Family Dollar Stores Management Discusses Q2 2013 Results - Earnings Call Transcript

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Family Dollar Stores (NYSE:FDO)

Q2 2013 Earnings Call

April 10, 2013 10:00 am ET

Executives

Kiley F. Rawlins - Vice President of Investor Relations & Communications

Howard R. Levine - Executive Chairman, Chief Executive Officer and Member of Equity Award Committee

Mary A. Winston - Chief Financial Officer, Chief Accounting Officer and Executive Vice President

Michael K. R. Bloom - President and Chief Operating Officer

Analysts

John Heinbockel - Guggenheim Securities, LLC, Research Division

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Bernard Sosnick - Gilford Securities Inc., Research Division

Paul Trussell - Deutsche Bank AG, Research Division

Mark Wiltamuth - Morgan Stanley, Research Division

Wayne L. Hood - BMO Capital Markets U.S.

Edward J. Kelly - Crédit Suisse AG, Research Division

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Nathan Rich

Meredith Adler - Barclays Capital, Research Division

Operator

Good morning. My name is Jessica, and I will be your conference facilitator today. I would like to welcome everyone to the Family Dollar Earnings Conference Call. [Operator Instructions] Today's call is being recorded. [Operator Instructions] I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin your conference.

Kiley F. Rawlins

Thank you, Jessica, and good morning, everyone. Thank you for joining us today.

Before we begin, you should know that our comments today will include forward-looking statements regarding various operating initiatives, sales and profitability metrics and capital expenditures, as well as our expectations for future financial performance. While these statements address plans or events which we expect will or may occur in the future, a number of factors, as set forth in our SEC filings and press releases, could cause actual results to differ from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, April 10, 2013. We have no obligation to update or revise our forward-looking statements except as required by law, and you should not expect us to do so.

Our call today will begin with some opening comments from Howard Levine, Chairman and CEO. Then Mary Winston, CFO, will review our financial results for the second quarter of fiscal 2013 and our outlook for the rest of the year. Then Mike Bloom, President and COO, will share an operational update. Following our prepared comments, you will have an opportunity to ask questions. [Operator Instructions].

Now I'd like to turn the call over to Howard Levine. Howard?

Howard R. Levine

Thanks, Kiley, and good morning, everyone. This morning, we reported that earnings per share in the second quarter increased 5.2% to $1.21, and that comparable store sales increased 2.9%. Our investments to drive trips and become more relevant to our customers continued to deliver results. More customers are visiting their local Family Dollar for great values on their basic needs, as evidenced by our double-digit market share gains in Consumables over the last 12-, 26- and 52-week periods. Maintaining our strong value image is paramount as our customers balance their finances during these uncertain times, and we know from our customer surveys that our price and value perception remain strong.

Similar to other retailers, a confluence of factors pressuring our customer's discretionary spend led to sales volatility during the quarter. Whether it's the payroll tax increase, tax refund delays, gas prices or difficult weather comparisons, all of these factors make near-term trends difficult to predict. The unforeseen income tax refund delay had a particularly large impact on the business in late January and early February, but we saw sales trends improve as the tax refunds started to make their way into our customer's wallets.

As we move into the second half of fiscal 2013, our discretionary sales continue to be challenged by both the financial pressures facing our customers, as well as unseasonably cold spring weather. As a result, we have adjusted our plans for the rest of fiscal 2013 to reflect the expectation that our customer's discretionary spend will remain constrained near term.

Considering the pressure on the business over the past few months, I'm very proud of how our teams have adapted to the near-term uncertainty, while also staying focused on executing our long-term growth strategy. Our store growth targets are on track this year, and we are pleased with our returns. Our SKU additions in food and HBA are improving our new store sales and return metrics, and then -- and this is opening up even more new store opportunities around the country. Our new store pipeline is robust, and our latest real estate models continue to reflect an opportunity to double the size of the chain.

Our renovation plans are also on track this year. We've renovated, relocated or expanded about 330 stores through the second quarter and expect to complete about 850 by year end. We are refreshing the chain through our comprehensive renovation program. And by the end of the fiscal year, about 60% of our stores will reflect an improved shopping experience for our customers. We are pleased with the returns, and renovated stores continued to comp above the chain average.

Our global sourcing and private brand initiatives are gaining momentum and delivering results. We're improving markups while also enhancing our merchandise quality, and our long-term targets are on plan.

While this year is proving to be more challenging than we originally expected, our strategy of value and convenience position us well. Our customer's discretionary spend is clearly constrained right now. She is making choices, but she continues to rely on Family Dollar to make ends meet. Although we expect challenges in the near term, I remain excited about our growth opportunities. I'm confident that our investments to drive trips and market share gains position us well to meet our long-term financial goals. Now I'd like to turn the call over to Mary Winston. Mary?

Mary A. Winston

Thank you, Howard, and good morning, everyone. This morning, we reported earnings per share within our guidance despite sales that were lower than our expectations. Softer-than-planned discretionary sales resulted in more gross margin pressure during the quarter, but a balance of strong expense control and a favorable tax rate resulted in earnings per share within our expectations.

In the second quarter, total sales increased 17.7% to $2.9 billion, and comp store sales increased 2.9%. During the quarter, we opened 126 new stores and closed 17 stores compared to 83 openings and 32 closings in the second quarter last year. Reflecting both expected and unexpected headwinds, sales trends were volatile in the quarter.

