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Smart & Final Stores (NYSE:SFS)
Q3 2018 Earnings Conference Call
Nov. 14, 2018 5:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the Smart & Final Stores, Inc. third-quarter 2018 earnings conference call. [Operator instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Laura Bainbridge, investor relation.

Please go ahead.

Laura Bainbridge -- Investor Relations

Thank you. Thank you for joining us today as we discuss Smart & Final Stores' second-quarter 2018 financial results, which was a 16-week quarter ended October 7, 2018. Participating on today's call will be Dave Hirz, Smart & Final's president and CEO; and Rick Phegley, Smart & Final's CFO. Scott Drew, EVP of operations, will be available for the Q&A portion of the call.

Before we begin, we want to remind you that comments made during this conference call and webcast contain forward-looking statements and are subject to risks and uncertainties. Our actual results could differ in a material manner from those expressed in such forward-looking statements for any reason, including those listed in the company's SEC filings. The company assumes no obligation to update any such forward-looking statements. Please also note that past performance is not a guarantee of future results.

During this conference call, the company will refer to certain non-GAAP financial measures, including adjusted net income, adjusted net income per diluted share and adjusted EBITDA. The company uses these as measures of operating performance, not as measures of liquidity. These measures should not be considered in isolation from, or as a substitute for, measures prepared in accordance with generally accepted accounting principles. In addition, these non-GAAP measures may not be comparable to similar measures used by other companies.

Please refer to the company's earnings release made available on its Investor Relations website for definitions and reconciliations of these measures to the most directly comparable GAAP measures. With that, I will hand the call over to Dave Hirz, Smart & Final's president and chief executive officer.

Dave Hirz -- President and Chief Executive Officer

Thanks, Laura, and good afternoon, everyone. There are a lot of positive developments at Smart & Final in what continues to be a very dynamic industry environment. From a high-level view, our operational performance remained strong, with the rapid expansion of our e-commerce business and stable in-store metrics in both of our banners, while maintaining strong merchandise margins, holding to our value-price position against key competitors and continuing to increase sales penetration rates with our important business customers. Our key competitive strengths, unique itemization, including key products for small businesses, value pricing, industry-leading private label and a dominant assortment of warehouse club packs continue to make both of our store banners attractive places for business and household customers to shop, both in-store and online.

We've said it before, we're not a conventional grocery company. In the third quarter, our financial and operating performance was solid with year-to-year growth in overall sales, banner comparable store sales, banner merchandising gross margin rates and strong growth in online sales. Net sales for the quarter increased by 2.8% year over year, led by six-tenth of a percent comparable store sales growth. As we'll describe in more detail, we achieved this sales growth despite increasing deflation in a couple of key categories, which was a bit of a surprise after experiencing inflationary trends in many categories earlier in 2018.

Our comparable store sales, net of inflation and cannibalization, was up 1.6%, our strongest quarter of the year and stronger than our fiscal-year 2017.Gross margins remained strong this quarter and were the highest we've seen in over 10 years, reflecting good merchandise mix and our efforts to reduce product-acquisition costs and control margin-related expenses. Our adjusted EBITDA in the quarter was $62.3 million, which is a trailing 12-month EBITDA increase of over 9% as compared to the prior 12-month period. Adjusted net income and adjusted diluted EPS in the quarter increased by over 30%, including an income-tax benefit which Rick will review. We've also continued to use our strong cash flow from operations to reduce overall financial leverage with $46 million of debt reduction since the beginning of the year.

The key financial challenge to the stronger income growth has been the return of deflation in our key commodities. On a sequential-quarter basis, we flipped from a positive 0.8% inflation to a negative 0.7% deflation or a sales growth headwind of 1.5%. While only seven of our 26 product categories were deflationary, with the most meaningful impacts felt in produce, meat and cheese, these categories collectively represent more than 1/4 of our consolidated sales. And early in the fourth quarter, these deflationary trends have persisted.

As we've described before, deflating product price is especially challenging in an environment, where nearly all of our operating costs, including wage rates continue to inflate. In the third quarter, the competitive environment was stable in both of our store banners. In the Smart & Final banner, toward the end of the quarter, we cycled last year's increase in promotional intensity. In today's environment, our focus remains on what we are able to control, enhancing the customer shopping experience in both our Smart & Final and Smart Foodservice Warehouse stores, both online and through merchandising and customer service initiatives, continuing to invest in our people, systems and infrastructure to strengthen our competitive positioning and maintaining the disciplined approach to capital spending, prioritizing our strong operating cash generation to reduce balance-sheet leverage.

Across both of our banners, we're working to support traffic and basket-building initiatives. With the Smart & Final banner, we remain committed to our unique assortment of business and household items offered at exceptional values, generally priced 6% to 12% below conventional grocers. We're leaning into our strengths in deep-value warehouse club packs, unique SKUs for small-business customers and our high-quality private-label products. As a reminder, we offer twice the number of warehouse club pack SKUs when compared to a typical club store and more than 10 times the variety found in a conventional grocery store.

Our club size comparable store sales in the quarter increased at four times the rate of the overall Smart & Final banner counts .In the quarter, 30% of our banner sales continued to come from our business customers. Business customers are one of our key differentiations in the market and our business customer remains healthy, delivering comparable store sales growth that was double the overall Smart & Final banner growth rate, despite greater exposure to deflationary product categories in their sales mix. As you know, our private-label offerings deliver especially compelling values in both price and high-quality products, and during the quarter, we continued to see total sales growth in our private-label products above our consolidated rates. Growth continues to be led by our flagship private-label brand, First Street and our natural and organic brand, Sun Harvest.

Over the last several quarters, we've been consolidating some smaller private-label brands into the First Street label for better brand recognition and more cohesive marketing. Overall response has been positive and sales of First Street branded products now account for almost 85% of our total private-label sales. Our Sun Harvest line continues to deliver strong sales growth, along with exceptional margin rates, led by an expanded SKU assortment and innovation in this important and growing category. In both First Street and Sun Harvest, we have an active private-label brand development program to ensure that we main current with market trends and expand the breadth of products available to all of our customers.

