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Family Dollar Stores (NYSE:FDO)

Q3 2006 Earnings Conference Call

June 22, 2006, 10:00 a.m. EST

Executives:

Kiley Rawlins, Divisional Vice President, Investor Relations and Communications

Howard Levine, Chairman and CEO

James Kelly, Vice Chairman and Chief Financial and Administrative Officer

Analysts:

Tina Wang, Citigroup

Michael Baker, Deutsche Bank

Dan Weaver, Raymond James

Ibe, Lehman Brothers

Mark Miller, William Blair

Mark Husson, HSBC Securities

Jeff Stinson, Cleveland Research Company

John Zolidis, Buckingham Research Group

Charles Grom, JP Morgan

Mitchell Kaiser, Piper Jaffray

Operator

Good morning ladies and gentlemen and welcome to the Family Dollar Third Quarter Earnings Conference Call. This call is being recorded by Verizon and CCBN. If you have any objections you may disconnect at this time. At this time, all participants are in a listen-only mode. After the prepared statement by the Company, we will open the call for questions from the participants. And now I will like to turn the meeting over to Ms. Kiley Rawlins, Divisional Vice President, Investor Relations and Communications. Ms. Rawlins, you may begin.

Kiley Rawlins, Divisional VP, Investor Relations and Communications

Thank you, Christie. Good morning everyone and thank you for joining us today. With me this morning are Howard Levine, Chairman and CEO; and Jim Kelly, Vice Chairman, Chief Financial and Administrative Officer.

Before we begin, you should know that our comments today will include forward-looking statements, which are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act. These statements address Company’s plans and activities or events, which we expect will or may occur in the future. However, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ from our plans. We refer you to and specifically incorporate precautionary statements contained in today’s press release and our other SEC filings. You are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date of this call. The Company does not undertake to publicly update or revise its forward-looking statements.

In addition this morning, we will discuss non-GAAP financial measures, which are intended to help investors understand Family Dollar’s ongoing business performance. These measures include operating expenses, net income, and earnings per diluted share, each excluding litigation charges. A reconciliation of these non-GAAP financial measures to the comparable GAAP financial measures is included in our earnings release issued this morning and available on our website in the News Releases section of our investor page.

We’ll begin this morning with some comments on the quarter’s financial results from Jim, and then Howard will share some of his thoughts with you. Jim…

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Thanks Kiley and good morning all. Today, we reported that net income for diluted share for the third quarter increased nearly 16% to $0.37 compared to $0.32 for the third quarter of fiscal 2005. As I reviewed the details of the quarter’s financial results I reached two conclusions: first, focused sales driving initiatives can improve the relevancy of Family Dollar benefit to its customers, and thereby drives sales even during challenging economic times. We continue to focus on three sales driving initiatives -- coolers, Treasure Hunt, and urban, and they were the engines behind much of our 3.7% comp store sales growth this quarter.

The second conclusion that I reached was that better execution could lead to improved financial performance to include income growth, improved return on capital, and expansion of the operating margin as a percent of sales. As you know, we slowed a number of things down this year to place greater emphasis on performance improvement. This morning we will share with you some of the indicators of progress resulting from these efforts but not withstanding the progress that we are making, I assure you that we are most aware that there is much that remains to be done.

I would like to begin my review with comments of our operating results. Sales trends during the third quarter were consistent with those reported in earlier quarters to include a larger transaction size and slightly lower transaction counts. We believe that these trends reflect a consolidation of trips by our customers resulting from both higher energy prices and the concentration of purchases around the pay cycle. Gross margin for the third quarter as a percent of sales was flat with the third quarter of last year. As a percent of sales, lower shrink cost offset increased freight cost resulting from higher fuel cost. While sales of lower margin consumable merchandise continued to increase faster than higher margin merchandise, better purchase markups across the majority of the departments offset the impact of this unfavorable sales mix.

Markdowns also were slightly higher this quarter as a percent of sales. Given that we significantly increased markdowns in the third quarter last year, some additional details maybe useful. Last year, we accelerated markdowns of apparel as a response to cooler shrink conditions and excess inventory. This year our apparel inventories are much leaner, but we added markdowns in support of the Treasure Hunt strategy and a renewed focus on inventory productivity. As you know, this year Robert George joined us Executive Vice President Merchandising, and Mike Kvitko recently joined us as Senior Vice President, Softlines. Both Robert and Mike believe that we can improve the shopping experience for our customers by lowering inventory levels in keeping our fashion offering fresh.

Additionally, lower inventory levels will make our stores easier to operate and easier to control inventory strength. To support the transition to this more aggressive merchandised strategy, we had higher markdowns this quarter and also expect slightly higher markdowns next quarter. Afterwards, we expect markdowns to settle around more historic levels.

Selling, general and administrative expenses as a percent of sales were also largely unchanged from the third quarter of last year. The effective expensing equity based compensation and higher bonus accruals were largely offset by the improved performance of our urban stores and lower insurance cost.