Let me take a moment to provide additional color around our sales dynamics. As we reported on our first quarter call, December comp store sales increased about 2.5%. Moving from our most discretionary month of the year to our most consumables month, January began very strong. But the unanticipated delay in income tax refunds impacted our business, and our strong sales trends weakened. As we progressed through February, our customers began to receive their tax refunds, and sales improved in the final 3 weeks of the quarter. Sales in the quarter were strongest in the Consumables category.

To provide our customers with more value and convenience, last year, we launched a number of growth initiatives to increase our relevance to the customer and to drive greater sales productivity. This drove both increased traffic and a higher average ticket during the quarter. Similar to last quarter, sales were especially strong in tobacco and refrigerated and frozen food. As a reminder, we have established a new relationship with McLane to service our coolers and supply tobacco to our stores. We continue to be very happy with both sales and profitability results, and both are exceeding our expectations. The partnership is driving higher sales. And this, combined with the improved markups in our coolers, is resulting in incremental operating profit.

Strong Consumables sales growth, combined with soft discretionary sales, resulted in about 490 basis points sales mix shift during the quarter. In the second quarter, Consumables increased 26.6% and represented 69.5% of sales compared to 64.6% of sales in the second quarter last year.

While other margin levers, including markdowns, inventory shrinkage, markup and freight, were all in line with our expectations, the substantial mix shift resulted in additional pressure on gross margin during the quarter. For the quarter, gross margin declined 146 basis points as compared with the second quarter of fiscal 2012.

SG&A expense, as a percentage of sales, decreased 20 basis points to 25.9% in the quarter. Most expenses were leveraged during the quarter as a result of the 2.9% growth in comp store sales and the extra week of sales in the quarter. Reflecting our pay-for-performance philosophy, incentive compensation costs decreased as a percentage of sales. This was due to our relative performance against our internal targets in the second quarter this year versus last year. In addition, we experienced less pressure this quarter from insurance expense than we had anticipated, largely due to lower medical expenses and better-than-expected workers compensation and general liability trends. Consistent with the last few quarters, this improvement was offset by higher marketing expense. Marketing expense, as a percentage of sales, increased about 20 basis points.

The income tax rate was better than our expectations at 35.6% in the quarter as compared to 36.5% last year. The lower tax rate was due primarily to the legislative reinstatement of work opportunity tax credits and foreign tax benefits associated with our global sourcing efforts.

Net income for the quarter was $140.1 million compared to $136.4 million in the second quarter of fiscal 2012, and earnings per diluted share was $1.21 compared to $1.15 last year. The extra week provided for $189 million in additional sales and about $0.07 of earnings per diluted share.

Merchandise inventories at the end of the quarter were $1.5 billion compared with $1.2 billion at the end of the second quarter last year. Average inventory per store at the end of the quarter was about 17% higher than last year. The growth in inventory was a result of our Consumables assortment expansion and some early seasonal receipts. We continue to expect that, by the end of the year, inventory growth will be more in line with sales growth.

Capital expenditures in the second quarter increased to $213 million as compared to $105 million in the second quarter last year. The growth in capital expenditures was primarily related to increased investment in new stores, mostly due to an increased number of fee development stores. During the second quarter, we invested $89 million in fee development stores as compared with $20 million last year. In connection with this program, in the quarter, we closed a sale-leaseback transaction for 126 stores, generating net proceeds of about $162 million.

In the second quarter, we repurchased $50 million of our common stock. In addition, we paid about $25 million in dividends to shareholders. As a reminder, back in January, our Board of Directors approved a 23.8% increase in our regular quarterly dividend. This was our 37th consecutive year of dividend increases and reflects our confidence in the company's long-term growth potential.

Now let's turn our expectations to the remainder of fiscal 2013. As Howard indicated, we were driving double-digit sales in Consumables and gaining market share. Our margin drivers are on track, and our teams are doing a good job managing expenses. However, the near-term uncertainty and our recent discretionary sales trends have caused us to take a more cautious view for the remainder of the year. We now expect comp store sales in the second half of fiscal 2013 will increase between 2% and 4%. Reflecting our sales quarter-to-date, we expect that comp store sales in the third quarter will be in the lower end of this range. As a reminder, last year in March, we experienced great spring weather that benefited our Apparel and Seasonal categories. As we anniversary-ed this performance, comp store sales in March this year came in around 2%. In the fourth quarter, we expect that comp sales will be in the upper end of the range as we continue to move through the summer selling season. We expect modestly less gross margin pressure in the third quarter as compared to the second quarter, and we look for further easing of gross margin pressure as we move through the fourth quarter. In the fourth quarter, we will anniversary many of the sales-driving initiatives launched in the fourth quarter of fiscal 2012, and we expect to see more benefit from the maturing of our margin-driving initiatives.

We also expect that our cost control efforts will continue to deliver SG&A leverage in both the third and fourth quarters. For the third quarter, we expect that earnings per diluted share will be between $0.98 and $1.08 compared with $1.06 last year. For the fourth quarter, we expect that operating margin will increase modestly and that earnings per diluted share in the fourth quarter will be between $0.85 and $0.95 per share compared with $0.69 last year. As a reminder, in the fourth quarter of fiscal 2012, we incurred a litigation charge of $11.5 million or $0.06 per share.

