Fred's Management Discusses Q4 2012 Results - Earnings Call Transcript

Mar.28.13 | About: Fred's, Inc. (FRED)


Q4 2012 Earnings Call

March 28, 2013 10:00 am ET


Pat Watson

Jerry A. Shore - Chief Administative Officer, Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Bruce A. Efird - Chief Executive Officer, President and Director

Alan C. Crockett - Chief Merchandising Officer and Executive Vice President of GMM

Rick A. Chambers - Executive Vice President of Pharmacy Operation


Andrew P. Wolf - BB&T Capital Markets, Research Division

Jill R. Caruthers - Johnson Rice & Company, L.L.C., Research Division

Paul Trussell - Deutsche Bank AG, Research Division

Lynda Guthmann


Good day, and welcome to the Fred's Fourth Quarter Conference Call. Today's call is being recorded. At this time, for opening remarks, I would like to turn the call over to Mr. Pat Watson. Please go ahead, sir.

Pat Watson

Good morning, everyone. This is Pat Watson with Corporate Communications. Thank you for joining Fred's to review the company's financial and operating results for the fourth fiscal quarter and year ended February 2, 2013. Before we begin, I would like to remind everyone that management's comments in this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks. It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued earlier today and the company's annual report on Form 10-K and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information. Lastly, I would like to point out that management's remarks during this conference call are based on information and understandings believed accurate as of today's date, March 28, 2013. Because of the time-sensitive nature of this information, it is Fred's policy to limit the archive replay of this conference call webcast to a period of 30 days. This call is the property of Fred's. Any distribution, transmission, broadcast or rebroadcast of this call for commercial purposes in any form without the express written consent of the company is prohibited.

With those announcements, I'll turn the call over to Jerry Shore, the company's Chief Financial Officer. Good morning, Jerry.

Jerry A. Shore

Good morning, Pat, and good morning to everyone on the call. Thank you for joining us for our discussion of the fourth quarter and fiscal 2012 results. With me this morning and available for questions are Michael Hayes, Chairman; Bruce Efird, Chief Executive Officer; Rick Chambers, EVP of Pharmacy Operations; and Alan Crockett, EVP and Chief Merchandising Officer. As the company reported in its press release earlier this morning, for the fourth quarter of 2012, total sales increased 7% to $533.4 million compared with $497.6 million in the same quarter last year, and comparable store sales increased 4.8%. Total sales for 2012 increased 4% to a record $1.955 billion versus $1.879 billion for the 52-week fiscal 2011. Comparable store sales increased 1.1% for the year.

I will remind you that the fourth quarter consisted of 14 weeks compared to 13 weeks last year. The 2012 year had 53 weeks compared with 52 weeks last year. Adjusting these results for 13- and 52-week periods, we eliminated the week ended February 2, 2013. On the adjusted basis, the fourth quarter comparable store sales decreased 2.8% compared with an increase of 0.1% in the same quarter of last year. On an adjusted basis, comparable store sales for the year decreased 1.4% versus an increase of 0.5% for fiscal 2011.

The sales mix comparison for the fourth quarter was as follows: household goods were 23.2% this fourth quarter, which decreased from 24.7% last year; apparel and linens, 6.3% this quarter, decreased from 7.2%; health and beauty, 7.5%, increased from 7.1%; paper and chemical, 8.5%, increased from 8.2%; food and tobacco, 16.7%, increased from 16.2%; pharmaceuticals, 36.2%, increased from 34.6%; and franchise, 1.6%, decreased from 2.0%. For the quarter, comparable store customer traffic decreased 2.8% from last year, while the average customer transaction was approximately flat at $20.84.

The sales mix comparison for the full year was as follows: household goods were 22.6% for the year, which decreased from 23.3% last year; apparel and linens, 6.3% this year, decreased from 6.9%; health and beauty, 7.5%, increased from 7.4%; paper and chemical, 8.8%, increased from 8.7%; food and tobacco, 16.7%, decreased from 16.8%; pharmaceuticals, 36.3%, increased from 34.9%; and franchise, 1.8%, decreased from 2.0%. For the full year, comparable store customer traffic decreased 2%, while the average customer ticket increased 0.6% to $20.40.

Sales per average selling square foot in 2012 increased to $204 per square foot from $199 last year. For the fourth quarter of 2012, Fred's net income was $6.6 million compared with net income of $9.8 million in the year-earlier period. Earnings per diluted share were $0.18, down from $0.26 per share in the same quarter last year. For 2012, Fred's net income was $29.6 million compared with net income of $33.4 million last year, with earnings per diluted share of $0.81 from $0.87 last year. The earnings impact as a result of the 14th and 53rd week was $1 million or $0.03 per share. Also, the settlement with the state of Tennessee of an outstanding tax matter in the second quarter 2012, as well as other tax-related assumptions and estimates, had a favorable impact on earnings per diluted share of $0.12 during the year. Excluding this favorable tax credit, earnings per share would have been $0.18 for the fourth quarter and $0.69 for the year. EBIT, or earnings before interest and taxes, for the fourth quarter of 2012 totaled $8.5 million or 1.6% of sales, down from $14.2 million or 2.9% of sales in the same quarter last year. EBIT for the full year of 2012 was $39.1 million or 2% of sales from $51.2 million or 2.7% of sales in the prior year.

