NGVC Natural Grocers by Vitamin Cottage Inc

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read in conjunction with our unaudited consolidated financial statements and notes thereto included elsewhere in this Form 10-Q and with the audited consolidated financial statements and notes thereto in our Form 10-K. This MD&A contains forward-looking statements. Refer to “Forward-Looking Statements” at the beginning of this Form 10-Q for an explanation of these types of statements. Summarized numbers included in this section, and corresponding percentage or basis point changes, may not sum due to the effects of rounding.

Company Overview

We operate natural and organic grocery and dietary supplement stores that are focused on providing high-quality products at affordable prices, exceptional customer service, nutrition education and community outreach. We offer a variety of natural and organic groceries, body care products and dietary supplements that meet our strict quality standards. We believe we have been at the forefront of the natural and organic foods movement since our founding. We are headquartered in Lakewood, Colorado. As of December 31, 2020, we operated 160 stores in 20 states, including Colorado, Arkansas, Arizona, Idaho, Iowa, Kansas, Louisiana, Minnesota, Missouri, Montana, Nebraska, Nevada, New Mexico, North Dakota, Oklahoma, Oregon, Texas, Utah, Washington and Wyoming. We also operate a bulk food repackaging facility and distribution center in Golden, Colorado.

We offer a variety of natural and organic groceries and dietary supplements that meet our strict quality guidelines. Our stores range from approximately 5,000 to 16,000 selling square feet, and average approximately 11,000 selling square feet.

The growth in the organic and natural foods industry and growing consumer interest in health and nutrition have enabled us to continue to open new stores and enter new markets. During the five fiscal years ended September 30, 2020, we increased our store count at a compound annual growth rate of 9.1%. In fiscal year 2020, we opened six new stores. We plan to open five to six new stores in fiscal year 2021, one of which opened during the three months ended December 31, 2020. As of the date of this report, we have signed leases for an additional six new stores that we plan to open in fiscal years 2021 and beyond. We plan to relocate three to five stores in fiscal year 2021. Between December 31, 2020 and the date of this Form 10-Q, we did not open any new stores and we have not relocated any stores so far in fiscal year 2021.

Performance Highlights

Key highlights of our performance for the three months ended December 31, 2020 are discussed briefly below and in further detail throughout this MD&A. Key financial metrics including, but not limited to, daily average comparable store sales, are defined in the section “Key Financial Metrics in Our Business,” presented later in this MD&A.

Industry Trends and Economics

We have identified the following recent trends and factors that have impacted and may continue to impact our results of operations and financial condition:

Outlook

We believe there are several key factors that have contributed to our success and will enable us to increase our comparable store sales and continue to profitably expand. These factors include a loyal customer base, increasing basket size, growing consumer interest in nutrition and wellness, a differentiated shopping experience that focuses on customer service, nutrition education and a convenient shopper-friendly retail environment, and our focus on high quality, affordable natural and organic groceries and dietary supplements.

We expect the rate of new store unit growth in the foreseeable future to be comparable to recent years, depending on economic and business conditions and other factors, including the impact of the COVID-19 pandemic and related government mandates. Over the long term, we believe there are opportunities for us to continue to expand our store base, expand profitability and increase comparable store sales. However, future sales growth, including comparable store sales, and our profitability could vary due to increasing competitive conditions in the natural and organic grocery and dietary supplement industry and regional and general economic conditions. In the future, we believe there are opportunities for increased leverage of costs and increased economics of scale in sourcing products. However, due to the fixed nature of certain of our costs (in particular, our rent obligations and related occupancy costs), our ability to leverage costs may be limited.

Our operating results may be affected by the above-described factors as well as a variety of other internal and external factors and trends described more fully in Item 1A - “Risk Factors” in our Form 10-K and Part II, Item 1A – “Risk Factors” in this Form 10-Q.