Although we are facing a more challenging fiscal 2013 than we originally anticipated, we are adjusting our plans, mitigating risk in more discretionary categories, controlling expenses and working to deliver earnings growth for the year. For the full year, we now expect that net sales will increase between 12% and 13%, and comp store sales will increase between 3% and 4%. We expect earnings per share for fiscal 2013 will be between $3.73 and $3.93.

And now I'd like to turn the call over to Mike Bloom. Mike?

Michael K. R. Bloom

Thank you, Mary, and good morning, everyone. I will begin my discussion this morning with more color on our second quarter results, and then I will provide an update on our business initiatives. This quarter, Consumables sales continued to be very strong, driven by our assortment expansions and our partnership with McLane. Our strategy to drive trips and become more relevant is delivering results, and we once again drove higher traffic and market share gains. Sales were strongest in food; tobacco; and health, beauty and personal care. Food remains strong across the board. Our shelf-stable assortment continues to resonate with our customers, and our refrigerated and frozen food sales once again outperformed our expectations. Food, especially convenience foods, are big trip drivers for our customers, and we've been investing over the last few years to expand our assortment.

Our partnership with McLane is critical to our long-term growth in the refrigerated and frozen food categories, and has enabled us to expand our assortment, improve our consistency and increase profitability. With McLane now servicing our stores every week, our cooler in-stocks are over 97%, running in line with our expectations and a nice improvement over last year. In addition to supporting our cooler program, McLane also supplies our tobacco. About 7,000 stores are currently selling tobacco, and the tobacco basket characteristics have remained consistent.

Health, beauty and personal care sales were also strong in the quarter. This was our best cold season in several years, as our expanded and more relevant over-the-counter assortment enabled us to capture more trips from customers during a bad flu season.

As Mary and Howard mentioned, our Apparel and Home sales remain challenged. Our customer is making choices, and this has caused us to reset our expectations for the rest of the year. As we move into the second half, we remain focused on short-term levers within our control. Reflecting the uncertainty in our discretionary business, we continue to manage our markdown risk. In the back half of the year, we have cut about $100 million in receipts, mostly in Home and Apparel. In addition, our discretionary inventories are clean heading into the spring and summer selling season, as we took the necessary markdowns during the second quarter to spur sales and clear fall and winter merchandise. To better optimize our in-store space for Home and Apparel, we are tweaking our layout for new and renovated stores. We have learned a lot since launching our chain-wide renovation program, and we continue to incorporate these learnings as our store layout continues to evolve.

While discretionary sales have been soft, seasonal remains an opportunity. Our customers still love to celebrate holidays and events with their families. We had a great Valentine's Day this year, and our Easter sell-throughs were good considering the cooler weather and calendar shift. Longer term, I still believe our discretionary categories play an important role in our business, and we have an opportunity to improve the productivity of our assortment. We will continue to listen to the customer and make changes where appropriate to become more relevant. These categories differentiate the shopping experience, drive higher gross margins, and we remain committed to improving their performance.

And as we manage our evolving sales and margin mix, improving inventory productivity and strengthening our margin drivers are keys to improving our long-term profitability. As we've discussed, our growth in inventory over the last year has been primarily the result of our assortment expansions in HBA, tobacco and food. However, we continue to expect that inventory growth will be more in line with sales growth by the end of the fiscal year. Moving forward, we will continue to proactively manage our markdown risk, and we will stay focused on SKU rationalization within Consumables to improve inventory turns.

Our foreign sourcing efforts continue to gain momentum. We continue to convert purchases to country of origin, identify new direct-to-factory suppliers and expand our geographic reach to lower-cost countries. Over the last 2 years, we've opened offices in Hong Kong, Shenzhen and Shanghai, and just recently, we opened a new overseas sourcing location in Bangkok, Thailand. Our initial markups for imported merchandise improved significantly over last year, and I'm very pleased with our progress. We remain on track with our sourcing goals, and we expect the margin benefits to accelerate from a greater flow-through in sales as we move through the rest of 2013 and into 2014.

Private brand consumable sales increased 27.5% in the quarter and grew to nearly 18% of sales. We remain on track this year to add 500 new Family Dollar private brand consumable SKUs to the assortment with about 400 coming in the second half of the year. We expect to finish the year with about 1,500 private brand SKUs in the assortment, up about 30% over last year.

While we are working to improve our markups to drive more profitable sales, we are also focused on SG&A leverage through tight cost control and efficiency improvements. Being a low-cost retailer is part of our DNA, and I am pleased with how well our teams managed expenses in the second quarter. While we work to mitigate the impact of the mix shift, we are challenging ourselves to become more efficient as an organization with the goals of removing non-value-added costs and optimizing the workload for our stores. As we continue to face sales headwinds, we will continue to partner with suppliers and leverage reverse auctions to drive down our cost of goods. We are working to optimize our circulars and in-store signage. We are simplifying tasks at store level, and we are better aligning store labor with sales trends.

While the near-term environment may remain challenging, I believe the future is bright. Our teams are making good progress across multiple fronts to drive the business forward. We are driving trips and gaining market share, course correcting where necessary in our discretionary categories, and our margin drivers are delivering results.