EBITDA, or earnings before interest, taxes, depreciation and amortization, during the fourth quarter of 2012 totaled $19.3 million or 3.6% of sales compared with $24.1 million or 4.8% of sales in the same quarter last year. EBITDA for the full year totaled $78.6 million or 4% of sales from $85.3 million or 4.5% of sales in the prior year.

Fred's gross profit for the fourth quarter increased 8% to $148.6 million from $137.7 million in the prior year period. Gross margin for the quarter was 27.9%, an increase of 20 basis points over the 27.7% gross margin in the same quarter last year.

During the fourth quarter, pharmacy department margins improved primarily as a result of the ongoing shift of brand to generic drugs. Although top line sales are adversely affected, the gross profit and gross margin performance in the pharmacy department were positive. General merchandise gross margin decreased in the quarter primarily due to the significant sales mix shift affecting initial markup.

Also during the fourth quarter, LIFO expense on pharmacy department inventory adversely impacted overall gross margin by approximately 33 basis points as a result of a large drug inflationary increase during the final month.

Gross profit for the full year 2012 increased 5% to $566.3 million from $538.5 million last year. Gross margin for 2012 improved 30 basis points to 29% versus 28.7% last year. For the year, gross margins in our pharmacy departments increased as a result of the higher initial markup from the brand-to-generic shift, as well as higher rebates on generic drugs. The gross margin on general merchandise was lower than the prior year due to the sales mix shift and higher shrinkage.

LIFO expense for the year increased 41% due to a significant rise in the inflation index. This increase adversely affected overall gross margin for the year by approximately 16 basis points.

SG&A expenses for the fourth quarter were 26.3% of sales, 150 basis points higher than the 24.8% last year. For the quarter, the 150 basis point de-leverage of expenses is primarily attributed to 100 basis points from pharmacy department expenses, primarily a result of the pharmacy growth coupled with the negative top line impact of brand-to-generic drugs. Also, 27 basis points came from insurance expense due to higher group medical, workers compensation and general liability reserve increases.

For the year of 2012, SG&A expenses were 27% of sales, 100 basis points higher than the 26% in 2011. For the year, the 100 basis point de-leverage was primarily attributed to 20 basis points in depreciation and amortization, which is mostly related to new pharmacy growth; 65 basis points in pharmacy expenses other than D&A related to growth of the brand -- related to growth and the brand-to-generic shift impact; and 11 basis points in insurance expense due to higher medical costs.

Depreciation and amortization expense totaled $10.8 million in the fourth quarter and $39.5 million for the year-to-date period. This compares to $9.9 million in the quarter and $34.2 million year-to-date in 2011.

For the fourth quarter of 2012, net interest expense totaled $147,000 versus $134,000 last year, and for the year of 2012, net interest expense totaled $549,000 versus $397,000 in 2011. Income tax expense in the fourth quarter was 21.4% of pretax income compared with 30.4% in the same quarter last year. The lower rate reflects available Work Opportunity Tax Credits following congressional approval for 2012 and other tax-related adjustments recorded during the quarter. For the year, the income tax rate was 23.1% of pretax as compared to 34.1% last year. The reduced rate resulted from the Tennessee tax settlement and other related adjustments totaling $4.2 million or $0.12 per share.

Moving to the balance sheet, cash and equivalents were $8.1 million, down from $27.1 million in the year-earlier period. The reduction in cash is attributed to increased inventory purchases and other working capital needs, as well as $9.2 million in share repurchases for the year and dividend increases of $8.1 million. The dividend portion includes a onetime special dividend payment of $7 million that was paid in December 2012.

Total inventories at year end increased 6.4% to $353.3 million compared with $331.9 million at the end of 2011. The increase is attributed to the early receipts of spring merchandise in areas such as lawn and garden and home, additional inventory related to our new auto and hardware expansion and the miss in sales during the fourth quarter. We expect the sales miss portion of the increase will be alleviated by controlling purchases during the first half of the year. At the end of the first quarter of 2013, we currently expect inventory to be slightly above the levels of quarter-end 2012.

Capital expenditures for the fourth quarter of 2012 totaled $8.1 million compared with $8.2 million in the last quarter of 2011. Capital expenditures for the quarter were as follows: $6 million for existing store improvements, $1.9 million for new store and pharmacies and $200,000 for technology, distribution and corporate expenditures.

For the full year of 2012, capital expenditures totaled $27.2 million compared with $49.2 million for 2011. Capital expenditures for the year were as follows: $15.2 million for existing store improvements, $6.5 million for new stores and pharmacies and $5.5 million for technology, distribution and corporate expenditures. Additionally, $20.2 million was spent on acquisitions of pharmacies during 2012 as compared to $16.8 million in 2011.

Total indebtedness was $13.5 million compared with $7.3 million at the end of 2011. At the end of 2012, there were $6.9 million of borrowings under the company's revolving line of credit.

