 12.4%, driven by strong growth in sales to Vitamin Shoppe, which increased 64% in the quarter. By contrast, third-party sales were down 28% in the quarter, partly attributable to our SKU rationalization program as part of our restructuring plan. Excluding restructuring costs of $13.7 million pretax, the operating loss at Nutri-Force during the quarter was $2.2 million compared to an operating loss of $1.8 million in the second quarter of last year.
We expect improvements in operating trends as we continue to reduce the complexity of this business and transition more of our private brand production in-house. This restructuring activity should be substantially completed by the end of this year, and at that point we estimate that third-party sales should run at approximately $15 million on an annualized basis.
Moving down the P&L. Excluding $10.7 million of charges relating to Nutri-Force, gross profit margin declined 48 basis points, driven principally by deleveraging. More specifically, the factors driving gross margin performance during the quarter were as follows. Product margins expanded 165 basis points year-over-year, this includes an estimated 70 basis points of favorability from cycling last year’s unprofitable BOGO promotion mentioned earlier. Favorable product category mix shift, including the impact from the growth of private brands, and early benefits from vendor partnerships contributed to the rest of the growth.
Lower sales resulted in lower inventory turns and lower inventory purchases, thereby delaying the timing of the realization of cost of goods sold savings initiatives. Although the timing of the savings is a little slower than originally expected, we continue to expect an overall gross margin benefit from this initiative of approximately 80 basis points in 2017 and an incremental close to 100 basis points in 2018. This is one of our key profit driving initiatives and we are pleased with the progress we have made as it will help to support continued year-over-year growth in product margins even as we make margin investment to grow the business. The bottom line is that we’ve achieved good results in improving our product cost and the impact will be more evident in our results as the inventory sells through.
Product margin improvement was offset by occupancy and supply chain, which both deleveraged by approximately 100 basis points, mainly given the lower sales. Supply chain is also temporarily running at a higher cost level as we are opening a new DC in Arizona and are working to wind down operations of our DC in North Bergen.
Reported SG&A expenses were $86.8 million, and include $3 million in expenses related to the Nutri-Force turnaround. Excluding certain cost for both years, SG&A as a percentage of sales delevered by 230 basis points. This deleveraging is mainly driven by a combination of store payroll, advertising and other store operating costs. SG&A also includes higher medical cost of approximately $1 million due to a higher level of large claims within our workforce.
The P&L was also impacted by impairment charges. During the second quarter, impairment indicators were identified including a significant decline in the quarter’s sales performance, decline in the company’s market capitalization and a reduction in balance of year expectations. Based on our analysis and impairment of goodwill for the retail reporting unit was recorded in the amount of $164.3 million. In addition, we recorded a store impairment charge of $3.8 million. Both of these charges are non-cash.
The operating loss in the quarter was impacted by slower top line growth, impairment charges and a larger loss at Nutri-Force, which includes the restructuring charges. Adjusted operating income in the quarter was $13.5 million compared to an adjusted $24.1 million in the same period of the prior year with adjusted margins of 4.4% in the second quarter of ’17 compared to an adjusted 7.2% in the second quarter of ’16.
Now for a few more comments about our cost savings initiatives. As we continue to look to streamline the business, we have made the difficult decision to close our North Bergen distribution center upon lease expiration next summer. This facility is our longest running distribution center and the team has been very loyal. On behalf of the leadership team, we want to thank them for their years of service. The transition of the supply chain operations from North Bergen to other DCs is expected to be substantially completed by the end of this year. As a result of this closure, we expect to incur charges of approximately $4 million, of which $3 million is expected to be incurred in 2017.
The annualized savings associated with this closure is estimated at $4 million to $5 million, and we expect to achieve this full savings run rate by the second half of 2018. This savings is in addition to the savings of $36.5 million discussed on previous calls. As a reminder, of the $36.5 million in savings, $25.5 million is expected to be generated from the work related to vendor partnerships and more efficient pricing and promotion spending, which is ramping up as we move through the year. As previously mentioned, given the lower purchasing volume and inventory turns driven by lower sales, the timing of the realization of the benefits has slowed. However, we continue to expect significant savings. For the year as a whole, we expect to realize incremental year-over-year COGS savings of $12 million and SG&A savings of $4 million tied to these initiatives.