And now I'll turn the call back over to Howard for some closing remarks. Howard?

Howard R. Levine

Thanks, Mike. Before we take your questions, I'd like to make a few final remarks. We've implemented a lot of change over the last few years to position the organization for long-term sustainable growth, and we are seeing tangible results. We are growing our store base, gaining market share, improving the shopping experience and driving higher markets from our margin drivers. The current environment is more challenging than we had expected, and we are adjusting our plans and expectations accordingly. We are controlling what we can control. We're reducing expense -- we are reducing receipts in more discretionary categories to mitigate our risk exposure, and we are adjusting our expenses to reflect a softer sales environment with a focus on becoming a more efficient organization. As a shareholder who takes a long-term view of the business, I continue to believe that our mission to serve our customers, who rely on our great values and convenience, will drive the business to higher levels of profitability.

And now, operator, we would be happy to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from John Heinbockel with Guggenheim.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So 2 things. March comps up 2%. Do you guys not think -- I know you say 2% to 4% is the range, but more like the lower end. Do you not think that sales will get better as the weather gets warmer, and we do more spring business in April and May?

Howard R. Levine

Sure, John. That's a question that we've discussed a lot, frankly. And one of the thoughts that we had was in considering this is just how unpredictable and how uncertain things are. So just as an example, when I take a look back over the last several months, we came through the first quarter with a 6.6% comp, finished with a strong November, had a great Thanksgiving sell-through, great Thanksgiving holiday. December was soft. Whether that was to the fiscal cliff conversations or something else, we're uncertain. We moved into January. We had high single-digit comps the first 3 weeks. Then the tax refund delay issue began to impact us for the next 3 weeks, and February finished on a strong note. Now we're up against probably the best weather that we had in the entire spring and summer selling season from last year, and sales came in a little softer than we had anticipated. I'm in the camp with you. I do believe that as the season warms up and consumers are more in the mood to buy apparel, that there is an opportunity to do that. We just thought it made some sense to be a little more cautious and take some of the risk out. And I think it's important to understand that -- and a great example of this is the March this year to last year. Our core customer buys when they need it. When it's cold and wet, they have no need for spring and summer selling merchandise. Conversely, last year when we had probably the best weather we've had in many, many seasons, we had some great apparel sales. So it's just a lot of uncertainty out there, and you also saw the jobs report last week. That gave another leg of uncertainty out there, what's going to happen with that and all the other governmental discussions that are going on out there, from job growth to subsidies and entitlements, et cetera. So we just thought it made sense to reset, get a little more cautious and really look to try to do better than what we have given in guidance and take a little longer-term view in our approach.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Okay, great. And then for Mike, you talked about repositioning Home and Apparel within the layout. Can you walk -- maybe walk through that a little bit more, where those areas are going in the layout? And then, are you also changing the composition of what you're selling, i.e., price points, fashion content, more basics or no?

Michael K. R. Bloom

Sure. Sure, John. So as far as the layout goes, simply stated, we're moving Apparel back to the front of the store, and it's going to go right in front of Consumables. HBA will remain in the front of the store. Apparel will be in the front of the store, and then food will come right behind Apparel. So it's a little tweaked. So that's basically the layout change. As far as the mix goes, John, we continue to work on the mix. We continue to tweak. We're -- as Howard mentioned, our customer buys on need, and basic apparel is showing some stability. But we've learned a lot over the last year or so. And we'll continue to tweak, whether it's -- you're right, whether it's colors or fashion or whether it's more leggings or more camisoles or whether it's the colors. Yes, we continue to do that. That's what we do. And so yes, we've got a fairly new team down there. We've mentioned that, I think, on the last call, and proud of the work they've done. I can tell you, I think we mentioned this in the last call as well. Howard and I have been intimately involved in this and real proud of sort of where they're going, the decisions they're making, the mix, the supplier relationships. So again, just looking for stability in that business.

Howard R. Levine

And John, if I could just add to that in terms of price points and assortment. One of the things that was a call out, even through the holiday, was the customer was focused on lower price points, and I would say that's the same thing in the Apparel category. So we're really focused on staying at that $10 and below price point in the Apparel categories. The other big factor is she's really focused on great value. You've got to really give her the value to prompt her to make those purchases, more so than I've seen in a long time. So it will continue to be major focuses for us to making sure that we provide that great value, lower price points and really trying to get her back over into that side of the store. As Mike said, a lot of good work has been made. Appreciate that the lead times on some of those categories are pretty long, given that they come in from Asia and all over the world, but we feel good that we're making some progress. In the near term, we're taking a more cautious view. You heard a substantial reduction in receipts, really focusing on improving the productivity. So we're not forecasting big increases for the remainder of the year in those categories. We're looking for better sales through -- better sell-throughs and just focusing on enhancing the productivity there.

Operator

We'll go next to Anthony Chukumba with BB&T Capital Markets.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

I had a question on the guidance. If you look at your performance for the first half of the year and you back out the extra week, your earnings are basically flat year-over-year. And then for this next quarter, you're estimating they're going to be flat to possibly down. But then when you look at your fourth quarter guidance, you're essentially assuming a pretty significant year-over-year increase in earnings. So I was just wondering -- I mean, is there something, with the calendar, some sort of something that you're anniversary-ing or just something else that gives you that confidence that, just from an earnings perspective, your results will be much, much stronger in the fourth quarter than they've been year-to-date?

