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Dollar General Corporation (NYSE:DG)

Q3 2012 Results Earnings Call

December 11, 2012 10:00 AM ET

Executives

Mary Winn Gordon - Vice President, IR and Public Relations

Rick Dreiling - Chairman and CEO

David Tehle - Chief Financial Officer

Analysts

Matt - Deutsche Bank

Matt Boss - JPMorgan

Dan Wewer - Raymond James

Colin McGranahan - Bernstein

Joseph Parkhill - Morgan Stanley

Meredith Adler - Barclays

Scot Ciccarelli - RBC Capital Markets

John Heinbockel - Guggenheim Securities

Ed Kelly - Credit Suisse

John Zolidis - Buckingham Research

Aram Rubinson - Nomura

Matt Nemer - Wells Fargo Securities

Deborah Weinswig - Citigroup

Operator

Ladies and gentlemen this is the Dollar General Corporation Third Quarter 2012 Earnings Conference Call on Tuesday, December 11, 2012 at 9:00 a.m. Central Time. Good morning. And thank you for participating in today’s call which is being recorded by Conference America, no other recordings or rebroadcast of this session are allowed without the company’s permission.

It is now my pleasure to turn the conference over to Ms. Mary Winn Gordon, Dollar General’s Vice President of Investor Relations and Public Relations.

Mary Winn Gordon

Thank you, David, and good morning, everyone. On the call today are Rick Dreiling, our Chairman and CEO; and David Tehle, our CFO.

We will first go through our prepared remarks and then we will open up the call up for questions. Our earnings release for the quarter can be found on our website at dollargeneral.com under Investor Information Press Releases.

Let me caution that today’s comments will include forward-looking statements about our expectations, plans, objectives, anticipated financial and operating results and other non-historical matters.

Our 2012 forecasted financial results and initiatives, anticipated capital expenditures and planned operating and merchandizing initiatives for fiscal 2013 and comments regarding expected consumer economic trends are some examples of forward-looking statements.

Important factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our earnings release issued this morning, our 2011 10-K, which was filed on March 22, 2012 and in the comments that are made on this call. We encourage you to read that.

You should not unduly rely on forward-looking statements, which speak only as of today’s date. Dollar General disclaims any obligation to update or revise any information discussed in this call.

We will also reference certain financial measures not derived in accordance with GAAP. Reconciliations to the most comparable GAAP measures are included in this morning’s earnings release. This information is not a substitute for the GAAP measures and may not be comparable to similarly titled measures of other companies.

Now, it’s my pleasure to turn the call over to Rick.

Rick Dreiling

Thank you, Mary Winn. Good morning, everyone, and thank you all for joining us. Today, we plan to discuss the results of our third quarter, update you on our outlook for the fourth quarter and provide a preview on some of our major initiatives for 2013.

We are pleased with our sales and earnings for the third quarter. Our performance has been encouraging over the Thanksgiving weekend and start of the holiday season. However, we continue to be cautious for the remainder of the year.

Our customer tends to buy closer to need and that tendency is even more pronounced around the holidays. I’d like to share a few highlights from the third quarter and then David will provide more detail on our financial results.

Our total sales increased 10.3% over last year to $3.96 billion. Same-store sales grew 4% and both customer traffic and average ticket on our comp stores increase for the 19th consecutive quarter. For the 39-week year-to-date period, same-store sales were at -- were up 5.3%.

Operating profit increased 16% to $361 million or a record for the third quarter of 9.1% of sale, up 47 basis points from last year, due to 50 basis points of SG&A leverage offset by 11 basis point decrease in gross margin. Interest expense was down $11 million. Adjusted net income increased 22% to $210 million and adjusted earnings per share increased 26% to $0.63.

Also during the quarter, we repurchased 296 million of our own common stock, increasing our year-to-date repurchases to $596 million. These are very solid results and I’m very pleased with our team’s ability to produce sales, manage our operating expenses and improve our capital structure and what we view as an uncertain external operating environment.

In third quarter, same-store sales growth was driven by consumables with the strongest gain in imperishable, including beer and wine, candy and snack, health and beauty. Performance in home décor and domestics continued the favorable trends we’ve seen all year with strong results in bath and bathing. Within our seasonal category, sales were strongest in stationary summer and seasonal events, as well as in mobile phones, phone accessories and phone cards.

Although, sales of our fashion hanging apparel were disappointing, certain categories including infants and toddlers, accessories and undergarments were strong. Markdowns in apparel increased in the quarter as we continue to learn more from apparel pricing strategies and improve our apparel inventory management.

As the trends in the quarter, overall the quarter started out strong with August and September running between 4% and 5%. In October, we experienced some modest slowdown the 3% as the competitive environment continued to intensify and we started to lap price increases in our highly consumable categories that we pushed off in early 2011. We started to pass through these price changes in the third and fourth quarter of 2011.

The most recent syndicated Nielsen data indicates that we continue to make market share gains in consumable with high single-digit growth in unit sales and Dollar market share on a four-week, 12-week, 24-week and 52-week basis consistent with the trend we have seen for the last five years.

We continue to remain very focused on growing our unit sales and increasing our market shares as we go forward. As David will discuss when he provides our outlook, we intend to make selective gross margin investments to ensure we continue to drive unit growth and build loyalty with our customers.

We are making great progress on our efforts to optimize square footage productivity at our existing stores to our Phase V merchandising initiative. Year-to-date, we have optimized about 10,000 planograms. We have refined our strategy and accelerated our plans to impact a significant number of our legacy stores over the next 12 to 18 months.

We continue to make progress improving our in-stock levels. Over the last two years we have reduced our number of out of stock items by nearly 50%. In addition to increasing sales, this improvement is continuing -- contributing to positive result and our customer satisfaction scores.

Through our customer connection surveys, our customers indicate they are more satisfied than ever with our overall shopping experience as our scores continued to improve. And as we have for the last four years, we are on track to once again, remove over $50 million in costs from our business operations that do not impact our customer service level. This program remains very relevant to the Dollar General culture providing our customers with everyday low prices.

Now I’ll turn the call over to David to discuss the details of our third quarter performance and our outlook for the rest of the year. When he finish, I’ll share in greater detail some of our operating initiatives and plans for 2013. David?