At the end of the fourth quarter, there were 644 company-owned full-size stores, 47 company-owned express stores and 21 franchise stores for a total of 712 discount general merchandise stores, which include 346 pharmacies. During the fourth quarter, Fred's opened 4 net new locations consisting of 6 full-service store openings and a net reduction of 2 Xpress pharmacy locations.

For the full fiscal 2012, the company opened 12 net new locations consisting of 20 full-service store openings, 14 full-service store closings and a net 6 new Xpress pharmacy locations. For the full year, we opened 24 new pharmacies and closed 3. The total -- the 2012 ending store count of 712 is 2% higher than the same period last year. At year end, there were 346 pharmacies, which is a 6.5% increase over last year. Total selling square footage increased by 0.4% for the year, ending the year at 9,624,000 square feet.

In the equity area, during 2012, the company repurchased 650,000 shares for $9.2 million. Additionally, the cash dividend was increased by 20% from $0.20 per share to $0.24, excluding the onetime special dividend of $0.19 paid in the fourth quarter. The payout for dividends in 2012 increased to $15.9 million from $7.7 million in the prior year, $7 million of which was the onetime special dividend. And for the year, net cash provided by operating activities was approximately $46.2 million.

Moving to guidance for 2013, in the first quarter, the company expects total sales to increase -- to be in the range of negative 1% to a positive 1%. Comparable store sales are expected to be in the range of negative 1% to negative 3%, which compares to a negative 0.3% in the first quarter last year. March sales had been negatively impacted by weather, primarily affecting lawn and garden and other seasonal merchandise. This estimate also considers the continuing impact of the pharmacy department brand-to-generic shift. We anticipate general merchandise sales to be positive during the quarter, which has improved over last year's negative comp store sales during the first quarter. Earnings per diluted share are forecasted to be in the range of $0.26 to $0.30 per share for the first quarter compared with $0.28 in the same quarter last year.

Looking ahead for the full year, the company expects total sales to increase 1% to 3%, or 3% to 5% excluding the 53rd week in 2012. Comparable store sales for 2013 are expected to be flat to an increase of 2% in 2013, excluding the effect of the 53rd week in 2012. We anticipate general merchandise increases to continue the positive comp performance throughout the year. The pharmacy department comp store sales will continue to be negative through the first 2 quarters due to the brand-to-generic shift, and we expect pharmacy department comparable store sales to turn positive by the end of 2013 as the large generic drug shift of 2012 is anniversaried. Based on this outlook, the company expects total earnings per diluted share for 2013 to be in the range of $0.77 to $0.88. Excluding the impact of the $0.12 favorable income tax rate in 2012, the increase in earnings per share is projected to be 12% to 28% in 2013.

We realize the EPS range is larger than we have typically given in the past. This expansion is done as a result of the volatility we've seen of noncontrollable LIFO and insurance expenses, which we experienced at the end of the year. As health care reform moves forward, we expect continued volatility in these areas and have added additional reviews to raise awareness of trends that may develop. LIFO expense is valued off of government price index that is normally issued 2 to 3 weeks after the end of each period. Group medical expense, once our benefit programs are put in place, are set for the year and not controllable. Our EPS plan also considers the continued impact of third-party reimbursement reductions on pharmacy department sales and margin, which is projected to be $5.2 million or approximately $0.09 per share this year. We project EBITDA to improve to a range of $83 million to $95 million for the year of 2013, which is an increase of 5% to 20%. We are projecting a normalized income tax rate for 2013 of $0.36 to 37%. Capital expenditures for 2013 are expected to be in the range of $22 million to $28 million. Additionally, $16 million to $20 million is planned for acquisitions of pharmacies during 2013.

The breakdown of capital expenditures is as follows: new stores and pharmacies, $6 million to $8 million; existing store maintenance, $7 million to $9 million; auto/hardware expansion and other new concepts, $4 million to $6 million; distribution, $2 million; and technology and corporate upgrades, $3 million.

We plan to open in the range of 20 to 25 new stores and 25 to 30 new pharmacies in 2013. Closings are anticipated to be approximately 20 stores and 3 pharmacies. However, as we look forward, there are considerably more lease stores without pharmacies that reached either the end of their lease or new option periods. As part of our reconfiguration plan, which will be presented in detail shortly, we will do more evaluation of current stores without pharmacies for opportunities of pharmacy expansion, new general merchandise concepts or closures. We will evaluate approximately 60 stores with lease-end lives, which currently produce cash flow but could not be considered for one of these opportunities. Although the current plans are for 20 store closures in 2013, we will evaluate additional closures to take advantage of the lease end and profit improvement opportunities.

Free cash flow, which we identify as net cash provided by operating activities minus capital expenditures and pharmacy acquisitions, is expected to be in the range of $18 million to $22 million for 2013. We will have minimum borrowings under our line of credit during the first quarter and do not anticipate borrowings for working capital needs after the first quarter end. The board authorization for share repurchase remains open and will be used opportunistically.

This concludes our financial summary. I will now turn the call over to Bruce Efird, CEO.

