At Home Group Inc. (HOME) Q3 2018 Earnings Conference Call Transcript

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At Home Group Inc. (NYSE: HOME)
Q3 2018 Earnings Conference Call
Nov. 29, 2017 4:30 p.m. ET

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Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Greetings, and welcome to the At Home Third-Quarter Fiscal Year 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press * 0 on your telephone keypad. As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Bethany Perkins. Thank you. You may begin.

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Bethany Perkins -- Director, Investor Relations

Thank you, Matt. Good afternoon, everyone, and thank you for joining us today for At Home's Third-Quarter Fiscal Year 2018 Earnings Results Conference Call. Speaking today are Lee Bird, chairman, chief executive officer, and president; Peter Corsa, chief operating officer; and Judd Nystrom, chief financial officer. After the team has made their formal remarks, we will open the call to questions.

Before we begin, I need to remind you that certain comments made during this call may constitute forward-looking statements and are made pursuant to, and within the meaning of, the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In particular, statements about our outlook and assumptions for financial performance for the fiscal years 2018 and 2019 and our long-term growth targets as well as statements about the markets in which we operate, expected new store openings, potential growth opportunities, and future capital expenditures are forward-looking statements. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those are referred to in At Home's press release issued today and in filings that At Home makes with the SEC.

The forward-looking statements made today are as of the date of this call, and At Home does not undertake any obligation to update any forward-looking statements. Finally, the speakers may refer to certain adjusted or non-GAAP financial measures on this call such as adjusted EBITDA, adjusted operating income, adjusted and pro forma adjusted net income, and pro forma adjusted earnings per share. A reconciliation schedule showing the GAAP versus non-GAAP financial measures is available in At Home's press release issued today. If you do not have a copy of today's press release, you may obtain one by visiting the Investor Relations page of the website at investor.athome.com.

In addition, from time to time, At Home expects to provide certain supplemental materials or presentations for investor reference on the Investor Relations page of its website. I will now turn the call over to Lee. Lee?

Lee Bird -- Chief Executive Officer, President and Chairman

Thank you, Bethany. Good afternoon, everyone, and thank you for joining us to discuss our third-quarter Fiscal 2018 results. This quarter, we once again demonstrated the exciting momentum in our business. We are driving strong results across a variety of price points and style archetypes, indoor and outdoor décor, everyday and seasonal product categories, and new and existing stores across the country.

Our new store growth of 18%, combined with our merchandising and marketing initiatives, drove net sales growth of 25%, including a 7.1% increase in comp store sales. I'm especially pleased that the third quarter marks our 14th consecutive quarter of 20-plus percent sales growth and our 15th consecutive quarter of positive comp store sales increases. Beyond our top line, I am pleased that we continue to deliver industry-leading profitability by significantly expanding operating margins and more than doubling pro forma adjusted net income and EPS. As we focus on achieving sustainable, long-term growth, we are committed to reinvesting in the business to advance the strategic priorities I'll discuss today.

First and foremost, our customer is our top priority, and getting to know and serve her better is always a key objective for us. We have delivered five consecutive quarters of mid- to high single-digit comps, which demonstrates that customers are embracing the look and superior value of our products. As I mentioned on our last call, we launched the first At Home credit card and loyalty programs during the third quarter to make it even easier for her to get the looks she loves. The customer response to both of these programs, particularly the enthusiasm we have seen with enrollment rate and the basket sizes of new members, has surpassed our initial expectation.

While the programs are still in their infancy, we are excited about leveraging them as a basis for eventual CRM capabilities, so that we can strengthen our customer relationship and, over time, provide a targeted and personalized shopping experience. In the meantime, we continue to gather insights through customer research, which has recently shown that not only are we attracting a younger customer, but that millennials are now our fastest-growing segment and now represents one-third of our core customer base. We believe this demographic shift is both as a result and a driver of our strategic focus on providing more décor options to meet her preferred style, which brings me to our second priority, assortment. We strive to give our customers the broadest assortment at the lowest prices in the industry.

Our large-format stores allow her to get a physical sense for trend-relevant décor and take it home immediately, while also enabling us to cover all styles of home décor under one roof. We flex the mix of our assortment between categories or style archetypes as customer preferences and demographics change over time. In recent quarters, we have shifted portions of our mix toward contemporary looks to align with the preferences of our younger customer. Not coincidentally, contemporary was our highest comping style archetype in Q3.

We continue to focus on acquiring customers at earlier life stages, from decorating their first dorm room to their first apartment or house to continuing with them to their forever home for an expanding family and, again, as they downsize in retirement. One of our most successful initiatives on this journey has been the expansion of our back-to-campus program, which comped positively by double digits this quarter even as we incorporated more value-priced items into the assortment. Finally, our category reinvention strategy also drives sales growth by ensuring continuing – continuum -- continual newness for our customers. Our independent research shows the majority of our core customers are drawn in by the thrill of the treasure hunt in our stores, which we provide by introducing 20,000 fresh new items annually.