We've also made customer service a major focus in 2018 with measurable benefits. To date, we've seen reduced front-end wait times, meaningful improvements in our mystery shopper scores and higher levels of on-shelf in-stock rates, which, based on independent audits, are impressive at over 98%. At the same time, we're investing in both our delivery and buy-online, pick up in store offerings. Across both banners, we're seeing strong adoption rates for our e-commerce offerings.

The Smart & Final banner recorded a 100% increase in e-commerce sales and the Smart Foodservice banner saw over 500% sales growth, led by our buy-online, pick up in store, click-and-carry offering. And after a successful pilot in the San Francisco Bay Area, we recently added a second delivery pilot for our Smart Foodservice banner in the Portland, Oregon market. With this third-party delivery option, we're serving small businesses and restaurant customers with temperature-controlled vehicles up to a 50-mile radius from our pilot stores. We're supporting this continued growth over e-commerce and delivery channels through measured investment in our back-end infrastructure and more aggressive online and print promotional campaigns.

In particular this year, we've implemented new warehouse management and purchasing systems, upgraded our core financial backbone to SAP S/4 financials and strengthened our system's security infrastructure, all of which are a stronger base for online commerce. Our key focus on our e-commerce investment strategy is greater capture and leverage of customer-specific information and purchase history, so that we can serve our best customers even better. We also continue to invest in our brick-and-mortar operations and believe the combination of our unique merchandising, value pricing and investments and customer-focused initiatives will continue to support customer traffic in today's environment. This includes our work with Nielsen, where we're beta testing select pricing and promotional strategies to identify learnings that can be implemented on a broader scale.

We've invested over $4.5 million in pricing refinements since we started working with Nielsen earlier this year, and we're already beginning to see improving traffic at the Smart & Final banner stores. Key to supporting our growth is having the right mix of stores and locations and ensuring they're maintained regularly. In the Smart & Final banner, we opened three new stores in the third quarter. We ended the third quarter with 324 stores, including 260 Smart & Final stores and 64 Smart Foodservice stores.

Early in the fourth quarter, we opened a new Extra! store in Long Beach, marking our 200th Smart & Final Extra! store since the introduction of the Extra! format 10 years ago. In the balance of 2018, we expect to close one additional legacy format store for a total of four strategic legacy store closings in 2018. The quality of our Smart & Final banner stores remains strong, with over 90% of our stores being new or remodeled in just the past 10 years. And as for our Foodservice banner, we now expect to open two new stores in the fourth quarter for a total of three new stores in 2018.

Looking forward to 2019, we continue to be cautious of our new store development, given the challenging environment for our Smart & Final banner stores. In 2019, we plan to open two to three additional Smart & Final Extra! stores and complete up to three legacy to Extra! store relocations or expansions. The planned new stores in Southern California and Las Vegas represent attractive and opportunistic real-estate locations. In the Smart Foodservice banner, we plan to open four to five new stores in 2019, all within our existing footprint.

We continue to be optimistic about growth prospects for the banner, with strong food away from home trends, a robust and healthy small-business environment in the Pacific Northwest and a well-positioned store format with an attractive niche. And we're actively planning for future store growth options for the Smart Foodservice banner. Consistent with our past practice, we expect to provide a more complete guidance for 2019 on our fourth-quarter earnings call. In addition to store development, we also recognize the importance of investing in our 12,000 associates, who are the most important component of making our stores a great place to shop.

We have several programs in place to support the ongoing education for associates and their families. Since 2016, we've invested over $2 million in support of our associates' education through tuition reimbursement and scholarships. To assist in our associates' education goals, we offer to cover all costs, including books for eligible associates attending community college. We currently have hundreds of associates participating in the program.

Because almost 45% of our sales are from small businesses and local clubs and organizations, we believe that we play a special role in every community in which we operate, becoming part of the fabric of their community. We support our communities through the Smart & Final and the Smart Foodservice charitable foundations, where we fund hunger relief programs and partner with local organizations, including Little Leagues, AYSOs, local food banks, K-12 schools and a wide range of other nonprofit community groups. We provide our employees with paid time off to volunteer for the charities they care about the most. In the third quarter, our associates dedicated over 1,100 hours toward coastal cleanups, helping feed the homeless, supporting charity walks and many other important causes.

Turning back to the larger picture, we're not conventional in our stores or our approach to our business. We remain focused on solidifying our unique position in the market, supporting growth in traffic and transaction size through our merchandising and shopper-experience initiatives and making measured investments in our people, systems and infrastructure. And with that, I'll hand the call over to Rick.

Rick Phegley -- Senior Vice President and Chief Financial Officer

Thank you, Dave, and good afternoon, everyone. Today, I'll discuss our third-quarter results and our outlook for fiscal 2018. So let's begin with sales. As noted in today's release, consolidated net sales in the third quarter were $1.5 billion, up 2.8% versus the third quarter of 2017.

Net sales growth was driven by the sales contribution of stores that opened over the last 12 months as well as consolidated comparable store sales growth of 0.6%. Comparable store sales growth was supported by strong average ticket growth in both store banners. This represents our sixth consecutive quarter of positive comparable store sales with Smart & Final banner comps increasing by 0.2% and Smart Foodservice Warehouse banner comps increasing by 2% during the third quarter. In the Smart & Final banner, sales increased by 2.6% over the prior year.

Average ticket in the third quarter increased by 1.6%, with an underlying estimated deflation rate of 0.6% and a decrease in comp traffic of 1.4%, a rate which was an improvement from both the first and second quarters of 2018. The gross-margin rate in the Smart & Final banner was 16%, up 1% from the margin rate in the third quarter of 2017, reflecting strategic sourcing, business customer growth and our strong merchandising initiatives. In the third quarter, operating and administrative expenses as a percentage of sales in the Smart & Final banner were 14%, about 100 basis points higher than the year-ago quarter, reflecting increases in store-level labor costs due to the impact of minimum-wage increases, an increase in third-party e-commerce fees as a result of our growing sales and other inflation-driven, store-level cost increases. In the Smart Foodservice banner, sales increased by 3.3% from the prior-year quarter, with a comparable store sales growth rate of 2%.