Bruce A. Efird

Thank you, Jerry. Good morning, everyone. I appreciate you joining us for the fourth quarter and fiscal 2012 conference call. On today's call, we will deviate from our normal protocol and spend more time on future strategies with specific emphasis on our reconfiguration plans. We will share with you more detailed prepared comments from Alan Crockett and Rick Chambers relative to these plans as they will lead the reconfiguration plan and its execution.

The fourth quarter brought to a close a challenging year in 2012 in which our team was very disappointed with our overall performance, as well as the adjustments at year end. To address these adjustments experienced at the end of the year, the team will add reviews throughout the business since we expect the volatility to continue. We will take additional measures to raise the awareness of trends that may develop.

Looking back at 2012, we continue to see generally weak economic conditions throughout the Southeast, reducing discretionary spending, creating a mix shift toward consumables. Given that trend, we do not see the typical sales and traffic increases needed to improve profitability. From a competitive landscape perspective, our largest competitor increased advertising spending by 70% to 100% throughout the year, which impacted our overall results. Recognizing that the competitive landscape will more likely intensify in 2013 and the economic outlook for our customers will lag with the general economy, we needed an aggressive plan for 2013. We had to first address the general merchandise sales mix shift away from higher-margin discretionary products, attack expenses and validate the product changes to ensure 2012 is not repeated in 2013.

Shifting to expenses, we did not react fast enough to reduce expenses commensurate with our sales shortfall and product mix shift, resulting in the de-leveraging of SG&A expenses in 2012. We have implemented initiatives that are in place for 2013 to address this expense de-leverage, including a corporate restructure and reduction in force executed in February of this year that will result in a net expense reduction of approximately $1.5 million in 2013. Later in the call, Alan will outline additional store expense reduction plans for 2013. I will note that our 2012 expenses were impacted by $5.4 million or a 16% increase in depreciation and amortization primarily related to pharmacy acquisition investments directed towards future growth.

In 2012, our pharmacy business continued to accelerate despite the top line sales pressure created by the ongoing brand-to-generic shift. Overall, we were pleased with our comp script growth of 3.7%, our new pharmacy growth and our immunization and clinical services growth. As Jerry noted, despite the overall challenges in 2012 earnings, our team delivered $78.6 million in EBITDA.

Now let me shift to our plans going forward. When we talk about Fred's, it's really a picture of 2 businesses, with our pharmacy operation performing exceptionally well and general merchandise performance challenging our overall results. The main thesis behind our planned reconfiguration is to elevate our general merchandise performance while accelerating our pharmacy department and health care services growth. The purpose of our reconfiguration plan is to regain the momentum we had in the prior 3 years, driving toward our 4% operating margin goal. Today, we know that our stores with integrated pharmacies consistently exceed 4% operating profit on a fully loaded P&L basis. The main focus of our reconfiguration plan is to improve our overall store productivity and space efficiency while enhancing the product selection in stores with pharmacies. Reconfiguration is a 3-year plan centered around 2 fundamental principles. Number one, we will aggressively accelerate our pharmacy presence and further leverage our pharmacy department while tailoring our general merchandise mix toward our pharmacy customer in our stores with pharmacies. Reconfiguration in general merchandise is centered around expanding space and discretionary product line. Based on our 2012 test, our new hardware and automotive expansion will be implemented in 2013, with plans to reconfigure approximately 12% to 15% of our general merchandise space over the next 3 years. The goal of these changes is to shift our general merchandise business to a healthier balance between higher gross margins, discretionary product lines and consumables.

With that introduction, I will turn the call over to Alan Crockett to share further details. Alan?

Alan C. Crockett

Thank you, Bruce, and good morning. Let me begin by addressing our prior year performance in general merchandise and our plans to improve that performance. We will begin a 3-year reconfiguration plan designed to improve overall performance in terms of productivity and profitability of the store. This reconfiguration plan will include the following. Number one, tailoring our product mix and space in general merchandise toward higher-margin discretionary departments or categories that have higher customer acceptance and margin. The reconfiguration in general merchandise will begin with 3% to 5% of our linear space being reallocated to automotive and hardware and seasonal. In the third and fourth quarter of 2012, we began testing our reconfiguration plan by reallocating space in 78 stores to expand automotive and hardware. This test allowed us to validate the first phase of reconfiguration. The test stores are returning above-plan results for the automotive and hardware departments, returning 30% to 40% comps and the entire store performing 150 to 200 basis points above the remainder of the chain in comp sales.

Also, we are seeing a positive impact in our core 5 departments of home, pet and paper and chemical in these stores, with comps in those departments running approximately 300 basis points above the remainder of the chain. As we roll out reconfiguration, we expect to have approximately 50% of our stores reset with the new automotive and hardware format by year end. At the same time, we are rolling out the auto and hardware expansion, we will be testing a new destination store centered around hardware, automotive, pet and home.

Number two, tailoring our product mix and space to leverage the customers' expectations of a full-service pharmacy in the 347 stores where we have a pharmacy. Example of the space that will be tailored to appeal to the pharmacy customer would include an expansion of health and beauty aids, cosmetics, eye care, vitamins and pain relief and durable medical equipment, just to name a few examples.

