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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

x                QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2014;

OR

o                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 001-35608

Natural Grocers by Vitamin Cottage, Inc.

(Exact name of registrant as specified in its charter)

(303) 986-4600

(Registrant’s telephone number, including area code)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act).

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of April 29, 2014 was 22,476,986.

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Natural Grocers by Vitamin Cottage, Inc.

Quarterly Report on Form 10-Q

For the Quarterly Period Ended March 31, 2014

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Except where the context otherwise requires or where otherwise indicated, all references herein to ‘‘we,’’ ‘‘us,’’ ‘‘our,’’ ‘‘Natural Grocers,’’ and ‘‘the Company’’ refer collectively to Natural Grocers by Vitamin Cottage, Inc. and its consolidated subsidiaries.

Forward-Looking Statements

This report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 in addition to historical information. These forward-looking statements are included throughout this report on Form 10-Q, including in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” All statements that are not statements of historical fact, including those that relate to matters such as our industry, business strategy, goals and expectations concerning our market position, future operations, margins, profitability, capital expenditures, liquidity and capital resources and other financial and operating information are forward-looking statements. We have used the words “anticipate,” “assume,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “future” and similar terms and phrases to identify forward-looking statements in this report on Form 10-Q.

The forward-looking statements contained in this report on Form 10-Q are based on management’s current expectations and are subject to uncertainty and changes in circumstances. We cannot assure you that future developments affecting us will be those that we have anticipated. Actual results may differ materially from these expectations due to changes in global, regional or local political, economic, business, competitive, market, regulatory and other factors, many of which are beyond our control. We believe that these factors include those referenced in “Risk Factors” in our report on Form 10-K for the year ended September 30, 2013 (our “Form 10-K”), as amended by Part II, Item 1A of this report on Form 10-Q. Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove incorrect, our actual results may vary in material respects from those projected in these forward-looking statements.

Any forward-looking statement made by us in this report on Form 10-Q speaks only as of the date of this report. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by any applicable securities laws. You are advised, however, to consult any further disclosures we may make in our future reports to the Securities and Exchange Commission, on our website or otherwise.

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PART I. Financial Information

Item 1.  Financial Statements

NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Balance Sheets

(Unaudited)

(Dollars in thousands, except per share data)

See accompanying notes to unaudited interim consolidated financial statements.

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NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Statements of Income

(Unaudited)

(Dollars in thousands, except per share data)

See accompanying notes to unaudited interim consolidated financial statements.

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NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Statements of Comprehensive Income

(Unaudited)

(Dollars in thousands)

See accompanying notes to unaudited interim consolidated financial statements.

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NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Statements of Cash Flows

(Unaudited)

(Dollars in thousands)

See accompanying notes to unaudited interim consolidated financial statements.

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NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Notes to Unaudited Interim Consolidated Financial Statements

March 31, 2014 and 2013

1. Organization

Nature of Business

Natural Grocers by Vitamin Cottage, Inc. (Natural Grocers or the holding company) and its consolidated subsidiaries (collectively, the Company) operate retail stores that specialize in natural and organic groceries and dietary supplements. The Company typically operates its retail stores under its trademark Natural Grocers by Vitamin Cottage® with 81 stores as of March 31, 2014, including 32 stores in Colorado, 13 in Texas, six in Oregon, five each in Kansas and New Mexico, four in Montana, three each in Arizona, Idaho, Nebraska and Oklahoma, two in Wyoming, and one each in Missouri and Utah, as well as a bulk food repackaging facility and distribution center in Colorado. The Company had 72 stores as of September 30, 2013.

2. Basis of Presentation and Summary of Significant Accounting Policies

Consolidated Financial Statements

The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial statements and are in the form prescribed by the Securities and Exchange Commission in Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The information included in this report on Form 10-Q should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended September 30, 2013.  In the opinion of management, the accompanying consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation.  Interim results are not necessarily indicative of results for any other interim period or for a full fiscal year. The Company reports its results of operations on a fiscal year ending September 30.