Our Q2 reinventions of elevated bedding and patio furniture drove positive results into Q3, and the strong customer response to our seasonal offerings for fall, Halloween and Christmas contributed meaningfully to our third-quarter comp. Our multi-year mission to become the home and the holiday décor headquarters has generated a lot of momentum in our seasonal business and has enabled us to raise our outlook for the fourth quarter as well. Another strategic priority is to expand the At Home brand, which we have funded through sales and profit growth over the past few years. Ramping our targeted marketing spend from 0 just a few years ago to 3% of sales in Fiscal 2018 has enabled us to support even more priority markets and invest additional dollars in a new TV campaign, digital engagement, and expanded influencer program.

We are measuring our TV and digital activities against a control group of markets before, during, and after the advertising run. And we are very pleased that it has driven increased sales and traffic in the supported stores. Our efforts continue to drive positive outcome, including progress on increasing brand awareness, which remains a significant opportunity for us. In Q3, we focused on launching our Insider Perks loyalty program and optimizing our website, particularly for mobile users, as now more than half of athome.com visitors access our website through a mobile device.

We reduced the time users spend loading our web pages by 65%, upgraded our visual branding with creative photography, and enhanced our online search and filter functions to make it easier for customers to preshop our broad selection at low prices. As a result, we drove an almost 80% increase in page views since Q3 of last year. We showcased our new and enhanced inventory in our weekly email, and our email open rates increased by more than 50%. Our loyalty strategy continues to -- our loyalty strategy includes converting our over 3 million email members to our budding Insider Perks program, including our efforts to enhance our customers' digital experience.

We believe we are focusing on the right areas to support the expansion of our brand and continue to driving comp store sales. Another strategic priority and major opportunity for At Home is new-store growth. At 149 stores today, we have grown our store count by over 21% on a compounded annual rate over the last five years, but we are still less than one-fourth of our potential U.S. footprint.

We continue to address our substantial whitespace in Q3 by opening eight stores, divided evenly between new and existing markets and between new builds and second-generation leases. Newly entered markets included Odessa and El Paso in western Texas; Rochester, New York, in the Northeast; and Shreveport, Louisiana, in the South. Our existing market expansion included in the Phoenix; Washington, D.C.; Detroit; and Houston metro areas. If you recall, at our second-quarter call, we were uncertain if two Houston area ground-up builds planned for Q3 would open this year due to the impact of Hurricane Harvey.

As we did before and during the storm, I am proud to say that our teams embodied our core value of working together to open locations in Richmond, Texas, in Q3 and in Pearland, Texas, soon after. We continue to deliver new-store performance ahead of expectations for the broader class of Fiscal 2018, adding to the confidence we have in our fully identified Fiscal 2019 pipeline and our growth strategy moving forward. Speaking of our team, they have been critical to propelling our business forward -- business thus far, and we believe they should share in the At Home success. At the beginning of Q3, we awarded restricted stock units to every At Home store director as well as to expanded group of home office team members.

Additionally, the second-half momentum of our businesses had increased our targeted incentive compensation for both the home office and the field. With the broader retail industry focused on wage pressures, I'm incredibly pleased that our store-level associate can earn a 5% bonus of their annual earning, while store directors and managers have uncapped bonus potential. We strive to take great care of our store team members, knowing that they will, in turn, do the right thing for our customers. Our commitment to providing a great culture and exciting growth environment, compelling workplace opportunities, and rewarding compensation structure has recognized this quarter by Great Place to Work council, which makes us eligible for Fortune magazine's Best Places to Work list in 2018.

Better yet, the enthusiastic feedback from our team members validates that we are, indeed, achieving on yet another strategic priority. With that, I'd like to turn the call over to Peter Corsa, our chief operating officer, who will discuss the progress we are making on our operational objectives. Peter?

Peter Corsa -- Chief Operating Officer

Thank you, Lee. Good afternoon, everyone. As chief operating officer, I focus primarily on two strategic areas: first, providing our customers with an exceptional self-help shopping experience, and second, ensuring that we have the right operating systems, processes, and procedures in place to efficiently and cost-effectively deliver that experience and scale for growth. On the customer-facing side, we continue to drive results by merchandising our seasonal assortment along specific themes, making it easier for the customer to design an entire room in her basket.

We launched this strategy several years ago with our Christmas assortment and given its positive performance over the past three years, we expanded it to Halloween in Fiscal 2017 and then to our fall, tabletop, and back-to-campus assortments in Fiscal 2018. Customers can now explore each theme collection online if they prefer to browse and price-compare before coming into the store. As we mentioned, we focused our back-to-campus assortment on lower-priced items this year, giving us an opportunity to highlight compelling value in our check lane and end caps and to drive units sold. With regard to the holidays, this year, we incorporated blade signage and lifestyle photography to bring our products to life and visually inspire our customers' décor both on and around the Christmas tree.

We applied this signage to tabletop décor in our main aisle, which also houses our feature tables that continue to show exceptional strength. Our success in these initiatives continues to demonstrate the importance of creating an inspirational atmosphere through compelling visual merchandising. It also gives our customer an opportunity to see, touch, and feel our products, so she can be even more excited about incorporating them into her home. And finally, the key to scaling our business and reaching more customers is to ensure we are operating efficiently and effectively.

In the third quarter, we completed the implementation of a yard management system to manage receipts more efficiently at our single cross-dock distribution center. We also hired David Heartquist, previously from Michaels and Walmart, to lead our direct-sourcing team. The progress the team has made in a short amount of time has positioned us to receive our first wave of directly sourced décor in Q4 of this year. We are proud to share that we achieved our targeted product cost savings on these basic commodity items, which we recognize over the turn of the inventory in Fiscal 2019.

