Natural Grocers by Vitamin Cottage, Inc. - Quarter Report: 2020 March (Form 10-Q)

 

Table of Contents

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

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

 

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2020

 

OR

 

☐	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)

 

Delaware		45-5034161
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

12612 West Alameda Parkway		80228
Lakewood, Colorado (Address of principal executive offices)		(Zip code)

 

(303) 986-4600

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class	Trading symbol	Name of each exchange on which registered
Common Stock, $0.001 par value	NGVC	New York Stock Exchange

 

Indicate by check mark 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 ☒ No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes ☒ No ☐

 

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

 

Large accelerated filer ☐		Accelerated filer ☒
Non –accelerated filer ☐		Smaller reporting company ☒
		Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

 

The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of May 4, 2020 was 22,510,846.

 

 

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Table of Contents

 

 

Except where the context otherwise requires or where otherwise indicated: (i) 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 and (ii) 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 2020” refers to the year from October 1, 2019 to September 30, 2020).

Forward-Looking Statements

This Quarterly Report on Form 10-Q (this 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 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, future growth, pending legal proceedings and other financial and operating information, are forward looking statements. We may use the words “anticipate,” “assume,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project,” “future,” “target” and similar terms and phrases to identify forward-looking statements in this Form 10-Q.

The forward-looking statements contained in this 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 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. In addition, our actual results could differ materially from the forward-looking statements in this Form 10-Q due to risks and challenges related to the COVID-19 pandemic, including: the length of time that the pandemic continues; the inability of customers to shop due to illness or quarantine, isolation or stay-at-home orders; shifts in demand to more online shopping or to lower-priced or other perceived value offerings; the temporary inability of our employees to work due to illness; temporary store closures due to infections at our stores or government mandates; stay-at-home measures, safety directives and operating requirements imposed by local, state or federal governmental authorities; the extent and duration of the economic recession resulting from the COVID-19 pandemic, including its impact on consumer spending, the unemployment rate, interest rates and inflationary and deflationary trends; disruptions in the production of the products we sell; disruptions in the delivery of products to our stores; increased operating costs; and the extent and effectiveness of any COVID-19-related stimulus packages implemented by the federal and state governments.

In addition to the foregoing, we believe the factors that could cause our actual results to differ materially from the forward-looking statements in this Form 10-Q include those referenced in Item 1A - “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended September 30, 2019 (the Form 10-K) and Part II, Item 1A - “Risk Factors” in this 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 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 applicable securities laws. You are advised, however, to consult any disclosures we may make in our future reports filed with the Securities and Exchange Commission (the SEC). Our reports and other filings with the SEC are available at the SEC’s website at www.sec.gov. Our reports and other filings with the SEC are also available, free of charge, through our website at www.naturalgrocers.com.

PART I. Financial Information

Item 1. Financial Statements

NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Balance Sheets

(Dollars in thousands, except per share data)

See accompanying notes to unaudited interim consolidated financial statements.

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.

NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Statements of Cash Flows

(Unaudited)

(Dollars in thousands)

See accompanying notes to unaudited interim consolidated financial statements.

NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Consolidated Statements of Changes in Stockholders’ Equity

For the Six Months Ended March 31, 2020 and March 31, 2019

(Unaudited)

(Dollars in thousands, except per share data)

See accompanying notes to unaudited interim consolidated financial statements.

NATURAL GROCERS BY VITAMIN COTTAGE, INC.

Notes to Unaudited Interim Consolidated Financial Statements

March 31, 2020 and 2019

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

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

Company Overview

We operate natural and organic grocery and dietary supplement stores that are focused on providing high-quality products at affordable prices, exceptional customer service, nutrition education and community outreach. We offer a variety of natural and organic groceries, body care products and dietary supplements that meet our strict quality standards. We believe we have been at the forefront of the natural and organic foods movement since our founding. We are headquartered in Lakewood, Colorado. As of March 31, 2020, we operated 157 stores in 20 states, including Colorado, Arkansas, Arizona, Idaho, Iowa, Kansas, Louisiana, Minnesota, Missouri, Montana, Nebraska, Nevada, New Mexico, North Dakota, Oklahoma, Oregon, Texas, Utah, Washington and Wyoming. We also operate a bulk food repackaging facility and distribution center in Golden, Colorado.