Now, I’d like to quickly update you on a few other financial matters. We’ve continued our stock buyback program during the third quarter and have year to date acquired approximately 13.9 million shares or approximately 8% of the shares outstanding as of the first of this fiscal year. Year to date we have expended approximately $334 million of $24.12 per share on this program. As of the end of the third quarter, we have approximately 2.6 million shares remaining under the current repurchase authorizations approved by our Board of Directors.

Through the first three quarters, we have spent approximately $144 million on capital assets and expect to spend around $200 million this fiscal year. This estimate is a bit lower than originally planned for the year, primarily as a result of fewer new store openings. We now expect to open around 350 new stores as opposed to the initial target of around 400 stores. As we indicated at the beginning of this year, we want to slow down our new store openings to focus on improving our new store development processes and to increase our returns on investment from new stores.

Progress is being made in this area via business, albeit slower than expected. We have created a more strategic approach to new store growth using a market optimization methodology, and we have strengthened our site selection approval process. In addition, we see opportunity to improve our build-to-suit programs and our processes surrounding the actual opening and operating of new stores. Together, these enhancements will be the foundation for our expected improvement and new store performance.

We are convinced that new store openings will remain a significant part of our growth strategy and in the longer term we’d like to return to our historical growth of 8-10%. However, we would like to see our returns on capital improve before considering a more aggressive deployment of capital. We will provide further guidance relative to plans during our year end conference call.

Inventories at the end of the third quarter were approximately 3% lower on a per store basis than at the end of the third quarter last year. I mentioned earlier our efforts to more aggressively manage fashion inventories and that is having an effect. For example, softline inventories, which include both apparel and soft home goods, i.e. towels, sheets, etc., were down around 5% at quarter end. We are also seeing productivity improvements in the consumable area where inventories were down nearly 2%. Importantly, in stock positions are also slightly better.

Now for our outlook for the fourth quarter in fiscal year. This morning we raised guidance for the fiscal year from a range of $1.19 to a $1.24 to a range of $1.24 to $1.27. Excluding the legal charge we took in the second quarter, the guidance changed from a range of $1.37 to $1.42 to a range of $1.41 to $1.44. This incorporates fourth quarter guidance of $0.19 to $0.22 versus $0.18 per share for the fourth quarter last year. Incorporated in this guidance is an expectation of mid single digit comp store growth paced by consumable sales. As you may recall, our comp performance for the fourth quarter last year was disappointing in part because of issues with schematic sets in the consumable area. We expect solid growth from this area of our business, both as a result of the cooler initiative and as a result of easier comparisons. We also recognize that this will pressure the gross margin as a percent of sales. On the other hand, we plan on leveraging expenses. And now Howard has a few remarks. Howard…

Howard Levine, Chairman, Chief Executive Officer

Thank you, Jim. Good morning and thank you for joining us. Third quarter results were better than we expected and reflect the hard work and efforts of all of our associates. I’m particularly pleased with these results given the current macro-environment. In these difficult times we remain focused on two basic tasks -- becoming more relevant to our customers and improving our execution. If we can do these two things better, we can deliver stronger returns to our shareholders. Today, we get about 1% of our customers pocket book. The opportunities become more relevant to our customers is tremendous and our enhanced food strategy and Treasure Hunt initiatives are designed to increase our share of our customer spin.

There are a number of frequent fill-in food trips that our customers make, and our enhanced food strategy is intended to make us a better choice to meet these needs. Coolers provide the foundation that allows us to be a viable alternative for these trips. And as we move forward and enhance our overall food assortment, we intend to be even more relevant to our customers.

In January 2005, we began the first phase of our enhanced food strategy, the rollout of coolers. Today, about 3100 of our stores have coolers and we are on track to have coolers in about 3500 stores by the end of our fiscal year. We are testing an expanded food assortment and food step stamps in a number of stores. What we learn from these tests and the impact on our basket and customer traffic trends will shape the future of our food assortment.

Food like many consumables is a strong traffic driver, but it is difficult to differentiate solely with consumables. That is why we launched our Treasure Hunt initiative last year. Treasure Hunt items are high margin goods that create customer excitement and differentiate us from our competition, and they require better merchandising and marketing. Perhaps especially when times are difficult, our customers want to provide their families with fun unique values that won’t break the pocket book. Our initial item focus is evolved into a more comprehensive strategy designed to create storewide events that create excitement for our customers and associates. As we leverage the traffic created by coolers to drive higher sales of more discretionary items, we can drive even larger baskets.