While this initial wave is immaterial to our total assortment, it represents the first return against our two-penny direct-sourcing investment this year, and we look forward to growing the program in the years to come. As the program ramps, we believe it will enable us to redeploy the product savings into lower prices, increased brand awareness, and better quality to further strengthen our customer value proposition. With that, I'd like to turn the call over to Judd, who will walk through our financial performance in more detail and discuss our outlook for the remainder of Fiscal 2018. Judd?

Judd Nystrom -- Chief Financial Officer

Thank you, Peter. Good afternoon, everyone. I will begin my prepared remarks with a review of our third-quarter Fiscal 2018 results and then discuss updates for our outlook for fiscal years 2018 and 2019. As always, additional information is available in our earnings release, which can be found on our Investor Relations website.

As we highlighted, our 7.1% comp in the third quarter once again demonstrated broad-based strength across our entire business. We drove positive comps in both everyday and seasonal categories and across all major geographies and vintages. In addition, stores more than five years old continued to drive the majority of our comp. Overall, we delivered our 14th consecutive quarter of 20-plus percent net sales growth and our 15th consecutive quarter of positive comp store sales increases.

Our comp sales were consistently strong throughout the quarter, despite tougher comparisons and the disruption of hurricanes Harvey and Irma early in the quarter. Excluding the impact of these third-quarter hurricanes, we estimate that we would have delivered an 8.3% comp sales increase. On a two-year basis, our comps accelerated for the third straight quarter as we continue taking market share in a large and growing industry. We are also very pleased with the consistent strength in the rest of the business that has continued into the fourth quarter.

In Q3, we delivered 25% net sales growth, driven by strong results from both comp and new stores, with new-store productivity at its highest level in 10 quarters. We continue to believe that our Fiscal 2018 class of new stores will be one of our strongest ever. Along with our substantial top-line growth, we delivered a 61% increase in adjusted operating income and 130 basis points of adjusted operating margin improvement year over year, which we achieved through expense leverage as we continue to expand the business. While third-quarter marketing expense dollars remained flat to prior year, on a year-to-date basis, we continue to ramp our spend to advance the brand awareness initiative Lee discussed.

In the context of our 25% sales increase and 18% store growth in Q3, net inventories increased only 12% versus the prior year. There were two primary drivers of our inventory dynamic this quarter. The first driver is the normalization of inventory and capitalized freight levels now that we have completely cycled our prior year strategic investment in incremental low-priced inventory. The second driver is that we are exiting the third quarter with a clean inventory position due to targeted markdowns on products largely related to our Fiscal 2018 and 2019 category reinvention.

While these targeted markdowns resulted in a headwind to gross margin during the quarter, they position us to continue driving critical newness to customers over the next year and deliver significant gross margin expansion in Q4. We continue to maintain our consistent track record of over 80% of our net sales at full retail price, which we have delivered every quarter during our nearly five years as a management team. As a reminder, we include all store-level occupancy and distribution costs in reported gross margin. Therefore, we plan for gross margin to fluctuate quarterly based on a variety of strategic factors.

In the third quarter, for example, we generated tailwinds from lapping distribution costs related to last year's strategic step-up in inventory and by achieving meaningful occupancy leverage on our 7.1% comp. On the other hand, we experienced headwinds from increased outbound freight as well as the timing of sale-leaseback transactions in Fiscal 2017 and 2018. As a management team, we focus on delivering consistent gross margin on an annual basis, which we have done for the previous four fiscal years. We expect to deliver consistent annual gross margin again in Fiscal 2018.

Ultimately, we are very pleased to have increased pro forma adjusted net income by 150% and pro forma adjusted EPS by 133% to $0.07 in the third quarter. Turning now to our Fiscal 2018 outlook. Our strong year-to-date performance and continued momentum enable us to raise the expected range for Fiscal 2018 net sales to $939 million to $944 million, which would represent growth of over 23% over Fiscal 2017. In addition, we are increasing our annual comp store sales outlook to approximately 5.7% to 6%.

Given this top-line strength and the hard work of our team members to deliver on our full-year plans, we expect to incur one to two pennies of incentive compensation in Q4, which is in addition to the incremental penny we incurred in Q2. Including the incentive compensation and the two-penny investment direct sourcing that we committed to earlier this year and continued investments in price and brand awareness, we are very pleased that our outlook of 33% to 37% pro forma adjusted net income growth is above our long-term growth target of 25%. We are also raising our pro forma adjusted EPS outlook for the year to $0.77 to $0.79. Our EPS outlook assumes annual gross margin consistency that I mentioned earlier; continued operating margin expansion, as laid out in our long-term growth targets; interest expense of $21.5 million; a 37.5% annual effective tax rate; and 63.5 million diluted shares outstanding.

Net of total expected sale-leaseback proceeds of approximately $110 million, Fiscal 2018 capital expenditures are expected to be between $110 million and $130 million. Our outlook for the fourth quarter is net sales range of $281 million to $287 million and comp store sales growth of approximately 4%. The implied 11% two-year stack is on par with the 11% two-year comp we delivered in Q3 and illustrates the continued momentum in our business. We expect to deliver at least 120 basis points of gross margin expansion, driven primarily through product margin and the lapping of incremental distribution costs incurred last year.

