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Family Dollar Stores (NYSE:FDO)

Q3 2013 Earnings Call

July 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

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

Deborah L. Weinswig - Citigroup Inc, Research Division

Mark K. Montagna - Avondale Partners, LLC, Research Division

Scott Andrew Mushkin - Wolfe Research, LLC

Edward J. Kelly - Crédit Suisse AG, Research Division

Paul Trussell - Deutsche Bank AG, Research Division

Laura A. Champine - Canaccord Genuity, Research Division

Patrick McKeever - MKM Partners LLC, Research Division

Meredith Adler - Barclays Capital, Research Division

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

Steven Forbes - Guggenheim Securities, LLC, 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] 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. Good morning, everyone, and 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 expenditure, 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 expectation. 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, July 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 third quarter of fiscal '13 and our outlook for the fourth quarter. And 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 diluted share were $1.05 and that comps increased nearly 3%. Our assortment additions over the last 2 years have continued to make us more relevant, and we continue to gain market share. Market share is a key metric that we monitor as it tells us whether or not we are gaining share of wallet. It's tough out there right now for our customers, and their spending remains constrained. From our most recent Nielsen Homescan panel data, we know that our customers' spend in the total market has declined over the past year. However, at Family Dollar, we continue to gain share of her wallet. This positive trend tells us that our value proposition continues to resonate with our customers.

While our consumables sales remained strong, our discretionary category remained under pressure. In this difficult environment, we are positioning the company appropriately for both the short and long term. We are focused on controlling expenses, improving inventory productivity, stabilizing gross margin and driving operational efficiencies. As we manage these headwinds, we will continue to refine our assortment based on customer response to sustain our market share momentum, and we remain committed to investing in our future through our new store opening strategy and through our chain-wide renovation program.

We are on target to open about 500 new stores this year, and our new store pipeline remains as strong as ever. Our real estate models continue to reflect an opportunity to double the size of the chain. In addition, our renovation program remains on track. This important initiative is refreshing our brand and improving the customer experience. And as a result, our renovated stores continued to outperform the rest of the chain. By the end of the fiscal year, about 60% of our chain will reflect a much improved shopping experience, and our goal is to renovate the entire chain by 2016.

Finally, I'd like to talk about our management team. As CEO, one of my biggest responsibilities is to make sure that we have a leadership team in place that can successfully adapt to a changing customer and dynamic retail environment while also consistently delivering strong financial returns. As our business continues to evolve, we have proactively made changes to our management team to position the company for the long term. We have continued to enhance our leadership team, adding expertise in key growth areas and promoting strong internal talent to strengthen our capabilities. We have also reorganized our teams to drive better execution and increase cross-functional collaboration.

While we expect that our customer will continue to face near-term economic challenges, I feel really good about the team we have in place today and our strategic direction. I am confident that we're well positioned to drive further market share gains and deliver strong financial returns.

And 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 sales and earnings per share at the upper end of our guidance. Many of the trends we saw in the first half of the year continued this quarter. Consumables sales remained strong and discretionary sales remained soft, resulting in continued gross margin pressure. Despite top line headwinds, we had nice SG&A leverage in the quarter as our teams did a good job managing expenses and driving efficiencies.

In the third quarter, total sales increased 9% to $2.6 billion, and comp store sales increased 2.9%. During the quarter, we opened 129 new stores and closed 3 stores compared to 103 openings and 7 closings in the third quarter last year. Sales in the quarter were strongest in the consumables category. Higher average ticket and increased traffic drove the comp during the quarter.

For the quarter, gross margin declined 114 basis points as compared with the third quarter of fiscal 2012. Strong consumables sales growth, combined with soft discretionary sales, resulted in about 360 basis points of mix shift during the quarter. In the third quarter, consumables sales increased about 15% and represented 72.5% of sales compared to 68.9% of sales in the third quarter last year. The sales mix shift to lower margin consumables was the largest driver of the gross margin pressure this quarter.