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

The growth in the organic and natural foods industry and growing consumer interest in health and nutrition have enabled us to continue to open new stores and enter new markets. During the five fiscal years ended September 30, 2019, we increased our store count at a compound annual growth rate of 12%. In fiscal year 2019, we opened six new stores. We plan to open six to seven new stores in fiscal year 2020, four of which opened during the six months ended March 31, 2020. No new stores were opened between March 31, 2020 and the date of this Form 10-Q. As of the date of this report, we have signed leases for an additional three new stores that we plan to open in fiscal years 2020 and beyond. We have also purchased the property for one additional new store. We plan to relocate one store in fiscal year 2020. We have not relocated any stores so far in fiscal year 2020.

Performance Highlights

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

Industry Trends and Economics

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

COVID-19 Pandemic

On March 11, 2020, the World Health Organization announced that COVID-19 infections had become a pandemic, and on March 13, 2020, the U.S. President announced a National Emergency relating to the disease. National, state and local authorities have recommended social distancing and imposed or recommended quarantine, isolation and “stay-at-home” measures on large portions of the population, including mandatory business closures. These measures are expected to have a serious adverse impact on the U.S. economy. Many economists expect the United States to enter a recession as a result of the pandemic. The duration and severity of such recession are unknown at this time. The effectiveness of the U.S government’s economic stabilization efforts in response to the pandemic, including proposed government payments to affected citizens and industries, is uncertain.

To date, all of our stores have been deemed an “essential business” by relevant government authorities and have continued operating since the start of the COVID-19 pandemic. We believe we have acted proactively in response to the COVID-19 pandemic. The steps we have taken to protect the health and wellbeing of our customers and employees (whom we refer to as the “good4u Crew” or “Crew”) as a result of the pandemic include:

Starting in late February 2020 through March 31, 2020, we experienced unprecedented levels of net sales due to the COVID-19 outbreak as stay-at-home measures were implemented by states across our footprint, customers stocked-up on essential items and dining out options were constrained or eliminated. During the three months ended March 31, 2020, the COVID-19 pandemic also led to an increase in online orders for home delivery, which we offer at substantially all our stores in partnership with a third party.

Although net sales in April 2020 moderated from the peak levels experienced in March 2020, comparable store sales for April 2020 were significantly higher than in the same period in fiscal year 2019. During April 2020, average transaction count declined compared to April 2019, as stay-at-home directives generally remained in place in our markets, resulting in less frequent customer shopping trips. However, the decline in average transaction count during April 2020 was more than offset by an increase in average transaction size.

Since the COVID-19 outbreak, we have experienced shortages and delays in the delivery of certain products to our stores. We have taken steps to mitigate these disruptions to our supply chain and such disruptions have moderated, although certain products remain in relatively short supply or are unavailable.

While we are closely monitoring the economic impact of the COVID-19 pandemic on our business, the long-term impact of the pandemic is unknown at this time. We expect the impact of the COVID-19 pandemic on our financial condition, results of operations and cash flows will largely depend on the extent and duration of the pandemic, the governmental and public actions taken in response, and the effect the pandemic will have on the U.S. economy. Moreover, the COVID-19 pandemic makes it more challenging for management to estimate future performance of our business, particularly over the near term. See “The ongoing COVID-19 pandemic has impacted our operations and this or other future pandemics could materially impact our business, results of operations and financial condition” under “Item 1A.-Risk Factors.”

Additional information regarding the impact of the COVID-19 pandemic on our business and results of operations is provided below in this MD&A.

Outlook

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

We currently expect the rate of new store unit growth in the foreseeable future to depend on economic and business conditions and other factors, including the impact of the COVID-19 pandemic. During the past few years, we have enhanced our infrastructure to enable us to support growth. In addition, in recent years we believe we have enhanced customer loyalty through our {N}power^® customer loyalty program.

Over the long term, we believe there are opportunities for us to continue to expand our store base, expand profitability and increase comparable store sales. However, future sales growth, including comparable store sales, and our profitability could vary due to increasing competitive conditions in the natural and organic grocery and dietary supplement industry and regional and general economic conditions. In the future, we believe there are opportunities for increased leverage in costs, such as administrative expenses, as well as increased economies of scale in sourcing products. However, due to the fixed nature of certain of our costs (in particular, our rent obligations and related occupancy expenses), our ability to leverage costs may be limited.