Let me now provide some clarity around our tax rate in the quarter. As I mentioned at the beginning of my presentation, the second quarter ’17 EPS was negatively impacted by $1.2 million from discrete tax charges and non-deductible goodwill related to changes in accounting rules as we adopted new accounting for stock-based compensation earlier this year. For the remainder of the year, we expect the tax rate to be approximately 40%, plus additional $6 adjustments of approximately $500,000.
Turning now to our balance sheet and cash profile. We ended the quarter with cash and cash equivalents of $2 million, convertible notes with a total face value of $144 million and $3 million drawn on our credit facility. Cash flow generated from operations in the quarter was approximately $18 million. Capital expenditures of $18 million were higher in the quarter, mainly driven by the new Arizona DC. We continue to expect capital expenditures of approximately $45 million, including over $15 million for the new DC for the full year. Our cash flow generation coupled with our credit facility provides sufficient liquidity to support our business as well as maintain financial flexibility.
Now turning to our outlook for the full year. Our industry has been undergoing a period of unprecedented and very rapid change and has shown heightened volatility, a trend we expect to continue for the remainder of the year. Although, it is difficult to predict how the competitive environment shakes out through the remainder of the year, our revised forecast reflects several initiatives we are deploying, including investments in pricing and promotions, particularly in the sports category, and actions on our part to change the trajectory of the business, including the rollout of our subscription program.
Given the level of volatility in the market and the increase in variability of our results with the number of initiatives being launched in the back half of the year, we have reset our expectations and are modifying our approach to guidance. Instead of providing specific EPS guidance, we are providing guidance around key levers that drive our business. I will walk you through each of these and also refer you to table 5 in today’s earnings release for reconciliation of reported to adjusted metrics.
Starting with sales. We expect full year comparable sales growth rate of a negative mid-single digit. This assumes an improvement in sales trend from the first half of the year driven by the launch of our new pricing strategy, SPARK Auto-Delivery subscription service and customer acquisition investments, all of which were tested for several months prior to this rollout. As previously noted, early Q3 comps to-date have improved from first half trends and provide us a measure of confidence with this guidance.
Reported full year gross margin rate of 30.2% to 30.7%. This includes charges associated with the Nutri-Force restructuring and North Bergen closure this year. Excluding these charges, full year gross margins of 31.3% to 31.8%, representing a decline of a 120 to 170 basis points. This decrease is mainly due to deleverage in supply chain and occupancy cost. This decrease is partially offset by an expected increase in product margins of 50 to 75 basis points. The increase in product margins is being driven by cost of goods sold savings from vendor partnerships and favorable category and private brands mix shift, partially offset by margin investments associated with changes to our pricing strategy and other sales driving initiatives previously discussed.
Full year SG&A expense of $342 million to $347 million, including charges associated with the Nutri-Force restructuring. Excluding these charges, full year SG&A expense of $335 million to $340 million is expected. This includes planned increases in advertising spend in the back half of the year to support growth initiatives. Full year capital expenditures of $45 million including the build-out of the distribution center in Arizona, IT investments, approximately 15 new stores, and 10 to 15 brand defining store transformations.
As the year continues, we expect improvements in performance driven by increasing gross margins from reduced cost of goods sold, improvements in sales trends from the initiatives and investments in our business previously discussed, and lower losses from Nutri-Force as the benefits from the restructuring begin to be realized. This ends our prepared remarks. We’d be happy to take your questions now. Operator, please open the lines to questions.
Question-and-Answer Session
Operator
[Operator Instructions] And we will take our first question from Sean Kras with Barclays.