In addition, both shrink and markdowns increased as a percentage of sales. Markdowns in the quarter were mostly in our consumables category, and this was driven by 2 main factors. To help introduce our new assortment, we continued to promote our merchandise introductions to drive customer awareness. Also in the third quarter, we had markdowns related to our annual food schematic reset. This schematic reset occurred in the second quarter of last year, so this is just a shift in the timing of markdowns year-over-year.

These factors were partially offset by improved merchandise markups and lower freight costs. Our foreign sourcing and private brand programs continued to improve our merchandise margins. The decrease in freight expense was mainly due to our supply chain relationship with McLane, which resulted in less merchandise being handled through our own distribution network.

SG&A expense as a percentage of sales decreased 27 basis points to 27.4% in the quarter. Both advertising and distribution center expenses decreased as a percentage of sales. Using improved capabilities, we are optimizing our marketing events to drive greater returns.

Distribution center expenses were leveraged mainly as a result of improved productivity through operational efficiencies, lower case volume as we anniversary our inventory build from last year and the shift in volume from our distribution network to McLane. Expenses increased faster than the rate of sales in the quarter through store labor and store occupancy cost. Our organization did a great job leveraging expenses nearly 30 basis points on our 2.9% comp sales increase, when our breakeven comp has historically been between 3% and 4%.

Net income for the quarter was $120.9 million compared to $124.5 million in the third quarter of fiscal 2012, and earnings per diluted share were $1.05 compared to $1.06 last year. Merchandise inventories in the quarter were $1.5 billion compared with $1.4 billion last year.

In the third quarter, we began to anniversary many of our consumable assortment additions, and as a result, average inventory per store was down about 1% versus last year. Our discretionary inventories continue to be well controlled.

Consistent with our philosophy on capital allocation, our first priority when investing capital is to invest in the business. Capital expenditures in the third quarter were $190 million as compared to $155 million in the third quarter last year. The growth in capital expenditures was primarily related to increased investments in new stores, mostly due to investments in fee development stores.

As a reminder, in our Fee Development Program, Family Dollar funds the purchase of the land and construction cost of new stores. This is a more cost-effective alternative to our historical build-to-suit program and enables us to leverage our investment-grade credit ratings to lower our overall cost of occupancy over the life of the store. To secure attractive cap rates for these properties, the timing of deals is important. To take advantage of the current real estate environment and secure historically low cap rates, we've expedited the closing of select deals. As a result, we now expect the capital expenditures in fiscal 2013 will be between $750 million and $800 million.

In conjunction with this program in the fourth quarter, we intend to close our fourth sale-leaseback transaction. We expect the net proceeds to be between $170 million and $180 million. For the full fiscal year, we expect the total net proceeds from our sale-leaseback transactions to be between $330 million and $340 million.

Now let's turn to our sales and earnings expectations for the fourth quarter and full year. We continue to expect sales growth to be driven by consumables and for discretionary sales to remain pressured. Reflecting our June results, we now expect comp store sales in the fourth quarter will be around 2%. We also expect the gross margin pressure and SG&A leverage in the fourth quarter will be minimal.

As a reminder, this 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. Based on these factors, we now expect that earnings per diluted share in the fourth quarter will be between $0.82 and $0.87, 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. For the full year, we now expect that earnings per diluted share will be between $3.77 and $3.82.

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

Michael K. R. Bloom

Thank you, Mary, and good morning, everyone. About a year ago, we began a major push to become more relevant for both our current customers and for future Family Dollar shoppers. We added about 1,000 consumables SKUs to the assortment, mostly in food, health, beauty, personal care and tobacco. We are a year or so into this investment, and we are pleased with the results. Consistent with our recent quarters, food and health and beauty aids sales were very strong. We are driving trips, and we continue to gain market share.

Today our customers are focused on their basic needs. They love our new assortment and are voting with their wallets as we provide them with fantastic values and a much broader selection to meet their needs. Consumable comps increased nearly double digits, with the best growth coming in refrigerated and frozen food, tobacco and health care. Our McLane relationship continues to be a differentiator. We are in stock, and we now have a consistent assortment across the entire chain.