The holding company was incorporated in Delaware on April 9, 2012. The accompanying consolidated financial statements include all the accounts of the Company’s wholly owned subsidiaries, Vitamin Cottage Natural Food Markets, Inc. (the operating company), Vitamin Cottage Two Ltd. Liability Company and Natural Systems, LLC. The operating company formed the holding company in order to facilitate the purchase of the remaining noncontrolling interest in Boulder Vitamin Cottage Group, LLC and consummation of the Company’s initial public offering (IPO) during fiscal year 2012.  All significant intercompany balances and transactions have been eliminated in consolidation.

The Company has one reporting segment, natural and organic retail stores.  Sales from the Company’s natural and organic retail stores are derived from sales of the following products, which are presented as a percentage of sales for the three and six months ended March 31, 2014 and 2013 as follows:

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the balance sheet date and reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Recent Accounting Pronouncements

In February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update, or ASU, No. 2013-02 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income.” ASU No. 2013-02 supersedes

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the presentation requirements for reclassifications out of accumulated other comprehensive income in both ASU No. 2011-12 and 2011-05.  ASU No. 2013-02 requires an entity to disaggregate the total change of each component of other comprehensive income either on the face of the income statement or as a separate disclosure in the notes. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This update was effective for the Company beginning in the quarter ended December 31, 2013. The adoption of this update did not have a material effect on the Company’s consolidated financial statements.

3. Earnings Per Share

Basic earnings per share (EPS) excludes dilution and is computed by dividing net income by the weighted average shares outstanding during the period. Diluted EPS reflects the potential dilution that could occur if the Company’s granted but unvested restricted stock units were to vest, resulting in the issuance of common stock that would then share in the earnings of the Company. Presented below are basic and diluted EPS for the three and six months ended March 31, 2014 and 2013, dollars in thousands, except per share data:

There were 3,558 non-vested restricted stock units (RSUs) for the three and six months ended March 31, 2014 excluded from the calculation as they are antidilutive.  There were 4,856 antidilutive non-vested RSUs for the three and six months ended March 31, 2013.

The Company did not declare any dividends in the three and six months ended March 31, 2014 or 2013.

4. Long-Term Debt

Credit Facility

The Company has a revolving credit facility.  The operating company is the borrower under the credit facility and its obligations under the credit facility are guaranteed by the holding company.

On December 12, 2013, the Company entered into an amended and restated $15.0 million credit agreement that, among other things, (i) extended the maturity date of the Company’s revolving credit facility by three years to January 31, 2017, (ii) provides the Company with the right to request the issuance of letters of credit under the credit facility up to $3.0 million, (iii) allows the Company to increase the amount available under the revolving credit facility, up to an additional amount that may not exceed $10.0 million by obtaining an additional commitment or commitments, (iv) eliminated a requirement for a consolidated earnings before interest, taxes, depreciation and amortization to revenue ratio and (v) amended the unused commitment fee from 0.20% to amounts ranging from 0.15% to 0.35% based on certain conditions.

The Company had no amounts outstanding on the revolving credit facility as of March 31, 2014 and September 30, 2013.  During the six months ended March 31, 2014, the Company made and repaid draws on the revolving credit facility.  As of March 31, 2014, the Company had an undrawn, issued and outstanding letter of credit of $0.7 million which was reserved against the amount available for borrowing under the terms of the revolving credit facility.  There was an available balance of $14.3 million and $15.0 million as of March 31, 2014 and September 30, 2013, respectively, under the revolving credit facility.

As of March 31, 2014 and September 30, 2013, the Company was in compliance with the debt covenants under the credit facility.

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Capital and Financing Lease Obligations

From time to time, the Company enters into various leases that are included in capital and financing lease obligations.  The Company does not record rent expense for these capitalized real estate leases, but rather rental payments under the capital leases are recognized as a reduction of the capital and financing lease obligation and as interest expense (see Note 5).

