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 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. All references to a “fiscal year” refer to a year beginning on October 1 of the previous year and ending on September 30 of such year (for example “fiscal year 2016” refers to the fiscal year from October 1, 2015 to September 30, 2016). 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 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, 2015, we operated 107 stores in 18 states, including Colorado, Arkansas, Arizona, Idaho, Kansas, 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. The size of our stores varies from 5,000 to 16,000 selling square feet. During the twelve months ended December 31, 2015, our new stores averaged approximately 12,000 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, 2015, we increased our store count at a compound annual growth rate of 21.4%. In fiscal year 2015, we opened 16 new stores, and we currently plan to open 23 new stores in fiscal year 2016, four of which opened during the three months ended December 31, 2015. As of the date of this Form 10-Q, we have opened one additional new store in Arkansas and have a total of 21 signed leases for new stores that we plan to open in fiscal years 2016 and 2017 in Arizona, Arkansas, Colorado, Idaho, Iowa, Missouri, Oregon, Texas, Utah, and Washington. So far in fiscal year 2016, we have relocated two existing store locations. During the remainder of fiscal year 2016, we plan to relocate one additional store location and remodel two existing store locations.

Performance Highlights

Key highlights of our recent performance are discussed briefly below and are discussed in further detail throughout this MD&A. Key financial metrics, including, but not limited to, comparable store sales, daily average comparable store sales, mature store sales and daily average mature store sales are defined under the caption “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 continue to expand profitably and increase our comparable store sales. 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 shopper friendly retail environment, and our focus on high quality, affordable natural and organic groceries and dietary supplements.

We plan for the foreseeable future to continue opening new stores and entering new markets at or above recent levels of growth. During the past few years, we have successfully expanded our infrastructure to enable us to support our continued growth. This has included successfully implementing our enterprise resource planning system, hiring key personnel, developing efficient new store opening construction and operations processes and relocating and expanding our bulk food repackaging facility and distribution center. We believe the implementation of our Human Resources Information System, or HRIS, has enabled us to more efficiently and effectively onboard and train our employees at all locations. During fiscal year 2015, we redesigned our website (www.naturalgrocers.com) to enhance functionality, create a more engaging user experience and increase its reach and effectiveness. In addition, in fiscal year 2015 we introduced the {N}power^TM customer appreciation program at all of our stores, which we believe will enhance customer loyalty and increase customer engagement levels.

We believe there are opportunities for us to continue to expand our store base and focus on increasing comparable store sales. However, future sales growth, including comparable store sales, could vary due to increasing competitive conditions in the natural and organic grocery and dietary supplement industry. As we continue to expand our store base, we believe there are opportunities for increased leverage in costs, such as administrative expenses, as well as increased economies of scale in sourcing products. However, due to our commitment to providing high-quality products at affordable prices and increased competition, such sourcing economies and efficiencies at our bulk food repacking facility and distribution center may not be reflected in our gross margin in the near term.

Our operating results may be affected by a variety of internal and external factors and trends described more fully in the section “Risk Factors” contained in our Form 10-K.

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 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. We do not record in costs of goods sold and occupancy costs rent payments for leases classified as capital and financing lease obligations. Rather, these rent payments are recognized as a reduction of the related obligations and as interest expense. Additionally, depreciation expense related to the capitalized asset is recorded in store expenses.

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 capitalized real estate leases, land improvements, leasehold improvements, fixtures and equipment and computer hardware and software. Additionally, store expenses include any gain or loss recorded on the disposal of fixed assets, primarily related to store relocations. The majority of store expenses are comprised of salary-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 certain 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 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 capital or financing leases, no pre-opening rent expense is recognized. 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.

Operating income

Operating income consists of gross profit less store expenses, administrative expenses and pre-opening and relocation expenses. Operating income can be impacted by a number of factors, including the timing of new store openings and store relocations, whether or not a store lease is classified as an operating or a capital or financing lease, as well as increases in store expenses and administrative expenses. The amount of time it takes for new stores to become profitable can vary depending on a number of factors, including location, competition, a new market versus an existing market and the strength of store management.