Once again, our customers love our assortment and our great values, and they are coming to Family Dollar to save money on great quality national brands and private brands. This relationship has been a home run, and we are delivering incremental operating profit due to better markups and higher sales.

We are pleased with the early returns from our investments to broaden our food, health, beauty and tobacco assortment. As we anniversary these additions, our momentum will naturally slow. But I will tell you that I believe we are still in the early stages, and we have the opportunity to drive further customer awareness and sales.

As expected, our apparel, home and seasonal sales were challenged in the quarter. While no retailer likes to talk about it, it's hard to talk about our third quarter performance without mentioning weather. As everyone knows, last year we had great weather early in the quarter, in fact, some of the warmest on record. It was our best apparel and seasonal sales performance of the year. This year, conversely, we cycled that great weather with much cooler temperatures and rain. Our seasonally sensitive areas were hit particularly hard earlier in the quarter. It was good to see trends in these categories improve as we moved into April and May.

Although weather played a big factor this quarter, the economic backdrop remains very challenging for our customer. She's stretching her budget and forced to make choices. She's coming to us for her basic needs, and we're gaining share in those businesses.

We continue to plan our discretionary categories conservatively. We are managing our receipts and optimizing space. We have identified assortment and execution opportunities, and we have made the appropriate changes to fix them. While it's early, we are executing and making progress. Our core discretionary businesses are showing some improvement. And as we progressed through the quarter, our sales trends in ladies, bedding, footwear, housewares and electronics all improved. Our teams are doing a good job managing in a tough sales environment.

As I discussed in our last call, while we are managing through this difficult sales period, our organization remains laser-focused on key levers within our control to expand profit margins and drive SG&A leverage. We are focused on improving profitability through inventory productivity, improving merchandise markups, increasing operational and supply chain efficiencies and reducing costs.

Our growth in inventory over the last year has been primarily the result of our assortment expansions in health and beauty aids, tobacco and food. This quarter, we cycled the inventory build and inventory per store was down year-over-year. Our inventories are well controlled, and we are now focused on SKU rationalization within consumables to improve inventory productivity.

When we talk about improving merchandising markups, what we are laser-focused on as an organization is lowering our cost of goods across all lines of business. This is accomplished through both cross-functional execution and developing strong supplier relationships.

Let me give you just one area where we've been making progress: batteries. Since I joined Family Dollar 21 months ago, it's been my goal to get in front of all of our major suppliers to continue to help educate them on our size and scale and to communicate the future growth opportunity at Family Dollar. We are partnering to lay the foundation for profitable growth for the next decade. We've been making good progress. And for example, last quarter, we signed an agreement with Procter & Gamble to make Duracell batteries our only national brand in all of our stores.

Exclusive agreements in segments where there is low customer loyalty, like batteries, are good for our customers, our stores and our profitability. Collaboration between our global sourcing and private brand teams epitomizes the importance of cross-functional collaboration, and we are making good progress. Last quarter, we shifted our entire Family Dollar private brand battery program direct to factory. Now while markups vary by category, this move in private brand batteries increased our merchandise markups by about 1,000 basis points.

Our recent accomplishments in our battery program are what we are aiming to mirror across the entire merchandising organization. And while we are working to improve our markups to drive more profitable sales, we are also focused on operational efficiency. Addressing shrink is a good example of where we are looking to drive efficiency. We believe that there is a relationship between shrink, inventory levels and store manager turnover, and we are pleased to report that inventory growth and store manager turnover trends are stabilizing. But we are also making further investments to drive shrink improvement. We're evaluating our security tagging program. We are utilizing a new security DVR camera system that is more user-friendly than our previous platform, and we are adding additional cameras to the sales floor in new stores.

In addition to operational efficiencies, we are also focused on simplifying store tasks. We are looking at everything from the number of schematic resets to the number of in-store signage changes to how we unload our trucks. This is a people business, and I hold myself personally accountable for making things easier for our team members to run our stores and to take care of our customers.