Sean Kras
I appreciate that the industry is evolving extremely rapidly, and that you’re trying to keep up and evolve as well. So I guess my primary question is, don’t you maybe think that you’re maybe trying to do too much just because it seems like there is a lot of irons in the fire and maybe on a stand-alone basis, any particular one might necessarily move the needle enough?
Colin Watts
It’s a good question, Sean, and it’s one that obviously we ask ourselves every week. I mean, we want to make sure that we are focusing on the critical priorities that we think will substantially impact performance and quickly. It’s the reason really that there is three major initiatives in the back half of this year that we’re focusing all of our intensity against. One of them is around the customer acquisition focus, both online and in store. The second one is the rollout of the shop with confidence program, which is focused a lot on price value to our customers, and the last is the launch of the Auto-Delivery program.
We know we can handle those three. We’re very comfortable about the execution of those three. We know we’ll do them in a very strong way. There are obviously other programs that we give visibility to, that are in pilot positions like brand defining store, like some of the other things that we’re doing across Nutri-Force. And while we give visibility on these calls to the progress of those, I would think of those as more of a pipeline of future initiatives that we’re preparing ourselves to consider as opposed to a distraction with the short term. Short term is clearly focused on the critical three and making sure that we’re in a position to better compete.
Sean Kras
Okay. That’s helpful. And my follow-up is, I guess a little bigger picture. When you look at pricing and promotion in the sports nutrition category, would you characterize it as irrational or just that the new competitive set just views monetization and margin differently than you do and maybe some other specialty players?
Colin Watts
I’m always careful about characterizing anything as irrational, because rational or irrational depends on the seat you’re in. I would suggest that, what we can see in the numbers that we capture around levels of competitive spending for specific players as well as overall in the market is at a historically high level. In that over the past year but particularly accelerating on a year-to-date basis, we’re seeing that people are spending a lot more to try to win a customer pool that’s not necessarily expanding any faster. So it’s a very volatile period of time. It’s an aggressive period of time. We need to make sure that we put ourselves in a competitive position, but also understand that 60% plus of our sales base actually sits over in the VMS category as opposed to the sports category, and we continue to hold our own in that area and we’re going to continue to look to bolster that area for the business as we move forward.
Operator
And we will take our next question from Shane Higgins with Deutsche Bank.
Shane Higgins
First one is just trying to better understand the competitive pressure from the sports nutrition category. Is that, and I think you have touched on this briefly in your remarks, but is that coming mostly from the specialty? Is it coming from the food, drug, mass, club, online competitors? Just trying to get a better sense of kind of the lay of the land in that category, and if that’s changed the complexion of that competition, has that changed over the last few quarters? Thanks.
Colin Watts
Great question, Shane. So I would say from all fronts, we’ve seen in earnings releases and we’ve seen in terms of some of the coverage even from analysts, that some of the mass players, whether it’s club or it’s big box, have started to increase their share of shelf and their overall focus in promotion against areas like sports protein and some of the sports supplement areas, as well as the bars market has been very, very aggressive. We’ve obviously seen significant incursion online. Players like Amazon and others online have increasingly focused on this category as areas where they want to try to target growth. And I think, in the specialty area, we’ve seen particular competitors who’ve been using sports as primary areas for recovery of their business, and we know that they’re spending aggressively in terms of online acquisition as well as targeted promotions to try to drive that business.
So it’s a category that is, it’s under siege right now. I don’t believe, we don’t believe that this can continue for forever. But we do expect and we are trying to be appropriately conservative in assuming that at least through the end of this year we’re going to continue to see aggressive competitive spending, and we are raising our level of competitive spending and focus in the category as well to make sure we can be competitive.
Shane Higgins
Okay. Great. Thanks. Just as a follow-up. I saw that you guys took an impairment charge on 24 retail stores. As you guys have leases that are coming up over the next year or so, what are your thoughts in terms of store closures? Anything you can share on that front would be great. Thanks.