Interest expense

Interest expense consists of the interest associated with capital and financing lease obligations, net of capitalized interest. Interest expense also includes interest we incur on our outstanding indebtedness, including under our Credit Facility.

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*Figures may not sum due to rounding.        

Three months ended December 31, 2015 compared to the three months ended December 31, 2014

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

Net sales

Net sales increased $21.9 million, or 15.0%, to $167.8 million for the three months ended December 31, 2015 compared to $145.9 million for the three months ended December 31, 2014, primarily due to a $16.6 million increase in sales from new stores and a $5.3 million, or 3.6%, increase in comparable store sales. The comparable store sales increase was primarily driven by a 1.9% increase in daily average transaction count and a 1.7% increase in average transaction size. Comparable store average transaction size was $36.61 in the three months ended December 31, 2015. Mature store sales increased 0.4% in the three months ended December 31, 2015 compared to the three months ended December 31, 2014. The rate of growth in our comparable and mature store sales, while positive, has moderated in part due to the impact of increased competition in the natural and organic sector and general economic conditions in certain of our markets.

Gross profit

Gross profit increased $6.0 million, or 14.2%, to $48.3 million for the three months ended December 31, 2015 compared to $42.3 million for the three months ended December 31, 2014, primarily driven by an increase in the number of comparable stores. Gross margin decreased to 28.8% for the three months ended December 31, 2015 from 29.0% for the three months ended December 31, 2014. Gross margin in the three months ended December 31, 2015 was negatively impacted by an increase in occupancy costs as a percentage of sales, partially offset by an increase in product gross margin for the three months ended December 31, 2015 compared to the three months ended December 31, 2014. The positive impact in product margin is due to increases in product margin across most departments in the three months ended December 31, 2015 compared to the three months ended December 31, 2014. Occupancy costs as a percentage of sales increased in the quarter ended December 31, 2015 compared to the quarter ended December 31, 2014, primarily due to higher occupancy cost at newer stores.

We had 13 and 11 store leases that were classified as capital and financing lease obligations for the three months ended December 31, 2015 and 2014, respectively. If these leases had qualified as operating leases, the straight-line rent expense would have been included in occupancy costs, and our costs of goods sold and occupancy costs as a percentage of sales during the three months ended December 31, 2015 and 2014 would have each been approximately 55 and 60 basis points higher, respectively, than as reported.

Store expenses

Store expenses increased $4.9 million, or 15.6%, to $35.9 million for the three months ended December 31, 2015 compared to $31.0 million in the three months ended December 31, 2014. Store expenses as a percentage of sales were 21.4% and 21.3% for the three months ended December 31, 2015 and 2014, respectively. The increase in store expenses as a percentage of sales was primarily due to increases in salary-related expenses, depreciation and other store expenses. Store expenses were favorably impacted by lower incentive compensation and other discretionary benefits expense, reflecting our pay-for-performance philosophy.

Administrative expenses

Administrative expenses increased $0.5 million, or 12.5%, to $4.8 million for the three months ended December 31, 2015 compared to $4.2 million for the three months ended December 31, 2014, primarily due to the addition of general and administrative positions to support our new store growth. Administrative expenses as a percentage of sales were 2.8% and 2.9% for the three months ended December 31, 2015 and 2014, respectively. The favorable impact on administrative expenses of lower incentive compensation and other discretionary benefits expense, reflecting our pay-for-performance philosophy, was partially offset by deferred compensation expense and, to a lesser extent, stock compensation expense.

Pre-opening and relocation expenses

Pre-opening and relocation expenses increased $0.4 million, or 64.3%, for the three months ended December 31, 2015 to $0.9 million compared to $0.6 million for the three months ended December 31, 2014, due to the impact of the timing, nature and location of the new store openings and relocations. We opened four new stores and relocated two stores in the three months ended December 31, 2015 and opened four new stores in the three months ended December 31, 2014. Pre-opening and relocation expenses as a percentage of sales were 0.6% and 0.4% for the three months ended December 31, 2015 and 2014, respectively.

Interest expense

Interest expense, net of capitalized interest, decreased less than $0.1 million, or 11.2%, for the three months ended December 31, 2015 compared to the three months ended December 31, 2014 primarily due to an increase in capitalized interest. If the capital and financing lease obligations had qualified as operating leases, interest expense as a percent of sales would have been approximately 35 and 50 basis points lower than as reported for the three months ended December 31, 2015 and 2014, respectively.