While the current sales environment remains challenging, I believe that our future is bright and that we are making the right tactical and strategic decisions to move the business forward. We are focused on promotional efficiencies to drive higher awareness of consumable additions, and we are executing our plan to turn around discretionary. We are continuing to invest in our future through new store openings and our store renovation program. We have introduced a new store format to better position our discretionary categories, and we are also looking at reinvigorating our checkout area. We are building supplier relationships, and we are focusing on lowering our cost of goods.

Our united goal as an organization is to deliver the best possible values to our customers, and we remain committed to this mission. I believe this consistent focus will lead to higher sales and higher profitability, and we have a long runway ahead of us.

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. This year is proving to be more challenging than we had originally planned. While we continued to invest for the long term, we have adapted to the slower sales environment. Our team has repositioned the company by focusing on what we can control. We have taken a more aggressive stance on managing expenses. We are controlling and improving inventory productivity. We are stabilizing gross margin, and we are driving operational efficiencies. As a result, I believe today we are now better positioned to compete and drive profitability as we finish the year and prepare for fiscal 2014.

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

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to David Mann with Johnson Rice.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

In terms of the guidance for the fourth quarter on the sales line, can you talk about is that a -- it seems like it's slower than what you had talked about on the last call. Is that mainly on the consumables side, discretionary side? And why do you think sales have slowed in June versus where they were in April and May?

Howard R. Levine

Yes. Good morning, David. This is Howard. As I said in my opening comments that when we looked at the Nielsen data, one thing that's pretty clear is that our customer is spending less in the overall marketplace. Fortunately, she's spending more with us, not as much as we'd like, but we are improving market share and growing that. The biggest factor for the additional weakness, in my opinion, is the consumer is just more challenged than we had anticipated. She is making choices. Things are very tough right now. While we're not going to go into a lot of detail about June specifically, what I can tell you is that comps in consumables were up about mid-single digits. As we talked about in the call in the prepared remarks, what we also saw was the beginning of what I will say some stabilization in our discretionary businesses. While comps are still not positive, if you all recall, one of the things that was our major focus over the remainder of this year was to drive gross margin accretion. While it's a little early to call out a trend in that, I think the month of June did begin to see some strong stabilization there. We're looking to continue that. And that's just a result of some of the work that the team's done on managing expenses, controlling inventory and improving the assortment where we have. So we're starting to see some signs there. And that's a very nice trend for us despite some of the challenges that the consumer is facing today. And finally, what I'll tell you is, and as a shareholder myself, one of the things that I was most focused on getting us in a position to be able to operate profitably in a slower sales environment. And I think you're seeing some signs of that in what we accomplished in the third quarter and how we've talked about guidance for the fourth quarter. Expenses are under tight control. Inventory is improving. Gross margin is stabilizing. And we're forecasting to grow our earnings in the fourth quarter and finish off the year and really continue some of that work into fiscal '14.

Operator

We'll go next to Deborah Weinswig with Citigroup.

Deborah L. Weinswig - Citigroup Inc, Research Division

Can you update us on your inventory initiatives? I was very impressed with your increase in inventory productivity.

Howard R. Levine

Sure. One of the things that we've talked about -- I know it seems like longer than it should have been. But when you take a step back and look at what we've done over the last couple of years in terms of investment in inventory, it was pretty substantial. As we looked back, it was over 1,000 SKUs that we've added. And we knew that once we added those SKUs that we would have some higher inventory levels than we typically would prefer and typically what we've shown historically. We also indicated that as these businesses matured that we would start to see some inventory productivity improvements. And really, what you're seeing is a result of some of those efforts. The team has worked really hard on improving the assortment, culling out some of the SKUs that have not performed well, adding other SKUs that will replace those to continue to be more relevant to our customer. But at the end of the day, what we're most pleased with is we are more relevant to our customers. We have a better and improved assortment and look to continue to grow and manage that.

Deborah L. Weinswig - Citigroup Inc, Research Division

Okay. And then in terms of a follow-up. You talked about improving the assortment in discretionary and then [ph] gross margin impact there. I don't know if you could dive into a little bit more the details there. I know you have made some changes in your team as well.