We expect some adjusted SG&A deleverage driven primarily by incentive compensation as well as by preopening costs and marketing investments to continue to support our biggest growth opportunities, new stores and brand awareness. Ultimately, we expect to deliver meaningful operating margin expansion and pro forma adjusted EPS between $0.33 and $0.35 in the fourth quarter of Fiscal 2018. To further support our capital plan, including new-store expansion, we expect to complete a sale-leaseback transaction of $45 million to $50 million in Q4, which is in addition to the $62.6 million in proceeds we generated in the third quarter this year. As we look toward Fiscal 2019, we are very excited about the continued strong growth that lies ahead.

We will provide more robust annual and first-quarter guidance on our conference call in the spring, but we'd like to highlight that our Fiscal 2019 new-store pipeline is fully identified and approved, giving us confidence in our top- and bottom-line potential for next year. While new opportunities for second-generation locations typically arise throughout the year and especially in January, our pipeline is currently comprised of approximately 75% leased and 25% owned stores. Factoring in the economics of this projected mix, we expect to deliver 25% pro forma adjusted net income growth next year as we maintain our focus on driving consistent quality results and increasing the bottom line faster than the top. In summary, our performance and more importantly, our potential continues to be very promising, and we look forward to taking great care of our customers, team members, and shareholders as we near the end of a very exciting and strong Fiscal 2018.

I will now turn the call back to Lee for his final remarks.

Lee Bird -- Chief Executive Officer, President and Chairman

Thank you, Judd. In the third quarter, our exceptional top-line performance and meaningful income growth once again demonstrated the broad-based strength in our business. As we think about the future, we believe At Home is ideally positioned as the low-priced, trend-nimble, value player in a fragmented home décor industry that continues to grow. As we expand across our significant whitespace, we're committed to reinvesting in the right people, products, and opportunities to continue to give our customers the compelling in-store experience for years to come.

Operator, please open the line for questions.

Questions and Answers

Operator

Thank you. At this time, we will be conducting a question-and-answer session. If you would like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue.

You may press *2 to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the * keys. One moment, please, while we poll for questions. Our first question is from John Heinbockel from Guggenheim Securities.

Please go ahead

John Heinbockel -- Guggenheim -- Analyst

So Lee, let me start with -- it looks like for a while now, comps are running better than you thought at the time of the IPO. Is that sort of a permanent step-up or at least directionally, because of the brand that you're building? Because I'm sort of curious as -- if that's true, that obviously will give you a lot more dollars to play with investment-wise, right, as you go forward. Do you think it will pull forward some investments that you otherwise might have made later? And what would be the most fertile places for you? Is it direct sourcing? Is it taking marketing beyond three? What are the areas with the greatest potential?

Lee Bird -- Chief Executive Officer, President and Chairman

Thanks, John. Yes, I would say we're really grateful, first and foremost, for our recent higher comps in this retail industry, where we're really pleased that we've got that type of performance. It's been aided by those low-priced units certainly in the first half. If we had easier compares in the first half, one of the best parts of what we had for third quarter was it was actually getting tougher compares.

And so we had strong momentum going through the summer. We mentioned that in the end of our second-quarter call. We said it maintained itself and continued into the third quarter. But we had a question about the hurricane.

We were able to weather that storm, literally, and be able to bounce back. And we're really pleased with that. And our momentum has continued into the fourth quarter, so we're really grateful for that. I would say, and Judd has always mentioned the fact that we always focus on multiple levers.

And we always reach for higher. We look at all the levers and see opportunities. We will see opportunities going forward. We already reiterated the forecast for the fourth quarter.

As we have that performance being strong, we will reinvest it. The areas that we like the most are direct sourcing, for sure. We already -- we've pulled that ahead into this year because we had better performance than expected, at least better than planned. We hope for better, and we plan for better, but we can't necessarily commit to that.

So we invest against direct sourcing, and we'll start to see the benefit of that next year. The marketing campaign, we've been investing against marketing and we'll continue against investing against marketing. And that's gaining traction. Our brand awareness is growing.

We're going to continue to reinvest against price and value all day long. We want, and you could see, if you look at our pricing, we continue to be below our competitors' sales prices. We have great value. We've invested more in quality and continued to drive price down.

And on the marketing side, we're working on digitally enabling sales, so all of that investment we mentioned in my prepared remarks. And the last one, the investment that's coming up is our second D.C. That's not going to hit next year at all, but it will be an investment that we have to make in the future. We'll be planning it next year.

We'll be investing it the following year. But those reinvestments are necessary for the long-term strategy.

John Heinbockel -- Guggenheim -- Analyst

And then maybe as a follow-up. As we think about pricing, right, which is a little bit opaque in your product categories because we're on brands, what are the analytics around price elasticity? And how much, as you get some of those savings, how much should go to the customer in the form of lower pricing? And how much -- and I know it'll vary by category and probably by item, but what work are you doing to kind of test elasticity to make sure that you're, when you take the pricing down, you're getting bang for your buck?

Lee Bird -- Chief Executive Officer, President and Chairman

Yes. We look at a competitive pricing model all the time. It's not necessarily, "Hey, if we can increase price, we will," or decrease price. We look at our price versus our competitors, each and every competitor.