Key Financial Metrics in Our Business

In assessing our performance, we consider a variety of performance and financial measures. The key measures are as follows:

Net sales

Our net sales are comprised of gross sales net of discounts, in-house coupons and returns and allowances. In comparing net sales between periods, we monitor the following:

Cost of goods sold and occupancy costs

Our cost of goods sold and occupancy costs include the cost of inventory sold during the period (net of discounts and allowances), shipping and handling costs, distribution and supply chain costs (including the costs of our bulk food repackaging facility), buying costs, shrink expense, third-party delivery fees and store occupancy costs. Store occupancy costs include rent, common area maintenance and real estate taxes. Depreciation expense included in cost of goods sold relates to depreciation of assets directly used at our bulk food repackaging facility. The components of our cost of goods sold and occupancy costs may not be identical to those of our competitors, and as a result, our cost of goods sold and occupancy costs data included in this Form 10-Q may not be identical to those of our competitors and may not be comparable to similar data made available by our competitors. Occupancy costs as a percentage of sales typically decrease as new stores mature and increase sales. Rent payments for leases classified as finance lease obligations are not recorded in cost of goods sold and occupancy costs. Rather, these rent payments are recognized as a reduction of the related obligations and as interest expense.

Gross profit and gross margin

Gross profit is equal to our net sales less our cost of goods sold and occupancy costs. Gross margin is gross profit as a percentage of net sales. Gross margin is impacted by changes in retail prices, product costs, occupancy costs and the mix of products sold, as well as the rate at which we open new stores.

Store expenses

Store expenses consist of store-level expenses, such as salary and benefits, share-based compensation, supplies, utilities, depreciation, advertising, bank credit card charges and other related costs associated with operations and purchasing support. Depreciation expense included in store expenses relates to depreciation for assets directly used at the stores, including depreciation on land improvements, leasehold improvements, fixtures and equipment and computer hardware and software. Depreciation expenses on the right-of-use assets related to the finance leases of the stores are also considered store expenses. Additionally, store expenses include any gain or loss recorded on the disposal of fixed assets, generally related to store relocations, as well as store closure and lease termination costs. The majority of store expenses consist of labor-related expenses, which we closely manage and which trend closely with sales. Labor-related expenses as a percentage of sales tend to be higher at new stores compared to comparable stores, as new stores require a minimum level of staffing in order to maintain adequate levels of customer service combined with lower sales. As new stores increase their sales, labor-related expenses as a percentage of sales typically decrease.

Administrative expenses

Administrative expenses consist of home office-related expenses, such as salary and benefits, share-based compensation, office supplies, hardware and software expenses, depreciation and amortization expense, occupancy costs (including rent, common area maintenance, real estate taxes and utilities), professional services expenses, expenses associated with our Board, expenses related to compliance with the requirements of regulations applicable to publicly traded companies, and other general and administrative expenses. Depreciation expense included in administrative expenses relates to depreciation for assets directly used at the home office including depreciation on land improvements, leasehold improvements, fixtures and equipment and computer hardware and software.

Pre-opening and relocation expenses

Pre-opening and relocation expenses may include rent expense, salaries, advertising, supplies and other miscellaneous costs incurred prior to the store opening. Rent expense is generally incurred from one to four months prior to a store’s opening date for store leases classified as operating. For store leases classified as finance leases, we recognize pre-opening interest expense. Other pre-opening and relocation expenses are generally incurred in the 60 days prior to the store opening. Certain advertising and promotional costs associated with opening a new store may be incurred both before and after the store opens. All pre-opening and relocation costs are expensed as incurred.

Interest expense, net

Interest expense consists of the interest associated with finance lease obligations net of capitalized interest, and our Credit Facility.

Income tax expense

Income taxes are accounted for in accordance with the provisions of Income Taxes (ASC 740). Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are remeasured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amounts expected to be realized. Income tax expense also includes excess tax benefits and deficiencies related to the vesting of restricted stock units.