Average transaction amount in the third quarter increased by 2.1%, with an underlying estimated deflation rate of 0.9%.Store traffic on a year-over-year basis declined by 0.2%, an improvement of 20 basis points from the prior quarter and including the impact of cannibalization from new stores. The Smart Foodservice banner gross-margin rate in the third quarter was 14.9%, up 40 basis points compared to the prior-year quarter. A stronger merchandise margin accounted for most of the increase, with distribution and occupancy expense rates fairly flat as a percentage of sales. Operating and administrative expense, including store and labor costs as a percentage of sales in the Smart Foodservice banner, was 7.3% in the third quarter, up slightly from the prior-year quarter.

On a GAAP basis, our third-quarter net income was $10.2 million. On a year-to-year third-quarter basis, interest expense increased as a result of higher market rates and also reflecting booked interest expense related to accounting for build-to-suit store-development projects. Income-tax expense in the third quarter reflects a lower rate than we recorded in the second quarter, including the favorable tax effect of accelerated depreciation deduction that's included in our 2017 income-tax return. This brought the effective rate for the third quarter to about a 2% tax benefit, which we expect will reduce the full-year effective tax provision expense rate below 10%.

This positively impacted our third-quarter GAAP EPS by approximately $0.04 per share, bringing our third-quarter earnings to $0.14 per fully diluted share based on about 74 million shares. To better understand our operating performance, we focus on adjusted EBITDA, which by excluding unusual and certain other charges, is more useful for comparison and analysis in connection with sales trends. In the third quarter, adjusted EBITDA was $62.3 million, with solid EBITDA growth in both banners. Adjusted net income was $16.9 million or $0.23 per fully diluted share, a 35% increase from the same period in 2017.

Also, as noted in our earnings release, we closed one additional legacy Smart & Final store in the third quarter where the lease was expiring and the store's performance was marginal. Turning now to the balance sheet and cash flow statements. We ended the quarter with cash and cash equivalents of $62.2 million as compared to $60.9 million in the year-ago quarter. Our working capital remains well controlled and in line with our expectations with investment and inventories of $292 million.

Our strong cash flow allowed us to pay down debt in the quarter, bringing our total debt balance to $660 million at quarter end. And at quarter end, we had $35 million outstanding under our $200 million revolving credit facility, a reduction of $46 million year to date, with half of that paid down in the third quarter. Net debt to adjusted EBITDA at the end of the third quarter was approximately 3.2 times and we expect to see further reduction by year-end. We ended the quarter with cash generated from operations of $109.5 million, and we remain in a strong liquidity position.

Turning now to our guidance for 2018. We continue to refine our store development plans and two stores scheduled to open late in 2018 will now open in early 2019, one each in the Smart & Final and Smart Foodservice banners, with both stores impacted by construction delays. In the key sales metrics, we expect full-year sales growth in the range of 3.5% to 3.75% with the revised guidance incorporating inflation at 0%, additional legacy store closures in 2018 and the delay of two stores to 2019. For comparable store sales, we expect full-year comps of 1% to 1.25% the lower end of our previously guided range and also reflective of the lower than originally expected inflation rate.

In adjusted EBITDA, we have narrowed the guidance range to $180 million to $185 million for the full-year 2018. Assumed within this outlook is 0% product price inflation for the full year. As you may recall, when we first offered guidance for 2018, we were anticipating approximately 1% inflation for the year. Given the year-to-date performance, this guidance implies a fourth-quarter adjusted EBITDA in the range of $40 million to $45 million.

For guidance on adjusted net income and adjusted EPS, we expect to achieve results at or slightly above the upper end of the prior guidance range. We now guide to a range of $34 million to $36 million for adjusted net income and $0.46 to $0.48 per share for adjusted fully diluted EPS. This reflects, in part, our favorable income tax rate year to date and our expectations for interest expense at current market rates. Guidance for capital expenditures and weighted average number of shares remain in the previously issued ranges.

Looking beyond the current year to 2019, as Dave mentioned, we plan to open two to three Smart & Final banner stores and four to five new Smart Foodservice stores, along with three relocations or expansions of Smart & Final legacy stores to new Extra! format stores. As a result, we expect that our 2019 capital spending commitments will remain relatively modest, which provides the opportunity to continue to deploy our free cash flow to reduce financial leverage. And with that, I'll turn the call back to Dave.

Dave Hirz -- President and Chief Executive Officer

Thanks, Rick. Thanks again for your participation in today's call. As we discussed, the third quarter was marked by solid sales growth and strong margins in spite of deflationary pressures. We're making targeted investments in total to support digital commerce and our infrastructure, and we're building on our core strengths in value pricing and merchandising.

We're excited about many of the trends we saw in the third quarter and are continuing to see early in the fourth quarter. On a more serious note, California has recently been severely impacted by wildfires, and for the Smart & Final and Smart Foodservice families, this has really hit home. Many of our associates in the impacted areas had to be evacuated. Sadly, a couple also lost their homes.

During this difficult time, our thoughts and prayers are with our associates, customers and communities impacted by these fires. Through our foundation and our generous customer contributions, we've raised funds for relief efforts, provided donations of food and supplies to first responders, evacuation centers, churches and animal shelters. Even in the midst of this tragedy, I'm inspired by how our associates always step up to support first responders' efforts on the ground. I want to thank our associates for their ongoing commitment to make Smart & Final stores not only a great place to shop and work but a positive and meaningful partner for our communities.

And now we'd be happy to take your questions. 

Questions and Answers:

Operator

Thank you [Operator instructions] Our first question comes from the line of Bill Kirk with RBC Capital Markets. Please proceed with your question.