So we look at if it's an item that looks similar to a competitor, we look at that competitor and make sure that we're a certain percent off their sales price. So -- and we do that across all of our -- and every single department has -- we comp shop every single month and every single quarter, we have 10 competitors we compare against for every single department because every department has a different competitor group. For example, Wall Art may have Art.com, and Art.com doesn't show up obviously for Halloween, harvest, and Christmas, where maybe it's another set of players like a Michaels, a Hobby Lobby, or some of the NAS guys and home improvement guys and so on. So we just, we make sure that we've got the best value and the right price against every single one of our competitors every single month, and that's what drives our pricing equation.

If we see -- and we want to make sure that ours has the best value, and we've talked about investing against quality to make sure the value is there and not just make it cheap, for example.

Operator

Thank you.

Dan Binder -- Jefferies -- Analyst

Thanks, John.

Judd Nystrom -- Chief Financial Officer

Our next question is from Dan Binder from Jefferies. Please go ahead.

Dan Binder -- Jefferies -- Analyst

Thanks and congratulations on a good quarter. Given the clearance and the price investments, is it fair to say that most of the comp was driven by traffic? Or did you have ticket in there as well?

Judd Nystrom -- Chief Financial Officer

So I'll hit that, Dan. What we'd tell you is we're very pleased overall with all the levers of comp, candidly. We've been focused on them for years. What we'd tell you is basket has maintained that relative $65 that we had when we had the IPO.

So we're doing it in units, and we're doing it through transactions and so forth. But it's been a very measured approach. Different drivers move in different quarters, but we're making a tremendous amount of progress, and we're very pleased with the quarter and how it turned out, the momentum we've carried into Q4.

Dan Binder -- Jefferies -- Analyst

Great. My other question around comp store sales. You noted the disruption from the hurricanes. I'm just curious, subsequent and during this recovery period, certain categories will benefit home improvement, mainly.

But I imagine there's a lot of home furnishing-type items that get ruined from flooding as well. And I'm just curious if you're seeing any kind of unusual benefits in -- particularly in the Houston market

Lee Bird -- Chief Executive Officer, President and Chairman

So we went into the hurricane in those markets that were impacted, and they were doing great. The hurricane impacted -- obviously impacted sales of net 120 basis points. The stores rebounded back, and they're slightly higher than where they were before, but it hasn't meaningfully changed the comp. Overall, what we'd tell you is we have continued momentum.

We don't expect there to be a significant tailwind from it. For our category, it's the customers not repairing their home and doing things related to that, so we don't expect there to be a tailwind. We're pleased that we started with strong momentum and we continue with strong momentum in those markets.

Dan Binder -- Jefferies -- Analyst

Great. And if I could, just one more question on the reinvention strategy. Can you give us a little bit of clues on to what the focus would be for next year? You cited in your formal remarks some of the things you did in Q2 and Q3. I'm just curious what's left to do for next year.

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, Dan. For FY '18 this year, as we mentioned before, better patio was a focus. Bedding, better bedding was a focus. And our -- an upgrade to the holiday business, continuing multi-year effort.

Those have proven to be very successful. FY '19 is wall décor and patio. And so we mentioned in our remarks, as we prepare for reinvention, we end up having to clear the department a little bit more than usual. So for example, our margins were slightly affected in Q3 due to these planned reinventions for next year.

So for wall décor and patio, specifically patio cushions, we typically have a -- usually a higher carryover for the inventory for that, for patio cushions. We always keep them selling in full price, the ones that are carryover styles. But we've dramatically improved the assortment with a lot of newness, so a lot of styles were discontinued that would have been carried over. So we mark those down.

We're grateful that the markdown strategy has worked, and we've cleared the inventory. That's why inventory finished the quarter so clean as well. But we work really -- and we're really excited about what's coming. And I would say that this strategy was planned.

It's delivered the outcomes, and these reinventions continue to be the engine for our growth going forward. And we have a five-year plan for our reinventions. So we know what we're going to be doing next year and the following year. It allows us to tell our customers that something's new going on in the store and gives us the competitive advantage we feel against the competition.

Judd Nystrom -- Chief Financial Officer

Great. Thank you.

Operator

Thanks, Dan.

Joshua Siber -- Morgan Stanley -- Analyst

Thanks, Dan.

Judd Nystrom -- Chief Financial Officer

Our next question is from Simeon Gutman from Morgan Stanley. Please go ahead.

Lee Bird -- Chief Executive Officer, President and Chairman

Hey, this is Joshua Siber, on for Simeon. One question, if you look back over the last four quarters, how much of the accelerated comp would you estimate was driven by the lower-priced inventory that you've added to stores?

Joshua Siber -- Morgan Stanley -- Analyst

Yes, this is Judd. What I would tell you is that it varies by quarter. But this quarter, it was only 1%. In prior quarters, it was 1% to 2%, just dependent on the quarter.

And Q2, it was a little bit higher because we were up against our lowest unit volumes and unit comps. When you look at it year over year, it might have been a 3% or a 4%. I think we highlighted in the transcript a 4%. But last quarter, in particular, Q3, it was 1%.

And when we look at it, we've already now lapped it, so it shouldn't be that going forward.

Lee Bird -- Chief Executive Officer, President and Chairman

And that's why we're really pleased about this quarter. It wasn't about the lower-priced units. It was a broad-based comp performance. We hit regions across the country, all -- think about all of our districts continued to be strong, product categories, everyday and seasonal, all price points.