Mary A. Winston

Thanks for the question. This is Mary. I'll take that. Just to talk a little bit about how we set our guidance and what we're seeing in the back half of the year, all of your observations are correct. Year-to-date, we have been relatively flat from an EPS growth perspective. And I think what you're seeing in our fourth quarter assumptions and our full back half assumptions is the continuation of what we've talked about already. So the things that we expect to see in the back half of the year are continued strong consumables sales growth, although we will be cycling or anniversary-ing some of those launches as we move into the fourth quarter. We expect to continue to see challenges in the discretionary business for all the reasons we've just talked about: the pressure on our customer, the uncertainty in the macroeconomic environment, and we're managing the cost side. So from a margin standpoint, we're managing all of the factors that flow into margin. We're managing our receipts, which will help, of course, with our markdown performance and our inventory performance. Shrink is always a potential headwind, but we're continuing to manage that. And the biggest factor in the fourth quarter is the acceleration in the contribution we're expecting from our margin-enhancing initiatives. So as we've talked about on previous calls, we're working on our global sourcing efforts, our private brand initiative. And all of those efforts, we expect to see ramping up as we go through the back half of the year, so they are having impact now. They're going to have more impact in the third quarter than in the second quarter, and yet more impact in the fourth quarter. So we're reflecting all of that in the guidance that we've given. And the final thing I'll comment on is our expense control. We've taken a hard look at our expenses. We're managing expenses tightly, and probably more impact of that is in the fourth quarter than in the other quarters. So all of that plays into what we expect in the back half.

Operator

We'll go next to Bernard Sosnick with Gilford Securities.

Bernard Sosnick - Gilford Securities Inc., Research Division

As you look out toward the anniversary of the initiatives over the last year, what do you have in mind in terms of future stimulants to sales, now that Consumables are up close to 70% of total sales? And could you give us a little bit of insight as to what the Consumables sales were, excluding the new initiatives over the last quarter or 2?

Howard R. Levine

Bernie, this is Howard. We're not going to -- I'll go right to question 2. Unfortunately, we're not going to be able to address that one. But your first question, I'd like to talk about just for a second. Just to reiterate what our long-term goals are in terms of our comp performance, as we've talked about these mid-single-digit comps. And we believe that we still have several legs of growth on many of the changes that we've put into our business. When you think about the McLane assortment, for example, that decision to go to McLane was not driven by lack of sales in some of those categories. We were having great comps in those categories, and we continue to have great comps on top of those strong comps as a result of the improved assortment, of improved in-stock and the weekly deliveries that we are getting from that business. I'd say the same thing with the remainder of food. We continue to tweak and improve that assortment and would expect those categories to continue to mature. And then finally, on the HBA side of things, that is a longer-term maturation, as we've talked about before, and continue to believe that we have opportunities to drive comps there. And while it may not be in vogue to talk about it, I still think there's other categories within our assortment that we're looking at that aren't so robust right now. For example, Seasonal, we've talked about as being an important part of our customer's spend. There's been a lot of good work on that as you could appreciate. We've done a significant deep dive into our past holiday sales and are working on trying to improve some of those sell-throughs and think there's a lot of opportunity there. And the other holidays are extremely important to us as well. So we think we've got some great plans out there to drive our business, still staying focused on expenses and really trying to stabilize that gross margin, which I think is a great opportunity for us to strive for.

Michael K. R. Bloom

And I would just add one thing, it's Mike. If you think about the last 1.5 years, we've executed a lot in our stores. And we expect that as we -- as things have settled down at store level, we will start seeing better execution, just in general, from the lack of the initiatives that we've executed over last 1.5 years. So that should also help.

Operator

We'll go next to Paul Trussell with Deutsche Bank.

Paul Trussell - Deutsche Bank AG, Research Division

Just want to dig a little bit more into gross margins. As already mentioned, in order to achieve your guidance, you will need to have some sequential improvement on the merchandise margin front. If you can just kind of first break down for us in a little bit more detail what the impact were -- was from the particular factors that drove margins down 146 basis points in 2Q between markdowns, the weak discretionary sales, tobacco, shrink, the McLane transition, and just how should we think about those specific categories going forward? What's the opportunity from private label and sourcing? And while I know it's early, as you begin to cycle some of these items that you rolled out the beginning of the fiscal year, how should we be thinking about gross margins a little bit longer term into '14?

Mary A. Winston

This is Mary again. That's obviously a great question. Unfortunately, many of those details we don't get into, so in terms of the specific quantification of some of the components of margin that you mentioned. So it's hard for me to say a lot more detail than what I've said. We really are, though, looking at every aspect of the factors that influence margin. And just to touch on them again, we're doing a lot to manage our markdowns. We're managing our shrink effectively. We are expecting some benefit from freight. I don't think I mentioned that earlier, as we've opened our new DC and will be opening the Utah DC later this year. And so fuel prices are always a wild card, but we do expect some benefits from that on the margin line. And then again, we are very pleased with all of our margin-enhancing initiatives. So all of those initiatives are on track and delivering what we expected. And so they're just going to continue to ramp and continue to have a greater impact on gross margin as we go through the third quarter, the fourth quarter and into fiscal '14.