Bill Kirk -- RBC Capital Markets -- Analyst

Thank you for taking the questions. So over the last couple of months, Costco has called out some strength in some of your most important markets. Has their success in those regions -- has that limited your comp store sales growth?

Dave Hirz -- President and Chief Executive Officer

I don't believe it's had an impact. If I look at our sales growth in the quarter, at the beginning of the quarter, it's actually fairly consistent with sales growth in the second quarter. In the back half of the quarter, sales and traffic really strengthened and our five weeks into quarter 4 continues to strengthen. We think much of the change in the quarter has to do with cycling the competitive intensity that started a year ago, late in the third quarter.

But we don't see any real competitive impacts over and above normal.

Bill Kirk -- RBC Capital Markets -- Analyst

OK, got it. And when I look at your merchandise margin, am I seeing the benefits of capturing some of that input deflation? Or is that the benefits of not chasing some of that lower margin promotion activity?

Dave Hirz -- President and Chief Executive Officer

On product margin, we have a strong product margins, really just leveraging CPG cost of goods, more success in our strategic sourcing initiatives, primarily around lower cost of goods for our private label and then mix changes from some of our merchandise and initiatives helped. But on gross margin, Rick?

Rick Phegley -- Senior Vice President and Chief Financial Officer

Sure. Bill, I think, what you'd see is most of the improvement came from merchandise margin, but we had a little bit of improvement in terms of the other margin elements in distribution and occupancy cost as well.

Bill Kirk -- RBC Capital Markets -- Analyst

OK, that's it for me. Thank you.

Dave Hirz -- President and Chief Executive Officer

Thanks.

Operator

Our next question comes from the line of Edward Kelly with Wells Fargo. Please proceed with your question.

Edward Kelly -- Wells Fargo -- Analyst

Yeah. Hi, guys. Good afternoon. So I wanted to ask some questions about the guidance.

So you've been keeping EBITDA like reasonably stable, even up in some quarters for most of the year but Q4 looks like it's expected to be softer. Can you just provide a bit more color on what's driving this and how we should be thinking about some of the individual pieces in Q4?

Rick Phegley -- Senior Vice President and Chief Financial Officer

Sure. And I think, to a large extent, this is reflective of what we see in inflation and deflation. And we started the year, as you know, with a much stronger inflationary picture coming out of a decent Q4 and with that -- at that point, we're forecasting 1% inflation, overall, for the year. And we've seen a fairly steady deterioration, albeit recently a little moderating, but pretty steady deceleration through Q3 and early into Q4.

And it just makes it tough to leverage costs. So I think, we have a story that's very consistent on the EBITDA front with what we see on the inflation front.

Edward Kelly -- Wells Fargo -- Analyst

OK. And just Rick, thinking about 2019. And I know, it's a little early to give color, but as we think about 2018, I mean, this has clearly been a tougher year, given a return in deflation, outsized cost investments, the competitive environment's a little tough. But you've generally done a pretty good job, I think, from an EBITDA standpoint.

As we think about next year, how do we think about the potential areas of relief, the potential areas of risk? What has to happen for you to grow EBITDA next year?

Rick Phegley -- Senior Vice President and Chief Financial Officer

I think, No. 1, would be we do believe that we'll see some spring back in inflation to a more normalized level. This is a very sustained period of deflationary activity over the last few years, really unusual. And many of the underlying statistics, including most recent PPI statistics, would point to a more normal level of inflation on a go-forward basis or at least less deflationary, which will help leverage costs.

In addition, we continue to see good growth in average ticket in both banners, very strong and stable gross margins in both banners. As Dave mentioned, overall gross margin rate is the highest it's been in 10 years and a growing e-commerce business. And we think all of those can provide the impetus for a stronger 2019, and we also look forward to continued deleveraging on financial leverage in 2019.

Edward Kelly -- Wells Fargo -- Analyst

Great. And just Dave, one last question for you maybe. As we think about the Foodservice business, comps are pretty good this quarter despite the fact that you're over-indexed to some of these deflationary categories. Just overall, what are you seeing here? How are you feeling about the new stores that you've been opening? Maybe some color on how they're ramping.

And then just an update on the strategic emphasis of this business going forward. It sounds like you do remain optimistic about store growth.

Dave Hirz -- President and Chief Executive Officer

Yeah, we really do. We're really happy with what's going on in foodservice. It does seem like that foodservice customer continues to strengthen, and we continue to benefit from the trend for food away from home. New stores, again, they were new to us, and we spent some time studying them, but I would tell you, as we -- although we still study them, we're pretty happy with the results.

We've opened 11 new warehouse stores in the last 36 months. And on average, they are at or above pro forma expectations. We're seeing good success in existing markets, where we suffered a little bit of cannibalization but they then ramp much faster than a new market. But even in new markets, they're ramping sales and EBITDA in line with expectations.

So we're pretty bullish on the growth prospects of the banner.

Edward Kelly -- Wells Fargo -- Analyst

Great. Thanks, guys.

Dave Hirz -- President and Chief Executive Officer

Thank you.

Operator

Our next question comes from the line of John Heinbockel with Guggenheim Securities. Please proceed with your question.

John Heinbockel -- Guggenheim Securities -- Analyst

So two things. I wanted to go back to the gross margin drivers. So strategic sourcing, it sounds like that was the biggest driver in the quarter of gross-margin improvement in both the segments. Is that fair?

Dave Hirz -- President and Chief Executive Officer

I don't know it's the biggest driver, but it's a big driver. Our private-label margins continue to get stronger than overall margins, and a lot of that is better costs and goods from our strategic sourcing department that we run here internally. But we also have had some success with lower cost of goods from CPG companies. Although you listen to the press, they say they're all here trying to raise costs but we've had some luck there.

And then some of our merchandising initiatives have continued to help us with the mix changes and help us with the product-margin growth.