Interest

The Company incurred gross interest expense of approximately $0.7 million and approximately $0.4 million in the three months ended March 31, 2014 and 2013, respectively, and approximately $1.4 million and approximately $0.7 million in the six months ended March 31, 2014 and 2013, respectively, related primarily to interest on capital and financing lease obligations.  The Company did not capitalize any interest for the three or six months ended March 31, 2014 and 2013, and had insignificant amounts of amortization of deferred financing costs for the three and six months ended March 31, 2014 and 2013.

5.  Lease Commitments

Capital and financing lease obligations as of March 31, 2014 and September 30, 2013, are as follows, dollars in thousands:

6. Property and Equipment

The Company had the following property and equipment balances as of March 31, 2014 and September 30, 2013, dollars in thousands:

As of March 31, 2014 and September 30, 2013, respectively, capitalized real estate leases for build-to-suit stores includes the assets for the Company’s buildings for build-to-suit stores under capital lease finance obligations, and capitalized real estate leases includes assets for the Company’s buildings under capital leases (see Note 5).

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Construction in process includes zero and approximately $1.3 million as of March 31, 2014 and September 30, 2013, respectively, related to construction costs for build-to-suit leases in process for which the Company was deemed the owner during the construction period.

Depreciation and amortization expense for the three and six months ended March 31, 2014 and 2013 is summarized as follows, dollars in thousands:

7. Supplementary Balance Sheet Information

Restricted Cash

As of September 30, 2013, the Company held $0.5 million in restricted cash which represented cash that was pledged as collateral for a standby letter of credit related to the Company’s workers’ compensation insurance. As of March 31, 2014, the Company had released the restricted cash balance which existed as of September 30, 2013, and had no restricted cash balance outstanding.

Accrued Expenses

The composition of accrued expenses is summarized as follows as of March 31, 2014 and September 30, 2013, dollars in thousands:

8.  Investments

The Company had available-for-sale securities consisting of certificates of deposit totaling approximately $0.1 million as of March 31, 2014, which were classified as short-term.  The Company had available-for-sale securities generally consisting of certificates of deposit, corporate bonds and municipal bonds of approximately $1.1 million as of September 30, 2013, which were classified as short-term.  At March 31, 2014 and September 30, 2013, the average maturities of the Company’s short-term investments were approximately one month and approximately five months, respectively.  There was no other-than-temporary impairment on available-for-sale securities as of March 31, 2014 or September 30, 2013.

During the three and six months ended March 31, 2014 and 2013, the Company recorded insignificant amounts of interest income and expense relating to amortized premiums paid.

9. Fair Value Measurements

The Company records its financial assets and liabilities at fair value in accordance with the framework for measuring fair value in authoritative guidance. The framework establishes a fair value hierarchy that distinguishes between assumptions based on market data (observable inputs) and the Company’s own assumptions (unobservable inputs).  The three levels are defined as follows:

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Non-financial assets, such as goodwill and long-lived assets, are accounted for at fair value, if determined to be impaired, on a non-recurring basis.  These items are tested for impairment on the occurrence of a triggering event or in the case of goodwill, at least on an annual basis.

The carrying amounts of financial instruments not included in the table below, including cash and cash equivalents, restricted cash, accounts receivable, accounts payable and other accrued expenses, approximate fair value because of the short maturity of those instruments.

As of March 31, 2014 and September 30, 2013, the Company had the following financial assets and liabilities that were subject to fair value measurements according to the fair value hierarchy, dollars in thousands:

The money market fund and available-for-sale securities are carried at fair value. For debt securities for which quoted market prices are not available, the fair value is determined using an income approach valuation technique that considers, among other things, rates currently observed in publicly traded debt markets for debt of similar terms to companies with comparable credit risk. During the three and six months ended March 31, 2014, the Company made no purchases of available-for-sale securities.  During the three and six months ended March 31, 2013, the Company made purchases of $0.2 million and $0.4 million, respectively, of available-for-sale securities.  During the three and six months ended March 31, 2014, the Company had $1.0 million and $1.0 million of maturities of available-for-sale securities, respectively.  During the three and six months ended March 31, 2013, the Company had $0.3 million and $0.3 million of maturities of available-for-sale securities, respectively.  During the three and six months ended March 31, 2014 and 2013, and for the fiscal year ended September 30, 2013, there were no transfers between levels and the Company had no Level 3 assets.  See Note 8 for additional disclosures.