It just -- it was a broad-based comp performance, not driven by one particular area.

Joshua Siber -- Morgan Stanley -- Analyst

OK. And regarding e-commerce and omnichannel, what's the next step of your omnichannel build-out?

Judd Nystrom -- Chief Financial Officer

Our thinking on e-commerce hasn't changed, Joshua. We focus on the digital opportunity. We've always talked about digitally enabling sales. I shared in my prepared remarks the progress against that.

Think about the page loading faster, number of page views, and so on. We've increased our digital spend. We're seeing great traction. We launched the loyalty program.

Our focus really is on the consumer. And there's a lot of the research out there and even done by other analysts like yourself that have said the four most important things in this category to our -- to customers that look for home furnishings and home décor: lowest price; largest selection; see, touch and feel; and take it home immediately. You can do that every day, all day in our stores. And they -- but they price compare online.

So we've improved our website. We made it mobile, enabled for mobile in August. We've got the lowest prices in the industry. And I will tell you, prices are our biggest advantage as well as assortment, and we win all day with that.

Lee Bird -- Chief Executive Officer, President and Chairman

OK. Thanks very much.

Operator

Thank you.

Daniel Hofkin -- William Blair -- Analyst

Thank you, Joshua.

Judd Nystrom -- Chief Financial Officer

Our next question is from Daniel Hofkin from William Blair. Please go ahead.

Daniel Hofkin -- William Blair -- Analyst

Good afternoon, I guess, about the targeted markdowns. You, if you could quantify, perhaps, how much you think it hurt the gross margin within the quarter. And then conversely, it presumably helped your comps. How much of a benefit do you think that was? That's my first question.

Judd Nystrom -- Chief Financial Officer

Sure. Dan, this is Judd. So the targeted markdowns, to be clear, they were planned for the whole year. We had an opportunity, and were opportunistic within the quarter and saw some of that demand come in.

And we're very pleased with our inventory levels. We're up 12% as of the end of the third quarter. So we're very, very clean. What we'd tell you also that when we look at some of the markdowns overall, it didn't contribute to our comps that much.

It was not the largest driver at all. What we'd tell you is when we look at our performance for our comps, it comes back to all geographies, base for premium or good, better, best, all comped 5-plus percent or better. And the comp store sales on a two-year stack accelerated from where we were to the end of the year. So we're seeing more customers come into our store, and we're seeing them come more frequently.

And the exciting part is we're focused on the loyalty program and credit card that will help them.

Daniel Hofkin -- William Blair -- Analyst

OK. And then as far as the kind of some of the investments that you've talked about, including sounds like a second D.C. a couple years out, what's kind of your latest thinking about the free cash flow profile looking out over the next few years? What point do you feel like your earnings base kind of hits a certain level where you're outstripping your capital investments? Is that a couple of years out? Further out than that? What's your latest thinking on that?

Lee Bird -- Chief Executive Officer, President and Chairman

It's a few years out. I mean, we're committed to reducing our leverage and improve our cash flow. Leverage has been reduced by almost two turns over the past two years, so 4.8x to about 3.2x. We're going to continue to focus on new store growth.

And as a reminder, our paybacks are less than two years. And the pipeline's set for next year, and we're already working on the following year. So I would say it's a couple of years out. But we're focused on running the business and delivering great outcomes.

And I highlighted in my prepared remarks, we feel very comfortable delivering another year of 25% pro forma adjusted net income growth.

Daniel Hofkin -- William Blair -- Analyst

OK, great. And then someone may have asked this earlier. I missed a part of it. But did you address any early learnings from the loyalty program right off the bat?

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, Daniel. This is Lee. I would say we're really pleased right now with the enrollment. And so far, the overall performance of not only the loyalty program but the credit card program has surpassed our initial expectation.

It's driving basket. It's, but overall, it's being baked into our guidance. And we'll give you updates as the program matures. And so we're just pleased with what we're seeing.

We're grateful that our customers want to be a part of the program. And we feel like it's going to provide benefits for them, but the best part is they think so, too, because the enrollment rate is even higher.

Judd Nystrom -- Chief Financial Officer

Terrific. Best of luck in the fourth quarter.

Operator

Thanks, Daniel.

Brad Thomas -- KeyBanc -- Analyst

Thanks, Daniel

Judd Nystrom -- Chief Financial Officer

Our next question is from Brad Thomas from KeyBank Capital Markets. Please go ahead.

Brad Thomas -- KeyBanc -- Analyst

Thank you and good afternoon, and let me add my congratulations to all of you, guys.

Judd Nystrom -- Chief Financial Officer

Thanks, Brad.

Brad Thomas -- KeyBanc -- Analyst

Let's see here. Judd, you gave a little color on at least the gross margin outlook for next year being about flat. I guess, any more color you could provide on the puts and takes on gross margin next year and maybe the cadence as we start to model out the quarters for next year?

Lee Bird -- Chief Executive Officer, President and Chairman

Sure. So I can give you a macro view of 2019. We'll get more color on the quarters when we do our conference call coming up in the spring. What we tell you in terms of tailwinds, Peter talked about the direct sourcing.