Number three, the reconfiguration plan will occur in phases, with automotive and hardware and seasonal reallocation being the first phase occurring in 2013. We will continue in phases over the next 3 years, with approximately 12% to 15% of our linear space being reallocated from less productive categories on a sales per square foot and gross margin per square foot basis to more productive categories over that time.

Number four, the reconfiguration plan will be supported by an aggressive marketing campaign that will focus around our expanded discretionary businesses. In the case of 2013, the focus will be on automotive and hardware and our seasonal businesses. Marketing will increase our in-store messaging to draw attention to discretionary categories, direct mail campaigns to highlight expanded categories and an increase in our print advertising, with an increase of 7 midmonth ads being distributed that were not distributed in previous years. This increased distribution will create an additional 45 million impressions in 2013.

Number five, the reconfiguration plan will require a disciplined approach to handle the contraction and expansion of inventory based on productivity needs. In departments where inventory is contracting, we will begin a sell-down process prior to the reallocation of that space. Additionally, we will adjust the number of phasings and use the dynamics of our replenishment system to contract the inventory without requiring excessive markdowns. We have constructed our 2013 budget so that some of our promotional markdowns can be reallocated to deal with the contraction of inventory in departments or categories that are being reduced. This reconfiguration plan will require a reallocation of capital, and over time, the net impact to overall inventory will be 0.

Number six, we expect this 3-year reconfiguration plan to move our general merchandise mix back to a healthier balance between discretionary businesses and the consumables side of our business. In doing so, we are anticipating a gross margin increase of 50 to 75 basis points and improvement in the overall productivity of our store in terms of sales per square foot and gross margin per square foot, with an increase in gross margin per square foot of approximately 2%.

And finally, on the operational side of our business, as our mix has shifted more toward direct store delivery and consumable products over the last couple of years, we have not managed store expenses to accommodate for that mix shift. In order to better leverage expenses on a go-forward basis, we have built leverage of 47 basis points into our 2013 budget. We have also invested in new technology and loss prevention and expect a potential benefit of 5 to 15 basis points of improvement in general merchandise gross margin from shrink reduction.

Having concluded with an outline of our general merchandise reconfiguration plan, let me give you an update on a few other key initiatives for 2013. As part of our continuing strategy to broaden our assortment, we'll be adding new coolers and increase capacity in our top 100 stores in order to add additional branded frozen and refrigerated products. We will also expand brands across a number of categories, including soft lines, toys, automotive and hardware and lawn and garden, just to name a few. We feel strongly about our private label program and see upside in that portion of our business and have planned an increase of 39 basis points in our private-label penetration as a percentage of our overall consumables business, which equates to an additional $3.7 million in sales. In 2013, we also will be rolling out the second phase of our price optimization tool, which deals with optimization and management of promotions. This phase of price optimization should aid us in managing our promotional markdowns and enhancing gross margin. Over the last 2 years, we have grown our food and beverage business in the mid-single-digit comps, and our nonedible consumables business has grown in a low-single-digit range over the same time period. During that same period, we have been able to improve our margin in both food and beverage and nonedible consumables through the use of our price optimization tool we purchased 2 years ago. The single largest challenge we have faced with our consumable business has been our tobacco business, with mid-double-digit declines in tobacco throughout last year. As a result, we placed significant efforts around our correction plan designed to regain our tobacco trips. Through those efforts, we created our discount tobacco shop with the expansion of brand names and improved pricing, and our near-term results indicate that we have regained our tobacco traffic and are experiencing mid-single-digit increases in the tobacco category.

In summary, we designed this reconfiguration plan in our 2013 strategies to begin to move our general merchandise mix back to a healthier balance between higher-margin businesses and the consumables side of our business. However, the challenge we face in the short-term is the time lag and implementation of the margin enhancement programs as the growth in tobacco and consumables is well underway, keeping pressure on our margin. Our goal is to see the margin improvement take hold by the third quarter. The exciting part of reconfiguration is its ability to bring newness and improved profitability to our stores for the next 3 years.

I will now turn the call over to Rick Chambers, our Executive Vice President of Pharmacy Operations.

Rick A. Chambers

Thank you, Alan. I would like to take a few moments to share my thoughts on the role that pharmacy will play in our reconfiguration plans. Over the next 3 years, we will continue to transition Fred's pharmacy from being primarily a dispenser of product to that of a provider of health care services while we also increase our pharmacy penetration of our store base to 65% to 70% from the current 50% today. We are very excited about the opportunities that will be created for the company as this transition takes place. The pharmacy market is continually evolving, and we will continue to drive this evolution as we enhance our position as a provider of health care services. Currently, our stores with pharmacies generate an operating margin greater than 4%. As we move our pharmacy penetration to 65% to 70% of all stores, we will continue to help the company achieve its overall goal of a 4% operating margin.