John Heinbockel -- Guggenheim Securities -- Analyst

The other thing you called out was business customer mix. Now is that the business customer versus the retail customer being higher margin? Or is that within the business customer segment mix improving what they're buying, specifically?

Dave Hirz -- President and Chief Executive Officer

Overall, business customer penetration is continuing to be really strong even though now, 80% of our sales are coming from Extra! stores. And you know historically, Extra! stores penetration is around 27% and legacy stores are around 36%. But -- and now we're up to 80% of our sales from Extra! stores penetration that's still really, really strong in the quarter. Average sales from that business customer continues to be above double.

The household customer and that business customer really over-indexed as in private label. So it's a more profitable customer, both on the sales side and the margin side than household customers.

John Heinbockel -- Guggenheim Securities -- Analyst

And then just lastly, one of your -- one of the large traditional foodservice competitors in your market, right, FSA is being acquired. Is that an opportunity, given the disruption that could occur there, an opportunity for Smart Foodservice? And how do you take advantage of that?

Dave Hirz -- President and Chief Executive Officer

Yeah, I think, Derek and the team are watching that really close. That's a big acquisition, an expensive acquisition and it's too soon to tell, but we think potentially could present opportunities in the Pacific Northwest. But again, it's too soon to tell, but we're watching it really closely.

John Heinbockel -- Guggenheim Securities -- Analyst

All right. Thank you.

Operator

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

Karen Short -- Barclays Capital -- Analyst

Hi. Thanks. So I guess, I just want to go back to your comment on net comp. So net comp is not necessarily a definition that we're used to hearing.

And I guess, I'm asking this philosophically, because at the end of the day, cannibalization and inflation or deflation are just a function of the industry you're in. So I mean, maybe talk a little bit about why you think that's the right way of thinking about it. And then going with the net comp definition, it implies cannibalization of 30 basis points. So maybe help us think through how we should think about cannibalization going forward, given the unit growth kind of coming down?

Dave Hirz -- President and Chief Executive Officer

Sure. Cannibalization in the quarter was 20 to 30 points in both banners. We expect, on an ongoing basis, it will be in that range, again, probably depending on the stores where they open, but 20 points in the Smart & Final. When we look at comps historically, in what used to be the normal world, where we would run 2% inflation pretty -- it was pretty normal inflation for about a 10-year period, we would be running comps in a, call it, 3.5% comps, maybe 4% with the new stores.

So running about 150 points above inflation. When you're running negative deflation, it makes it much more difficult to get to 3.5% comps. So I think, a lot of the analysts, historically, have looked at kind of what's your net comps? When we looked at it last quarter, our total comps were up 60 points. We had 150-point swing in inflation from 80 points positive to 70 points negative.

And net of inflation, we feel pretty good about the growth, the strength in the third quarter versus the first and second quarter, particularly toward the end of the third quarter. Towards the end of the third quarter, we'd be again seeing closer to flat to positive traffic and early in the fourth quarter, we're feeling pretty good about traffic and comps.

Karen Short -- Barclays Capital -- Analyst

So, sorry, fourth quarter is flat to fourth quarter traffic? Is...

Dave Hirz -- President and Chief Executive Officer

Well, we're five weeks into the quarter, and I would say, that traffic has improved over Q3. It is flat to slightly positive in both banners. And so traffic is stronger and comps sales is stronger than quarter 3. But it really started -- the last month of quarter 3 was, by far, our strongest quarter, both for traffic and comps.

And then now five weeks into quarter 4, we're seeing the same trend we saw at the end of quarter 3.

Karen Short -- Barclays Capital -- Analyst

OK, so I guess, appreciating that there are several puts and takes to reported gross margin and obviously, you called those out, I guess what I'm wondering is given that traffic hasn't been overly robust, although it seems like it's improving a little bit, I mean, isn't it some -- isn't potentially a greater price investment, something that you need to consider to get traffic in and, I guess, overall comps into more leverageable territory?

Dave Hirz -- President and Chief Executive Officer

Yes, again, our take on investment is we've worked hard to maintain our gap in price position versus our competitors of 6% to 12% from conventionals. We have purposely not overinvested in promotional activity. And again, it was difficult cycling through the intensity of promotional activity. But since it ended about a month before the end of the third quarter, we've seen an uptick in traffic, an uptick in comps.

And we think, our promotional strategy today is the right strategy, and our level of pricing to our competitive and club competitors is the right place to be.

Karen Short -- Barclays Capital -- Analyst

OK, and then -- sorry, last question from me. Just on CAPEX, given what you just went over in terms of unit potential or unit growth, I mean, it seems to me like CAPEX total for fiscal '19 could be kind of in the $60 million range. Is that fair? Or are you going to be reallocating or allocating more CAPEX to some of these, I guess, e-commerce type or just IT-related initiatives?

Rick Phegley -- Senior Vice President and Chief Financial Officer

We always, Karen, have some special initiative in the year that tends to be in the range of $10 million. So I think, we've -- although we haven't given a specific number, obviously, for 2019, the range that you cited seems a little bit low to us.

Dave Hirz -- President and Chief Executive Officer

Let me tell you, on the investment mix on digital in 2018, the $60 million investment capital, we would expect that will be lower going forward. Really the heavy blocking and tackling and the build-out of the infrastructure, a lot of that was -- is being completed in 2018, and it should be lower in future years. Although, overall market continues to evolve, and we will still continue to invest in innovation in the future.

Karen Short -- Barclays Capital -- Analyst

OK, great. Thanks.

Operator

Our next question comes from the line of Tom Palmer, JPMorgan. Please proceed with your question.

Tom Palmer -- J.P. Morgan -- Analyst

Hey, thanks for taking my question. On the inflationary front, you mentioned that perishable categories are rolling over, and we've also heard from several packaged food companies who plan to take less price increases, I guess, more of a 2019 event. Is this consistent with what you are seeing? And if so, based on the timing of these planned price increases, at what point might we start to see center store inflation accelerate, maybe be a little bit of an inflationary tailwind for you?