Brenda Galgano
Yes. We continue to evaluate the store portfolio and look at the profitability by store and certainly as leases come up for renewal, we look at that very closely. In fact, we have a formal process whereby it’s reviewed by our real estate committee. And we look at the projections of the store profitability, also take into account the benefit we would potentially get with store transfers, and we make a decision based on those projections. We continue to expect that we’ll have store closures somewhat in the rate of what we’ve seen in past; five to ten a year, but we will continue to take a hard look at that and certainly we will be evaluating that as we look to our 2018 planning.
Operator
And we will take our next question from Stephen Tanal with Goldman Sachs.
Stephen Tanal
That’s helpful color on the channels. I guess if we just triangulate some of the comments, the color on the competition by category coupled with sort of the color on what hurt your comps the most, seems to suggest you may be losing traffic to specialty competitors, and I would think within that maybe GNC and some of the more aggressive promotional activity that’s happening there. Is that sort of a fair statement, a fair characterization of what’s going on at least in the sports, if not in the overall business?
Colin Watts
We don’t have strict visibility in terms of where the traffic is going. I think it’s fair to surmise based on what we’ve heard in terms of level of competitive spending and traffic changes that there may be some of that movement that’s going to other specialty competitors. It’s hard to believe that there is not also an impact that’s going on in the larger online competitors as well. So we’re making sure that we take a balanced approach on where we think our competition is coming from and also making sure that we’re competitive appropriately against both fronts.
Stephen Tanal
Understood. That’s helpful. And then just on the brand defining stores, the comp uplift of about 500 basis points, I guess would still suggest, if that is in reference to the overall comp that the stores are still comping down. My question would be, is that the case and to be clear, is the base that you’re comping against in those stores, the old format or the new one? And then finally, how fast are you planning to roll out that at this stage?
Colin Watts
Yes. So I’ll give you a quick answer and I’ll throw it over to Brenda to talk about some of the particulars in general. I think it’s fair to say that, it’s store dependent. We are seeing some of those stores comp positive. We’re seeing some of those stores that are falling short of comping positive, but all of them are seeing lift versus what they were seeing pre the changeover, and they’re performing much better than the balance of the chain as we move forward. Brenda, you want to try to tackle the other couple?
Brenda Galgano
Yes. So specifically in terms of how we’re measuring this comp, what we’re doing is we’re looking at the change in comp from pre-remodel to post-remodel, and we’re comparing that to the change in comps for the rest of the chain.
Colin Watts
Right. And then finally, to your question about the rollout strategy. Let’s start with the fact that we sort of think about these stores as both learning labs as well as, as we start to improve, improve, improve on each iteration, we’re going to be locking in by the end of this year to the formats that we think are the most appropriate for expansion throughout the chain or at least in targeted stores within the chain. What we have done this year, is we’ve selected those elements of the stores that are kind of no-brainers to expand rapidly to critical stores across the business and that’s why I talked about the 80 or so stores beyond the brand defining stores that are going to be picking up key elements from the BDS stores, including the Kombucha on tap bar, and including the fit freezer and cooler. Because we already can see that these elements in and of themselves are leading to strong comp lift and have a very strong ROI profile. So we’re moving on those now. And I would expect as we develop our 2018 plan, which is currently under development, you’re going to see a mix of stores that will have the broader BDS format, the full format, and you’ll see some that will continue to push forward with select pieces of the format where it makes the most sense to balance off the CapEx and to drive the best ROI for the business.
Operator
And we will take our next question from Chris Horvers with J.P. Morgan.
Chris Horvers
To follow up on the pricing question. So can you talk about where the price investments that you’ll make will be focused? Is it the majority in the sports category and very little in VMS? And is the strategy to go to an everyday low price or is it more competitive matching on a high-low basis? And how do you think about what the right price gaps are versus a GNC, versus bodybuilding.com or Amazon?