David Tehle

Thank you, Rick, and good morning, everyone. As Rick said, we’re pleased with our third quarter results. Total sales increased 10.3% to $3.9 billion, with same-store sales up 4%. Our total sales were impacted by later than expected store openings in the second and third quarters, and resulting slower ramp up of sales weeks.

Our gross profit rate was 30.9% for the quarter, down 11 basis points from last year’s third quarter rate and slightly below our expectations. Higher markdowns, lower price increases compared to last year, our higher consumables mix and higher shrink all pressured gross margin.

These factors were partially offset by higher incoming markup and improve transportation efficiency. Actual fuel rates were up about 6% from last year, but we achieve leverage on transportation from reduction in stem mile and improve carton per truck.

Our LIFO chart this quarter was nominal less than $100,000 versus an $11 million provision in the 2011 third quarter, as we’ve seen moderation in cost increases this year. Another notable item affecting our gross margin was our shrink performance.

Well, our total shrink units per store improved, our financial shrink increased due to an increase loss of SKUs greater than $5 at retail. Although, experiencing greater shrink, overall these high value SKUs are driving increase sales and higher margin dollars.

In the second half of 2013, we expect our trend of shrink improvement to resume as we rollout our new merchandizing strategy such as defensive fixtures and labeling, and we expand existing tactics to combat shrink.

SG&A improved by 58 basis points to 21.8% of sales with most of these due to increase retail labor efficiencies. Workers compensation and general liability expenses increased at a rate lower than the increase in sales.

The decrease in incentive compensation also contributed to the overall decrease in SG&A as a percentage of sales. SG&A results also reflect the favorable impact of our ongoing mine for cost reduction program, as well as the 10.3% increase in sales. Fees associated with the increase use of debit cards partially offset the improvement.

For the quarter operating profit was $361 million or 9.1% of sales, a strong improvement over last year. We continue to be pleased with our ability to balance sales, gross margin and expense leverage. This quarter Dollar General once again exhibited our commitment to control what we can control.

Interest expense was down $11 million from the prior year to $28 million due primarily to lower average interest rates. Our total outstanding debt balance is approximately $300 million higher than third quarter last year, due to our share repurchase activity. Our effective tax rate was 37.4%, compared to a rate of 37.1% in the third quarter of 2011.

Finally, our third quarter adjusted net income increased 22% to $210 million and adjusted earnings per share increased 26% to $0.63 per share. The reconciliation of adjusted net income and earnings per share to GAAP can be found in the morning’s press release.

Our strong operating performance resulted in cash flow from operating activities of $691 million year-to-date, up 14% from last year. Capital expenditures through the third quarter were $454 million with a focus on store growth, relocations and remodels.

As Rick mentioned, we repurchased $596 million of our common stock in fiscal 2012, of that $296 million was repurchased in the third quarter, including $250 purchased from Buck Holdings associated with the September secondary offering and $46 million was repurchased on the open market.

Since last December we have repurchased $781 million or 17.6 million shares and we have $219 million remaining under our current Board authorization. As of November 2nd, total inventories across were $2.33 billion, up 11.5% in total from the prior year third quarter and up 5.5% on a per store basis with most of the increase in consumables.

We are comfortable with our inventory levels and the quality of our inventory. Through the third quarter, we’ve opened 479 new stores this year, including 34 Dollar General Market and 24 Dollar General Plus stores, our new large format with expanded coolers and wider aisles.

We also remodeled or relocated 594 stores completing our remodel and relocations for the year. Out of these we remodeled 25 Dollar General Market and relocated or converted 82 stores to the Dollar General Plus format. We are encouraged by the topline results of these formats and are optimistic about their potential as we continue to work on increasing their profitability.

At the end of the third quarter, we had a total of 10,371 stores in 40 states, including 101 Dollar General Market and 113 Plus stores. Our stores in California are combination of traditional Plus and Market stores.

The 32 stores opened in California through the end of the third quarter are meeting our sales projections and we are on track to open a total of 50 stores in California by the end of the year. We broke ground on our 12 distribution center in Pennsylvania in November. This DC is expected to be fully operational in the first quarter of 2014.

Now for an update on our 2012 earnings guidance, based on our year-to-date performance and our current expectations, we are updating our full year adjusted earnings per share guidance to the range of $2.82 to $2.85. Our guidance includes a $0.04 per share benefit from tax audit settlement in the second quarter.

As a reminder, last year was a 53-week year with 14 weeks in the fourth quarter. This year’s fourth quarter includes only 13 weeks, as a result will affect our ability to leverage fix costs to the same extent as in the prior year.

For the year we currently expect total sales to increase between 8% and 8.58% over the 53-week 2011 fiscal year or between 10% and 10.5% on a comparable 52-week basis. Although, we are on track to meet our target of 625 new stores, our total sales for both the fourth quarter and the full year will continue to be impacted by the delayed ramp up in the sales weeks that I previously mentioned.

Same-store sales based on a comparable 52-week period are expected to increase 4.5% to 5%. Same-store sales for the fourth are expected to increase 3% to 4% as we are lapping a 6.5% same-store sales improvement in Q4 of 2011.

The strong comp growth in the fourth quarter last year benefited from two items that we do not expect to reoccur this quarter. First, like most of the retailers, we have to overcome extraordinary performance in January of 2012 when comps were up nearly 9% as spring sales were pull forward due to the exceptionally mild winter. And secondly, this is compounded by an approximately 200 basis point inflation headwind that we called out last year.

For Dollar General the fourth quarter is also very difficult to predict this year because of the current operating environment including continued high-end employment, uncertainty on the fiscal cliff and increased taxes, unpredictable weather in January, where one or two bad storms could significantly impact sales and the competitive environment.

We expect gross margin to be flattish in the fourth quarter for a few reasons. We expect an ongoing mix shift to consumables and we anticipate slightly higher year-over-year shrink.

Consistent with our strategy, we are in the process of implementing certain gross margin investments in pricing as we make selective strategic moves to continue to drive unit growth.

These investments include lowering prices in certain category, strategic expansion of zone pricing and incremental ad activity. This strategy is part of our goal to build customer loyalty or staying true to our everyday low price commitment.