Three months ended December 31, 2020 compared to the three months ended December 31, 2019

The following table summarizes our results of operations and other operating data for the periods presented, dollars in thousands:

Net sales

Net sales increased $35.0 million, or 15.2%, to $265.0 million for the three months ended December 31, 2020 compared to $230.0 million for the three months ended December 31, 2019, primarily due to a $29.2 million increase in comparable store sales and a $5.8 million increase in new store sales. Daily average comparable store sales increased 12.7% for the three months ended December 31, 2020 compared to the three months ended December 31, 2019. The daily average comparable store sales increase resulted from a 21.4% increase in daily average transaction size, partially offset by a 7.1% decrease in average transaction count. In the three months ended December 31, 2020, customers reduced their frequency of shopping trips as a result of social distancing practices associated with the COVID-19 pandemic and related government mandates, but increased their overall basket size per shopping trip. Comparable store average transaction size was $45.14 for the three months ended December 31, 2020. The increase in net sales during the three months ended December 31, 2020 was primarily driven by our customers’ response to the COVID-19 pandemic and related government mandates. Also contributing to the increase in net sales during the three months ended December 31, 2020 were marketing initiatives, promotional campaigns and increased membership in and usage of the {N}power customer loyalty program.

Gross profit

Gross profit increased $12.5 million, or 20.7%, to $73.0 million for the three months ended December 31, 2020 compared to $60.5 million for the three months ended December 31, 2019, primarily driven by the increased sales volumes resulting from the COVID-19 pandemic and related government mandates. Gross profit reflects earnings after product and occupancy costs. Gross margin increased to 27.6% for the three months ended December 31, 2020 compared to 26.3% for the three months ended December 31, 2019. The increase in gross margin during the three months ended December 31, 2020 was primarily driven by a decrease in store occupancy and shrink expenses, as a percentage of sales, and an improved product margin.

Store expenses

Store expenses increased $8.9 million, or 17.3%, to $60.3 million for the three months ended December 31, 2020 compared to $51.4 million for the three months ended December 31, 2019. In the three months ended December 31, 2020, we recorded $0.4 million in lease exit costs, primarily related to a lease termination fee, associated with one store that closed in the first quarter of fiscal year 2019. Store expenses as a percentage of sales were 22.8% and 22.4% for the three months ended December 31, 2020 and 2019, respectively. The increase in store expenses as a percentage of sales is primarily attributed to increased labor related expenses and lease exit costs.

Administrative expenses

Administrative expenses increased $1.5 million, or 25.5%, to $7.3 million for the three months ended December 31, 2020 compared to $5.8 million for the three months ended December 31, 2019. Administrative expenses as a percentage of sales were 2.8% and 2.5% for the three months ended December 31, 2020 and 2019, respectively.

Pre-opening and relocation expenses

Pre-opening and relocation expenses decreased $0.2 million, or 56.0%, to $0.2 million for the three months ended December 31, 2020 compared to $0.4 million for the three months ended December 31, 2019, due to the impact of the number and timing of new store openings and relocations. We opened one new store during the three months ended December 31, 2020 compared to opening two new stores during the three months ended December 31, 2019. We did not relocate any stores during each of the three months ended December 31, 2020 and 2019. Pre-opening and relocation expenses as a percentage of sales were 0.1% and 0.2% for the three months ended December 31, 2020 and 2019, respectively.

Interest expense, net

Interest expense, net of capitalized interest, remained flat at $0.5 million for each of the three months ended December 31, 2020 and December 31, 2019.

Income taxes

Income tax expense increased $0.6 million for the three months ended December 31, 2020 to $1.1 million compared to $0.4 million for the three months ended December 31, 2019. The Company’s effective income tax rate was approximately 22.6% and 19.2% for the three months ended December 31, 2020 and 2019, respectively.

Net income

Net income was $3.6 million, or $0.16 diluted earnings per share, for the three months ended December 31, 2020 compared to $1.9 million, or $0.08 diluted earnings per share, for the three months ended December 31, 2019.