The direct sourcing is making its way into our D.C. and is now hitting the stores. That will be a tailwind. It'll show up more to the back half of next year, but that will be a tailwind for the whole year.

We'll continue to leverage some of our fixed costs within supply chain and occupancy and so forth next year because the continued momentum we have in our business, we believe, is going to carry into next year. And we're well-positioned from an inventory perspective to get that newness. So that should be a tailwind. Sale-leaseback transactions, which we are doing right now on the fourth quarter and we'll do another one next year, will be a headwind.

Factor that all together, we'll be roughly flat for, hopefully, for the sixth consecutive year. So we manage our gross margins on an annual basis. I said that in our prepared remarks. And we're confident we can do that again in Fiscal '19.

Brad Thomas -- KeyBanc -- Analyst

Great. And then a follow-up on the earlier e-commerce question. I guess, this is kind of a broader digital question. We're seeing more and more companies start to offer these AR/VR capabilities.

I guess, as you guys think about your digital capabilities, are there any other areas, not necessarily tied to delivering to consumer, but just digital capabilities more broadly that we may be seeing you invest in sooner than -- rather than later?

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, Brad. This is Lee. I would say we're continuing to work on making the digital experience better. Some of those are pretty -- I'll say, there are some people out there pioneering some of those things, and we're not ready to be a pioneer.

We've got a lot of opportunities that's sitting there right in front of us around how to improve the digital shopping experience and how to connect our customer from online into the store. And so we're focused on those kind of things. We want to invest against a compelling in-store experience. That, to us, is the biggest opportunity.

So we're going to continue to make future investments to make it easier to shop. You should see that over the next couple of years as well. We already have an easy store, easy shopping experience for the customer, but we'd like to make it even easier. And there's ways to do that going forward.

And the investments will be around that versus some of the pioneering efforts some other people are trying.

Judd Nystrom -- Chief Financial Officer

Very helpful, thanks again.

Operator

Thanks, Brad

Matt Fassler -- Goldman Sachs -- Analyst

Thanks, Brad.

Judd Nystrom -- Chief Financial Officer

Our next question is from Matt Fassler from Goldman Sachs. Please go ahead.

Matt Fassler -- Goldman Sachs -- Analyst

A couple of questions. The first relates to the targeted markdowns that you took in the third quarter. To what degree do you think they took a little bit of weight off the fourth-quarter gross margin? I know that the markdowns were contemplated through the year. Sounds like perhaps they were accelerated a bit.

And is that one of the reasons you have a fourth-quarter gross margin anticipated up as much as it seems to be?

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, you are correct, Matt. The short answer is we pulled some of that forward. And we told you last quarter we expected gross profit to be flat roughly for the year. Nothing has changed related to that.

The sequence between the quarters did change a little more in Q3. Obviously, higher in Q4. We expect at least 120 basis points of gross profit expansion in the fourth quarter as opposed to a full-year plan.

Matt Fassler -- Goldman Sachs -- Analyst

Second question, just -- oh, sorry, go ahead.

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, just to provide a little bit more color. Our third quarter, we did have some really nice momentum on those Christmas items that we need to prepare for the reinvention. But remember, over 80% of our sales are full-priced and continue to be that for the third quarter. We continue to focus on being everyday low-price leader.

When we have reinventions, we do clear some product, and thankfully, it moved a little faster than we had planned. But it continues to stay within our model. More than 80% of our sales are full-price.

Judd Nystrom -- Chief Financial Officer

Gotcha. Second question I want to ask relates to your fourth-quarter same-store sales guidance. So you are guiding to the -- what would be -- turn out to be the softest comp of the year of 4%, having done 6%. And if you back out the storms, essentially, 8% and 8%.

And you did say it sounds like you exited the quarter well and started the fourth quarter well. At the same time, it is fair to note that you have two consecutive pretty stiff compares. Your best comps of each of '15 and '16 by far came in Q4. So how should we think about balancing -- as we think about the realistic comp and what's behind your forecast, the momentum that you clearly have in the absolute numbers that you've been printing with the tougher comparisons that you face in Q4?

Matt Fassler -- Goldman Sachs -- Analyst

Yes, Matt. We feel great about our business momentum. The third quarter was a strong quarter. The momentum, as we said, has continued.

The compare is harder in the fourth quarter. But if you look at the third quarter, we did a 7 off of a 4, so it's an 11 two-year stack. We've given you the forecast of a 4 off of a 7. So it's 11 two-year stack.

So you can see the momentum is just as strong in the fourth quarter as is the third quarter. It's just tougher compares. And then the compares get even harder in the back half of the fourth quarter.

Judd Nystrom -- Chief Financial Officer

And I would add, Matt, four years ago, we focused on our holiday assortment and becoming the holiday headquarters. When you look at the comp, including the outlook we provided for the fourth quarter of a 4 comp and you add up the last four years, on a same-store sales basis, we're up 25%. Clearly, our focus, our strategic initiative, our store execution, the product we're buying, it's working. And while there are more difficult comparisons, a 4 comp, as we've said, on a two-year stack is an 11, we're halfway through the quarter from a sales perspective.

We feel really good about it. We have a lot of momentum. But we're also mindful that we have some tough comparisons in January versus [inaudible]. But we had outstanding weather.

We know weather evens itself out over the course of a year. So we feel good about the 4. We have tremendous momentum. And we look forward to hearing our results this spring.