Howard R. Levine

Sure. Yes, Deborah. We announced this morning the departure of Paul White, who was our Chief Merchant. At the same time, we announced the hiring of Jason Reiser from Sam's Club as a Senior Vice President over the consumables area. We're very pleased with the arrival of Jason and certainly wish Paul all the best in his future endeavors. But the team continues to come together understanding what specifically is requested by our customer. I like the collaboration. I like the way we're working together and look to see that continue as we move into '14.

Michael K. R. Bloom

And Deborah, it's Mike. Specifically on discretionary, we've got a new team there as well. We've -- I'm very pleased with how that team is coming together and how they have dug deep into the business and identified the opportunities. And some of our stabilization are in areas like bedding, which we've been talking about. If you remember, I talked about we discontinued comforters, and we've recently bought them back into all stores. And comforters are, if you remember, that's the start of the purchase for the home and the bedroom. So whether it's bedding or housewares, we're seeing some really good stabilization in those businesses. The team has done a great job fixing the assortment. We're working on allocation, distribution, the mix. So really pleased with where we're going and what the team has done there.

Operator

We'll go next to Mark Montagna with Avondale Partners.

Mark K. Montagna - Avondale Partners, LLC, Research Division

My questions really deal on the rollout of the new SKUs. And I'm wondering essentially, are you done with the SKU rollout except for tweaking going forward? And then did the non-HBA get more SKUs than the HBA? And I'm really curious about the lag in the inventory turn of those new items versus the rest of the SKUs that are, say, legacy SKUs and when you think that turn gap could change -- could equal out.

Michael K. R. Bloom

Sure. It's Mike. We'll probably never be done tweaking our mix, right? That's what we do as retailers. It's hard. I've always said and I'll continue to say that we're going to go where that customer wants us to go. And right now, she's voting on consumables and basic needs. And whether it's HBA or food, in a lot of our -- that's where all of our additions have been. And I think it's been pretty balanced between those 2. But if we do see expansion in some of -- and further expansion in HBA or consumables, we'll manage that through less productive SKUs elsewhere in the store. I don't think we'll see a significant growth in overall SKU count. We'll manage the SKU count within the current mix of product.

Mark K. Montagna - Avondale Partners, LLC, Research Division

All right. So in terms of -- can you help us frame the progress of the SKUs that you've rolled out? And is there a way of saying that maybe those things are turning just at 20% below the rest of the legacy SKUs for those categories? That will help me understand how much of the gap needs to be closed and what kind of significant progress can be made.

Howard R. Levine

Yes. Let me see if I can answer that question. I mean, certainly, when you think about food versus health and beauty aids, we're going to see much quicker ramp-up in turns in the highly consumable food products than we are in the health and beauty aid products. But we see this as accretion to the total model, so -- and I don't know if that answers the question or not, but -- did I answer it or no?

Mark K. Montagna - Avondale Partners, LLC, Research Division

Yes -- no, that kind of answers it. It's kind of -- yes, that's close enough.

Operator

We'll go next to Scott Mushkin with Wolfe Research.

Scott Andrew Mushkin - Wolfe Research, LLC

I guess I wanted to -- I just wanted to understand the cadence of cycling the initiatives from last year as we progress through the fourth quarter. Is that something that happens Day 1 or is it kind of a ramp-up? And then I also think, Mike, you talked about SKU rationalization. I want clarity on that, and then I had a follow-up.

Howard R. Levine

The rollout of the SKUs started a few months ago last year and continued through the fourth quarter. And if you recall, the McLane initiative really didn't begin till mid-September of last year. So we're in the midst of beginning to lap some of those investments and anticipate some slowing as a result of that. But we continue to be very pleased with the investments we've made in the SKU additions. Food, HBA, the tobacco business, our McLane business continue to be very good, and we're on track there. I think the pressure points is with the consumer. Clearly, there's been some slowing, further slowing of the consumer, but we feel like we're well positioned to maintain some comp growth in the remainder of the quarter.