Execution separates the winners from the losers. Last year, our aggressive investment agenda created some distraction for our associates. This year, our management team is focused on improving our execution of the basic blocking and tackling in our business, and our solid comp trends reflect these efforts. Our urban initiative is one example of our efforts to improve execution. Last year, we made significant investments in people and processes to improve the operational consistency of our stores, and we created a more flexible and fluid organization that could respond quickly to the rapidly changing dynamics of an urban market. As a result, we have improved our store operating standards and our customers have responded enthusiastically. Stores in the urban initiative had consistently produced mid single digit comp sales increases even after the first year of implementation, and the financial returns of these stores have increased.

Last year, we shared with you that two-thirds of our urban initiative markets saw an improvement in profit margins. Our store operations group has worked relentlessly to stabilize our more challenging markets and to drive higher financial returns, and I’m pleased to report that we have made significant progress in improving the profitability of these markets. In the third quarter, approximately 80% of the markets in the urban initiative produced higher profit margins when compared with the third quarter of last year, and we are encouraged by the progressive improvement we have seen in the remaining 20%.

I’m also pleased to share with you that we continue to see improvement in our store manager retention. For the last five months we have seen a steady improvement in store manager and assistant store manager retention in both urban and core markets. I believe that this stabilization of our workforce has been one of the main contributors to the improvement in our shrink trends.

Finally, in addition to delivering solid comp store sales increases, we continue to work to reduce store level inventories. Our goal is to improve inventory productivity while maintaining the right balance of inventory, and that’s to stay in stock but not over stock. As Jim mentioned, same store level inventories were 3% lower this year than at the end of the third quarter last year. This improvement was a result of improved planning and flow with fashion merchandise, more aggressive strategies, and the continued refinement of our replenishment system.

Our replenishment system utilizes store sales and inventory data to create orders and enable the store managers to take a more active role in inventory control and focus more on merchandise presentation. Today, about two-thirds of our store managers utilize this replenishment process and do not submit weekly orders. This process has enabled us to lower inventory without negatively impacting sales or in stock levels. As you know, lower inventory levels creating more shoppable store and have a positive impact on shrink and management turnover, but we still have a lot of work to do in this area and we are clearly making progress.

In closing, I want to say how pleased I am with our performance so far this year. However, while it certainly feels like we stabilized the business and perhaps have achieved a turning point, we still have a lot of work to do to get back to our historic levels of profitability. By continuing to focus on the basics, becoming more relevant to our customers and improving our execution, I am confident that we can drive stronger returns to our shareholders.

I want to mention one housekeeping item before we open the Q&A session. On October 17th we will host an analyst day here in Charlotte. We will provide more details later this summer, but I hope that you will be able to join our management team for what I’m sure will be an informative day. Now, operator, we would be pleased to take questions.

Question-and-Answer Session

Operator

Thank you, sir. At this time, if you would like to ask a question, please press “*” then “1” on your touchtone keypad. You will be required to record your name prior to asking your questions. To withdraw your question, please press “*” and “2”. Once again that is “*” and “1” if you’d like to ask a question and “*” and “2” to cancel. One moment please while the questions register. Our first question is from Deborah Weinswig with Citigroup.

Tina Wang, Citigroup

Hi, good morning this is actually Tina Wang speaking on behalf of Deborah. Congratulations on a great quarter guys. My question for you was, along the lines of what you were saying about leveraging traffic trends from the consumables area, what are you doing specifically in the apparel area of the store that drives spillover sales?

Howard Levine, Chairman, Chief Executive Officer

Tina, the apparel area is an area that we’ve talked about for a number of years and have not really been totaled satisfied with the returns that we are getting out of that area. At the same time, we do continue to see some inventory productivity improvements. We think that there still is more to do. With the addition of Mike Kvitko some of the ideas and thoughts that we have to be more relevant to our customers, we believe that the apparel area will play an important role in the mix of our sales, particularly from a higher margin standpoint. So, we have seen some improvement, we continue to believe that we can be more relevant to our customers and are working very hard to get there.

Tina Wang, Citigroup

Okay, thanks.

Operator

Our next question is from Michael Baker with Deutsche Bank.

Michael Baker, Deutsche Bank

Hi, thanks. Two quick questions; one, you spoke about your purchase markups being higher, how are you doing that? Is it more imports or just better buying, and will that continue? Secondly, I just want to clarify the markdowns on the Treasure Hunt, were those planned markdowns or is that an indication that maybe you’re not selling the product in itself quite as well as you had hoped? Thanks.

Howard Levine, Chairman, Chief Executive Officer

Michael, improved markups have come from all of those areas that you mentioned. We’re doing a little better job on the buying side. Our global sourcing program is making some contributions to that area and we hope that we can continue to see some modest improvement in that area. So, we’re pleased with that and I think our merchandising group has done a very good job in that area when you consider some of the inflationary pressures that are out there today. Your second question, would you repeat that please?

Michael Baker, Deutsche Bank

Sure, the markdowns on the Treasure Hunt products, was that something that was planned in advance or is that a reaction to maybe some of the products? They’re not selling as well as you had hoped.