Paul Trussell - Deutsche Bank AG, Research Division

Okay. And then just on touching back on inventory, and Mike gave good detail on this. But if you can just go back again and just say what the mix is within your inventory today of Consumables versus the kind of discretionary categories? What is the potential risk that's kind of outstanding in your view, from a markdown perspective? And again, what should -- how should we think about the inventory assortment as we go through the balance of the year?

Howard R. Levine

Thanks, Paul. This is Howard. Again, the inventory, basically, as we've discussed for the past several quarters, almost all of the inventory increases are in our Consumable categories, to include tobacco. The teams have done a very good job of managing the risk in terms of our markdown risk exposure inventory. That's something that we've taken a very keen look at in the first half of the year, but even a tougher look or a more focused look in the back half of the year with the challenges that we're seeing, a substantial reduction in receipts in those areas and again, really trying to get those down on a year-over-year basis as we work through the rest of the year. So we took our medicine. We took our markdowns in the second quarter. We feel very good about the quality of our inventory as we move through the spring and summer selling season. Hope that helps.

Operator

We'll go next to Mark Wiltamuth with Morgan Stanley.

Mark Wiltamuth - Morgan Stanley, Research Division

You've got a lot of sales initiatives going on here. Could you give us some perspective on which ones may be working better? Is it the remodels, expanding the food mix, cigarettes, private brands, which of them do you think are working both from a sales and a margin perspective?

Howard R. Levine

Sure, Mark. It's hard when you report flat earnings to see what is actually working and what some of the work is that some of our teams are doing. But I want to point out and be very clear about it, the additions to our food and HBA assortments have been very successful for us. Our customer's response has been strong. I think it's an appropriate addition to our assortment and really positions us better competitively over the long term. It's something that our customers had asked for. We went in with a big bang approach. We added a lot of SKUs in a short period of time, and it pressured our inventory and pressured our business a little bit. But when I think back from the work that our teams have done and the way we're positioned now, I'm very pleased. I think we're a better company, more -- better -- in a better position to compete and feel very good about what we've done there. The timing of all these initiatives, unfortunately, isn't perfect. I'd say the same thing about the success in global sourcing. A lot of good investments have been made there, a lot of traction there. But anytime that you're going through some of those changes, there are some stresses that are put on the system, but we're getting those behind us and we're really starting to see some traction in some of those areas. If you've been in our stores and seen some of our private brand improvements and the quality of the product, it's been excellent. Our customer response has been very strong on some of our private brand additions, and we continue to add that. We've got 400 more SKUs that we're going to put in by the -- by the conclusion of this fiscal year. So the challenge that we're facing is a discretionary issue. And I will never tell you that there's not improvement or responsibility that we have from an execution standpoint in those categories, but they've been tough. And I will tell you it's amazing what a little warm weather will do. Now while it's very early in the year and in the month, we've had some decent days here as the weather has gotten back to more seasonable down here. Same assortment that we had a week ago, and you're seeing some -- we're seeing some good sales as a result of that. So when you're dealing with a customer that's stressed already and facing other challenges, she buys when she needs. And I think that we'll start to see some traction there, as I've talked about earlier, hopefully, as the weather warms up and be more seasonal through the year. But the initiatives that we've talked about are really gaining traction, I think really position us well. And we're very excited about that. The hard thing -- as I've said before, it's just hard to see given some of the headwinds that we're facing with discretionary, but feel very good about where we are from a business perspective. We're working very hard to stabilize those discretionary categories. And by the way, we're not looking for comps out of those areas. We are not planning big comps out of those areas. It's not as though we're looking for significant growth. It's more of a productivity gain for us than a comp store sales story on some of those discretionary categories. But we'll hang in there. Very excited about what is ahead of us and just felt that it was prudent to be a little more cautious, readjust some of our plans. When you're running a business and there's uncertainty out there, take some expense out, take some inventory risk out. And that's really what we've done and what we've talked about today.

Mark Wiltamuth - Morgan Stanley, Research Division

You mentioned on the gross margin declines that the mix shift was a big factor there. But you also talked about taking your medicine and taking markdowns. So how big was the markdown in the gross margin decline?

Mary A. Winston

Let me -- well, we won't quantify that specifically, but markdowns were up over what they were last year. But as a percentage of sales, we saw some benefit to margin from markdowns.

Howard R. Levine

That was due to the extra week, Mark.

Mary A. Winston

Yes.

Howard R. Levine

We took more markdowns on a comparable basis is what we're saying.

Wayne L. Hood - BMO Capital Markets U.S.

Okay. And timing-wise, when do you think the inventory growth starts to normalize, because you've kind of had an inventory growth outpacing sales growth for 8 quarters now?

Howard R. Levine

Yes, and it's a good question and it's something that nags at me as well, particularly in an uncertain environment. So we've taken a lot of receipts out of discretionary. We've done a lot of work to rationalize some of our Consumables inventories. That process will continue as time goes through. But we -- our goals and objectives, as we talked about, is trying to get inventory back in line with sales growth by fiscal year end.

Operator

We'll go next to Ed Kelly with Crédit Suisse.