Income taxes

Our effective income tax rate for the three months ended December 31, 2015 and 2014 was 38.0% and 37.5%, respectively.

Net income

Net income increased 5.2% to $3.7 million, or $0.17 diluted earnings per share, for the three months ended December 31, 2015 compared to $3.6 million, or $0.16 diluted earnings per share, in the three months ended December 31, 2014.

Non-GAAP financial measures

EBITDA

EBITDA is not a measure of financial performance under GAAP. We define EBITDA as net income before interest expense, provision for income taxes and depreciation and amortization.

EBITDA increased 11.5% to $12.7 million in the three months ended December 31, 2015 compared to $11.4 million for the three months ended December 31, 2014. EBITDA as a percent of sales was 7.6% and 7.8% in the three months ended December 31, 2015 and 2014, respectively. Stores with leases that are classified as capital and financing lease obligations, rather than being reflected as operating leases, increased EBITDA as a percentage of sales by approximately 55 and 60 basis points in the three months ended December 31, 2015 and 2014, respectively, due to the impact on cost of goods sold and occupancy costs as discussed above, as well as occupancy costs that would have been included in pre-opening expenses prior to the stores’ opening dates if these leases had been accounted for as operating leases.

We believe EBITDA provides 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 was a measure in our financial covenants under the Credit Facility and is a measure in our financial covenants under the New Credit Facility. Further, our incentive compensation plans base incentive compensation payments on EBITDA.

Furthermore, management believes some investors use EBITDA as a supplemental measure to evaluate the overall operating performance of companies in our industry. Management believes that some investors’ understanding of our performance is enhanced by including this non-GAAP financial measure as a reasonable basis for comparing our ongoing results of operations. By providing this non-GAAP financial measure, together with a reconciliation from net income, we believe we are enhancing investors’ understanding of our business and our results of operations, as well as assisting investors in evaluating how well we are executing our strategic initiatives. Our competitors may define EBITDA differently, and as a result, our measure of EBITDA may not be directly comparable to EBITDA of other companies. Items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA is a supplemental measure of operating performance that does not represent, and should not be considered as an alternative to, or substitute for, net income or other financial statement data presented in our consolidated financial statements as indicators of our financial performance. EBITDA has limitations as an analytical tool, and should not be considered in isolation, or as a substitute for, analysis of our results as reported under GAAP. Some of the limitations are:

Due to these limitations, 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 as supplemental information. We further believe that our presentation of this non-GAAP financial measurement provides information that is useful to analysts and investors because it is an important indicator of the strength of our operations and the performance of our business.

The following table reconciles net income to EBITDA for the periods presented, dollars in thousands:

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 New Credit 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 and corporate taxes.

As of December 31, 2015 we had $2.1 million in cash and cash equivalents, as well as $24.0 million available for borrowing under the $25.0 million Credit Facility. On January 28, 2016, the Company entered into the New Credit Facility (see Notes 4 and 12).

We plan to continue to open new stores, which has previously required, and may continue to require, us to borrow additional amounts. We plan to spend approximately $44 million to $46 million on capital expenditures during the remainder of fiscal year 2016 in connection with our 19 planned new store openings, one store relocation and two store remodels. We believe that cash and cash equivalents, together with the cash generated from operations and the borrowing availability under our New 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.

We anticipate that our new stores will require, on average, an upfront capital investment of approximately $2.2 million per store consisting of capital expenditures of approximately $1.7 million, net of tenant allowances, initial inventory of approximately $0.3 million, net of payables, and pre-opening expenses of approximately $0.2 million.

Following is a summary of our operating, investing and financing activities for the periods presented, dollars in thousands:

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 $2.6 million, or 37.5%, to $9.5 million for the three months ended December 31, 2015, compared to $6.9 million in the three months ended December 31, 2014. The increase in cash provided by operating activities was primarily due to an increase in net income, as adjusted for depreciation and amortization resulting from the addition of new stores, an increase in deferred income taxes and changes in working capital driven by the timing of payment on inventory and other purchases. Our working capital requirements for inventory will likely continue to increase as we continue to open new stores.