Howard Levine, Chairman, Chief Executive Officer

As you would expect in any program where there is discretionary purchases, particularly in the apparel area or in some of the seasonal areas, even when you have a good item you have some residue that you want to clean up. So, we plan to do that more aggressively. Additionally, while we have made some very good selection of some items within the category, there are always some that aren’t exactly as good as you thought they were when you bought them, and we’ve got to be aggressive in cleaning up those as well. I think it’s just a general trend that we’ve seen over the last several years of being more aggressive, of cleaning goods, making our stores more shoppable, and as inventory is our largest asset we do want to increase the productivity there to continue to improve our overall returns.

Michael Baker, Deutsche Bank

Okay, that makes sense. Let me just ask one other way, the Treasure Hunt product, is that a higher comping category or below average or is it still contributing to the gross profit rate and helping offset some of the lower margins on the more consumable products?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Michael, as I indicated in my comments, we are growing the fashion business, which is really another way of viewing the Treasure Hunt initiative. So, it is growing; it’s not growing as fast as the core consumable area, but it does continue to grow.

Michael Baker, Deutsche Bank

Okay, thank you very much.

Operator

Our next question is from Dan Weaver with Raymond James.

Dan Weaver, Raymond James

Jim, you noted that you would like to return your square footage growth to an 8-10% rate, but first you need to see better returns. I wonder if you could elaborate, was that specifically related to items like new store productivity or is it relating more to the overall return on capital for the entire enterprise?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

In looking or developing my comments I actually envision both of those, Dan. What we are looking for is to make sure that the primary energies of our Company are directed today towards the enhancement of profitability and return on capital. The growth of new stores is just another use of resources and as we curtail that a little bit proportionally, we have greater emphasis on the return on capital from all of our stores. I think secondly, though, we are making a lot of process change in the area of new stores and we hope to enhance their profitability as individual investments.

Dan Weaver, Raymond James

So, when you think about the publicly available financial data, the metrics that we can derive, what kind of thresholds or hurdles are there before you begin to bump up the unit growth rate?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I think from public data what you will be able to see is our return on capital as a Company increasing, and as you see that improvement you’ll see us more aggressively deploy capital.

Dan Weaver, Raymond James

Okay. And Howard, I have a question for you as well. With the three sales drivers, the comp sales growth makes perfect sense. Once we begin the anniversary initiatives such as coolers, why should we not be concerned that Family’s top line growth begins to slow as it did for your competitor once they anniversary their cooler rollout?

Howard Levine, Chairman, Chief Executive Officer

Dan, one of the things that I do want to clarify is that when we look at our food assortment the cooler program and the cooler rollout is really the first part of that, is the foundation of our expanded food program. We do not anticipate to have above average comp in the cooler program in the second year, but there are further legs of growth in the food area, and one of the things that I indicated in my comments was a test in expanded food assortment today. That is something that we are testing and how we can better link our food categories to what we’re doing in the coolers today and that’s something, as I said, we’re testing and it’s early yet, but along with that test…we talked about the four testing food stamps, and how those three legs would really complete what we’re talking about. So, we do think that food will play a growing role over the next several years and expect to continue to see comps, maybe not so from the cooler program but from other parts of the program that we’re looking at.

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Dan, if I could amplify on that a little bit. One of our lessons that we learned a few years back is that in a challenging economic environment you really need Company initiatives, and I emphasize the “yes” on that in order to successfully drive sales. So, that’s one of the reasons that we didn’t introduce a single initiative such as coolers but a multiple set of initiatives that we’ve talked about a lot here. But in addition to that, we created a business development unit within our business whose primary responsibility is to focus on those years two through four. So, what we’re really managing is a portfolio of initiatives overtime and it is that portfolio as we go through time that will give us sustainable comp growth, not simply one single initiative.

Dan Weaver, Raymond James

Okay, great, thanks and good luck.

Operator

Our next question is from Meredith Adler with Lehman Brothers.

Ibe, Lehman Brothers

Hi, this is Ibe for Meredith. Can you please go over some of the improvements you’ve made in your real estate strategy, and also can you talk about some of the ways that you expect to contain the real estate costs or rent?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Yes, I’d be happy to. I mentioned a couple of things. Clearly, the front end of the pipeline is an area that we’ve worked on extensively, and that front end includes market optimization. It includes the ability to select sites more efficiently and effectively and to evaluate sites more efficiently and effectively. So that is really the start and foundation of the entire process. We have evolved from that into a lot of work in engineering the exact specs on a store that we desire, and through more effective engineering of that we can bring down the cost of the store not only in terms of the initial capital but also the ongoing operating cost of a new store. That will have an impact on overall occupancy expense. In addition to that, we have a task force that is working on how to most efficiently open a store or more importantly a cluster of stores. So, we’re looking to become more market based as we open new stores. So, it’s a combination of all of those things that will enable us to open more successful stores and also, to your point, control rent more effectively.