Edward J. Kelly - Crédit Suisse AG, Research Division

I wanted to just get back to this discretionary business. And I -- there, obviously, if you think about the discretionary comp sale this quarter and if you do the math on it, it's down a lot. So some of this is macro and fiscal-related. Some of this is probably reallocation of square footage to Consumables. But when you think about your competitors, some of it seems like it might be company-specific as well. So I was hoping you could dissect this and help us understand how much might be self-inflicted, and maybe it's just because of where you're positioning end caps and what you're putting on them from a consumable standpoint and what you're doing with circular, what you're doing to specifically improve that in the near term? And I'm asking because I'm trying to figure out how we cycle this next year and how much we need the macro to get better versus the things that you can tweak internally.

Howard R. Levine

Yes, Ed, it's a very good question and it's something that we spend a lot of time working on. And before I answer, there will not be a day when I don't think that we couldn't do better in anything that we do in terms of how we merchandise our stores. But I think there's some important factors out there that we need to consider, of which a couple you mentioned. We have taken space away from Apparel now for several years, more specifically at a greater rate in the last couple of years to make room for the SKU additions in HBA and food. I think to really appreciate that, we've added a substantial number of SKUs in those categories over the last 2 years, which needed a place to go. And in order to find a place for those to go, we had to reduce some space in some of those categories. We knew that was going to happen and we knew the pressures that, that were going to put on the business, and particularly the mix. But we felt, given where the customer was telling us to go, that it was important to do that, and we went fast and we went hard. So during all those transitions, I think we did some things from an execution standpoint that we won't have to deal with this year. We've gotten all those SKU sets done. We're letting those grow, we're letting those bake, and there's a renewed effort and focus on some of the discretionary categories to drive those. I'll also point out that others may categorize different things within their discretionary categories than what we do, and the timing differences are, from a reporting standpoint, are also different. Just as an example, some may have diapers in infants and toddler categories, some may have diapers in the paper area or the HBA area. So it's important to be sensitive to that. But again, the thing that we're focused on is being in control of what we can control. We think we can do a better job. We're going to try to mitigate anything that was company-specific. But the best example I can give you is the March periods year-over-year. March last year, we had unseasonably warm weather. We had our best month of March in Apparel last year. This year, it was the polar opposite. And I think it's just important to understand that, when your low-income customer is in stress, they're going to buy in need, and I think that's been a big factor that we've been facing with today. I hope that helps.

Edward J. Kelly - Crédit Suisse AG, Research Division

Okay. And just one follow-up for you on competition. Can you just give us a little color on what you're seeing on that front both from Dollar Stores, Walmart, supermarket structures, et cetera? And then specifically, DG has launched tobacco. Has this had any impact on your tobacco business and the traffic that it's driving?

Howard R. Levine

On the tobacco question, not at this point. Our tobacco business continues to grow. We're in 7,000 stores today and have not seen any impact from that at this point. In terms of the competitive front, it's very competitive out there. Some of the bigger box retailers are certainly increasing their exposure. It appears to continue to be rational from that standpoint. And here at Family Dollar, we'll continue to review our plans to optimize our promotional strategies to continue to be competitive in that area and to drive traffic into our stores. So nothing unusual from that standpoint.

Operator

We'll go next to Scot Ciccarelli with RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Howard, you've made a number of references to kind of weather, cold weather versus what we had last year. Have you seen a lot of significant performance differences from different geographies that kind of back that up? And then related to that, I guess Mary referenced why you guys are expecting earnings to improve, particularly in the fourth quarter, but it wasn't clear to me why sales should be expected to accelerate in the fourth quarter.

Howard R. Levine

Sure. To answer the first part of your question, yes, we definitely look at things regionally and see different sales trends in terms of how they're impacted from weather. And I'll be candid with you. I'm not a weather guy. I really don't like talking about weather. But in all my years, I have not seen such polar opposites between 2 comparative months, March to March year-over-year. But I appreciate your comment. In regards to the sales trends over the back half of the year, we continue to believe that the investments that we've made in our assortment will continue to mature. The food business continues to grow, along with the McLane assortment. Our HBA assortment continues to grow and mature. And by the way, we're addressing issues that weren't working as well in some of those categories to incorporate those in our plans as we go forward. So it's kind of like Mike says, that's what we do. That's what we're here for. And I think that we've got a good plan and a good assortment as we move through the year.

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Okay. But just to be clear, you have seen significant regional differences where we -- maybe the weather comparisons are a little bit more abnormal?

Mary A. Winston

We have seen stronger comps in the, say, Southwest and West than we have in the Northeast and Midwest, that's -- that is true.

Operator

We'll go next to Deborah Weinswig with Citi.

Nathan Rich

This is Nathan Rich standing in for Deb. One question on the expense side. Marketing expenses you leveraged in the quarter, and you mentioned some opportunities to either reduce marketing costs and optimize the circular. Could you just maybe go into that in more detail in terms of what you're planning to do on the marketing side?

Michael K. R. Bloom

Yes, I'll talk to that as far as the circulars go and the marketing spend. I mean, look, we continue to learn, we continue to look for promotional efficiencies. We advertised -- we participated in several Sunday circulars last year, and we think that's important from a competitive perspective, from an awareness perspective for the consumer. Our consumer continues to go to the Sunday paper for value and certainly the coupons. And so look, it's just about continuing to learn and continuing to understand what's working, what's not working, so that we can have a more efficient spend. And again, it falls into that category of it's what we do, and we continue to look for ways to take costs out of the business. We talked about signing, reducing unnecessary signing, non-value-added signing in our stores. And so we'll continue to get better. I think our advertising year-over-year will probably be similar, but we'll be more efficient at it.