10. Share-based Compensation

The Company adopted an Omnibus Incentive Plan (the Plan) on July 17, 2012.  RSUs granted pursuant to the Plan, if they vest, will be settled in shares of the Company’s common stock.  Changes in non-vested RSUs outstanding under the Plan as of March 31, 2014 were as follows:

Each independent member of the Company’s Board of Directors is granted a number of RSUs under the Plan each year equal to the number of shares of common stock having a value of $50,000 based on the closing price of common stock on the New York Stock Exchange (NYSE) on the date of grant. All of these RSUs are granted on the date of the Company’s annual meeting of stockholders or, in the case of a mid-year appointment, a pro rata portion is granted at the time of appointment. In either case, the RSUs vest over a twelve month period and are expensed straight-line over that period.  The Company held its annual meeting of stockholders on March 5, 2014, and each independent member of the Company’s Board of Directors received awards based on the

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closing price of common stock on the NYSE on that date.  The RSU’s granted to the independent members of the Board of Directors at the Company’s annual meeting on March 6, 2013 vested on March 6, 2014.

The RSU grant to the Chief Financial Officer (CFO Award) under the Plan was in accordance with the terms of her employment agreement that was signed in June 2008, which stated she was entitled to receive a grant of RSUs equal to 1.2% of the fully diluted shares of the Company in connection with an IPO.  Two-thirds of the CFO Award vested immediately upon completion of the IPO and was settled in a combination of common stock and cash.  The remaining one-third was settled 100% in shares of common stock and vested, in three equal parts over a six, 12 and 18 month period following the IPO.  In January 2014, which was 18 months after the IPO, the final portion vested.

The Company recorded total share-based compensation expense before income taxes of approximately $0.2 million and $0.3 million in the three and six months ended March 31, 2014, respectively, and recorded less than $0.1 million in each of the three and six months ended March 31, 2013, respectively.  The share-based compensation expense is included in cost of goods sold and occupancy expenses, store expenses or administrative expenses in the consolidated statements of income consistent with the manner in which the applicable officer, board member or key employee’s compensation expense is recorded.  As of March 31, 2014, there was approximately $1.5 million of unrecognized share-based compensation expense related to non-vested RSUs net of estimated forfeitures, which the Company anticipates will be recognized over a weighted average period of approximately three years.

11. Related Party Transactions

The Company has ongoing relationships with related entities as noted below:

Isely Family Land Trust LLC:  The Company has one operating lease for a store location with the Isely Family Land Trust LLC (Land Trust). The Land Trust is owned by the Isely Children’s Trust and by the Margaret A. Isely Family Trust. Rent paid to the Land Trust was approximately $0.1 million for each of the three months ended March 31, 2014 and 2013.  Rent paid to the Land Trust was approximately $0.2 million for each of the six months ended March 31, 2014 and 2013.

Chalet Properties, LLC:  The Company has seven operating leases with Chalet Properties, LLC (Chalet). Chalet is owned by the Company’s four non-independent board members: Kemper Isely, Zephyr Isely, Heather Isely and Elizabeth Isely, and other related family members. Rent paid to Chalet was approximately $0.3 million for each of the three months ended March 31, 2014 and 2013.  Rent paid to Chalet was approximately $0.6 million for each of the six months ended March 31, 2014 and 2013.