Dave Hirz -- President and Chief Executive Officer

Soon, we hope. Again, the deflation in the quarter just started in quarter 3 and it really was pretty isolated. And I think, we said seven out of the 26 categories. And the lion's share of that was in -- first, in produce and then also in the meat department.

We saw -- when we were in an inflationary environment, we saw competitors being very rational passing through price increases and inflation. But we're seeing the same thing here when we're seeing produce costs come down 3% to 6%, we're seeing competitors lower retails in many cases. And in produce, too. Produce is deflationary, depending on which banner you're looking at, 4% to 7% deflationary.

And we're seeing retails coming down there, too. So unfortunately, retails get passed through in a deflationary environment as they do in an inflationary environment.

Tom Palmer -- J.P. Morgan -- Analyst

OK, thanks. I know, you've been asked a lot about the gross margin uptick. I had maybe a little bit different of an angle to ask about it. You talked about how you're using more analytics maybe to kind of refine merchandising and promotions.

How much have you let your price gaps drift on items that maybe customers are not as price-sensitive to? So I know, that you've kind of cited that your gaps remain consistent, but is that across the entire store? Or have -- is this a key driver? Is that what's helping to kind of drive this margin higher?

Dave Hirz -- President and Chief Executive Officer

Yeah, that's a great question. If I look at our gaps, we're 6% to 12% lower than our conventional competitors. That is wall to wall, so we're priced in every item carried in all of our conventional competitors or mass merchant competitors on a monthly basis and strong commodities on a weekly basis. We actually, since we began our analytics with Nielsen earlier in the year, we've actually invested $4.5 million in lower retails to drive traffic.

Most of that's focused on highly elastic and sensitive items that are really important to our value shoppers. We think that's part of what's helping us build traffic here at the end of Q3 and now in Q4, is the price investments that we made. So again, the investment has been really on items that, as you mentioned, are highly elastic and highly price-sensitive items, and we think it makes sense to put our investment dollars there.

Operator

Our next question comes from the line of Rupesh Parikh with Oppenheimer. Please proceed with your question.

Rupesh Parikh -- Oppenheimer & Co. Inc. -- Analyst

Good afternoon. Thanks for taking my questions. So maybe first on the SG&A line. We saw pretty meaningfully deleverage during the quarter.

So I was just hoping to understand, what type of leverage point you guys believe you need to -- or what type of comps you believe you need to leverage the SG&A line? And I was just hoping to just get more clarity in terms of how you're thinking about some of these cost headwinds going into next year.

Rick Phegley -- Senior Vice President and Chief Financial Officer

Great question. So we've said before that in an inflation environment that's more normal kind of a 2% inflation environment, which, as Dave said, has really been more of a long-term trend, that if we can get top-line inflation in that same range, that we can leverage the P&L quite well. I think, in the current environment, we would say that we just need to leverage the costs and the top line at something that's a positive number. And the negative deflation has really been a challenge.

So rather than give you a specific number, I would just say a closer correspondence to the underlying cost inflation, you'll see meaningful leverage in the income statement.

Rupesh Parikh -- Oppenheimer & Co. Inc. -- Analyst

OK, great. And then switching topics. It sounds like, especially quarter-to-date, your commentary on traffic suggests an improvement of what you're seeing this quarter. So I'm just curious, if you -- I know, you guys laid out a number of traffic-driving initiatives earlier this year.

I was just wondering which ones do you think have been most effective in helping to drive the improvement there.

Dave Hirz -- President and Chief Executive Officer

We think -- many traffic-driving initiatives around our business customer. We had some initiatives in pilot in the seven-store MSA in Central California. And early in the quarter, we rolled that out to 45 more stores. We think, that helped us drive some traffic with our business customer, specifically household traffic.

I'll tell you, one of our main focus initiatives is really around Nielsen analytics, both pricing and promotion. In addition to that, I think, we're making good traction on customer service. I know, we've talked about it but our shopping experience in store, I think, is better. Our wait times are better.

Our in-stock, I think, is industry-leading. I think in quarter 3, our in-stock was actually 98.4% in the Smart & Final banner, really, really strong in-stock. I think, that builds a ticket, but I think it also builds traffic when you can be relied upon to have the items of stock the customers are looking for. So I think, it's a combination of things.

And then, of course, just cycling the promotion activity that started in the third quarter in 2017 has helped to stabilize and let us begin growing traffic again.

Rupesh Parikh -- Oppenheimer & Co. Inc. -- Analyst

OK, great. Thank you.

Operator

[Operator instructions] Our next question comes from the line of Paul Trussell with Deutsche Bank. Please proceed with your question.

Paul Trussell -- Deutsche Bank -- Analyst

I just wanted to circle back on the deflation commentary. Just for clarification, you mentioned, I think, 150 basis points or so sequential headwind from 2Q to 3Q. As we think about the fourth quarter, should we expect deflation levels? Or is your expectation that deflation will be very similar sequentially? Or has it actually been further deflationary? And then also just wanted to get more details on the adoption and growth trends of the online business. I think, you highlighted like triple-digit growth.

So if you can just give us maybe a bit of an update on what you're seeing and kind of customer response and how you're thinking about the cadence of that going forward.

Dave Hirz -- President and Chief Executive Officer

All right. On your first point on comps, again, comps were -- I mean, inflation was 70 points negative in the quarter. In quarter 2, they were 80 points positive so that 150-point headwind, obviously, was a battle. We're five weeks into quarter 4, and we're still seeing deflation.

I would call it slightly better than it was in quarter 3, but we're still having inflation in the quarter. But if you look at our guide for the year, year to date, we're running at about 1% comps. Our guide for the year is 1% to 1.25%, so we're feeling pretty good about comps in the fourth quarter, based on the trend in the last four weeks of Q3 and the first five weeks of Q4, we feel pretty good about where comps are going. Online delivery, online sales in the Smart & Final banner is actually up 102%, instead of 100% and Smart Foodservice up 500%.