We will also continue to aggressively pursue acquisition opportunities to drive additional growth as demonstrated by our increase in the number of acquisitions by over 45% during the last 4 years. Our increased number of pharmacy locations will be achieved via the following three-pronged strategy. First, we will add pharmacies to existing stores that, today, do not have a pharmacy. These additions will be in the range of 15 to 20 per year. Second, all new stores will open with a pharmacy, whether they open through acquisition or cold start. And in either our 16,000 or 8000 square foot format, our new openings will be in the range of 25 to 30 per year. And thirdly, we will pursue those opportunistic acquisitions that will operate as an Xpress pharmacy unit while serving as a precursor to a future Fred's or Getwell location. We will open in the range of 5 to 10 Xpress units per year. We are very bullish about the acquisition market as demonstrated through prior successes, but just as important is the fact that there are over 2,900 independent pharmacies currently operating in our 7 core states, with over 50% of those pharmacies operating in communities of 10,000 people or less. Maintaining our current rate of completed acquisitions over the last 3 years will enable us to achieve a pharmacy penetration of 65% to 70% of all stores. With our established growth strategy into these types of markets, along with a continued aging population and the health care reform changes being implemented in January of 2014, we envision a sustainable growth strategy for the coming years.

We anticipate health care reform and the impending changes to be overall accretive to our financial performance. In the absence of any readily available industry modeling, we have conducted some very preliminary modeling to project the impact to both sales and prescriptions. We project the impact to be beneficial to top line sales, pressure gross margin rates but overall accretive to earnings. As the future pharmacy continues to evolve, we are well positioned to leverage the future specialty pharmacy growth that the industry is experiencing, thus providing our pharmacy teams another vehicle to practice at the high end of their license. This positioning is currently being validated as we roll out one of the most important initiatives in the history of the pharmacy division, the Fred's specialty pharmacy program. Specialty pharmacy is the fastest-growing segment of the pharmacy industry. The $80-plus billion specialty pharmacy market is expected to grow at a rate of over 15% per year during the next 3 to 5 years, with over 50% of new drug approvals by 2015 coming from the specialty category. We are very confident that our relationship with Diplomat Specialty Pharmacy has us well positioned to grow with this expanding market. Just this past Monday, we completed the early phase of our rollout and welcomed our new Director of Specialty Pharmacy. We continue to look at all opportunities to enhance our offering via increased operational capability, enhanced marketing activities and evaluation of acquisition alternatives.

As we look at our health care services offerings, we were very pleased with the results from the most recent flu season and the number of immunizations that were administered by our pharmacists. We saw an 85% increase year-over-year and have plans in place to generate an over 30% increase during 2013. Also, our clinical services team, in concert with our operations team, continues to execute our clinical services initiatives at a very high level, thus supporting our concierge or appointment-based model developed to drive compliance and adherence for our multiple script patients.

As we continue to expand our pharmacy footprint across the company, it is important to point out that this process is a combined effort with Alan and his team to better differentiate our format with pharmacies from other small box competitors. As we expand our current offerings, we will also include an expanded pet offering in both over-the-counter and prescription products. All these expanded offerings will allow us to more accurately reflect our desired pharmacy presentation, thus bringing more clarity to our brand.

2012 was a record year for our pharmacies. We dispensed 17 million prescriptions, representing a 3.7% script comp and a 9.2% total script increase. The momentum generated from the record year in 2012 will be leveraged to, one, continue the advancement of our clinical services offerings; number two, move forward the implementation of our specialty pharmacy program; and number three, achieve our pharmacy growth of 65% to 70% penetration by 2015. We are very confident that Fred's will be well positioned to meet the expanding needs of our patients as the health care delivery system in the U.S. changes over the next 3 to 5 years.

Now I will turn the call back over to Bruce for wrap-up.

Bruce A. Efird

Thanks, Rick. To summarize our reconfiguration plan, we will reallocate our assets to aggressively accelerate the number of stores with pharmacies from approximately 50% of our store base today to a range of 65% to 70% by the end of 2015, which will be a 40% increase. This accelerated growth in pharmacy and health care services capitalizes on the success in our pharmacies in the anticipated expanded customer base as health care reform takes effect.

We see specialty pharmacy as a significant enhancement to our health care services and are pleased with the early results of our specialty script growth and our relationship with Diplomat Pharmacy Services. In addition to our relationship with Diplomat, we are actively engaged in expanding our platform as we build our internal capabilities while exploring all avenues of specialty expansion. We will accomplish the expansion of a number of stores with pharmacies through a combination of accelerated acquisition in existing stores, new store openings with pharmacies, additional Xpress pharmacies and the attrition of underperforming stores without pharmacies.

Shifting to our reconfiguration plans for general merchandise, we will tailor our product mix, marketing and space allocation toward higher-margin discretionary departments and categories with specific emphasis on hardware, automotive and seasonal category expansions in 2013. I'm confident that these changes, coupled with our aggressive marketing campaign, will move our general merchandise mix to a more productive balance. In addition to space and product reconfiguration, we believe that better store expense management, considering our direct store delivery product mix shift, our loss prevention and shrink technology, coupled with our markdown management phase of price optimization technology, are well positioned to deliver the results Jerry outlined in our guidance.

The confidence I have in our reconfiguration plan is based on the fact that the primary components of the plan have been tested and validated. For example, the hardware and auto growth projections were validated in 2012, along with the sales growth projected in the additional midmonth ad distributions. Specialty pharmacy projections have been reviewed and adjusted to our market.