Nathan Rich

And if I could just throw in one more. Could you talk about the pipeline of new stores that you have in the works? I noticed CapEx ticked up a little bit. So could you maybe also talk about that and just how you feel about -- how you feel longer term about square footage growth?

Howard R. Levine

Sure, Nathan. We feel very good about our long-term growth plans. Our pipeline is as full as it's ever been. Our fee development program is working very nicely for us. And what you saw in terms of CapEx adjustment that we made was just some timing of some land payments through the -- by the end of the fiscal year, to position us for openings for next fiscal year. Nothing major there. It's just a slight timing difference. But what I also mentioned in my comments was, due to the fact that we've expanded our food and McLane assortments along with the HBA, it's really opened up even more opportunities for us in some markets that may have been difficult for us to enter in before, as we play a slightly different role in some of those markets as a food retailer or fill-in food retailer, along with much more competitive pricing on HBA side as compared to some of the drugstore competitors out there. But we feel very good about where we stand in terms of the pipeline and some of the new store opportunities out there.

Operator

We'll take our last question from Meredith Alder -- Adler, excuse me, with Barclays.

Meredith Adler - Barclays Capital, Research Division

I am going to beat a dead horse and go back and talk a little bit about how you are positioned with Apparel and Seasonal merchandise in the third and fourth quarters. I think, Mike, you talked about reducing risk, but it wasn't exactly clear to me if you meant reducing risk in terms of your guidance. I know you have cut orders, but do you actually -- are you positioned to take advantage of sales if they come back? Or have you just derisked the Apparel and Seasonal inventories so much that it can't go down, but it can't go up either?

Howard R. Levine

When we were talking about risk, we were talking about it from both perspectives, risk out of the discretionary inventories with reduced receipts, as well as taking some risk out from a markdown exposure and the way that would impact our view for the remainder of the year. In terms of -- and you're not beating a dead horse. It's a good question. But in terms of us not having enough inventory as we work through the back of the year, one thing I joke about with our guys is, as long as I've been around, I've never had that issue and look forward to maybe dealing with that, making an emergency trip up to New York to chase down some goods. But that would be a good day here to be able to go up and look for that. I think we've got enough goods for our season, and I think we can adapt and move quickly if we need to go fill in some spots. But right now, we feel very good about the way we've positioned ourselves, given the uncertainties and the current trends of taking risk out from a receipt standpoint, which helps mitigate markdown risk, which helps position us better from an EPS standpoint as we work through the remainder of our year.

Meredith Adler - Barclays Capital, Research Division

And then just kind of a related question, I think you said you have a new team that's buying, I guess, Apparel. The Apparel that's in the stores now or was there in the winter season, was that influenced by this team? Or will we see more of their decision-making in the fall, winter of 2013, '14?

Howard R. Levine

It's the latter. It's more for fall and winter of this year. They were not involved in the purchases from this past season.

Meredith Adler - Barclays Capital, Research Division

And do you expect that to make a difference?

Howard R. Levine

I absolutely do, yes.

Meredith Adler - Barclays Capital, Research Division

Okay. I just actually have one final question. It's all related to the same thing though, because you were talking about kind of doing a deep dive on, say, holiday sales and what worked and what didn't work. Is there anything about your process, your decision-making process, that you think needs to be adjusted? I mean, I think you had a great -- not this last Christmas, the Christmas before, you did really well in toys. And I don't think that -- I think you said that this Christmas wasn't so good. Could you have anticipated that, or was it just the consumer's behavior is just almost impossible to predict?

Howard R. Levine

Yes -- no again, Meredith, I would tell you we always owned the decision and feel like some of the decisions we made impacted the results, and we're addressing some of those. But I would also say the majority of the issues that we faced were an uphill battle with what our consumer was facing. And she bought toys, but instead of buying 4 or 5 items, she might have only bought 2 or 3 items. Instead of spending $25, she might have only spent $15. So we have incorporated some of those learnings into some of the decisions for this season, for this next season, and think that we'll be excited and hopefully get back to December sales that we were accustomed to the prior few seasons. But -- so there's things that we can control. There were some things that impacted us from a consumer standpoint. And again, we're controlling what we can control there and getting a more focused assortment, I think a stronger assortment, and feel like we'll be well positioned. We continue to develop and work on some of those things, but there's been a great collaborative effort across merchandise categories, across the business, to understand what worked and didn't work and really implement some of those decisions in some of our buy plans as we move forward.

Michael K. R. Bloom

Yes, Meredith, it's Mike. I feel very good about our process, our planning process, our assortment process, our decision-making process, our partnerships with our supplier partners, our partnerships with our factories overseas. I feel very good about the process. The data that we have to help us make decisions continues to get better and better. So I feel really good about the process in itself.

Kiley F. Rawlins

So we unfortunately did not get to all of the question today. As always, Kevin and I will be available after this call for any follow-up questions you have. Thank you for your continued interest in Family Dollar, and have a great day.

Operator

This does conclude today's conference. Thank you for your participation.

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