We estimate SG&A expenses for the fourth quarter to increase about 4% over last years fourth quarter. This will result in deleverage of SG&A primarily due to the 53rd week comparison.

Operating profit excluding this year’s secondary offering expenses is now expected to be in the range of $1.630 billion to $1.645 billion. We are selling approximately 335 million weighted average diluted shares and a full-year effective tax rate of about 37% including the second quarter tax settlement.

Interest expense is expected to be in the range of $130 million to $135 million. We are now well positioned for the company’s migration to an investment grade capital structure. We are committed to managing our leverage ratios to achieve and maintain investment grade ratings.

As such we are currently targeting an adjusted debt-to-EBITDA ratio of below 3.0 times which we believe will provide our most efficient capital structure. At the same time, if circumstances in the debt equity markets are such that we deem it prudent to temporarily increase or decrease our debt levels means we may do so.

Capital expenditures in 2013 are expected to be in the range of $600 million to $650 million. We plan to open more than 140 stores in the fourth quarter for a total of 625 new stores for the full year.

We expect to have approximately 110 Dollar General Market stores and more than 120 Dollar General Plus stores by the end of the fiscal year. As we do typically, we plan to provide 2013 financial guidance when we released Q4 2012 earnings in March of next year.

As you build your models for 2013, some of the factors such as weather and inflation that we have discussed that impact the fourth quarter of 2012 will carryover into the first quarter given that we’re revamping strong comp growth of 6.7%.

With that, I will turn the call back over to Rick.

Rick Dreiling

Thank you, David. Looking forward to 2013, we’re putting plans in place that continue to build on our commitment to our four key operating priorities; driving productive sales growth, increasing gross margins, leveraging process improvement and information technology to reduce costs and strengthening and expanding Dollar General’s culture of serving others.

We’re still in the process of wrapping up our plans for 2013 but I wanted to share a few of our more significant initiatives with you today. Let’s start with our first priority of driving productive sales growth.

The returns on our new stores remain some of the best in retail, thank to the capabilities that we have developed in our real estate model. In 2013, we expect to open approximately 635 new stores, including another 50 stores in California.

Our pipeline for new stores is full and ahead of where we were last year. At this point, we do not anticipate facing in 2013 delay in new store openings and a lag in store sales weeks that we faced this year.

We also planned to continue our remodel and relocation program with an additional 550 stores in 2013. In total, we expect square footage growth of approximately 7% for the fourth consecutive year.

We currently expect that about 20 of our new stores in 2013 will be DG Markets and 40 will be Dollar General Plus stores. We’re excited about the unique opportunities that these formats provide us. 2012 has been a year of learning for these concepts that we continue to lag the potential and flexibility to capture growth in the market place that they provide.

These additional new stores will provide us with more experience as we look to drive the sales productivity and returns of these formats and to determine the appropriate role they should play going forward in our store planning growth.

Additional key initiatives to drive productive sales growth include the following eight initiatives. Ongoing category management efforts, the roll out of tobacco and cigarettes, significant expansion of Phase 5 legacy stores, further cooler additions, continued roll out of beer and wine, the addition of more than 150 private brand items, further leverage of zone pricing and a continued focus on reducing our out of stock position.

Let me provide you with a little more detail on each of these sales initiatives. We plan to roll out cigarettes and tobacco to the majority of our stores by the end of the second quarter of 2013.

We did initial test to cigarettes and tobacco in Nevada beginning in 2011 and expanded that test further to Florida in 2012. As we have used our test and learned approach to this launch, we have given this initiative time to develop. While the category is in structural decline and is low margin, we know that our core customer over indexes with tobacco and cigarettes and we expect the category to drive traffic.

We have secured an exclusive distribution agreement with Nash Finch that does not require us to sacrifice margin from other categories such as candy and health and beauty aids to subsidize the distribution of tobacco and cigarettes.

The competitive environment has changed, and I view this as a response that will allow us to get our fair share of this traffic. One of our most exciting opportunities is the ongoing expansion and refinement of Phase 5 of our merchandising evolution to about 4200 legacy stores.

This objective is to implement our most productive planograms at the optimal linear footage with the right SKU set based on sales per square foot across the chain. This initiative has been tested in 2012 with strong results. This multi-year project will affect stores that have not been remodeled or relocated.

For example, these planogram changes will allow us to expand high sales and high margin categories such as health and beauty aids where we are underpenetrated and in laundry, where we clearly know the best performing planogram set. Additional categories in package include auto, hardware and apparel to name just a few.

In our legacy stores, we were able to set the most productive planograms with the optimal SKUs. In total, over time, we expect this optimization to add up to 300 SKUs across various categories.

In addition, we will also be further expanding our SKU count in health and beauty across the balance of our store as we optimize other areas. Based on our initial experience, we expect a strong sales lift from Phase 5 and our store teams are excited to implement this program.

Additionally, we plan to further expand our cooler presence. Currently, our new stores are opening with 16 coolers and we plan to install additional cooler doors in approximately 2,200 existing locations to better serve our time conscious customer. 2013 will be our third consecutive year of increasing the cooler sets in our existing stores. In 2012, we’ve increased the number of coolers in 1300 stores, still needing approximately 4300 of stores today with eight or few cooler doors that may still have cooler expansion opportunities.

Fresh and refrigerated foods help us drive customer traffic and increase basket size by serving a greater share of our customers’ needs. When we expand cooler doors in the store, we typically see a lift in our average basket from about $11 to more than $17 when perishables were in the basket.

We’ve made great progress on the roll out of beer which we currently have in over 4100 stores including 3300 stores where we also sell wine. With the target to have beer or both beer and wine in 50% to 60% of our stores in total, there continuous to be a comp sales list opportunity for us overtime.

Adding beer and wine to a store has typically added about 100 basis points lift in comp sales to that store. We are very pleased with our partnership with Gallo who produces our private brand, [Wine Spring Creek] which we are now selling at a rate of over 1400 cases per week.

An additional sales driver includes the expansion of 150 private brand in Rexall SKUs across the consumable category, bringing our expected private brand penetration up to about 25% near term with continued opportunities for growth.