Scott Andrew Mushkin - Wolfe Research, LLC

And the clarity on the SKU rationalization that I think Mike mentioned. Are you taking out some of the 1,000 SKUs you added in originally, or what was that you commented about?

Michael K. R. Bloom

Yes, absolutely. We continue to SKU rationalize. We'll do that. That's a -- that's not a one and done. We'll do that forever. But yes, we've learned a lot. Not all 1,000 SKUs worked. And so yes, certainly, some of those SKUs are coming out. And we'll continue -- our business -- a lot of our growth comes from new items, new technology, innovation. So we'll continue to add items where our customer wants us to add and continue to rationalize where it's not working. So absolutely.

Scott Andrew Mushkin - Wolfe Research, LLC

Okay, perfect. And then one question about expenses. Labor and rent I think are your 2 largest expenses, and I think it was mentioned that they were up greater than sales. Yet it was also mentioned that you were able to leverage store expenses. So I'm just trying to understand how long that can continue with your 2 largest expenses growing pretty quickly.

Mary A. Winston

Scott, this is Mary. I'll take that question. Yes, as it relates to your -- first of all, your comments are correct. Our occupancy and labor were -- we did not leverage those expenses in the third quarter. And I think there are a number of factors there. I think first of all, we are certainly a low-cost operator. We've operated with a very thin labor model for many years. I think the reality is at some point, your labor costs do become relatively fixed because at some point, you have to have people with basic level of labor to operate the stores. Occupancy also is a fixed cost. So when you consider those 2 large buckets of spending being relatively fixed, and that represents about 2/3 of our SG&A, it's very hard to comp that or to lever that as our comps get pressured. As I mentioned in my prepared remarks, our breakeven is usually 3% to 4%. So we felt really good about our results this quarter, leveraging 30 basis points on a comp of 2.9%. As we look forward to the fourth quarter, where we're looking at around 2% from a comp standpoint, it's certainly going to be harder to leverage those expenses. Again, as we've talked about, we think we've got a lot of things going on that resonate with the customer. We're prepared when the customer is ready to spend more. We believe they'll continue to spend in our stores. And so as our comps tick back up, we will see SG&A leverage. But at the 2% lever, probably not. That's not what we're looking for next quarter.

Operator

We'll go next to Edward Kiley with Crédit Suisse.

Edward J. Kelly - Crédit Suisse AG, Research Division

I have a question for you on the gross margin. I was hoping that you can maybe provide a little bit more color on how you'll get to a flattish year-over-year gross margin in Q4. And I ask this question because if you look at mix, for instance, I mean, I think you look at sort of where you are in the decline in Q3 versus the decline in Q4, by our math, the mix might help you by 40, 50 basis points on the comp trend. But there's still sort of 60, 70 basis points in here that seems like needs a little bit more color on sort of how you'll get there, and I was hoping you could provide that.

Mary A. Winston

Sure, Ed. This is Mary. Let me just talk a little bit about how we're thinking about our fourth quarter gross margin, and you did touch on one of the biggest factors. We are cycling the launch of many of the consumables. The mix shift won't be as great in the fourth quarter as what we've seen in recent quarters. We'll be anniversarying about a 330-basis-point mix shift from the fourth quarter last year. So the comparison will certainly be easier this year, and that's a big factor. As both Mike and Howard mentioned, we are seeing some stabilization in our discretionary business. And as that business stabilizes, and we get the mix impact of that, clearly, that's the higher-margin piece of our business as compared to consumables, so that is going to have an impact. And then the rest of it is the things that we've been talking about all along. As you know, we've been very focused on our global sourcing program. And while we started that initiative a couple of years ago, we're really starting to get some momentum. And as we've been indicating all year, we're seeing increasing benefits from that throughout the year. So the benefit from that program will be larger in the fourth quarter than it was earlier in the year. And the same can be said of private brands. As we've talked about, we launched close to 500 new private brand SKUs recently. And so that's going to have a nice impact on our margins in the fourth quarter as well. So when we roll all those things together, that's where we're seeing the benefit. We also expect to see some continued benefit from freight. I would say that markdowns and shrink will continue to be headwinds for us as we go into the fourth quarter. But when we roll it all together, we do expect to see margins improved in the fourth quarter.