Ibe, Lehman Brothers

Okay, on a separate note, you commented that the improvements from the urban initiatives came from the stabilization of workforce. Can you comment on some of the other areas that you saw improvement? In addition, can you talk about some of the learning you’ve had on some of the more difficult stores to manage? You previously said that it’s not a one side stitch or model and that some of the programs needed to be tailored to some of the individual communities.

Howard Levine, Chairman, Chief Executive Officer

Sure, let me start with the comment about the stabilization of the workforce. That stabilization of the workforce was really one of the key purposes behind the design of the urban initiatives. One of the issues that we were dealing with in these markets were they were more challenging, they were fast changing, and there were some things that we needed to do to better support our management team in those markets, plus we came up with a more fluid organization supporting our district managers, our area operation managers with some flexible workforce to help compensate for some of those changes. And I think that along with the training programs that we’ve come up with to better train our people as to what we expect along with some additional payroll in those stores has been a big help in calming things down out there. So, we’re very pleased with the direction there and as I was clear to point out, we still have a lot of work to do. The issue with some of the stores and some of the markets that are not performing as well is some of those things such as management which we think we’ve addressed, and something that I mentioned in the last call is that we opened up a lot of stores in some of these more difficult markets. So, we were really piling on to ourselves and creating more work on top of a challenged situation. That is getting more stabilization and we would expect to see those remaining markets to continue to show some positive trends.

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

One of the things we’ve talked about in looking at the urban initiative is like Howard reviewed with you a moment ago with the food initiative. The urban initiative has multiple phases too. For example, inventory flow is significantly more important in a high volume smaller box environment like you find in the urban market. So, we have a task force that’s really focused very hard on the highest volume stores and trying to improve how we can keep their inventory fresh, and as you know it would have to turn then much, much faster than the average store. We are also looking at how to more effectively optimize our pricing in the urban markets and that will be an important additional stage. Then, we are on various test bases looking at how does one tailor the inventory to be even more relevant to our urban customer base. So there are another three areas that the more we work on this project the more we see the relevancy of, and the potential that we initially identified is perhaps much greater than we imagine.

Ibe, Lehman Brothers

Okay, thank you all. One last question, do you plan on doing a back-to-school circular?

Howard Levine, Chairman, Chief Executive Officer

Our advertising plans are very comparable to last year.

Ibe, Lehman Brothers

Okay, thank you very much.

Operator

Our next question is from Mark Miller with William Blair.

Mark Miller, William Blair

Hi, good morning. Based on past periods where you’ve seen store manager turnover begin to shift favorable and I guess I’ve obviously gone the other way, what’s been your experience with shrink? And I guess I’d be interested in how many stores you’ve done inventory counts more recently and based on what you’re seeing with management turnover as the leading indicator, what might we expect as we go forward for shrink?

Howard Levine, Chairman, Chief Executive Officer

Mark, as we’ve talked before, when we see a stabilization of management in our stores all the performance metrics are good to include not only shrink but overall profitability. As we’ve talked about before, the majority of our stores do have stabilization and we do see those kinds of indicators. So, we are very motivated to continue to improve the manager and assistant manager retentions at Family Dollar, as well as looking to see how we can promote more from within. That is also something that we think is very important to our success, is growing our own and creating that career path for our associates. So, overall, management retention is an extremely important part and it is a leading indicator for us while we feel that we are headed in the right direction on shrink.

Mark Miller, William Blair

And then, Jim, based on your prior comment about urban potentially having more opportunity for the Company and given that shrink is part of the pay back from those investments, how are you now looking at the ROI on those investments? You haven’t commented to what extent you might expand that program, how should we think about future investments in that program?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I think you have to look at that consistent with the other actions of Family Dollar where we have been able to drive higher returns we typically manage to those returns. But right now, we’re not really providing any further guidance in terms of where we’re going with this next year. We will in our next conference call discuss these specifically.

Mark Miller, William Blair

Okay, one final question on intermediate longer term objectives with regard zone pricing and direct imports. Can you talk about what you’ve determined as you’ve done more analysis on these two things, and I guess I would be curious from your perspective which you think is a bigger potential benefit, and also of these two which might be near term relative to the other? Thanks.

Howard Levine, Chairman, Chief Executive Officer

Mark, we believe that both of those initiatives will be very positive contributors to our margin. On the pricing side, we continue to gain learning there and are expecting to further grow that initiative further into next fiscal year. There are a lot of positive things that could come from zone pricing, but just overall pricing, how that will play an important part of our overall margin. So, we’re pleased with the direction that we’re getting there, we’re learning a lot of good things, and as I’ve said before we do have the technological capability to zone price, but the way we’re looking at pricing today is more than just zone pricing. We’re looking at pricing optimization and how that will play an important role for us. Global sourcing, as we said before, we import about 40% of what we sell. Today, it’s primarily outsourced, and what I mean by that is we primarily lease agents today. As our new merchandising team gets settled in, we do believe that will be a significant opportunity on the margin side to go more direct and to more fully develop global sourcing. So, that’s probably a little longer term than the other, but both of those initiatives we believe will be important in helping our gross margin.