12. Commitments and Contingencies

Legal

The Company is periodically involved in various legal proceedings that are incidental to the conduct of its business, including but not limited to employment discrimination claims, customer injury claims and investigations. When the potential liability from a matter can be estimated and the loss is considered probable, the Company records the estimated loss. Due to uncertainties related to the resolution of lawsuits, investigations and claims, the ultimate outcome may differ from the estimates. Although the Company cannot predict with certainty the ultimate resolution of any lawsuits, investigations and claims asserted against it, management does not believe any currently pending legal proceeding to which the Company is a party will have a material adverse effect on its business, prospects, financial condition, cash flows or results of operations.

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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 report on Form 10-Q and with our Form 10-K. This discussion and analysis contains forward-looking statements. Refer to Forward-Looking Statements at the beginning of this report 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 2014” refers to the year from October 1, 2013 to September 30, 2014).  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 believe we have been at the forefront of the natural and organic foods movement since our founding. We are headquartered in Lakewood, Colorado, and as of March 31, 2014, we operated 81 stores in 13 states, including Colorado, Arizona, Idaho, Kansas, Missouri, Montana, Nebraska, New Mexico, Oklahoma, Oregon, Texas, Utah and Wyoming, as well as a bulk food repackaging facility and distribution center in Colorado.

We offer a variety of natural and organic groceries and dietary supplements that meet our strict quality standards. We regularly review and update these standards.  During the three months ended March 31, 2014, for example, we updated our dairy standards and, as a result, plan by April 2015 to sell only pasture-raised, non-confinement dairy products.

The size of our stores varies from 5,000 to 16,000 selling square feet.  During the twelve months ended March 31, 2014, our new stores averaged approximately 11,500 selling square feet.

The growth in the organic and natural foods industry and growing consumer interest in health and nutrition has enabled us to continue to open new stores and enter new markets. During the five fiscal years ended September 30, 2013, we grew at a compound annual growth rate of 21.7%.  In fiscal year 2013, we opened 13 new stores, and we currently plan to open 15 new stores in fiscal year 2014, nine of which we opened during the six months ended March 31, 2014.  Since March 31, 2014 and as of the date of this report, we have opened two additional new store locations, signed leases for the remaining four new store locations expected to open in the remainder of fiscal year 2014 in Kansas, Oklahoma, Oregon and Washington, and have signed leases for four new store locations expected to open in fiscal year 2015 in Colorado, Kansas, Nevada and Oklahoma.  Additionally, we completed the remodel of one existing store location in the six months ended March 31, 2014 and plan to remodel one additional existing store in fiscal year 2014.

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.

·    Net sales.  Net sales were $130.3 million for the three months ended March 31, 2014, which is an increase of $23.9 million, or 22.4%, compared to net sales of $106.5 million for the three months ended March 31, 2013.  We reported net sales of $250.9 million for the six months ended March 31, 2014, which is an increase of $48.6 million, or 24.0%, compared to net sales of $202.3 million for the six months ended March 31, 2013.

·    Comparable store sales.  Comparable store sales for the three and six months ended March 31, 2014 increased 6.9% and 8.7%, respectively, over the three and six months ended March 31, 2013.

·    Daily average comparable store sales.  Daily average comparable store sales, which removes the effect of the additional one selling day for the occurrence of Easter in March of 2013, increased 5.7% and 8.1%, respectively in the three and six months ended March 31, 2014 over the three and six months ended March 31, 2013.

·    Mature store sales.  Mature store sales for the three and six months ended March 31, 2014 increased 4.9% and 5.9%, respectively, over the three and six months ended March 31, 2013.

·    Daily average mature store sales.  Daily average mature store sales, which removes the effect of the additional one selling day for the occurrence of Easter in March of 2013, increased 3.7% and 5.3%, respectively, in the three and six months ended

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March 31, 2014 over the three and six months ended March 31, 2013.

·    Net income.  Net income was $4.0 million for the three months ended March 31, 2014, which increased $0.8 million, or 24.3%, when compared to net income of $3.2 million for the three months ended March 31, 2013.  We reported net income of $6.9 million for the six months ended March 31, 2014, which increased $1.5 million, or 27.3%, when compared to net income of $5.4 million for the six months ended March 31, 2013.