Edward J. Kelly - Crédit Suisse AG, Research Division

And Mary, as we look out to 2014, is the gross margin a line item that you think you could keep more stable going forward now?

Mary A. Winston

Well, we're still in the process of developing our 2014 plans, so I won't be overly specific on that. But I think we are expecting continued ramp from a program perspective on global sourcing, private brands. Those programs will continue to ramp. Overall, when we put all that together, we're currently thinking flattish as a percent of sales.

Edward J. Kelly - Crédit Suisse AG, Research Division

And then one last question for you on -- just quickly on the sale-leaseback. How do we think about the run rate of the sale-leaseback going forward now as we try to figure out what your free cash flow generation is going to be? Maybe it's 3 30 to 3 40 this year. Is that a decent way to think about it over the next few years?

Mary A. Winston

Probably, that number is pretty consistent with what we did last year as well. Last year the number was 3 60. Generally ballpark, we think about executing the sale-leaseback transaction every 6 months. So generally, we're targeting 2 per year. Now obviously, that can fluctuate depending on the timing of opening stores, closing deals, accumulating the right portfolio of stores. But generally speaking, that's the ballpark you should be in.

Operator

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

Paul Trussell - Deutsche Bank AG, Research Division

A question on just share repurchases. I just noticed that you did not buy back any shares in the third quarter. I believe that was the first time in the last 4 years that, that occurred. Is that just more of a timing when you received the proceeds from sale-leasebacks or because of the increased CapEx spend? If you can just give some additional color on that, please.

Mary A. Winston

Sure. I would say the short answer would be yes, it could be considered timing for the factors that you mentioned a moment ago. But I will remind you of what our capital allocation priorities are. We believe investing in the business is our top priority. And you can see that we're doing that based on the investments we're making in our store base, both in new stores and renovations. And so that's been the focus from our capital utilization standpoint. Second is our dividend program, and year-to-date we paid dividends of about $78 million. We increased our dividend substantially in January, about a 24% increase, and that's our second priority for returning value to shareholders. And then we view share repurchase as opportunistic. So we do repurchase enough shares to offset any dilution in the year. We've done that on a year-to-date basis. Repurchases year-to-date has been about $75 million. So as we have excess cash and the market opportunity appears appropriate, we will repurchase shares, but again, it's on an opportunistic basis.

Paul Trussell - Deutsche Bank AG, Research Division

Great. And then just as a follow-up, one of the comments that you guys made recently was that your consumer -- you did a survey and your consumers, you found out that your consumers were not all aware of the changes that you had made in the store including all the additions to assortment, the addition of tobacco et cetera. What has been the strategy or what is the strategy from a marketing standpoint to improve the awareness, to continue to gain additional visits in the store?

Michael K. R. Bloom

Sure. I'll take that. It's Mike. Yes. We're doing a lot. Certainly, our breakdown is maybe there's probably 3 or 4 key components. One is it's just time, right? It's busying the store. It's having the right merchandise in the store, the right sign in the store, the right navigation in the store. So that's one. Second is our circular activity. We advertise on a lot of Sundays throughout the year. And we continue to make sure that we're focusing on our health and beauty aids and certainly our food assortment. Third is we're doing a lot of digital. And lastly, we're looking at other avenues, right, like radio and maybe a little bit of direct mail and pockets. So we're looking at all avenues, but the primary ones are the circular. And again, like I've been saying for a while, health and beauty aids matures at a much slower rate just because of the use-up rate versus consumables. So that's how we're thinking about it.

Paul Trussell - Deutsche Bank AG, Research Division

And just very, very quickly. With a challenged consumer, are you seeing anything in the marketplace that suggests other retailers are getting more promotional? Or how would you describe the environment?