These SKU additions build upon are very successful private brand and proprietary brand programs like Rexall that are margin enhancing. We expect to exit 2013 with a total of private brand SKUs of nearly 2300, an increase of about 8% with new product introductions in candy, snacks, food, perishables, paper, home cleaning and health and beauty aids.

With this increased private brand offering, we will have more than doubled private brand SKUs over the last five years. As demonstrated by a record of strong unit growth, our pricing capability has become a key competency of Dollar General.

We worked very hard to make sure our prices are right for our customers everyday. Over the last 12 months, we had significantly improved our capability and understanding of zone pricing and markdown optimization with the conversion to demand tech.

Demand tech has provided us with most robust analytics and more comprehensive understanding of our shoppers and categories. Going forward, we will build upon this experience to use zone pricing as a strategic competitive tool and to strengthen our position as an everyday low price operator.

I believe this will give us more flexibility in the market place. We will continue to take an aggressive stance towards improving our store out of stock position. This is a never ending effort which requires focus on store-level perpetual inventory as well as improved execution across ordering, fulfillment, stocking and delivery. Our goal is to reduce our average number of out of stocks by another 25% in 2013.

Our compelling sales initiatives for 2013 will be complemented by real estate model that we expect to provide us with 150 to 200 basis points of comp annually. This lift is driven by our strong new store maturation curve and a sales increases from relocations and remodel.

We’re very excited that we have accomplished to drive sales productivity over the last five years from $165 per square foot to $215 today. I believe our 2013 sales initiative will resonate well with our customers.

Going forward, we also believe we have the opportunity to expand gross margin. Private brand expansion, innovative and new sourcing strategies, strength optimization, distribution and transportation efficiencies and our focus on relevant non-consumables should all contribute to gross margin expansion over time. However, in 2013, we expect the roll out of tobacco and cigarettes to pressure our gross margin for the year.

Our goal is for our gross margin initiative to reduce some of that pressure. As David mentioned, these initiatives should also have given the flexibility to invest in those things essential to our model, driving units and staying true to our everyday low price promise to our customers.

Overall, our performance of the Thanksgiving weekend and start of the holiday season has been encouraging. However, we continue to be cautious for the remainder of the year, given the competitive environment, the significant comp overlap we have in January and the growing near-term pressures in packing our core customer’s confidence in spending.

Like most retailers, I have rarely seen weekly sales fluctuate as much as we have seen recently. It is my belief that our core customers concerned about our financial outlook which is resulting in a dynamic that is driving the current competitive environment to be more promotional. As a result, I believe our quarter four sales outlook is balanced given the uncertainties we are facing.

We make great progress due to our strong retail disciplined across merchandising, store growth and operational execution. More importantly, we have a clear path for ongoing improvements and sustainable long-term growth.

It continues to remain to be an exciting time at Dollar General. Before we open for questions, I want to extend my sincere thanks to over 93,000 Dollar General employees that are exemplifying our mission of serving others everyday as they strive to help our customers save time and money in the current economic environment.

Mary Winn, I’ll open the call up for questions now.

Mary Winn Gordon

Thank you, Rick. And operator, we will now take the first question please.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Charles Grom with Deutsche Bank.

Rick Dreiling

Good morning, Chuck.

Matt - Deutsche Bank

It’s actually [Matt] for Chuck. He is on a plane. I was hoping we could talk a little bit about the cigarette rollout. Obviously, an important initiative, just kind of the impact on margins, you said obviously low pressure margins but some of the puts and takes with how you believe you can execute in terms of gross margins going forward.

Rick Dreiling

Yeah. Let’s talk about cigarettes and what we think is going to happen. We have it in a pretty large test right now. We anticipate the sales comp lift will be greater than what we’ve seen with beer and wine. We’re going to take about two quarters to roll it out. You have to remember we have over 10,000 stores. It’s going to take time to get the licenses being done. And we want to do it the right way. In regards to the margin, it is a low margin category and we believe that we have initiatives underway that will help offset that but we will see margin pressure to the course of the year because of the cigarette roll out. David, I don’t have anything.

David Tehle

Yeah. The only other thing to say is clearly because of the sales increase we’ll get from cigarettes. We should obviously help us on the SG&A front in terms of SG&A leverage as we look at the year too. So clearly impact the margin negative or a positive impact on our SG&A and our ability to lever our expenses.

Matt - Deutsche Bank

Great. Thanks.

Rick Dreiling

Thank you, Matt.

Mary Winn Gordon

Operator, we’ll take the next question please.

Operator

Our next question comes from Matt Boss with JPMorgan.

Rick Dreiling

Good morning, Matt.

Matt Boss - JPMorgan

Good morning. Could you just walk through your gross margin guidance for 4Q, particularly the underlying markdown and mix impact. You talked a little about competition. What are you seeing that’s different from three months ago that seems to be adding some incremental cost in here?

Rick Dreiling

Let me -- I’ll discuss the environment and David, I’ll let you take him through the margin. When we went into quarter three as I look at the first two periods of the quarter, the value messaging, the intensity of the value messaging was increasing. People were running more ads, bigger ads with the actual physical vehicle was larger trying to attract attention. We saw promotional activity in terms of more coupons, yeah, limit one, limit two, with great retails in them.

But what happened in the last period, we saw outright price increases start showing up in ad decreases, excuse me, show up in the ad. In other words, the competitive environment in regards to pricing got hotter in October. And as David brought out and I’m going to leave up to him now, we’ve made a decision in the fourth quarter, we want to protect our unit growth and we intend respond to that.

David Tehle

Yeah. We’ve said we’re going to be flattish in terms of the overall results. We are going to be investing in price strategically. So we will have some selective price decreases. We are relying heavily on zone pricing.

We’ve had zone pricing for a couple of years and we’ve been fine tuning it. And I think its becoming more and more of a tool for us to help develop what we want in the model here. And then we will have some increase ad activity overall too.

I want to keep in mind here our overall goal in terms of why we are doing this is for the long-term benefit of Dollar General. We want to drive units and customer loyalty. And again, we believe that driving units and staying true to our EDLP strategy, our EDLP pricing is very, very important.

We’ve said this many times. We talked about this at our Analyst Meeting this past summer that those two things are going to trump just about everything else in our model and we are going to stay true to that because we truly believe that will ultimately drive the most shareholder value for Dollar General, and quite honestly the most customer loyalty.