Matt Fassler -- Goldman Sachs -- Analyst

My last question, still on the top line related to new space productivity. We had modeled, I think, very consistent with your guidance, the best new space productivity that you would have put up in more than two years. And obviously, there's some quirks in measuring this and the timing of store openings, et cetera. But you came out even better, roughly 100% productivity of new space relative to the average.

Was there anything in particular? And I realize that this calculation represents four quarters or so worth of openings. Is there anything in particular that you saw out of the cohort of stores or kind of real estate type or one or two stores in particular that you're able to identify that would explain kind of a pop in new space productivity? And it seems to have accelerated to a greater degree than your comp did over the course of the year.

Judd Nystrom -- Chief Financial Officer

Sure, Matt. What we'd tell you is, as a management team, we've been opening stores for five years now. And for four consecutive years, we've actually seen our average unit volumes increase for four years. I said in my prepared remarks we believe this will be our strongest vintage ever.

And we're very, very confident in that. We're looking at average unit volumes. What we'd tell you, specifically to your question, is sometimes, we can have ground-up builds, which generate higher sales. And we experienced some higher in the third quarter, like we did this year.

We had four ground-up builds, versus last year, we had two ground-up builds overall. But what we keep coming back to is, we're getting better at opening locations. We're doing it in what we call open home perfectly. We have a team focused on that, cross-functional team.

And we're very pleased with the outcomes. And the new-store pipeline we have for next year we believe positions us to have even the strongest pipeline yet.

Matt Fassler -- Goldman Sachs -- Analyst

Understood. Thank you so much for all of that.

Lee Bird -- Chief Executive Officer, President and Chairman

Thanks, Matt

Judd Nystrom -- Chief Financial Officer

Thanks, Matt

Operator

Our next question is from Curtis Nagle from Bank of America Merrill Lynch. Please go ahead.

Curtis Nagle -- Bank of America/Merrill Lynch -- Analyst

Great. Thanks very much. Just a quick question on new openings for next year. I guess, would you guys consider accelerating growth if you were to come across what could be particularly high-returning second-use sites that might come available early in the year as you suggest they could?

Lee Bird -- Chief Executive Officer, President and Chairman

Yes, Curtis. This is Lee. We have a model that we have been successful operating within. And we've talked about that top-line growth driven by high teens unit growth, single -- low single-digit comp store sales, so revenue of roughly 20% and then earnings growth of 25%.

We like that model. We stay very disciplined with it. There may be a larger amount of excess big boxes out there that allows us to be more picky. And so -- and now that the pipeline for next year is locked, we -- we're looking at the following year.

So we'll be thoughtful about the following year. This gives us a chance, by having a larger quantity to look at, to pick out better locations, allows us to be -- improve our new-store performance by having better locations, also allows us to spend some more time negotiating leases to make sure we get the right rents and be more thoughtful about it. So we're spending time focused on delivering the outcomes on a consistent basis. And the larger pipelines, and we've got the deepest pipeline we've ever had.

It just works in our favor.

Curtis Nagle -- Bank of America/Merrill Lynch -- Analyst

I see. So effectively, it sounds like favoring quality over quantity. That makes sense. And then just a quick...

Lee Bird -- Chief Executive Officer, President and Chairman

So we're still doing a lot [inaudible] 20% [inaudible].

Curtis Nagle -- Bank of America/Merrill Lynch -- Analyst

[Inaudible] the unit growth, yes. Fair enough.

Judd Nystrom -- Chief Financial Officer

Twenty percent unit growth, that's still a lot, but we're going to deliver and deliver a really strong outcome with that 20% growth.

Curtis Nagle -- Bank of America/Merrill Lynch -- Analyst

Understood. And then just as a very quick follow-up. In terms of, I guess, where you expect inventory to be on a year-over-year basis at year-end?

Judd Nystrom -- Chief Financial Officer

Sure. Curtis, this is Judd. So Q3, we were at 12% inventory growth. And as a reminder, we had 18% increase in stores.

So we exit inventory in a clean position. For the fourth quarter, I'd expect it to tick up a little bit. We might be closer to store growth, so call it 18%, 21% neighborhood. We do have inventory that we're accumulating for stores that are going to open in Fiscal '19.

So we'll see some of that build in, and that will increase that and be the biggest driver as well as bringing in some of the reinvention inventory, particularly in patio. That's going to drive us. We want to make sure we're in a great position. But our inventory overall will be very clean exiting this year.

Lee Bird -- Chief Executive Officer, President and Chairman

Very good. Thanks and good luck for the rest of the year.

Operator

Thanks, Curtis.

Duration: 55 minutes

Call Participants:

Bethany Perkins -- Director, Investor Relations

Lee Bird -- Chief Executive Officer, President and Chairman

Peter Corsa -- Chief Operating Officer

Judd Nystrom -- Chief Financial Officer

John Heinbockel -- Guggenheim -- Analyst

Dan Binder -- Jefferies -- Analyst

Joshua Siber -- Morgan Stanley -- Analyst

Daniel Hofkin -- William Blair -- Analyst

Brad Thomas -- KeyBanc -- Analyst

Matt Fassler -- Goldman Sachs -- Analyst

Curtis Nagle -- Bank of America/Merrill Lynch -- Analyst

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