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

Key Financial Metrics in Our Business

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

Net sales

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

Cost of goods sold and occupancy costs

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

Gross profit and gross margin

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

Store expenses

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

Administrative expenses

Administrative expenses consist of home office-related expenses, such as salary and benefits, share-based compensation, office supplies, hardware and software expenses, depreciation and amortization expense, occupancy costs (including rent, common area maintenance, real estate taxes and utilities), professional services expenses, expenses associated with our Board, expenses related to compliance with the requirements of Sarbanes-Oxley, 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.

Interest expense, net

Interest expense consists of the interest associated with finance lease obligations (previously classified as capital and financing lease obligations) and our Credit Facility, net of capitalized interest and interest income.

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, 2020 compared to the three months ended March 31, 2019

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

Net sales

Net sales increased $47.1 million, or 20.4%, to $277.5 million for the three months ended March 31, 2020 compared to $230.4 million for the three months ended March 31, 2019, primarily due to a $42.3 million increase in comparable store sales and a $4.8 million increase in new store sales. Daily average comparable store sales increased 17.0% for the three months ended March 31, 2020 compared to the three months ended March 31, 2019.  The daily average comparable store sales increase resulted from a 13.1% increase in daily average transaction size and a 3.5% increase in average transaction count. Comparable store average transaction size was $41.60 for the three months ended March 31, 2020.  Daily average mature store sales increased 15.4% for the three months ended March 31, 2020 compared to the three months ended March 31, 2019. The increase in comparable store sales during the three months ended March 31, 2020 was primarily driven by significantly increased net sales starting in late February 2020 as a result of the COVID-19 outbreak. Prior to late February 2020, comparable store sales for the second quarter were generally consistent with the prior fiscal quarter. During March 2020, our comparable store sales increased by approximately 40% compared to March 2019, driven by our customers’ response to the COVID-19 outbreak. Also contributing to the increase in comparable store sales during the three months ended March 31, 2020 were marketing initiatives, promotional pricing campaigns and increased membership in and usage of the {N}power customer loyalty program.

Gross profit

Gross profit increased $15.6 million, or 25.1%, to $77.8 million for the three months ended March 31, 2020 compared to $62.2 million for the three months ended March 31, 2019, primarily driven by the increased sales volumes resulting from the COVID-19 pandemic. To a lesser extent, the increase in gross profit reflected an increase in the number of stores. Gross margin increased to 28.0% for the three months ended March 31, 2020 compared to 27.0% for the three months ended March 31, 2019. The increase in gross margin during the three months ended March 31, 2020 was primarily driven by a decrease in store occupancy and shrink expenses, both as a percentage of sales, and a shift in sales mix to higher margin products.

We had 21 store leases that were classified as capital and financing lease obligations for the three months ended March 31, 2019. As of September 30, 2019, 23 leases were classified as capital and financing lease obligations. As a result of our adoption of ASC 842 effective October 1, 2019: (i) eight previous capital financing lease obligations were derecognized and reclassified as operating leases; (ii) 10 previous capital finance leases were classified as finance leases; and (iii) six previous capital lease obligations were classified as finance leases. As of March 31, 2020, we had 17 leases that were classified as finance leases. The leases that were reclassified to operating leases now generate rent expense, which is recorded as occupancy expense, rather than a reduction of the lease obligation and as interest expense.

Store expenses

Store expenses increased $6.7 million, or 13.4%, to $56.9 million for the three months ended March 31, 2020 compared to $50.2 million for the three months ended March 31, 2019. The increase in store expenses during the three months ended March 31, 2020 was primarily driven by our hiring of approximately 650 temporary Crew members to support operational demands and wage increases and bonuses for our store Crew members, all related to the COVID-19 pandemic. Store expenses as a percentage of sales were 20.5% and 21.8% for the three months ended March 31, 2020 and 2019, respectively. The decrease in store expenses as a percentage of sales was primarily attributable to enhanced leverage of store expenses due to the increased sales volumes resulting from the COVID-19 pandemic, partially offset by the adoption of ASC 842.

Administrative expenses

Administrative expenses increased $1.3 million, or 22.2%, to $7.0 million for the three months ended March 31, 2020 compared to $5.8 million for the three months ended March 31, 2019. The increase in administrative expenses during the three months ended March 31, 2020 was primarily driven by higher compensation, including bonus expense, and an increase in hardware, software and communications expenses. Administrative expenses as a percentage of sales were 2.5% for each of the three months ended March 31, 2020 and 2019. 