In summary, we expect challenges in the near term, but I'm confident in our ability to drive improved performance in 2013, with operating earnings per share growth in the range of 12% to 28% over 2012.

Now I will turn the call over to our operator, Mary, for questions.

Question-and-Answer Session


[Operator Instructions] And we will take our first question from Andrew Wolf with BB&T Capital Markets.

Andrew P. Wolf - BB&T Capital Markets, Research Division

I guess the question I'd like to ask is -- you're projecting EBITDA growth this year. How do you view that sort of overall for the year between kind of the benefit of closing stores that are negative in EBITDA versus generating increases from what's left in the core? So sort of that sense for the year. And how does it break out sort of from the first half to the second half? Is there going to be some shifting of the benefit? How do you see the EBITDA flow?

Jerry A. Shore

Andy, this is Jerry, and I will comment on that, first of all. Keep in mind the store closings of 20 is really only 6 over what we had in 2012, so most of the EBITDA that's generated is going to be from our existing operations. In terms of where that comes from, it's going to be more in the back half. We do have, as stated with our guidance our earnings per share and EBITDA are much the same in the first quarter as they were last year, so most of the EBITDA generation starts in the second quarter and accelerates through the third and fourth quarter. But most of that is coming from existing and new operations and higher margins, as Alan talked about, in those more discretionary areas.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Just a follow-up. The sense I got is the 20 stores that are being slated to close this year, probably even on an individual basis, surely on an aggregate basis, but just as each store probably were more -- especially given the results for the year, probably lost more money per store than the 12 you closed last year. So it's not just a simple net pickup of 6 stores or the 14 you closed last year. Am I thinking right? Or is it -- or are you just trying to say they were all -- you're just taking out money-losing stores and that it's about the same amount each year?

Jerry A. Shore

I'm not saying that the stores this year are worse than the ones that we closed last year. On average, when we close a store from the inventory and operating -- or contribution margin, we save about $350,000 a store. So you can see that of the 20 -- of the 6 more closings that we have this year, we'll get about $350,000 in cash flow from those.

Bruce A. Efird

And Andy, at the core of the reconfiguration plan is the fact that we do have this somewhat unique window of opportunity with stores currently without pharmacies that -- which the lease life is either up or will roll off over the next 2 years. So that gives us the opportunity to reallocate our assets, focusing in more on pharmacy given, again, that the stores combined with pharmacies are currently operating above the 4% operating margin goal that we have in place.

Jerry A. Shore

One final thing, Andy. I will take you back to my comments that said we are going to look at potentially more stores as well. So the guidance was based on the 20, but we are going to evaluate those opportunities that we have with lease life's ending.


And we'll take our next question from Jill Caruthers with Johnson Rice.

Jill R. Caruthers - Johnson Rice & Company, L.L.C., Research Division

If you could talk about a bit on the addition of pharmacies to new stores as well as existing stores. I know in the past, you've talked about kind of a cold start pharmacy has a difficult time starting up versus kind of your move into more of the Xpress locations. Given that concern, how do you address -- it sounds like you're going to do a lot more cold start pharmacies going forward.

Rick A. Chambers

Yes, Jill, this is Rick. If we sent that message, that wasn't the message. It would be more centered around the acquisitions in the Xpress units that you alluded to in your question. There will be some cold starts. Typically, we are on the range of 6 to 8, the most being 10 cold starts a year, depending on the opportunity that exists. But we'll be somewhere in that average range of cold starts with a much more emphasized focus on the acquisition side.

Jill R. Caruthers - Johnson Rice & Company, L.L.C., Research Division

Okay. And then could you address on the general merchandise side under the reconfiguration? It looks as though you're definitely focusing more on discretionary products. Could you talk about that given the current macro environment? Seems as though the consumers are really focused more on the basic consumables, and you see some of your bigger-dollar store peers ramping up the consumables side versus discretionary. Could you talk about that variance?

Alan C. Crockett

Yes, Jill. The important thing for us is to focus on the discretionary side. We have -- with the tests we've done in auto/hardware, we have seen, as I've mentioned in my comments, great results from that. Seasonal is the trip driver for us. We know that. So this really is to focus on areas where -- are more discretionary from our point of view but the customers are responding to. As Bruce said, the good news is that a lot of this has been tested and validated in terms of auto/hardware, which is the main component of reconfiguration for 2013. So with the economic pressure that we're facing, the auto and hardware really goes to more of a DIY point of view and the customer doing more of their own things at home and with their automobile. So from a discretionary standpoint, we see that as a benefit with the economic conditions that exist. And with seasonal, as I said, we know that it's a trip driver for us, so to continue to focus on that.

Bruce A. Efird

And Jill, we still see opportunity to grow our consumables as well, as we've seen with the turn in our tobacco sales overall. We've been very pleased with paper and chemical growth, as well as pet growth, which is more consumable in nature. And it's not an intent to pull back on consumable growth. It's more an intent to accelerate the growth in our discretionary higher-margin departments to keep pace with -- with the intent to outpace our consumable growth in the future.