Rick Dreiling

Matt, if I could throw one thing on the table too. We are anticipating a sales mix shift in the fourth quarter also. And we talk a lot about the competitive environment, but I also think there is a change taking place in the customer environment right now.

I think the customer is fatigued, they are tired, they are scared, every time you turn on the television, there is a bunch of guys in a suit who are frowning, telling you the world is going to go over the fiscal cliff. And as that happens, I think the competitive environment heats up in response as we all try to hold on to the sales that are out there.

Matt Boss - JPMorgan

Great. And then real quick as we look to next year with some of these incremental investments on the table, can you speak to capital allocation priorities and your appetite for potentially increasing share repurchases next year, is that not something we should be thinking about?

David Tehle

Yeah. I think, we want to wait a little bit on that, obviously we are going to give full guidance as we get out into March of next year, when we release our fourth quarter earnings.

I will say that our priority remain the same as we’ve said before, our number one priority for capital is investing in the business because we believe that’s the best return for our shareholders, opening new stores, remodeling stores, doing relocations and then building the infrastructure that’s necessary to support that. And then our number two priority remain share repurchases as you mentioned. So we’ll have a little more clarity on that when we give full guidance in March.

Matt Boss - JPMorgan

Okay. Great. Thanks.

Rick Dreiling

Thanks, Matt.

Operator

Our next question comes from Dan Wewer with Raymond James.

Rick Dreiling

Good morning, Dan

Dan Wewer - Raymond James

Hi. Good morning. So Rick I was under the impression that the company was reducing inventory purchases heading into the fourth quarter, yet inventory per store at 5.5% entering the fourth quarter is higher than your comp sales guidance. Does this reflect the softness in October and just caught with a little bit extra inventory?

And then also can you talk about the inventory growth we should be thinking in 2013 with the addition of tobacco and some of these other initiatives?

Rick Dreiling

Yeah. Well, first of all, let me talk a little bit, when I communicated that we were buying down on our inventory. I apologize if I led you to believe that was across the Board, we had made a conscious decision to control the buy of seasonal merchandize.

As we -- we were -- we have been talking for about a year that we think Christmas could be a little tight and we wanted to maximize our sales through, what we are trying to do is raise sale through and lower our markdown. So I apologize if I miss led you that we are buying down on everything.

As we move into the fourth quarter, as I look at the inventory, we have a lot of new planograms coming. So we are going to -- that inventory will start to arriving in the fourth quarter for next year. Also we are buying around the Chinese New Year.

We learned a couple of years ago, we want to be very careful with that and not put ourselves in a position we short the consume. Along with those changes in planograms, we also have this change in Phase V, which is going to add little bit of inventory.

Now in regards David to 2013, I don’t know that we’ve necessarily put our arms around the cigarette impact.

David Tehle

Yeah. Yeah. I think we are still fairly met out and try to figure out what the investment in inventory is going to be and of course, part of that will depend upon how quick we get this initiative executed. So I’d rather hold off on that. I do want to point out though that in the quarter our total inventory turns were at 5.2 times and versus last year’s turns at 5.1 times.

So, again, we continue to be fairly pleased with what we are doing on inventory and again, we were up 5.5% on a per store basis on a four comp, but again that wasn’t that much out of line and we continue to watch the inventory turns very close, that’s probably the number one thing we look at, and most of that increase we saw in the quarter was in consumables and again, items that -- that are -- that continued to move pretty well.

Dan Wewer - Raymond James

Then David, in your comment you’d indicated that the shrink issue maybe continue through the first half of 2013 and then began to improve in the second half of that year. But you had also be completing the rollout of tobacco by the second half of 2013 and tobacco has a higher shrink rate than the house average?

David Tehle

Yeah. I know that’s right and obviously, that’s something we have to play into our model. Let me tell you some of the things we are doing on shrink that we think will gain traction as we get into the back half of the year and I touched very briefly on this. But we are investing more in defensive merchandizing fixtures, spiral pegs, flip-up windows, the antitheft labels that are on the product that seems to very, very effective.

We are going to the next phase of our exception based reporting. We are doing more point of sale work with that and system tracking to make sure that everybody is using this as they should be and our preliminary look fee at that in the small test we run, that’s going to be very effective.

And then we continue to develop our optimize shrink model on a store specific basis, but that driven analysis, looking at what the individual shrink should be for each of our over 10,000 stores versus where they are today and then taking appropriate action.

So I think we’ve got a lot of thinks going on. We see traction taking place and certainly we hope some of this will offset some of the incremental shrink that we might see out of cigarettes. And you are right, we are well aware that’s a high shrink category, that’s all been played into our estimates in our modeling as we’ve look it taking on this product.

Mary Winn Gordon

Okay. Operator, Dan if we can go ahead, move on to the next call, does that help.

Dan Wewer - Raymond James

Thank you.

Rick Dreiling

Thank you, Dan.

Operator

Our next question comes from Colin McGranahan with Bernstein.

Colin McGranahan - Bernstein

Good morning.

Rick Dreiling

Hi, Colin.

Colin McGranahan - Bernstein

I wanted to start kind of big picture just in terms of the environment you are seeing in demand, looking at the fiscal cliff, but looking at your category sales. In Q3, you actually look like you saw a little bit of improvement in seasonal and in home and even in apparel versus consumables slowdown a little bit. My first question is, how much of that you think is the uncertainty and what’s going on in the demand environment? How much of that is competitiveness in the consumables category specifically?

Rick Dreiling

Yeah. I would look at you and say, it’s probably a little bit of both. I think people are spending closer to nil. But I also think, Colin is the easiest to garner sales on the consumable side, promotional activity tends to go there first.

And as a retailer, I mean, I’m not telling anything you don’t know, there are four or five items you could pull the trigger on and drive a lot of traffic very quickly. And I think that’s what we’ve saw as we move through October, more and more focus on handful of key consumable items across the marketplace.

Colin McGranahan - Bernstein

Okay. That’s fair. And then in the fiscal cliff specifically, what are your expectations about how that might impact your actual customer in 2013 at this point?