·    EBITDA.  Earnings before interest, taxes, depreciation and amortization (EBITDA) was $11.2 million in the three months ended March 31, 2014, which increased $2.5 million, or 28.4%, from $8.8 million in the three months ended March 31, 2013.  We generated EBITDA of $20.6 million in the six months ended March 31, 2014, which increased $5.1 million, or 32.6%, from $15.5 million in the six months ended March 31, 2013.  EBITDA is not a measure of financial performance under GAAP. Refer to the end of this MD&A for a definition of EBITDA and a reconciliation of net income to EBITDA.

·    Liquidity.  As of March 31, 2014, cash and cash equivalents was $7.8 million, available-for-sale securities, consisting of certificates of deposit, was $0.1 million, and there was $14.3 million available under our $15.0 million amended and restated revolving credit facility.  As of March 31, 2014, the Company had an outstanding letter of credit of $0.7 million which was reserved against the amount available for borrowing under the terms of our revolving credit facility.  The Company had no amounts outstanding on the revolving credit facility as of March 31, 2014.

·    New store growth.  We opened five new stores during the three months ended March 31, 2014, and opened nine new stores during the six months ended March 31, 2014.  We operated a total of 81 stores as of March 31, 2014.  We plan to open a total of 15 new stores in fiscal year 2014, which will result in an annual new store growth rate of 20.8% for fiscal year 2014 compared to fiscal year 2013.

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:

·    Opportunities in the growing natural and organic grocery and dietary supplements industry.  Our industry, which includes organic and natural foods and dietary supplements, continues to experience growth driven primarily by increased public interest in health and nutrition. Capitalizing on this opportunity, we continued to open new stores and markets.  As we open new stores, our results of operations have been and may continue to be materially adversely affected based on the timing and number of new stores we open, their initial sales and new lease costs.  The length of time it takes for a new store to become profitable can vary depending on a number of factors including location, competition, a new market versus an existing market, the strength of store management and general economic conditions.  Once a new store is open, it typically grows at a faster rate than mature stores for several years after its opening date. Mature stores are stores that have been open for any part of five fiscal years or longer.

As we expand across the U.S. and enter markets where consumers may not be as familiar with our brand, we seek to secure prime real estate locations for our stores to establish greater visibility with consumers in those markets.  This strategy has resulted in higher lease costs, and we anticipate these increased costs continuing into the foreseeable future.  Our financial results for the three and six months ended March 31, 2014 reflect the effects of these factors, and we anticipate future periods will be impacted likewise.

·    Impact of broader economic trends.  The grocery industry and our sales are affected by general economic conditions, including, but not limited to, consumer spending, economic conditions, the level of disposable consumer income, consumer debt, interest rates, the price of commodities, the political environment and consumer confidence.

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, including 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 and developing efficient,

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effective new store opening, construction and operations processes and relocating and expanding our bulk food repackaging facility and distribution center in September 2012.  We will complete the implementation of a human resources information and learning management system in the third quarter of fiscal year 2014 which we believe will allow us to more efficiently and effectively onboard and train our employees at all locations.

We believe there are attractive opportunities for us to continue to expand our store base and focus on increasing comparable store sales. As we continue to expand our store base, we believe there are opportunities for increased leverage in fixed 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, such sourcing economies may not be reflected in our gross margin in the near term. Additionally, higher fixed costs of our bulk food repackaging facility and distribution center resulting from the September 2012 relocation and expansion may not be offset by retail price changes or volume increases 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, as amended by Part II, Item 1A of this report on 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, returns and allowances. In comparing net sales between periods we monitor the following:

·    Change in comparable store sales.  We begin to include sales from a store in comparable store sales on the first day of the thirteenth full month following the store’s opening. We monitor the percentage change in comparable store sales by comparing sales from all stores in our comparable store base for a reporting period against sales from the same stores for the same number of operating months in the comparable reporting period of the prior year. When a store that is included in comparable store sales is remodeled or relocated, we continue to consider sales from that store to be comparable store sales. Our comparable store sales data may not be presented on the same basis as our competitors. We use the term “new stores” to refer to stores that have been open for less than thirteen months.