Non-GAAP financial measures 

EBITDA and Adjusted EBITDA

EBITDA and Adjusted EBITDA are not measures of financial performance under GAAP. We define EBITDA as net income before interest expense, provision for income taxes, depreciation and amortization. We define Adjusted EBITDA as EBITDA as adjusted to exclude the effects of certain income and expense items that management believes make it more difficult to assess the Company’s actual operating performance, including certain items such as impairment charges, store closing and lease exit costs and non-recurring items. The adjustment to EBITDA for the three months ended December 31, 2020 related to lease exit costs associated with one store that closed in the first quarter of fiscal year 2019.

The following table reconciles net income to EBITDA and Adjusted EBITDA, dollars in thousands:

EBITDA increased 21.6% to $12.8 million in the three months ended December 31, 2020 compared to $10.6 million for the three months ended December 31, 2019. EBITDA as a percentage of sales was 4.8% and 4.6% in the three months ended December 31, 2020 and 2019, respectively.

Adjusted EBITDA increased 25.5% to $13.2 million in the three months ended December 31, 2020 compared to $10.6 million in the three months ended December 31, 2019. Adjusted EBITDA as a percentage of sales was 5.0% and 4.6% for the three months ended December 31, 2020 and 2019, respectively.

EBITDA and Adjusted EBITDA as supplemental measures

Management believes some investors’ understanding of our performance is enhanced by including EBITDA and Adjusted EBITDA, non-GAAP financial measures. We believe EBITDA and Adjusted EBITDA provide additional information about: (i) our operating performance, because it assists us in comparing the operating performance of our stores on a consistent basis, as it removes the impact of non-cash depreciation and amortization expense as well as items not directly resulting from our core operations such as interest expense and income taxes and (ii) our performance and the effectiveness of our operational strategies. Additionally, EBITDA is a component of a measure in our financial covenants under our Credit Facility.

Furthermore, management believes some investors use EBITDA and Adjusted EBITDA as supplemental measures to evaluate the overall operating performance of companies in our industry. Management believes some investors’ understanding of our performance is enhanced by including these non-GAAP financial measures as a reasonable basis for comparing our ongoing results of operations. By providing these non-GAAP financial measures, together with a reconciliation from net income, we believe we are enhancing analysts’ and investors’ understanding of our business and our results of operations, as well as assisting analysts and investors in evaluating how well we are executing our strategic initiatives.

Our competitors may define EBITDA and Adjusted EBITDA differently, and as a result, our measure of EBITDA and Adjusted EBITDA may not be directly comparable to those of other companies. Items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA and Adjusted EBITDA are supplemental measures of operating performance that do not represent, and should not be considered in isolation or as an alternative to, or substitute for, net income or other financial statement data presented in the consolidated financial statements as indicators of financial performance. EBITDA and Adjusted EBITDA have limitations as an analytical tool, and should not be considered in isolation, or as an alternative to, or as a substitute for, analysis of our results as reported under GAAP. Some of the limitations are:

Due to these limitations, EBITDA and Adjusted EBITDA should not be considered as a measure of discretionary cash available to us to invest in the growth of our business. We compensate for these limitations by relying primarily on our GAAP results and using EBITDA and Adjusted EBITDA as supplemental information.

Liquidity and Capital Resources

Our ongoing primary sources of liquidity are cash generated from operations, current balances of cash and cash equivalents and borrowings under the Credit Facility. Our Credit Facility consists of the $50.0 Revolving Facility and the fully drawn $35.0 million Term Loan Facility. Our primary uses of cash are for purchases of inventory, operating expenses, capital expenditures predominantly in connection with opening, relocating and remodeling stores, debt service, corporate taxes and cash dividends. As of December 31, 2020, we had $24.7 million in cash and cash equivalents, as well as $48.7 million available for borrowing under our Revolving Facility. On November 18, 2020, we entered into the $35.0 million Term Loan Facility maturing November 13, 2024. The Company borrowed $35.0 million under the Term Loan Facility in December 2020 to partially fund its previously announced special cash dividend of $2.00 per common share.