Rick Dreiling

That’s, I mean, that is a million dollar question. What I have to fall back on and what I have to fall back on is we’ve got 23 -- we are on the 23rd year of same-store sales growth. In tough time our customers that needed even, needed us more and in good times, they historically have a little bit more to spend. And I think if it does get bad the customer is going to truly need it and I think, we’ll continue to strive broaden our base.

Colin McGranahan - Bernstein

Okay.

Rick Dreiling

Anything else Colin?

Colin McGranahan - Bernstein

No. I’ll turn the call over, let someone else get chance.

Rick Dreiling

All right. Hey. Thanks.

Mary Winn Gordon

All right. Operator, we’ll take the next call.

Operator

Our next question comes from Joseph Parkhill with Morgan Stanley.

Rick Dreiling

Good morning, Joe.

Joseph Parkhill - Morgan Stanley

How are you? Sorry to believe, but just the change, I mean, thinking about cigarettes, is that, is it just like your test market performed better from either sales or profitability standpoint then you were originally thinking, or are you also seeing some type of competitive, dynamic, weird stores that overlap other retailers that are offering cigarette are performing weaker than the rest of the chain?

Rick Dreiling

Joe, that’s a really fair question, and the first thing I’ll say is, in regards to the sales, they are responding, they are performing about what we thought, maybe a little bit better. I will tell you the turning moment for me, I spend a lot of time in the stores was five weeks ago, as I’m visiting stores and between our customers and our store managers they are asking us, when are we going to put cigarettes in.

And I view this as response to the needs of our customer and our store managers are communicating they need it and we made a decision to go forward with it. It is a dying category. It’s a category that that’s going to feel really good for about a year.

We’ve done a really good job of controlling supply chain. We’ve done a really good job of managing the flow of the cigarettes in the store and getting them out the door. So we are doing it based on the wants and needs of our -- what our store managers are telling us our customers want.

Joseph Parkhill - Morgan Stanley

Okay. Great. That’s helpful. And then just as far as the deceleration in October in general have you been able to look at if that’s coming more from a lower income consumer or you are getting less trade down or anything changing there?

Rick Dreiling

Joe, I can’t tell you that. I don’t know. I will tell you that we did see an increase in the ad activity enough through the month of October.

Joseph Parkhill - Morgan Stanley

Okay. Thank you and good luck.

Rick Dreiling

Thanks Joe.

Mary Winn Gordon

And Operator we’ll take the next call please.

Operator

Our next question comes from Meredith Adler with Barclays.

Rick Dreiling

Good morning, Meredith.

Meredith Adler - Barclays

Good morning. Thanks for taking my question. I guess I would like to talk a little bit about the decision to invest in advertising and pricing promotion in the fourth quarter. You talked about that benefiting the long-term but you kind of feel like that been around awhile and it doesn’t always do that, that is just sort of spiral where everybody starts to beat each other up. How can I get some comfort that that’s not going to happen this time?

Rick Dreiling

Yeah. I think if you want to get some comfort, I would go back and look at the tail-end of 2010 when we made a decision as an organization to sacrifice some margin and invest it back into our pricing.

And you have to remember, when I talked about investing in our pricing, I’m not saying that we are going to take weekly items down, we are talking about investing in EDLP, taking -- we’ve seen sensitive items like perhaps coffee or cereal, and investing in that category. We are not talking about running coffee here at $1 a can. We are talking about making strategic investments in categories and items on an EDLP basis that are important to our customer.

Now we are talking about running an occasional more ad or so. But again I want to reinforce our commitment as the EDLP and if you want to look, if you look at our sales trends, this is very simpler to what happen to us couple years ago. Then you can look and see what immediately happen then when we made this commitment in 2011, where the customer responded greatly to it.

Meredith Adler - Barclays

Okay. Great. And then a question about apparel, I think, you have been very cautious about the amount of hanging apparel, especially women’s apparel that you have in the stores, are you feeling like sales are slowing or are weaker even than you had anticipated when you put that inventory in place and what is your outlook, because you obviously making decision for spring inventory already, what is your view and what it done in terms of orders for spring apparel?

Rick Dreiling

Yeah. I would think in regards to where we are on apparel as I look across the inventory. We might actually be just a little bit better. The promotional cycles that we are running through, I can’t tell you Meredith. The customer is responding to the promotional cycles. Again, we have to get them to respond when it’s not being as heavily promoted.

As we look into spring and summer of next year, I think, we pretty much taken the approach we took last year, pretty consistent. We have bought the inventory down, but we bought the amount of inventory we think we can sell.

Meredith Adler - Barclays

Okay. Great. Thank you.

Rick Dreiling

You bet.

Mary Winn Gordon

All right. Operator we will take the next question please.

Operator

Our next question comes from Scot Ciccarelli with RBC Capital Markets.

Rick Dreiling

Hey, Scot.

Scot Ciccarelli - RBC Capital Markets

Good morning, guys. How are you?

Rick Dreiling

Good. Thank you.

Scot Ciccarelli - RBC Capital Markets

Good. Rick, your comments that you really seeing weekly sales fluctuate as much as they have recently, the pretty strong statement given, you are pretty consistently cautious comment on the consumer for a couple of years here. Is it actually more volatile than what you saw in, say, 2007, 2008 or is there another period to look at or is there just -- you guys really haven’t seen as much volatility historically?

Rick Dreiling

I will tell you that we historically, while we have seen pay cycle changes, as I look at the weeks and I look at the period within the quarter, they flow pretty evenly. And what we’re seeing now is vacillation like I’ve never seen before. The first will be incredibly strong and then the sales were weak and then we will pick up on the 50s and then it weakened. And it’s just a much stronger cycle. And I think, Scott, it’s been driven by -- there is so much uncertainty, the customers trying to hang on as long as they can. And we’ve actually coined the phrase here, there is more days than there is dollars that appears like all of the sudden for the customer.

Scot Ciccarelli - RBC Capital Markets

Okay. And then your comments regarding the competitive environment, any more color on where it’s coming from. It sounds that from that the changes Wal-Mart made, is it drug, is it grocery, they are just kind of coming from across the board? Thanks guys.

Rick Dreiling

Yeah. I think it’s more or less across the board and certainly when you look at the weekly inserts, they are more promotional than we’ve seen in the first quarter and half of you the second.