Pre-opening and relocation expenses

Pre-opening and relocation expenses increased $0.5 million, or 314.0%, to $0.7 million for the three months ended March 31, 2020 compared to $0.2 million for the three months ended March 31, 2019, due to the impact of the number and timing of new store openings and relocations.  We opened two new stores during the three months ended March 31, 2020 compared to opening one new store and relocating one store during the three months ended March 31, 2019.  Pre-opening and relocation expenses as a percentage of sales were 0.2% and 0.1% for the three months ended March 31, 2020 and 2019, respectively. 

Interest expense, net

Interest expense, net of capitalized interest, decreased $0.8 million, or 59.7%, for the three months ended March 31, 2020 compared to the three months ended March 31, 2019.  The decrease in interest expense is primarily due to a decrease in the number of finance leases (formerly classified as capital and financing leases) during the three months ended March 31, 2020 as well as a decrease in the average outstanding balance owing under our Credit Facility.  The decrease in interest expense attributable to the lower number of finance leases is consistent with the increase in occupancy costs referred to above given the number of derecognized previous capital finance leases that have been reclassified as operating leases and that now generate straight-line rent expense rather than reduction of the lease obligation and interest expense.

Income taxes

Income tax expense increased $2.0 million for the three months ended March 31, 2020 to $3.0 million compared to $1.0 million for the three months ended March 31, 2019. The Company’s effective income tax rate was approximately 23.7% and 20.3% for the three months ended March 31, 2020 and 2019, respectively.

Net income

Net income was $9.7 million, or $0.43 diluted earnings per share, for the three months ended March 31, 2020 compared to $3.9 million, or $0.17 diluted earnings per share, for the three months ended March 31, 2019. The increase in net income during the three months ended March 31, 2020 was primarily attributable to the significant growth in net sales and margin improvement as a result of the impact of the COVID-19 outbreak.

Six months ended March 31, 2020 compared to the six months ended March 31, 2019

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

Net sales

Net sales increased $55.6 million, or 12.3%, to $507.6 million for the six months ended March 31, 2020 compared to $452.0 million for the six months ended March 31, 2019, primarily due to a $46.4 million increase in comparable store sales and a $9.4 million increase in new store sales, partially offset by a $0.2 million decrease in sales from one store that closed during the first quarter of fiscal 2019.  Daily average comparable store sales increased 9.7% for the six months ended March 31, 2020 compared to the six months ended March 31, 2019.  The daily average comparable store sales increase resulted from a 8.1% increase in average transaction size and a 1.5% increase in daily average transaction count.  Comparable store average transaction size was $39.50 for the six months ended March 31, 2020.  Daily average mature store sales increased 8.2% for the six months ended March 31, 2020 compared to the six months ended March 31, 2019.  The increase in comparable store sales during the six months ended March 31, 2020 was primarily driven by significantly increased net sales starting in late February 2020 as a result of the COVID-19 outbreak. Also contributing to the increase in comparable store sales during the six months ended March 31, 2020 were marketing initiatives, promotional pricing campaigns and increased membership in and usage of the {N}power customer loyalty program.

Gross profit

Gross profit increased $17.0 million, or 14.0%, to $138.3 million for the six months ended March 31, 2020 compared to $121.4 million for the six months ended March 31, 2019, primarily driven by the increased sales volumes resulting from the COVID-19 pandemic. To a lesser extent, the increased in gross profit reflected an increase in the number of stores. Gross margin increased to 27.3% for the six months ended March 31, 2020 from 26.9% for the six months ended March 31, 2019. The increase in gross margin during the six months ended March 31, 2020 was primarily driven by a decrease in store occupancy and shrink expenses, both as a percentage of sales, and a shift in sales mix to higher margin products.

We had 21 store leases that were classified as capital and financing lease obligations for the six months ended March 31, 2019. As of September 30, 2019, 23 leases were classified as capital and financing lease obligations. As a result of our adoption of ASC 842 effective October 1, 2019: (i) eight previous capital financing lease obligations were derecognized and reclassified as operating leases; (ii) 10 previous capital finance leases were classified as finance leases; and (iii) six previous capital lease obligations were classified as finance leases. As of March 31, 2020, we had 17 leases that were classified as finance leases. The leases that were reclassified to operating leases now generate rent expense, which is recorded as occupancy expense, rather than a reduction of the lease obligation and as interest expense.