In May 2016, our Board authorized a two-year share repurchase program pursuant to which the Company may repurchase up to $10.0 million in shares of the Company’s common stock. Our Board subsequently extended the share repurchase program, which will terminate on May 31, 2022. We did not repurchase any shares during the three months ended December 31, 2020. The dollar value of the shares of the Company’s common stock that may yet be repurchased under the share repurchase program is $8.3 million. Potential future share repurchases under the share repurchase program could be funded by operating cash flow, excess cash balances or borrowings under our Credit Facility. The timing and the number of shares repurchased will be dictated by our capital needs and stock market conditions.

We paid a special cash dividend of $2.00 per share and a quarterly cash dividend of $0.07 per share of common stock in the three months ended December 31, 2020. On February 3, 2021, our Board approved the payment of a quarterly cash dividend of $0.07 per share of common stock to be paid on March 17, 2021 to stockholders of record as of the close of business on March 1, 2021.

We plan to continue to open new stores, which may require us to borrow additional amounts under the Credit Facility. We believe that cash and cash equivalents, together with the cash generated from operations and the borrowing availability under our Credit Facility, will be sufficient to meet our working capital needs and planned capital expenditures, including capital expenditures related to new store needs for at least the next twelve months. Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day or, in the case of credit or debit card transactions, within days from the related sale.

Operating Activities

Net cash provided by operating activities consists primarily of net income adjusted for non-cash items, including depreciation and amortization and changes in deferred taxes, and the effect of working capital changes. Cash provided by operating activities increased $1.9 million, or 17.8%, to $12.3 million for the three months ended December 31, 2020 compared to $10.5 million for the three months ended December 31, 2019. The increase in cash provided by operating activities was primarily due to an increase in net income adjusted for non-cash items, partially offset by cash used for working capital requirements.

Investing Activities

Net cash used in investing activities decreased $8.3 million, or 69.1%, to $3.7 million for the three months ended December 31, 2020 compared to $12.0 million for the three months ended December 31, 2019. This decrease was primarily due to a $7.7 million decrease in property and equipment acquisitions during the three months ended December 31, 2020 compared to the three months ended December 31, due to the impact of the number and timing of new store openings and relocations.

We plan to spend approximately $24 million to $31 million on capital expenditures during the remainder of fiscal year 2021 in connection with five to six new store openings and three to five store relocations. We anticipate that our new stores will require, on average, an upfront capital investment of approximately $2.2 million per store.

Acquisition of property and equipment not yet paid decreased $3.2 million to $2.8 million in fiscal year 2021 compared to $6.0 million in fiscal year 2020 due to the timing of payments related to new store openings and relocations.

Financing Activities

Net cash (used in) provided by financing activities consists primarily of borrowings and repayments under our Credit Facility and dividends paid to stockholders. Cash used in financing activities was $12.5 million for the three months ended December 31, 2020 compared to $0.4 million of cash provided by financing activities for the three months ended December 31, 2019. During the three months ended December 31, 2020, the Company borrowed $35.0 million under the Term Loan Facility which was used to partially fund a portion of the $46.7 million of dividends paid to stockholders.

Credit Facility

The financing commitment under the Revolving Facility is $50.0 million, including a $5.0 million sub-limit for standby letters of credit. We borrowed $35.0 million under the Term Loan Facility in December 2020 to partially fund our previously announced special cash dividend of $2.00 per common share. The operating company is the borrower under the Credit Facility and its obligations under the Credit Facility are guaranteed by the holding company and Vitamin Cottage Two Ltd. Liability Company (VC2). The Credit Facility is secured by a lien on substantially all of the Company’s assets. The Company has the right to borrow, prepay and re-borrow amounts under the Revolving Facility at any time prior to the maturity date. On November 13, 2019, the Company amended the Credit Facility to extend the maturity date to November 13, 2024 and permit the operating company to pay cash dividends to Natural Grocers in an amount sufficient to allow Natural Grocers to repurchase shares of common stock and pay dividends on its common stock in an aggregate amount not to exceed $10.0 million during any fiscal year. On November 18, 2020, the Company amended the Credit Facility to provide for the Term Loan Facility and permit payment of a one-time dividend of up to $50.0 million no later than December 31, 2020.