·    Change in daily average comparable store sales.  Daily average comparable store sales are comparable store sales divided by the number of selling days in each period. We use this metric to remove the effect of differences in the number of selling days we are open during the comparable periods.

·    Change in mature store sales.  We begin to include sales from a store in mature store sales after the store has been open for any part of five fiscal years (for example, our mature stores for fiscal year 2014 are stores that opened during or before fiscal year 2009).  We monitor the percentage change in mature store sales by comparing sales from all stores in our mature store base for a reporting period against sales from the same stores for the same number of operating months in the comparable reporting period of the prior year.  When a store that is included in mature store sales is remodeled or relocated, we continue to consider sales from that store to be mature store sales. Our mature store sales data may not be presented on the same basis as our competitors.

·    Change in daily average mature store sales.  Daily average mature store sales are mature store sales divided by the number of selling days in each period. We use this metric to remove the effect of differences in the number of selling days during the comparable periods.

·    Transaction count.  Transaction count represents the number of transactions reported at our stores over such period and includes transactions that are voided, return transactions and exchange transactions.

·    Average transaction size.  Average transaction size is calculated by dividing net sales by transaction count for a given time period. We use this metric to track the trends in average dollars spent in our stores per customer transaction.

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

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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 report on 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 straight-line rent expense in cost of goods sold and occupancy costs for the leases classified as capital and financing lease obligations, but rather 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 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, the strength of store management, general economic conditions and the amount of time it takes a new store to become mature.

Interest expense

Interest expense consists of the interest associated with capital and financing lease obligations.  Interest expense also includes interest we pay on our outstanding indebtedness, which includes our revolving credit facility.

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Results of Operations

The following table presents key components of our results of operations expressed as a percentage of net sales for the periods presented:

Three months ended March 31, 2014 compared to the three months ended March 31, 2013

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

Net sales

Net sales increased $23.9 million, or 22.4%, to $130.3 million for the three months ended March 31, 2014 compared to $106.5 million for the three months ended March 31, 2013, primarily due to a $16.6 million increase in sales from new stores and a $7.3 million, or 6.9%, increase in comparable store sales.  Daily average comparable store sales increased 5.7% for the three months

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ended March 31, 2014 as compared to the three months ended March 31, 2013. The daily average comparable store sales increase was primarily driven by a 2.0% increase in daily average transaction count and a 3.7% increase in average transaction size.  Comparable store average transaction size was $36.76 in the three months ended March 31, 2014 compared to $36.37 in the three months ended March 31, 2013.  Daily average mature store sales increased 3.7% in the three months ended March 31, 2014 as compared to three months ended March 31, 2013.

Gross profit

Gross profit increased $6.9 million, or 21.8%, to $38.8 million for the three months ended March 31, 2014 compared to $31.8 million for the three months ended March 31, 2013, primarily driven by positive comparable store sales and new store growth.  Gross margin decreased slightly to 29.7% for the three months ended March 31, 2014 from 29.9% for the three months ended March 31, 2013 primarily due to an increase in occupancy costs as a percentage of sales for the three months ended March 31, 2014 as compared to the three months ended March 31, 2013, partially offset by an increase in product gross margin.  The positive impact in product margin is due to increased product margin across most departments, offset by a shift in sales mix towards products with lower margin in the three months ended March 31, 2014 as compared to the three months ended March 31, 2013.  Gross margin benefited from operating efficiencies at the bulk food repackaging and distribution center in the three months ended March 31, 2014 as compared to the three months ended March 31, 2013.  The increase in occupancy costs were primarily due to increased average lease expenses at new stores.

The Company had nine and seven leases for stores which were classified as capital and financing lease obligations for the three months ended March 31, 2014 and 2013, 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 March 31, 2014 and 2013 would have been approximately 60 and 40 basis points higher, respectively, than as reported.