Mark Miller, William Blair

Thanks Howard, that’s helpful.

Operator

Our next question is from Mark Husson with HSBC.

Mark Husson, HSBC Securities

Good morning. I just want to focus on store traffic. Obviously adding coolers generates traffic and that’s what you’ve said in the past. So, a negative 1.2% traffic must be a very disappointing number given the additional coolers, and doesn’t it imply that the non-cooler stores have got really quite full traffic trends?

Howard Levine, Chairman, Chief Executive Officer

Mark, we think that the coolers have actually brought more traffic to our stores and as we continue to expand on coolers and continue to grow some of our other initiatives, I think that traffic trends will improve. As we’ve commented before several times and as other retailers have reported and additionally AC Nielsen has supported, the other thing going on out there is gasoline prices and extreme increase in gasoline prices and what that has done to overall shopping patterns in that people are consolidating trips, the average basket is up to offset some of that but people, particularly lower income people, are being more judicious in the way they shop today.

Mark Husson, HSBC Securities

So, is the traffic better in the cooler stores than the non-cooler stores?

Howard Levine, Chairman, Chief Executive Officer

Yes.

Mark Husson, HSBC Securities

And just looking at the average ticket, can you sort of give us some idea of the average number of items in the basket, the price of the stuff that you started to sell in the mix, sort of Treasure Hunt higher price stuff is having an impact on the basket, or are they buying ten things instead of nine things?

Howard Levine, Chairman, Chief Executive Officer

The average basket size is about four to five items of which typically there’s food and some other items in there, and as we’ve said the whole idea behind the coolers is not just to sell coolers and food, it’s to grow the other side of the business, and we think we’re seeing some success in that. And a good way of looking at that is even during the holiday season…in fact the last two years where we as we started the Treasure Hunt initiative, our comps during those periods where pretty good when compared to the retail industry and things do get better and as the economy does improve for the lower income customer that will only continue to grow as part of the basket.

Mark Husson, HSBC Securities

So, it’s more price per item than items in basket that is growing?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

No, I think that you have a little bit of both those factors going, Mark. We have slightly higher item count, particularly when one focusses on the traffic that’s been driven with the coolers but also as a result of the Treasure Hunt initiatives we actually see. Those items are selling at a faster rate. So, overall it’s a blend. I’ll make one other point, Mark. The traffic pattern is something that we’re working hard to increase. If one looked at the overall comp store results as an indicator of market share gain or loss, I would suspect it would indicate that on an overall basis we continue to outperform most who are serving our customer base, and that would somewhat ease my concern that the loss of traffic count is an indicator of loss of market share.

Mark Husson, HSBC Securities

Okay, when you think about market share in the comp store sales number, historically you’ve opened very high levels of new spaces and presumably the comp store sales are the strongest in year two and year three, and as you stop putting new stores or as many new stores into the pipeline, aren’t you afraid that that comp is going to decelerate to a point where someone like your major competitor who is still opening dramatic amounts of space are going to start to outperform you just because of the maturation affect?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I think that we are always concerned about competitive conditions, but we’ve found if we focus on operating our stores we can consistently deliver very competitive comps. I think not withstanding the new store growth rates our focus on making our stores increasingly shoppable in a more compelling place to shop is really what is driving comp performance and will continue to drive comp performance. So, you have to kind of weigh the pluses and the minuses of aggressive new store growth and considering its impact on comps. Our decision to slow down new store growth and focus on the execution within our existing challenge to improve returns is driving much better comps today than most serving our customers.

Mark Husson, HSBC Securities

That’s absolutely right. One final question just on that, presumably it also reduces some of the cannibalization impact that you may have seen in the past, and can you just talk a little bit about the trends in cannibalization if you’ve managed to quantify them?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Clearly, in those markets where we have more dense stores there is an element of cannibalization that goes into our considerations. That’s one of the reasons we have evolved into a market optimization approach and that one needs to consider and accept a given level of cannibalization in order to maximize returns over the longer term. So, we still, as we’re building and focussing on driving density within our network, are absorbing a level of cannibalization.

Mark Husson, HSBC Securities

Is it going up or down?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I really don’t know.

Mark Husson, HSBC Securities

Okay, thank you very much.

Operator

Your next question is from Jeff Stinson with Cleveland Research.

Jeff Stinson, Cleveland Research Company

Good morning guys. You mentioned earlier in the call the payroll cycle and when you were discussing the comp store sales, I was wondering if you’ve seen any change in that cycle over the last six months, are things getting more pronounced or less pronounced with that?