Store expenses

Store expenses increased $9.0 million, or 9.1%, to $108.3 million for the six months ended March 31, 2020 compared to $99.3 million for the six months ended March 31, 2019. The increase in store expenses during the six months ended March 31, 2020 was primarily driven by our hiring of approximately 650 temporary Crew members to support operational demands and wage increases and bonuses for our store Crew members, all related to the COVID-19 pandemic. Store expenses as a percentage of sales were 21.3% and 22.0% for the six months ended March 31, 2020 and 2019, respectively. The decrease in store expenses as a percentage of sales was primarily attributable to enhanced leverage of store expenses due to the increased sales volumes resulting from the COVID-19 pandemic, partially offset by the adoption of ASC 842.

Administrative expenses

Administrative expenses increased $1.8 million, or 16.1%, to $12.9 million for the six months ended March 31, 2020 compared to $11.1 million for the six months ended March 31, 2019.  The increase in administrative expenses during the six months ended March 31, 2020 was primarily driven by higher compensation, including bonus expense, and an increase in hardware, software and communication expenses. Administrative expenses as a percentage of sales were 2.5% for each of the six months ended March 31, 2020 and 2019.

Pre-opening and relocation expenses

Pre-opening and relocation expenses increased $0.3 million, or 30.3%, to $1.1 million for the six months ended March 31, 2020 compared to $0.8 million for the six months ended March 31, 2019, due to the impact of the number and timing of new store openings and relocations.  We opened four new stores during the six months ended March 31, 2020 compared to opening five new stores and relocating two stores during the six months ended March 31, 2019.  Pre-opening and relocation expenses as a percentage of sales were 0.2% for each of the six months ended March 31, 2020 and 2019. 

Interest expense

Interest expense, net of capitalized interest, decreased $1.5 million, or 58.5%, for the six months ended March 31, 2020 compared to the six months ended March 31, 2019.  The decrease in interest expense is primarily due to a decrease in the number of finance leases (formerly classified as capital and financing leases) during the six months ended March 31, 2020 as well as a decrease in the average outstanding balance owing under our Credit Facility.  The decrease in interest expense attributable to the lower number of finance leases is consistent with the increase in occupancy costs referred to above given the number of derecognized previous capital finance leases that have been reclassified as operating leases and that now generate straight-line rent expense rather than reduction of the lease obligation and interest expense.

Income taxes

Income tax expense increased $1.9 million for the six months ended March 31, 2020 to $3.5 million compared to $1.6 million for the six months ended March 31, 2019.  The Company’s effective income tax rate was approximately 23.0% and 20.5% for the six months ended March 31, 2020 and 2019, respectively.

Net income

Net income was $11.6 million, or $0.51 diluted earnings per share, for the six months ended March 31, 2020 compared to $6.1 million, or $0.27 diluted earnings per share, for the six months ended March 31, 2019.  The increase in net income during the six months ended March 31, 2020 was primarily attributable to the significant growth in net sales and margin improvement as a result of the impact of the COVID-19 outbreak.

Non-GAAP financial measures 

EBITDA

EBITDA is not a measure of financial performance under GAAP. We define EBITDA as net income before interest expense, provision for income taxes and depreciation and amortization. The following table reconciles net income to EBITDA for the periods presented, dollars in thousands:

EBITDA increased 57.7% to $21.1 million in the three months ended March 31, 2020 compared to $13.4 million for the three months ended March 31, 2019. EBITDA increased 28.2% to $31.7 million in the six months ended March 31, 2020 compared to $24.7 million for the six months ended March 31, 2019.  The increase in EBITDA was primarily driven by the significant growth in net income resulting from the increase in net sales starting in late February 2020 as a result of the COVID-19 outbreak. EBITDA as a percentage of sales was 7.6% and 5.8% in the three months ended March 31, 2020 and 2019, respectively.  EBITDA as a percentage of sales was 6.2% and 5.5% in the six months ended March 31, 2020 and 2019, respectively. The number of stores with finance leases (previously classified as capital and financing lease obligations) decreased from 21 as of March 31, 2019 to 17 as of March 31, 2020 as a result of our adoption of ASC 842 effective October 1, 2019. Finance leases have a positive impact on EBITDA because, as discussed above, they result in lower cost of goods sold and occupancy costs. Conversely, the greater number of stores with operating leases during the six months ended March 31, 2020, led to higher cost of goods sold and occupancy costs, which negatively impacted both EBITDA and EBITDA as a percentage of sales.