Scot Ciccarelli - RBC Capital Markets

Got it. Thank you.

Rick Dreiling

Thank you.

Operator

Our next question comes from John Heinbockel with Guggenheim Securities.

Rick Dreiling

Hey, good morning, John.

John Heinbockel - Guggenheim Securities

Good morning, Rick. So a couple of things, the price adjustments you’re talking about on largely consumables. Is that right?

Rick Dreiling

That would be fair assessment.

John Heinbockel - Guggenheim Securities

Okay. Is that a function and you said more everyday price. Have you become little less happy with where you’re positioned on a basket. And if so, is that more that others have move down or I don’t imagine you guys have moved up too much?

Rick Dreiling

No. I think it’s more driven by the fact that we want to protect our unit growth. We’re very, very satisfied with unit growth, and what I have to look at is, we’re looking across all kinds of categories. And if we see unit growth slow somewhere, particularly in a sensitive category, we’re going to reinvest back into that category. And our pricing portion is consistent as, excuse me, as it has always been.

We are approximately 40% below drug, 20% below grocery and pretty much have parity with the big box operators. I view this John as Dollar General is doing much what we did two years ago that we want to protect what we have.

John Heinbockel - Guggenheim Securities

If you look at markdowns and shrink, which of those two was more of an issue in the quarter. It grows more year-over-year.

David Tehle

In third quarter, it would have been markdowns, John.

John Heinbockel - Guggenheim Securities

Okay. When you look at those two things then, you guys have been buying down to minimize markdowns and I think buying down every subsequent season. When do you think we get to a point where you bought down enough, that that kind of goes away in spring and then on shrink, are there things to be done prior to maybe mid year, more blocking and tackling that can drive some improvement before them?

David Tehle

I’ll take the shrink piece of it. We’re doing it right now. I mean, all those items that I mentioned the accepted base reporting, the defensive merchandising fixtures, the optimized shrink model, those are things that are being worked on as we speak right now. And we just think it will take a little time for us to get traction on those items. So that’s why we’re saying we think the bigger impact on that will take place in the back half of the year.

Rick Dreiling

In regards to the markdowns to John, not all markdowns are just on non-consumable side or the apparel side. I mean, we’ve been doing some vesting along the way on consumable items as well. I do think that we are getting better and better on the non-consumable side while we still have opportunities in hanging apparel. We are making a lot of progress in home and décor, stationery, a lot of those categories, we’re doing much better in.

John Heinbockel - Guggenheim Securities

Okay. Thanks guys.

Rick Dreiling

You bet.

Mary Winn Gordon

Operator, we’ll take the next call please.

Operator

Our next question comes from Ed Kelly with Credit Suisse.

Rick Dreiling

Good morning, Ed.

Ed Kelly - Credit Suisse

Hi. Good morning. How are you?

Rick Dreiling

Good. Thank you.

Ed Kelly - Credit Suisse

Rick, I wanted to ask you a follow-up on tobacco. Your competitor gave some pretty good stats on tobacco and the benefit to basket that type of stock. Can you maybe give a little bit more color on what you learned in your test markets?

Rick Dreiling

Yeah. I mean, I’ll tell you that what we’ve seen is the basket increases. It goes from about $10 to almost $14. By the way that’s a little bit less than the price of the cigarettes. That tells you they leave an item behind such as the cigarettes. So we have seen increases in traffic. And we’ve seen, Ed, a nice bump in the comp that goes with it.

Ed Kelly - Credit Suisse

Any sense as to the percent of the people that are buying tobacco from the stores that are actually new customers to Dollar General?

Rick Dreiling

That’s another good question. It’s a little soon for me to know that yet. But I can tell you, we’ve seen increased traffic.

Ed Kelly - Credit Suisse

Okay. And you say that tobacco, a one-time bump. Why wouldn’t tobacco sales build over time now?

Rick Dreiling

Yeah. I think it’s in -- Ed, it’s in decline. Units are declining every year. The only reason you’ve seen an increase is because the price increases for the customer.

Ed Kelly - Credit Suisse

Okay.

Rick Dreiling

Yeah. My theory is you’re going to get a nice bump for a year. Then that bump is going to moderate over time.

Ed Kelly - Credit Suisse

Okay. And just one last question for you, on the gross margin as we think about next year, if we were to exclude tobacco. So pretend that you are not going to launch tobacco. It seems like the gross margin might still be down because the LIFO charge could end up being a little bit of headwind again. You’re talking about investing in price, shrinks not better for back half. Is that the right way to think about it?

David Tehle

Yeah. Again, we’re not giving specific guidance at this point on next year. All I will say is that the tobacco is the overriding factor on what we mentioned on gross margin.

Ed Kelly - Credit Suisse

Okay. Thank you.

Mary Winn Gordon

Operator, we’ll move onto the next question please.

Operator

Our next question comes from John Zolidis with Buckingham Research.

Rick Dreiling

Good morning, John.

John Zolidis - Buckingham Research

Hi. Good morning. Question, thanks for giving us the monthly cadence during the quarter and also on the guidance, the color around January. I think I’m right in assuming that your guidance for 3% to 4% comp in 4Q assumes a lower comp than that during the month of January. So my question is about your comment on volatility and competitor price actions during the month of October in the context of your characterization of November as encouraging?

So in November, did you see a continuation of that volatility or did comps reaccelerate back towards the higher end of that 3% to 4% comp plan given difficult comparison in your assumption for January. Thanks.

Rick Dreiling

Yeah. I think the competitive activity continued in the November. We are right where we feel we should we be as we’re moving for the quarter right now. And again my concern is the really high comp number we have in January.

John Zolidis - Buckingham Research

Okay. So at minimum, we’re definitely running a little bit better than three to four with January expected to be lower than that?

Rick Dreiling

Well, yeah, as I said, I’m running right where I thought it would be at this stage of the game and I anticipate pressure will come in, will come in January. We’re very comfortable with our guidance of 3% to 4%.

John Zolidis - Buckingham Research

Okay. Thanks a lot and good luck. Have a great holiday.

Rick Dreiling

Hey, you too. Thanks a lot.

Mary Winn Gordon

All right. Operator, we’ll move to the next caller please.

Operator

Our next question comes from Aram Rubinson with Nomura.