Colin Watts
Yes. So, Chris, the way I would characterize it is not an EDLP strategy. Focused on those items that have a strong penetration across the majority of our customer’s baskets, it’s sort of focused on the SKUs and the product families that are the equivalent of our milk and eggs and butter. These are ones that you find in the majority of the baskets. They also tend to be SKUs that are characterized by a high degree of price elasticity. So customers are making their choices for trips, based on what they see in terms of relevant pricing for these products versus other competitors. When I think about how we think about the strategy moving forward, we’re not abandoning promotional pricing on the business nor is this only a sports initiative, although it is an area that’s impacted in large part in the sports categories because those tend to be a bit more price elastic, as we move forward.
And I think what you’re going to see is, you’re going to see as we saw on the test, that it’s going to improve our traffic, it’s going to improve our units movement, it will, short-term have an impact on the overall margin rate but we make that up quite quickly on the margin dollar front, both on other products that are in the basket as well as stronger retention of customers in the market itself. So it’s a measured strategy. It’s been built recognizing that our customers are now making their choices on an omni basis, so they’re looking at both online opportunities to purchase versus bricks and mortar opportunity, and it recognizes, I would call it, a bit of the new normal of what’s going on in the category itself. So we’re very, very confident that this is going to be a step in the right direction in continuing to repair our price value perception with our customers in critical categories.
Chris Horvers
So I guess, if I think back to the original strategy, I always thought that there was an investment in price and key value items predicated in how you thought about the gross margin outlook or the profitability of the business over the longer term. So what exactly has changed here? Because you’re basically, it looks like cutting — the product margin expansion that you had expected earlier this year versus what you’re seeing now is being cut by, looks like more than half. So what’s changed from the original strategy here?
Colin Watts
Yes. So I’d start with, we have to be a little careful about the product margin being attributed just to the change in the pricing strategy. Because one of the reasons that we’ve had to reduce our expectations on product margin flow through this year has to do with inventory turns and realization in our numbers. It’s just as we’ve seen sales slow, we’ve recognized that it’s going to take a bit more time for the full flow through of some of the benefits that we’ve had in COGS discussions and some of our partnership work with key vendors. That is actually a substantial piece of why you’ve seen us have to reduce our expectation on product margin for the year.
I think it’s fair to say Chris, that what you should think about in terms of this new pricing strategy is, it’s in line with the way that we’ve historically thought about pricing, which means we’ve thought about making sure that we have appropriate price benefits versus other specialty competitors and also make sure that we’re priced with the appropriate sort of price premium gap against mass competitors. What is new and which has been very eye opening and useful for us as we developed this strategy, is we are doing it on an omni basis. So we’re not just matching and developing the strategy versus bricks and mortar, we are looking at it both online as well as at the store level. And with that outlook and better understanding with some very good analytic work that was done around this, I think we’re in a better position to set pricing so that we can meet the needs of our customers, both relevant to bricks and mortar competitors and online.
I couple that with the announcement that I had as part of this discussion around price match. The reason we’re stepping in with price match is it allows us to have a dialog with our customers when they’re at our shelves, where they have questions about how our pricing in the store compares with both online as well as other bricks and mortar competitors, and we are prepared to match those prices where it’s appropriate. We’ve been in market now in test for over six months on that particular aspect of the program and it’s working very, very well. It puts our health enthusiasts who are our most important advantage, in a great position to dialog with the customer and not lose the sale to somebody’s Smartphone. And we think that that’s going to help us as we move forward.
Chris Horvers
Understood. So just to button up the question here. So I guess could you quantify or bucket how much of the change in the gross margin outlook is the delay in recognition of the benefits due to slower sales versus actual price investment?
Brenda Galgano
Just a high level estimate would be approximately two-thirds would be due to the investments in pricing. I would also add to that, gross margins is also being impacted by our expectations of some shifting in channels with the launch of SPARK Auto-Delivery, which comes at a bit of our lower margin than store sales. So that would be probably two-third to three quarters of the decline and then the other portion would be the cost of goods sold savings roll through.
Operator
And we will take our next question from Peter Benedict with Robert Baird.