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

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

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

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

Liquidity and Capital Resources

Our ongoing primary sources of liquidity are cash generated from operations, current balances of cash and cash equivalents and borrowings under the Credit Facility. Our primary uses of cash are for purchases of inventory, operating expenses, capital expenditures predominantly in connection with opening, relocating and remodeling stores, debt service and corporate taxes.  As of March 31, 2020, we had $29.4 million in cash and cash equivalents, as well as $49.0 million available for borrowing under our Credit Facility.  We are not currently receiving, and do not currently intend to apply for, direct financial assistance under any federal or state programs implemented as a result of the COVID-19 pandemic, including the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

In May 2016, our Board authorized a two-year share repurchase program pursuant to which the Company may expend up to $10.0 million to repurchase shares of the Company’s common stock.  In May 2018, our Board authorized a two-year extension of the share repurchase program. On May 4, 2020, our Board authorized an extension of the Company’s share repurchase program. As a result of such extension, the share repurchase program will terminate on May 31, 2022.  We did not repurchase any shares during the three or six months ended March 31, 2020. Between April 1, 2020 and May 4, 2020 (the latest practicable date for making the determination), we did not repurchase any additional shares of our common stock. The dollar value of the shares of the Company’s common stock that may yet be repurchased under the share repurchase program is $8.3 million. We expect funding of share repurchases will come from operating cash flow, excess cash and/or borrowings under the Credit Facility. The timing and the number of shares repurchased will be dictated by our capital needs and stock market conditions.

We paid a dividend of $0.07 per share of common stock in each of the first two quarters of fiscal year 2020. On May 6, 2020, our Board approved the payment of a cash dividend of $0.07 per share of common stock to be paid on June 16, 2020 to stockholders of record as of the close of business on June 1, 2020.

The opening of new stores may require us to borrow additional amounts under the Credit Facility. Subject to economic and business conditions, we plan to spend approximately $8 million to $13 million on capital expenditures during the remainder of fiscal year 2020 in connection with two to three new store openings and one store relocation. We are closely monitoring the impact of the COVID-19 pandemic on our liquidity and cash generated from operations. Currently, we believe that cash and cash equivalents, together with the cash generated from operations and the borrowing availability under our Credit Facility, will be sufficient to meet our working capital needs and planned capital expenditures, including capital expenditures related to new store needs for at least the next twelve months. Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day or, in the case of credit or debit card transactions, within days from the related sale.

Typically, our new stores require an upfront capital investment of approximately $2.1 million per store consisting of capital expenditures of approximately $1.6 million, net of tenant allowances, initial inventory of approximately $0.3 million, net of payables, and pre-opening expenses of approximately $0.2 million.

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

Operating Activities

Net cash provided by operating activities consists primarily of net income adjusted for non-cash items, including depreciation and amortization and changes in deferred taxes, and the effect of working capital changes. Cash provided by operating activities increased $30.8 million, or 136.2%, to $53.4 million for the six months ended March 31, 2020 compared to $22.6 million for the six months ended March 31, 2019.  The increase in cash provided by operating activities was primarily due to an increase in cash provided by working capital, as well as an increase in net income adjusted for non-cash items.  Our working capital requirements for inventory will likely increase as we continue to open new stores.

Investing Activities

Net cash used in investing activities increased $3.1 million, or 17.9%, to $20.1 million for the six months ended March 31, 2020 compared to $17.1 million for the six months ended March 31, 2019.  This increase was primarily due to a $1.1 million increase in software investments for internal use and a $1.1 million increase in property and equipment acquisitions during the six months ended March 31, 2020 compared to the six months ended March 31, 2019.

Financing Activities

Net cash used in financing activities consists primarily of borrowings and repayments under our Credit Facility.  Cash used in financing activities was $10.1 million for the six months ended March 31, 2020 compared to $3.6 million of cash used in financing activities for the six months ended March 31, 2019. During the six months ended March 31, 2020, the Company used cash generated from operations to repay the outstanding balance owing under the Credit Facility. Notwithstanding our repayment of the outstanding balance owing under the Credit Facility as of March 31, 2020, the Credit Facility remains in full force and effect.