Investing Activities

Net cash used in investing activities decreased $3.0 million, or 22.8%, to $10.2 million for the three months ended December 31, 2015 compared to $13.2 million for the three months ended December 31, 2014 due to a decrease in payment for acquisition, offset by an increase in cash paid for property and equipment. Cash paid for property and equipment increased $2.6 million in the three months ended December 31, 2015 compared to the three months ended December 31, 2014, driven by the timing of new store openings and store relocations and remodels.

Financing Activities

Cash used in or provided by financing activities consists primarily of borrowings and repayments under our Credit Facility, excess tax benefits on vested share-based compensation and payments of capital and financing lease obligations. Cash used in financing activities was $0.1 million for the three months ended December 31, 2015, compared to cash provided by financing activities of $3.0 million for the three months ended December 31, 2014. The decrease in cash provided by financing activities for the three months ended December 31, 2015 compared to the three months ended December 31, 2014 was primarily due to net borrowings of $3.1 million under our Credit Facility during the three months ended December 31, 2014.

Credit Facilities

Credit Facility 

As of December 31, 2015, the Company was party to the Credit Facility. On November 17, 2015, as provided for in the Credit Facility, the Company obtained a commitment to increase the amount available for borrowing under the Credit Facility from $15.0 million to $25.0 million. The operating company was the borrower under our Credit Facility, and its obligations under our Credit Facility were guaranteed by the holding company.

The Company had no amounts outstanding under the Credit Facility as of December 31, 2015. As of December 31, 2015, we had undrawn, issued and outstanding letters of credit in the amount of $1.0 million, which was reserved against the amount available for borrowing under the Credit Facility, and $24.0 million available for borrowing under the Credit Facility. For floating rate borrowings under our Credit Facility, interest was determined by the lender’s administrative agent and is stated at the prime rate less the lender spread, subject to the Company meeting certain financial measures. For fixed rate borrowings under our Credit Facility, interest is determined by quoted LIBOR rates for the interest period plus the lender spread, subject to us meeting certain financial measures. As of December 31, 2015, we were in compliance with the debt covenants of our Credit Facility.

New Credit Facility

On January 28, 2016, the Company entered into the New Credit Facility. In connection with entering into the New Credit Facility, the Company terminated the prior Credit Facility and all amounts owing thereunder were paid in full.

The operating company is the borrower under the New Credit Facility, and its obligations under the New Credit Facility are guaranteed by the holding company and VC2. The New Credit Facility is secured by a lien on substantially all of the Company’s assets. The amount available for borrowing under the New Credit Facility is $30.0 million (including a $5.0 million sublimit for standby letters of credit), and the Company has the right to increase the amount available for borrowing, by an additional amount that may not exceed $20.0 million if the existing lenders or other eligible lenders agree to provide an additional commitment or commitments. The Company has the right to borrow, prepay and re-borrow amounts under the New Credit Facility at any time prior to the maturity date. The New Credit Facility matures on January 31, 2021.

For floating rate borrowings under the New Credit Facility, interest is determined by the lender’s administrative agent and stated at the prime rate less the lender spread based upon certain financial measures. For fixed rate borrowings under the New Credit Facility, interest is determined by quoted LIBOR rates for the interest period plus the lender spread based upon certain financial measures. The unused commitment fee ranges is based upon certain financial measures.

The New Credit Facility requires compliance with certain customary operational and financial covenants, including a leverage ratio. The New 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, our New Credit Facility prohibits the payment of cash dividends to the holding company from the operating company, without the administrative agent’s consent except when no default or event of default exists. If no default or event of default exists, dividends are allowed for various audit, accounting, tax, securities, indemnification, reimbursement, insurance and other reasonable expenses incurred in the ordinary course of business.

Off-Balance Sheet Arrangements 

As of December 31, 2015, our off-balance sheet arrangements consisted of operating leases and the undrawn portion of our Credit Facility. All of our stores and facilities, with one exception, are leased. As of December 31, 2015, 13 store leases were classified as capital and financing lease obligations, and the remaining leases were classified as operating leases in our consolidated financial statements. 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.