Rick Dreiling

Good morning, Aram.

Aram Rubinson - Nomura

Good morning. Thanks for the color on the reserves. Your comment about competition, kind of, intrigued me. Competition can come from other channels. It can also come from yourself. Wondering if you can talk about cannibalization, kind of, with a historical perspective of where it’s been, where it’s running now, how you measure it and I guess, the bottom line is to mention there is maybe too many days for the dollars or there are too many stores for the dollars in your view?

Rick Dreiling

Yeah. I’ll take the last part of that question. And I’ll let David handle the tough part. Actually, I don’t think there are too many stores. I mean, our research model shows as we could double the size of this chain. I mean, there is over 10,000 opportunities for Dollar stores out there. I think it’s more of function right now that the consumer is very tight fisted. I think they’re making the purchases they need to make. And I think what we’re seeing right now is they’re just holding on.

And I think it’s also fair to say the higher in continues in retail and continues to do quite well right now. We’re starting to see the other end, starting to feel little bit pressure on the customer but again I always fall back to even though that pressure is there, that’s usually when our customer needs us more. They have less. They need a better bargain. And when they have more, they have ability to spend and David will talk about cannibalization.

David Tehle

Yeah. The cannibalization when it occurs, it’s usually somewhere around 8%. We have that played into all of our models as we open stores and we do all our returns on it. And we haven’t seen much -- we haven’t seen much change in that overall.

Rick Dreiling

And our new stores are still opening up at the rate they have opened over the last couple of years.

Aram Rubinson - Nomura

Again as you look over the years, can you give us the sense as to the proximity of stores that are opening to one and another in 2013, let’s say, greater proximity or more remote?

Rick Dreiling

That’s a good question. I really don’t have that kind of information in my head but I would look at you and say, I would imagine it’s very dissimilar to what it has been in the past. With the nice mix of rural locations as well as the metro locations coming up.

Aram Rubinson - Nomura

Thanks for taking the question.

Rick Dreiling

Hey, Aram, thanks a lot.

Mary Winn Gordon

Operator, we’ll -- I think we probably -- let’s try to see if we can get two more questions in, if we can. We’re going to close, stop at hour.

Operator

I’m sorry. Our next question comes from Matt Nemer with Wells Fargo Securities.

Rick Dreiling

Hey, good morning, Matt.

Matt Nemer - Wells Fargo Securities

Good morning, everyone. Just a quick follow-up on your 2013 sales drivers, could you just comment on the marginal productivity of the next 2200 cooler additions versus kind of the impact of cooler additions that we’ve seen over the last two years? And then secondly, can you quantify the Phase 5 lift of comps? Thanks.

Rick Dreiling

Yeah. Qualifying the Phase 5 lift of comps is a little soon yet but I will tell you we’re bullish on it as we were Phase 1, 2, 3 and 4 particularly Phase 1 and 2. And we’re bullish on it, Matt because you’re adding SKUs and more importantly you’re getting the best planogram into our legacy stores which should be worth some legs too. And I can’t remember what the first part of his question was…

Matt Nemer - Wells Fargo Securities

Productivity of the next 2200 cooler additions, how does that…

Rick Dreiling

Yeah. What we’ve called out was the increasing the basket that we see. And I believe that basket is I’ll recall goes from $11 to $17. So again, it’s kind of hard to go past that. We see a nice, nice basket there.

Matt Nemer - Wells Fargo Securities

Okay. Thank you.

Rick Dreiling

Thank you.

Mary Winn Gordon

Operator, we’ll take one more question, please.

Operator

Our last question comes from Deborah Weinswig with Citigroup.

Rick Dreiling

Hey, Deb, good morning.

Deborah Weinswig - Citigroup

Good morning and congratulations. So if you compare and contrast the discretionary and non-discretionary categories as you progress through the quarter. How did you see changes in those especially as the competitive environment seem to have heated up?

Rick Dreiling

Yeah. I think -- it’s another good question. I think that as we move through the quarter, we saw more pressure on the consumables towards the end of the quarter as the add intensity increased it. Again, I want to reinforce that’s the easiest place to go to drive traffic when you’re a consumable retailer. It’s also fair to say as we move through the quarter, we saw the non-consumable side, the performance start to lift.

Deborah Weinswig - Citigroup

All right. And then a last one, you’ve really been working very hard on the apparel category so well. What do you think it will take to get that category work for your customer base?

Rick Dreiling

Yeah. I think that we have made progress in certain pieces of apparel. We are very happy with the accessories. We’re happy with the underwear program. We’re seeing improvement in infants and toddlers and some improvement in men. I have to tell you we have struggled in hanging apparels for women. And as we move through calendar 2013, those are going to be kind of decisions we’re going to be looking at.

Deborah Weinswig - Citigroup

And what is it that, obviously on the home side, that category has ticked up for you. What do you think it is? And obviously, others have -- apparels works but what is it that you think has worked so well in home and what is it that you have learn that you can take over to some of the more discretionary categories such as in hanging women’s?

Rick Dreiling

Yeah. I think when you look at -- when you look at our, I’ll use, home, bed and bath, we are much more relevant today than we were two years ago, even a year ago, Deb, to be honest about it. And I think that has to do with the fact that we are doing a much better job of sourcing that product now.

We’ve broaden where we’re looking, broaden where we’re going. We’re not just China-concentric any more and I think that’s playing out in the quality of the product and I also give the merchants credit they’ve done some exciting things with quality they’ve set.

I think the difference we’re hanging apparel quite honestly you have to hit. You got to be right on color, you got to be right on pattern. I think we’re doing a lot of good things in regards to using separates rather than outfits, allowing the customer to mix and match the different pieces but while we’ve made progress we haven’t hit on all cylinders on it yet.

Deborah Weinswig - Citigroup

All right. Great. Well, thanks so much and best of luck.

Rick Dreiling

Thanks Deb.

Mary Winn Gordon

Great. Thank you, Operator. That will conclude our questions. Thank you to everyone for joining us today and your interest in Dollar General. Please feel free to call me with any questions and I look forward to speaking to you. Thank you.

Operator

Ladies and gentlemen, that concludes today’s presentation. You may disconnect your phone lines and have a wonderful afternoon.

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