Credit Facility

The maximum amount available for borrowing under the Credit Facility is $50.0 million, including a $5.0 million sublimit for standby letters of credit. The operating company is the borrower under the Credit Facility and its obligations thereunder are guaranteed by the holding company and VC2. The Credit Facility is secured by a lien on substantially all of the Company’s assets. The Company has the right to borrow, prepay and re-borrow amounts under the Credit Facility at any time prior to the maturity date. The Credit Facility matures on November 13, 2024.

For floating rate borrowings under the Credit Facility, interest is determined by the lender’s administrative agent based on the most recent compliance certificate of the operating company and stated at the base rate less the lender spread based upon certain financial measures. For fixed rate borrowings under the Credit Facility, interest is determined by quoted LIBOR rates for the interest period plus the lender spread based upon certain financial measures. The unused commitment fee is based upon certain financial measures.

The Credit Facility requires compliance with certain customary operational and financial covenants, including a leverage ratio. The Credit Facility also contains certain other customary limitations on the Company’s ability to incur additional debt, guarantee other obligations, grant liens on assets and make investments or acquisitions, among other limitations. Additionally, the Credit Facility prohibits the payment of cash dividends to the holding company from the operating company, provided that so long as no default exists or would arise as a result thereof, the operating company may pay cash dividends to the holding company in an amount sufficient to allow the holding company to: (i) pay various audit, accounting, tax, securities, indemnification, reimbursement, insurance and other reasonable expenses incurred in the ordinary course of business and (ii) repurchase shares of common stock and pay dividends on our common stock in an aggregate amount not to exceed $10.0 million during any fiscal year.

We had $0 and $5.7 million outstanding under the Credit Facility as of March 31, 2020 and September 30, 2019, respectively.  As of each of March 31, 2020 and September 30, 2019, we had undrawn, issued and outstanding letters of credit of $1.0 million, which were reserved against the amount available for borrowing under the terms of the Credit Facility.  We had $49.0 million and $43.3 million available for borrowing under the Credit Facility as of March 31, 2020 and September 30, 2019, respectively.

As of March 31, 2020 and September 30, 2019, the Company was in compliance with the debt covenants under the Credit Facility.

Share Repurchases

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

Off-Balance Sheet Arrangements 

As of March 31, 2020, our off-balance sheet arrangements consisted of: (i) the undrawn portion of our Credit Facility and (ii) leases that have been signed but whose terms have not yet commenced. As of March 31, 2020, the Company had signed two leases whose terms have not yet commenced; such leases are for one new store and one relocated store in fiscal year 2020 and beyond. The contractual obligation related to these leases is $10.7 million (see Note 7). We have no other off-balance sheet arrangements that have had, or are reasonably likely to have, a material effect on our consolidated financial statements or financial condition.

Recent Accounting Pronouncements

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

Critical Accounting Policies

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

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

To a limited extent, we are exposed to interest rate changes with respect to our Credit Facility. We do not use financial instruments for trading or other speculative purposes. There have been no material changes regarding our market risk position from the information provided under Item 7A – “Quantitative and Qualitative Disclosures about Market Risk” in our Form 10-K.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officers and principal financial and accounting officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Form 10-Q. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Based on that evaluation, our principal executive officers and principal financial and accounting officer concluded that our disclosure controls and procedures were effective as of March 31, 2020.

Changes in Internal Control over Financial Reporting

During the six months ended March 31, 2020, we implemented controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new lease accounting standard on our financial statements to facilitate the adoption of that standard effective October 1, 2019.

There were no changes in our internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. Other Information

Item 1. Legal Proceedings

We periodically are involved in various legal proceedings, including discrimination and other employment-related claims, customer personal injury claims, investigations and other proceedings arising in the ordinary course of business. When the potential liability from a matter can be estimated and the loss is considered probable, we record the estimated loss. Due to uncertainties related to the resolution of lawsuits, investigations and claims, the ultimate outcome may differ from our estimates. Although we cannot predict with certainty the ultimate resolution of any lawsuits, investigations and claims asserted against us, we do not believe any currently pending legal proceeding to which we are a party will have a material adverse effect on our business, prospects, financial condition, cash flows or results of operations.

Item 1A. Risk Factors

The risk factors below update those disclosed in Part I, “Item 1A-Risk Factors,” of our Form 10-K.