And we'll take our next question from Paul Trussell with Deutsche Bank.

Paul Trussell - Deutsche Bank AG, Research Division

Just want to kind of just start with the comp guidance for this quarter, so maybe just get us a little bit more comfortable with how that will improve over the year. So if you can give some color on what you believe maybe the impact from weather is, the earlier Easter. You have also the branded-to-generic change. If you can just maybe quantify some of those items, how you're running March to date, that would be helpful.

Jerry A. Shore

Paul, this is Jerry, and I will comment first kind of on the numbers side of it, and then I will turn it over to Alan and Rick to comment on their individual comps. In the month of February, we had a negative 1.5% comp. March, what we've seen is a severe weather impact, and so I'm now -- I now believe that we will be in the negative 1% to 3% because of that. Originally, I thought flat to negative 2%. Then April will be a better month for us, and we expect flattish comps in the month of April. So overall, that's how we're getting to the quarterly goal. And then as we go forward, as I said in my guidance, we do expect general merchandise to be positive, and then on the pharmacy side, we expect the impact of the brand-to-generic shift that we had so significantly last year will ease in the second and third quarters and then get positive. And I'll let Alan and Rick go from here.

Rick A. Chambers

Yes, Paul, this is Rick Chambers. And just to follow up what Jerry said that the majority of the back half of the year is where we'll see the large portion of that class of 2012 brand-to-generic conversions being anniversaried. And then obviously, in my comments, I had alluded to our specialty pharmacy program and that obviously being another big initiative for us this year. And that's obviously a ramped-up program that we'll start to see the benefit of in the back half to help support and supplement those comps in the back half of the year.

Alan C. Crockett

And on the general merchandise side, we still continue in the first quarter -- or we're seeing a reversal in the first quarter of the tobacco trends that we had from last year, as I commented on. So we're seeing strong results in tobacco, as well as beverage. Our core 5 areas, the pet, paper and health aids are doing well. The good news is home has started to improve for us in Q1. We've seen major improvement in home. Auto and hardware are performing well. And as Jerry said, the biggest issue in Q1 is the pressure on our seasonal businesses from the extremely unseasonably cool weather that we're having thus far and continuing as of today.

Paul Trussell - Deutsche Bank AG, Research Division

Understood. That is very helpful. And just regarding the competitive environment, you guys spoke to significant increases in advertising from peers, et cetera. Could you just talk a little bit more about what you're seeing on the pricing front? How do you feel about your price points versus what others are doing in the marketplace? Is there any need for significant investments?

Bruce A. Efird

Paul, near term, we don't see any significant need for investment in lowering prices or price points. We are currently very competitive with the competitive group that we typically compare to, so we're pleased with that. We do -- the second point from a promotional and advertising standpoint, we don't anticipate our largest competitor doubling their advertising as took place in 2012, so we see somewhat normalized. However, as Alan alluded to, we are being more aggressive toward our advertising with our 7 planned incremental distributed ads that will be in place this year, in which, based on our prior addition of midmonth ads that we distributed, shown good results. So overall, we believe that we're well positioned from a competitive standpoint, both promotionally and pricing.


And we'll take our next question from David Magee with SunTrust.

Lynda Guthmann

This is actually Lynda Guthmann in for David. We just had a couple of questions regarding pharmacy. First, what is the environment like for third-party reimbursements in 2013 relative to last year?

Rick A. Chambers

I missed that first word. You said the comparison between 2013 and 2012?

Lynda Guthmann

Yes, for the environment for third-party reimbursements.

Rick A. Chambers

Yes, it's been similar to -- this is Rick, by the way. It's been similar to 2012. We are starting to see some more pressure around, I'll say, preferred networks as opposed to restricted networks and the difference being, obviously, restricted limits access to the network, where preferred just puts you in a preferential co-pay position. We are starting to see some pressures on that. Where we are in the preferred networks, there are lower reimbursements, obviously, because you have a smaller set of retail providers in that group. But overall, generally the same, but again, we're keeping a very close eye on that as we move through '13 towards 2014 with the formation of the health care exchanges.

Lynda Guthmann

Okay. And then just to kind of follow up on that, are you guys, right now, expecting any sort of impact from the ObamaCare?

Rick A. Chambers

In 2013, we have no real significant impact planned in our 2013 budget. We do have that forecasted out into 2014, but I will say it is very preliminary on what we're looking at today both on the sales and margin perspective because it's so early in that process as we continue to negotiate with those payers.

Jerry A. Shore

Lynda, this is Jerry. I will add to that on the expense side of it. We do anticipate pressures from that on the insurance expense. I mentioned that and how we do expect that to escalate towards the end of this year and into 2014. And then we also expect a negative impact of that on LIFO as a result of inflationary index changes.


And at this time, we have no further questions. And I'd like to turn the call back over to Bruce Efird for closing remarks.

Bruce A. Efird

Thank you, and we appreciate your ongoing interest in Fred's, and we will conclude the call at this point in time. Have a great day.


And that concludes today's conference. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to All other use is prohibited.


If you have any additional questions about our online transcripts, please contact us at: Thank you!