Howard Levine, Chairman and CEO

We haven’t seen much change in there. It is pronounced and continues to be pronounced, Jeff.

Jeff Stinson, Cleveland Research Company

And if you look at the urban stores last year, if I remember correctly the fourth quarter was when you converted the largest number of stores last year. How much of the expense related to urban stores and the investment related in the urban stores last year might have been one time in nature that we won’t see this year?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I think there was an element of that, Jeff, and clearly you have the initiation of the process that grows some expenses. On the other hand, I would suggest to you that there were a significant number of stores that would be “urbanized” there in the last two or three weeks. So, they only would have three weeks of the higher cost versus a full quarter of those higher costs this year. So, net-net, I’m not modeling that we will get an overall positive impact as a result of the cycling of the urban other than what we are seeing now, which is absolutely improved performance within those markets, and that will have a favorable impact in the fourth quarter.

Jeff Stinson, Cleveland Research Company

Jim, if you look at that, would it be fair then to say maybe in the first quarter you would see some benefit from that?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

In the first quarter, you will basically be cycling full cost against full cost, and what I’m suggesting is in the fourth quarter the absolute cost that you’re cycling will be roughly the same but the reason will be different. The reason in the fourth quarter is you are eliminating the startup cost but you have a full quarter for all stores. The reason that it’s more comparable in the first quarter is that you are really cycling very similar situations.

Jeff Stinson, Cleveland Research Company

Got you, and then one last question as you guys look at inventory and bring the levels down here in the near term. Does this change your view at all as far as pack away merchandise and what you may do with that in the future?

Howard Levine, Chairman and CEO

One of our key initiatives is to continue to improve inventory productivity. Our markdown philosophy has always to been to aggressively markdown goods at the end of the season, and over the last several years we’ve continued to get more aggressive in cleaning up older merchandise. So, we look to see that continue into the fourth quarter but after that point we look to see it become more normalized.

Jeff Stinson, Cleveland Research Company

Thanks.

Operator

Our next question is from John Zolidis with Buckingham Research Group

John Zolidis, Buckingham Research Group

Hi guys, good morning. Can you talk about the shrink improvement in the quarter, can you quantify how much of a benefit that was to gross margin? And then, how sustainable do you think the improvement in shrink is? I guess when we get to next year and we start the anniversary a better level of shrink, does that mean that the pressure is from mix and other things are going to lead to gross margin declines? My second question is on the inventories which appear to be in really good shape. I’m just curious why we should expect to see more markdowns in Treasure Hunt in the fourth quarter given what appear to be very clean inventory levels? Thanks.

Howard Levine, Chairman and CEO

Let me start off with the last part of your question and then I’ll let Jim pick up with the first part. One of the things that Jim indicated in his comments and one of the things as a Company objective is to improve the shopability of our stores, to improve the returns of our overall Company, and increasing inventory is a good way to do that. We are very focused particularly with some of the newer merchandising talent that we brought in to continue to focus on cleaning up more aggressively. I wouldn’t read into if the Treasure Hunt initiative is not as successful or is not doing as well as we thought; it’s just a matter of cleaning as we go, clean up the residue as we go, and be more aggressive to ensure that our customers have a more shoppable environment. So, other than that, as I said we’ve got a very aggressive markdown philosophy and policy and we’ll look to continue to drive returns here.

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I would look at the markdown scenario as more of a transition that is more aggressive with the first mark as opposed to an indicator of an absolute increase in marks. For example, where we may have had a given fashion by with an expected sales period of three months, we may be looking at selling out in two months, and that may mean little more aggressive markdowns, but perhaps no more markdowns during the life of the merchandise. Indeed, that’s why I indicated or described this as a transition as opposed to something that would more on a permanent basis increase the level of markdowns. In terms of shrink, we’ve commented that we are now in that mid 3-4 range, 3.5 to 3.6. We’ve historically been closer to the 3 and 3.1, and in longer run we believe that we can get down to historic levels even with a heavier mix of urban stores. This really is the byproduct of the fact that a lot of our HR initiatives are leading to a more stable workforce and also the fact that we have introduced a lot more technology in terms of detection of shrink. So, directionally we see it going down and we see it going down over an extended period of time. Shrink is something that by its very nature as well as by the method of calculation is not something that you turn on a dime. So, we’re looking at several year processes with gradual but consistent downward direction within our shrink results.

John Zolidis, Buckingham Research Group

Okay great, and can you just quantify what the shrink did for the quarter? And then second, clarification on the markdown strategy, is this a change in strategy or is this the same strategy you’ve had previously.

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

I think the strategy in terms of markdowns has always been that we will on a timely basis markdown fashion merchandise in order to exit it. The difference is not necessarily the strategy, it’s in the relative aggressiveness of the strategy. So, instead of a markdown that may have occurred after week five of an item in the store, we may move it up to week three or week four. So, it’s just a more aggressive implementation of the same strategy. The second point was, are we going to quantify more specifically the shrink results? And in terms of quarter by quarter differences, we don’t provide any more color other than those items that are having the most significant impact.