The ongoing COVID-19 pandemic has impacted our operations and this or other future pandemics could materially impact our business, results of operations and financial condition.

The COVID-19 outbreak has had a significant impact on our operations. For so long as it continues, and in the event there is another widespread regional, national or global health epidemic or pandemic, our business could be severely impacted. While we are closely monitoring the economic impact of the COVID-19 pandemic on our business, the long-term financial impact of the COVID-19 pandemic is unknown at this time. We expect the impact of the COVID-19 pandemic on our financial condition, results of operations and cash flows will largely depend on the extent and duration of the pandemic, the governmental and public actions taken in response, and the effect the pandemic will have on the U.S. economy.

The impacts of the COVID-19 outbreak could include some or all of the following:

Any of the foregoing impacts of the COVID-19 outbreak could have a material adverse effect on our business, financial position and results of operations. The duration of any such impacts cannot be predicted because of the unprecedented nature of the COVID-19 pandemic.

Our sale of products containing cannabidiol (CBD) could lead to regulatory action by federal, state and/or local authorities or legal proceedings brought by or on behalf of consumers.

The Agricultural Improvement Act of 2018 (the 2018 Farm Bill) legalized the cultivation, processing and sale of “industrial hemp” (i.e., hemp containing no more than 0.3% tetrahydrocannabinol, or THC). Industrial hemp is used to produce CBD, a non-psychoactive compound. Despite the provisions of the 2018 Farm Bill and subsequent U.S. Department of Agriculture rules, uncertainty exists concerning the legal and regulatory status of finished products containing CBD. The Food and Drug Administration (FDA) has yet to establish a regulatory framework for the manufacture and sale of products containing CBD, and has sent warning letters to certain CBD manufacturers that are alleged to have marketed their products in violation of the federal Food, Drug, and Cosmetic Act (the FDCA) and the rules promulgated thereunder. The FDA also announced that it cannot conclude based on current published studies that CBD is generally recognized as safe (GRAS) for use in human and animal food products. Food and beverage products, including nutritional supplements, that contain non-GRAS ingredients are considered to be adulterated under the FDCA. In addition, certain state and local governments have taken action to restrict or prohibit the sale of products containing CBD. Further, class action lawsuits have been filed against certain CBD manufacturers alleging that their products are mislabeled and falsely advertised under state consumer protection laws.

We sell products containing CBD at certain of our stores. While we strive to sell products containing CBD only in states and localities where such sale is permissible, state and local authorities in those areas may adopt new laws and regulations, or adopt interpretations of existing laws and regulations, that restrict or prohibit the sale of products containing CBD. Further, we could be subject to regulatory action brought by federal, state and/or local authorities, or legal proceedings brought by or on behalf of consumers, that allege, among other things, that: (i) our sale of products containing CBD violates applicable federal or state law (including applicable state consumer protection laws); (ii) the products we sell that contain CBD are adulterated or have been misbranded or labeled in violation of applicable rules, regulations or standards of the FDA, the FDCA or any other federal or state law or agency; (iii) the products we sell that contain CBD have been labeled with (a) express or implied health claims that are not supported by appropriate scientific evidence or (b) claims that are difficult or impossible to verify; (iv) the products we sell that contain CBD have been labeled with inappropriate dosing instructions or use recommendations; (v) the products we sell that contain CBD have been improperly tested or evaluated or do not contain the stated concentration of CBD; and (vi) the products we sell that contain CBD contain more than the legally allowable concentration of THC. Any such regulatory action or legal proceeding could have a material adverse effect on our business, financial position and results of operations.

Item 5. Other Information

On May 4, 2020, our Board authorized an extension of the Company’s previously announced share repurchase program. As a result of such extension, the share repurchase program will terminate on May 31, 2022. The dollar value of the shares of common stock that may yet be repurchased under the share repurchase program is approximately $8.3 million. Repurchases will be made from time to time at management's discretion on the open market or through privately negotiated transactions in compliance with Rule 10b-18 promulgated under the Securities Exchange Act of 1934, as amended, subject to market conditions, applicable legal requirements and other relevant factors. Repurchases of common stock may also be made under a Rule 10b5-1 plan. The share repurchase program does not obligate the Company to purchase any particular amount of common stock and may be suspended, modified or discontinued by the Company without prior notice.

Item 6. Exhibits

EXHIBIT INDEX