Base rate borrowings under the Credit Facility bear interest at a fluctuating base rate as determined by the lenders’ administrative agent based on the most recent compliance certificate of the operating company and stated at the highest of (i) the federal funds rate plus 0.50%, (ii) the prime rate, and (iii) the Eurodollar rate plus 1.00%, less the lender spread based upon the Company’s consolidated leverage ratio. Eurodollar rate borrowings under the Credit Facility bear interest based on the London Interbank Offered Rate, or its successor rate (LIBOR), for the interest period plus the lender spread based upon the Company’s consolidated leverage ratio. The unused commitment fee is also based upon the Company’s consolidated leverage ratio. The Company will repay principal amounts outstanding under the Term Loan Facility in equal quarterly installments of approximately $0.4 million on the last day of each fiscal quarter, beginning on March 31, 2021 and ending on September 30, 2024, with the remaining principal amount payable on the maturity date. Amounts repaid on the Term Loan Facility may not be reborrowed.

The Credit Facility requires compliance with certain customary operational and financial covenants, including a consolidated leverage ratio. The Credit Facility also contains certain other customary limitations on the Company’s ability to incur additional debt, guarantee other obligations, grant liens on assets and make investments or acquisitions, among other limitations. Additionally, the Credit Facility prohibits the payment of cash dividends to the holding company from the operating company without the required lenders’ consent, provided that so long as no default exists or would arise as a result thereof, the operating company may pay cash dividends to the holding company in an amount sufficient to allow the holding company to: (i) pay various audit, accounting, tax, securities, indemnification, reimbursement, insurance and other reasonable expenses incurred in the ordinary course of business and (ii) repurchase shares of common stock and pay dividends on our common stock in an aggregate amount not to exceed $10.0 million during any fiscal year.

We had no amounts outstanding under the Revolving Facility as of December 31, 2020 and September 30, 2020, respectively. As of December 31, 2020 and September 30, 2020, we had undrawn, issued and outstanding letters of credit of $1.3 million, which were reserved against the amount available for borrowing under the Revolving Facility. We had $48.7 million available for borrowing under the Revolving Facility as of December 31, 2020 and September 30, 2020. We had $35.0 million of outstanding borrowings under the fully drawn Term Loan Facility as of December 31, 2020.

As of each of December 31, 2020 and September 30, 2020, the Company was in compliance with the financial covenants under the Credit Facility.

Share Repurchases

Certain information about the Company's share repurchases is set forth under the heading "Share Repurchases" in Note 6 of Notes to Unaudited Interim Consolidated Financial Statements included in Part I, Item 1 of this Form 10-Q.

Off-Balance Sheet Arrangements 

As of December 31, 2020, our off-balance sheet arrangements consisted of: (i) the undrawn portion of our Revolving Credit Facility and (ii) leases that have been signed but whose terms have not yet commenced. As of December 31, 2020, the Company had signed seven leases whose terms have not yet commenced; such leases are for four new stores, one store relocation and two store remodels in fiscal year 2021 and beyond. The contractual obligation related to these leases is $29.2 million (see Note 7). We have no other off-balance sheet arrangements that have had, or are reasonably likely to have, a material effect on our consolidated financial statements or financial condition.

Recent Accounting Pronouncements

See Note 2 to the consolidated financial statements included in this Form 10-Q.

Critical Accounting Policies

The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. Actual amounts may differ from these estimates. We base our estimates on historical experience and on various other assumptions and factors that we believe to be reasonable under the circumstances. We evaluate our accounting policies and resulting estimates on an ongoing basis to make adjustments we consider appropriate under the facts and circumstances. 

Critical accounting policies that affect our more significant judgments and estimates used in the preparation of our financial statements include accounting for income taxes, accounting for impairment of long-lived assets and accounting for leases, which are discussed in more detail under the caption “Critical Accounting Policies” under Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in our Form 10-K.