Again, online and Smart & Final is really primarily delivery. That's where most of the volume is coming from. We're pretty happy with our investments in delivery. A lot of our infrastructure build has been to support delivery.

In the Smart Foodservice Warehouse stores, a lot of the growth has been in the click-and-carry model, where it continues to grow. That explains a lot of the growth in the quarter. And average sale in that click and carry continues to be over $700 per customer versus about $100 in-store customer. So overall, digital delivery and Click-and-Collect is working pretty well in both banners and growing quickly.

Paul Trussell -- Deutsche Bank -- Analyst

Thank you for the color.

Operator

Our next question comes from the line of Vincent Sinisi with Morgan Stanley. Please proceed with your question.

Vincent Sinisi -- Morgan Stanley -- Analyst

Wanted to go to -- Dave, you mentioned earlier on in the prepared remarks about a more aggressive marketing campaign. Just to be clear, is that something that is within both banners? Or is that more -- I know you, mentioned more around kind of the household customers with pricing. But as you mentioned, your traffic has sequentially improved. So is it -- anything outside of that? Are you doing different sorts of mediums or cadence of advertising? That'd be great.

Dave Hirz -- President and Chief Executive Officer

Yeah, I don't know that the prepared remarks talked about an increase in marketing intensity. But we continue to focus all of our marketing efforts pretty evenly on both household and business customers. And as I mentioned, business traffic and business customers in the quarter was really strong. Household traffic was pretty flat up until the last month of quarter 3 and now as we entered quarter 4, the traffic and comps are better in both.

Vincent Sinisi -- Morgan Stanley -- Analyst

OK, and then maybe just a quick follow-up. I know, you gave kind of the '19 store growth by banner guide. Just more kind of holistically, longer term. You guys are getting certainly more and more comfortable with the Smart Foodservice banner growth there.

Just maybe any qualitative thoughts on -- going forward, are you at the point now where we should see that -- we know it's obviously bigger in terms of percent, but in terms of unit growth going forward, do you think we should see that over time meaningfully outpace your Extra! stores?

Dave Hirz -- President and Chief Executive Officer

Sure. I think, we've seen faster growth in Smart Foodservice this year, and we'll see it again next year. As I mentioned, we're pretty happy with the new store performance in the 11 stores we have opened in the last 36 months. The economics are actually pretty strong.

I think, I've mentioned before, our average Smart Foodservice Extra! store capital investment is about $1.8 million, so the return you need for a 25% cash on cash return is about $450,000 in the third year of performance. So we, again, are pretty bullish on Smart Foodservice, and we think we could see that growth outpace the Smart & Final growth certainly this year and in 2019.

Vincent Sinisi -- Morgan Stanley -- Analyst

OK, all right. Thanks very much, guys.

Operator

Our next question comes from the line of Greg Badishkanian with Citi. Please proceed with your question.

Garrett Klumpar -- Citi -- Analyst

Hey, guys. It's actually Garrett Klumpar on for Greg. Just going back to the 4Q-to-date inflation commentary, where are you seeing some of the moderation? Or are you actually seeing any of the categories that were deflationary or inflationary? Or where is the moderation coming from?

Dave Hirz -- President and Chief Executive Officer

Again, it's early in Q4 and the moderation is pretty small. We're still deflationary, but it has gotten slightly better than Q3. And it's been, I would say, primarily in meat more than produce. And again, keep in mind, about 19 of the 26 categories are not deflationary.

It's really just been a few categories and those categories improved slightly as we entered quarter 4.

Garrett Klumpar -- Citi -- Analyst

OK, that's helpful. And then just switching gears. I know, you talked about, obviously, in the Smart & Final banner, delivery is driving a lot of the online growth. But I think you also talked about piloting Click-and-Collect both in-house and using Instacart.

I wonder if you could just provide an update there on what you're seeing from a demand perspective and basket size and incrementality. And do you anticipate kind of using both models moving forward? Or do you think you'll end up going with either the in-house or the third-party?

Dave Hirz -- President and Chief Executive Officer

In which banner, in both banners?

Garrett Klumpar -- Citi -- Analyst

In the Smart & Final banner.

Dave Hirz -- President and Chief Executive Officer

OK. Yeah, in the Smart & Final banner, our growth was primarily from delivery. Delivery has resonated really strong with our customers, both on the instacart.com and also shop.smartandfinal.com, where 25% of our Internet sales now are flowing. And that's where really the fastest growth is on our website.

Click and carry at Smart & Final, we have a couple of different models going. One is in pilot in a six-store MSA in Central California for the business customer. We're trying the Smart Foodservice Warehouse stores type click-and-carry program. It's resonating but not as strongly as delivery.

Delivery, both with our household customer and business customer appears to be really the preferred model for the Smart & Final customer versus Click-and-Collect. It just not has not taken off in the pilot stores in the Smart & Final banner.

Garrett Klumpar -- Citi -- Analyst

All right, great. Thanks so much for the color.

Operator

Our next question comes from the line of Judah Frommer with Crédit Suisse. Please proceed with your question.

Yunhee Park -- Credit Suisse -- Analyst

Hi. This is actually Yunhee on for Judah. Thanks for taking our question. Quickly on the e-commerce front.

You mentioned your focus is getting a greater capture of customer data and purchase history. Can you share with us how much data you actually have currently on the customers? And are they new customers to Smart & Final? Thanks.

Dave Hirz -- President and Chief Executive Officer

Yeah, sure. The data that we get from our customers go through the Instacart site is actually fairly limited. The data that we get from the now 25% of our shoppers at Smart & Final they're going through shop.smartandfinal.com. We're getting all of that data.

Again, the customer that goes through our website is their purchase -- average purchase is higher than when they go through the market, the market site, the Instacart site. We think about 50% or so of those customers are new customers. We don't have really -- when you come to our site, we have all their data. We know how often they shop with us on our site, etc., etc.

But is it more difficult to tell if they shopped at Smart & Final previously. But today, we think it's probably a little north of half our customers are new to Smart & Final.