John Zolidis, Buckingham Research Group

Okay, thanks and good luck with the fourth quarter.

Operator

Our next question is from Charles Grom with JP Morgan.

Charles Grom, JP Morgan

Thanks, good morning. Could you speak to the 50 store shortfall, was it delivered on your part to slow or could you just not open the stores by end of August? The second followup to that is looking to 2007. I know you don’t want to comment too much on square footage, but can you give us a rough sense of should we see a 6-7% increase or more or less what we saw in 2006 now with above 5%?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

As it relates to the real estate store openings, we set out to accomplish a number of things this year, and in doing that we communicated two measurable things. One is we lowered the target to 400; as we indicated today that has become 350. The second thing that we communicated to you was that we had in prior years opened a very, very large number of stores in the last month of the year in August and that we were not going to do that this year. While we’ve lowered the number of stores, we are going to have more normalized openings in the month of August that will enable us to open those stores better and more cost effectively.

Charles Grom, JP Morgan

And on 2007?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

For 2007 guidance, you’re going to just have to stay tuned to the next conference call for that.

Charles Grom, JP Morgan

Fair enough and then could you speak to the comp difference between stores with and without coolers, specifically in the third quarter and how this changed relatively to the first half of the year and how the stores with coolers are actually comping in year 2 with having a cooler in the stores? Thanks.

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

The comp performance of the cooler stores has been fairly consistent through the year. We’ve indicated mid single digits, so that would give you about 3% or so higher comp than similar stores without coolers. We’ve also indicated that the urban stores are performing in a very similar fashion. They also are comping in that mid single digit range. We haven’t had a lot of stores that it cycles, so we can’t really comment too much in terms of how stores with coolers comp on top of comp. We would say that we did not build into any of our modelling that there would be comping on comp, and that’s why as Howard described earlier we developed a multiphase. What we do believe as part of that multiphase is that the increased number of trips that we are driving as relates to coolers can be leveraged through an enhancement of our overall food assortment. So, that’s our expectation going forward that we will continue to build on the coolers but the coolers themselves in the absence of any further change would not necessarily comp on top comp.

Charles Grom, JP Morgan

Okay, fair enough and then last question, on the current tone up you toned down your June comp to the low end of 4-6, what changed growth a few weeks back? Thanks.

Howard Levine, Chairman and CEO

We felt it would be prudent just to give a little update that we are towards the low end of our guidance. We still believe that that is a pretty good number and it’s pretty consistent with what we’ve been trending for the year. As we talked about there is this pay cycle issue, but we continue to believe that the initiatives that we’ve outlined will deliver mid single digit comps.

Charles Grom, JP Morgan

Thanks, good luck.

Kiley Rawlins, Divisional VP, Investor Relations and Communications

Christie, in the interest of time, I’ll think we’ll take one more question.

Operator

Thank you, mam. Our final question is from Mitchell Kaiser with Piper Jaffray.

Mitchell Kaiser, Piper Jaffray

Thank you and good morning. I was curious if you could comment about the new store openings. I think you mentioned a few things, being better and more efficient on the cost side. I think you also mentioned the process side, and then I think the demand site as well or the revenue side. I was wondering if you could be a little more specific on what you’re seeing, why you’ve toned it down a little bit?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Well, I think what we’re seeing is improvement in each of these processes. As I indicated in my prepared comments, the improvements have taken a little bit longer than what we had expected. So, coming into the fourth quarter we had a choice -- are we going to basically rush and cram openings into the fourth quarter in a fashion similar to prior years or are we going to continue our efforts towards a more stabilized systematic opening schedule? We chose the latter and in part as a consequence of that the results showed closer to 350 versus the initial target of 400.

Mitchell Kaiser, Piper Jaffray

Jim, can you be a little bit more specific on what part of the process you felt kind of didn’t meet your expectations?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

No, I don’t think it’s particularly useful to go into the details of that. I think largely it is just a matter that as we have taken on each component of the process, you’ve lost a week here or a week there and then when you start aggregating those you lose them, and really 50 stores is roughly a month to six weeks of opening. So, I don’t think in an initiative of this size that is particularly significant to ask.

Mitchell Kaiser, Piper Jaffray

But you can’t specifically point to any one thing?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

No.

Mitchell Kaiser, Piper Jaffray

Okay, thank you very much.

Kiley Rawlins, Divisional VP, Investor Relations and Communications

Thank you very much for joining us today for our conference call. As always, I will be available afterwards for your questions if we didn’t get to them today. Thank you.

Operator

Thank you for participating in today’s conference call. You may now disconnect.

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Source: Family Dollar Stores Q3 2006 Earnings Conference Call Transcript (FDO)
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