Store expenses

Store expenses increased $4.7 million, or 21.3%, to $26.9 million in the three months ended March 31, 2014 from $22.2 million in the three months ended March 31, 2013. Store expenses as a percentage of sales were 20.6% and 20.8% for the three months ended March 31, 2014 and 2013, respectively. The decrease in store expenses as a percentage of sales was primarily due to a decrease in salaries, benefits and related expenses at comparable stores, as well as a decrease in advertising expenses, partially offset by increases in depreciation and, to a lesser extent, utilities expense.  The decrease in salaries, benefits and related expenses at comparable stores was due to leverage from the increase in sales, as the increased salary related expenses required to support the sales growth was less than the increase in sales.  The decrease in advertising expenses was primarily due to lower television advertising during the quarter.

Administrative expenses

Administrative expenses increased $0.2 million, or 6.2%, to $3.5 million for the three months ended March 31, 2014 compared to $3.3 million for the three months ended March 31, 2013, primarily due to the addition of general and administrative positions to support our store growth, as well as increased share-based compensation costs.  Administrative expenses as a percentage of sales were 2.7% and 3.1% for the three months ended March 31, 2014 and 2013, respectively.  The decrease in administrative expenses as a percentage of sales was a result of our ability to support additional store investments and sales without proportionate increases in overhead expenses.

Pre-opening and relocation expenses

Pre-opening and relocation expenses increased $0.4 million, or 52.1%, in the three months ended March 31, 2014 to $1.2 million compared to $0.8 million for the three months ended March 31, 2013, due to the increased number of new store openings, the impact of the timing of the openings and possession of stores that are not yet opened, and the lease classification for those stores that were opened.  We opened five new stores for the three months ended March 31, 2014, all of which are classified as operating leases.  We opened four new stores for the three months ended March 31, 2013, three of which were classified as capital and financing lease obligations with no straight-line rent expense included in preopening and relocation expenses.  Pre-opening and relocation expenses as a percentage of sales were 0.9% and 0.7% for the three months ended March 31, 2014 and 2013, respectively.

Interest expense

Interest expense increased $0.3 million, or 75.6%, to $0.7 million in the three months ended March 31, 2014 compared to $0.4 million for the three months ended March 31, 2013 due to an increase in interest expense related to capital and financing lease obligations.  If the capital and financing lease obligations had qualified as operating leases, interest expense as a percent of sales would have been approximately 55 and 40 basis points lower than as reported in the three months ended March 31, 2014 and 2013, respectively.

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Income taxes

Our effective income tax rate for the three months ended March 31, 2014 and 2013 was 37.7% and 37.1%, respectively. The increase in our effective income tax rate was primarily due to an increase in federal income taxes.  Our federal income taxes increased because of additional taxable net income and a consequential higher tax rate.  Our additional taxable net income was due in part to the impact of prior deductions for bonus depreciation.

Net income

Net income increased 24.3% to $4.0 million, or $0.18 diluted earnings per share, in the three months ended March 31, 2014 from $3.2 million, or $0.14 diluted earnings per share, in the three months ended March 31, 2013.

Six months ended March 31, 2014 compared to the six months ended March 31, 2013

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

Net sales

Net sales increased $48.6 million, or 24.0%, to $250.9 million for the six months ended March 31, 2014 compared to $202.3 million for the six months ended March 31, 2013 primarily due to a $31.1 million increase in sales from new stores and a $17.5 million, or 8.7%, increase in comparable store sales.  Daily average comparable store sales increased 8.1% for the six months ended March 31, 2014 as compared to the six months ended March 31, 2013. The daily average comparable store sales increase was primarily driven by a 3.5% increase in daily average transaction count and a 4.4% increase in average transaction size.  Comparable store average transaction size was $36.67 in the six months ended March 31, 2014 compared to $36.03 in the six months ended March 31, 2013.  Daily average mature store sales increased 5.3% in the six months ended March 31, 2014 as compared to six months ended March 31, 2013.