Peter Benedict
Brenda, just clarifying, the product margin view up 50 to 75 basis points. Is that for the second half or is that for the full year?
Brenda Galgano
That’s for the full year.
Peter Benedict
Okay. And then on the SG&A, the guidance seems to imply kind of SG&A dollars may be up to high-single digits percent year-over-year on an underlying basis over the back half of the year. As we think longer term, I know there is more marketing that’s going into that, but any reason why that wouldn’t continue as we look into 2018?
Brenda Galgano
Yes. So you’re right. The main driver of that increase is the marketing spend. So I think it would be premature to provide guidance going beyond this year. We’re going to continue to closely monitor the returns on this incremental advertising spend and evaluate whether or not it makes sense to continue to step up the level of spend or to back down.
Peter Benedict
Okay. And then Colin, this one’s for you. Just trying to understand maybe how you think about at this point what the right margin structure may overall be for the business. Your success with stabilizing the business with a lot of initiatives. I mean, I think the second half outlook implies probably operating margins in the low single digits. Is that kind of maybe where this business needs to operate in order to grow again? Or I mean how much thought have you given to that, kind of what the longer term margin structure might look like once all these initiatives are playing out?
Colin Watts
I want to be careful about trying to provide something that would suggest longer term margin guidance in this area. I think we look at some of the steps we’re having to take in the back half of this year as temporary in nature and that we have to make sure we remain competitive, particularly as we’ve talked about in the sports market in a particularly volatile period of time. We are in the process of fairly heavy-duty planning work that I think we’re going to put us in a much better position to answer that question for both 2018 and longer term.
Peter Benedict
Okay. That’s fair enough. And then last just on the buyback, it looks like, [indiscernible]. Just curious how you are thinking about that? I mean, obviously, there’s a lot operational that you’re focused on right now, but what are your latest thoughts on the buyback? Thanks.
Brenda Galgano
Certainly, overall capital allocation is a topic that we discuss regularly with the board. Given the higher level of capital expenditures currently to build the new DC, more of our capital has been allocated towards that spend. But this is something that we continue to evaluate and have discussions with the board and buybacks would not be necessarily off the table going forward, something we’ll continue to look at.
Operator
And we will take our next question from David Schick with Consumer Edge Research.
David Schick
Two questions. First, you talked about the process you go through with stores when they come up for a lease. When you go back to the landlord community and say, we’re thinking about just recapturing this and we’re just not going to move. I mean is there any budging going on the landlord side to make this easier or is it just going to sort of end up with more net closures? That’s my first question. Just how the landlord community is treating these issues. And then second, the shape of the quarter. So you’ve talked about a number of different things that sort of started to work in different sizes, initiatives throughout the quarter and that things have been a bit better here in the third. Is that also the way the second looked? Was there a better trend later in the quarter than early? Thank you.
Brenda Galgano
Sure. I’ll take those questions. So with respect to discussions with landlords. Absolutely, as leases are up for renewal, we have discussions with landlords around opportunities to either lower the cost or in some cases, we’ll build out the ability to take out prices and things like that if sales are not meeting a certain threshold, or we’ll take shorter renewal term. So we’re definitely having some success in that and building more flexibility going forward should we make some other decisions about the stores. And I would also note that we are using outside help with that work.
With respect to the shape of the quarter, I did in my prepared remarks talk about the fact that June was better than April and May, and I would say that the third quarter was better than June. And the third quarter is really when we started to launch the initiatives, some of the initiatives that we’ve talked about. I will note however that we continue to see volatility. So it’s continuing to be a process but we are encouraged by what we’re seeing in the early part of the quarter.
Operator
And it appears there are no further questions at this time. I’d like to turn the call back over to Mr. Colin Watts for any additional or closing remarks.
Colin Watts
So I want to thank everybody again for joining us this morning and we look forward to speaking with you at the next quarter.
Operator
And ladies and gentlemen, that does conclude today’s conference. I’d like to thank everyone for their participation. You may now disconnect.
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