Yunhee Park -- Credit Suisse -- Analyst

Thanks. And then on the foodservice side. It sounds like it's benefiting from the online options. So can you comment on the types of customers that are utilizing the service? Are they restaurants or commissaries? And then quickly, what is the charge that foodservice customers are paying for delivery or Click-and-Collect? Thanks.

Dave Hirz -- President and Chief Executive Officer

Yeah, it is primarily restaurants. And it's a mix of new customers and existing customers. But even when it's an existing customer, their average purchase order size before was $100 in-store and now outside of the store, it's -- on the click and carry it's $700, so a really meaningful increase in the size of the order. The mix is very similar of a normal restaurant customer and then the charge in the Smart Foodservice Warehouse stores, we actually up-charge individual items to offset the cost of the labor involved in the click and carry.

The other thing it really helps us in click and carry is in every case, these are next-day deliveries. So we're taking the orders for the restaurants for next day. It allows us to be much more flexible in our labor when we put the orders together and have it ready the next day for the customer to pick up.

Yunhee Park -- Credit Suisse -- Analyst

Great. Thank you.

Operator

Our next question comes from the line of Andrew Wolf with Loop Capital Markets. Please proceed with your question.

Andrew Wolf -- Loop Capital Markets -- Analyst

Thanks. Good afternoon. With the fourth quarter looking better on the comps and traffic, I guess, a little bit less deflation. I'm trying to reconcile that with the bringing down the high end of guidance.

And obviously, you said, there's lessened environment turned deflationary and I understand why that's the main thing. But as you look at the third quarter versus the fourth quarter, how would you kind of apportion this bringing down the high end? I guess, what I'm really asking was the third quarter a bit lower than you expected due to deflation and maybe the fourth quarter is going to be even closer to your plan, given that your traffic and your comps are better. I'm just trying to understand the mix there between your expectations and your guidance.

Rick Phegley -- Senior Vice President and Chief Financial Officer

Sure, Andy. So I think, if you think about where we guided for the year, initially, we guided to $10 million EBITDA range, and we're looking for 1% inflation. And as we've said, the inflation has steadily dropped through the year, 1.4% positive in Q1, 0.8% in Q2, negative 0.7% in Q3. And what we've done now by narrowing the guidance range from $10 million range to a $5 million range is recognize the income effect of that lower inflation assumption for the year.

So it's really embodied within the overall P&L leverage relative to inflation more than anything else.

Dave Hirz -- President and Chief Executive Officer

If you look at the guide that we gave for the year, the guide we gave for the year was 1% to 1.25%. On a year-to-date basis, today, we're at 1%. So 1% to 1.25% for the year really implies that in fourth quarter, comps would be somewhere between 1% and 2%.

Andrew Wolf -- Loop Capital Markets -- Analyst

Yeah, yeah, and I saw that. Obviously, the traffic turning up that quickly. That's pretty -- I assume you feel somewhat good about the fourth quarter, at least, what you can control. And with the traffic turning up at the stores, I mean, I can go back and look, but how much of that is the comparison being sort of a little easier with the promotional environment anniversary-ing and no longer getting worse on a year-over-year basis? And how much of that is your own initiatives bringing back some customers?

Dave Hirz -- President and Chief Executive Officer

That's a good question. I mean, there's no doubt that when we cycled the promotion and sensed the increase from the end of Q3 a year ago, that we were cycling easier comps. But I think a lot of what's driving traffic here beginning in the middle -- end of the third quarter is really around our initiatives. The pricing and promotion activity with our Nielsen analytics, the customer-service initiatives, the in-stock, I think, is all helping to drive additional traffic.

And again, ticket is also improving it. Although ticket was strong in Q3, ticket is improving, because we continue, even in Q4, to drive comps in club and business and private label ahead of total store comps in the Smart & Final banner.

Andrew Wolf -- Loop Capital Markets -- Analyst

Just one last question if I could on the wage inflation you cited. I guess, you referenced the minimum wage increases, in, I guess, mainly in California and your other markets. Where is Smart & Final and Smart Foodservice, where are those banners relevant to the market? And are the minimum wage increases that are to come going to continue to inflate that line? Or are you guys in front of that?

Scott Drew -- Executive Vice President of Operations

So Andy, Scott here. What I would tell you on that, relative to other players, we have a much smaller percentage of our workforce that's really tied to minimum wage. Under 5% of all of our associates are at minimum wage. So this really strengthens our position relative to the other players who have more exposure in that area.

But to date, while we, along with others, we started passing this through in pricing, we've had a modest impact to our O&A. We absorbed these incremental costs, and we expect this to continue with the minimum wage increases. When you look at our average hourly rate out there at Smart & Final, it's north of $17. At Smart Foodservice stores, it's over $20 an hour.

So we're well positioned in the marketplace.

Andrew Wolf -- Loop Capital Markets -- Analyst

Great. Thank you very much.

Dave Hirz -- President and Chief Executive Officer

OK, Andy. Thank you.

Operator

[Operator signoff]

Duration: 70 minutes

Call Participants:

Laura Bainbridge -- Investor Relations

Dave Hirz -- President and Chief Executive Officer

Rick Phegley -- Senior Vice President and Chief Financial Officer

Bill Kirk -- RBC Capital Markets -- Analyst

Edward Kelly -- Wells Fargo -- Analyst

John Heinbockel -- Guggenheim Securities -- Analyst

Karen Short -- Barclays Capital -- Analyst

Tom Palmer -- J.P. Morgan -- Analyst

Rupesh Parikh -- Oppenheimer & Co. Inc. -- Analyst

Paul Trussell -- Deutsche Bank -- Analyst

Vincent Sinisi -- Morgan Stanley -- Analyst

Garrett Klumpar -- Citi -- Analyst

Yunhee Park -- Credit Suisse -- Analyst

Andrew Wolf -- Loop Capital Markets -- Analyst

Scott Drew -- Executive Vice President of Operations

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