Michael K. R. Bloom

Yes, so it's Mike again. I will tell you that certainly, we see nothing new. There's no new additional frequency in circulars. But the example is Walmart has been extremely promotional, several events during a week, midweek, weekend, but rational. So nothing new that has been new in the last several months. But it's a heavy promotional environment out there, and -- but rational is how I would characterize it.

Operator

We'll go next to Laura Champine with Canaccord.

Laura A. Champine - Canaccord Genuity, Research Division

Just to ask a follow-up question, whatever you're willing to say about the rationale behind the leadership changes in merchandising. And Mike, you called out that your merchandising folks have already [indiscernible] opportunity with assortment and execution. If you could specify what those are, that would be great.

Michael K. R. Bloom

Yes. So let me talk about the change in merchandising that we announced this morning with Paul. Paul has done a good job. He's been here 2.5 years, did a good job. And part of my role, as Howard mentioned even earlier in his comments, part of my role is to make sure we've got the right team in place that's going to take us forward. And that's where I felt we needed to make the change. And so we did, right? And the same, I would say the same -- I'd make the same comment about our logistics or distribution opening that we have right now. Charlie had been here a long time, did a great job, took us from 1 DC to 11 DCs. But as I think about a longer-term end-to-end supply chain solution for Family Dollar, I'm looking for the right individual that's going to get us to an end-to-end supply chain. And so that's why we make the changes, right? We continue to evolve. We continue to evaluate the team. And so that's why we make the changes. Some of the specifics. I think I was talking specifically about discretionary, some of the changes the team has made. Again, I could talk about bedding. I could talk about some apparel changes. But it's really about tweaking the assortment, making sure we have what the customer is looking for. We made a couple of mistakes. Like I mentioned, we took a big segment like comforters out of our stores. We felt we could manage it on a seasonal basis, and we were wrong. And we owned that and we fixed it. And we're seeing some really nice stabilization in that business. And as I said earlier, that business, believe it or not, leads to purchases in other businesses. So it's about understanding the consumer. We do a lot of consumer work here with the recent hire of Jocelyn Wong from Safeway. We're doing a lot of deep dives with the consumer to really get an understanding of how she's shopping and how she's using us. So we continue to evolve and make changes.

Operator

We'll go next to Patrick McKeever with MKM Partners.

Patrick McKeever - MKM Partners LLC, Research Division

I'm just wondering if you could give us an update on the tobacco stats that you've been providing for a while now. Did you see any change in those statistics during the quarter?

Michael K. R. Bloom

Sure. It's Mike again. No, we're still very pleased with the results. The basket stays the same, has stayed the same, I think we've said in the past. And it's still there. 40% of the transactions are tobacco only, and 60% have other items in the basket at our average company margin, which is good news. And we're pleased with the in-stocks. We're pleased with the shrink control. We're pleased with the segment. So yes, no changes. Just actually all good news there.

Operator

We'll go next to Meredith Adler with Barclays.

Meredith Adler - Barclays Capital, Research Division

Just going back to the change you're making in merchandising. I have sort of 2 related questions. The first is, could you talk about what you're looking for in a new Chief Merchant? You did a good job of saying what you want in distribution. But what are you looking for in merchandising?

Michael K. R. Bloom

Yes. So Meredith, it's Mike. It's about understanding small-box retail. It's about understanding, having an in-depth understanding of our consumer and how they're evolving; our competition, how they're evolving; our mix, how it's evolving; our marketing collaboration between marketing and supply chain. And to me, it's all about leadership, and I don't know if it's necessarily rocket science. But I think it's those types of qualities that we are looking for. Someone's got a deeper understanding of our business.

Howard R. Levine

And Meredith, if I could -- this is Howard. If I could just add some comments about the team and where we are and specifically regarding the Chief Merchant role. As I take it back and take a step back and look at some of the changes, particularly with Mike and Mary coming in, Mike almost 2 years ago and Mary almost 1.5 years or so ago -- about right, Mary, give or take? We're in the process of really rebuilding the senior team, and I think that we've got some great additions in Mike and Mary. As we look to fill out some of the other senior-level positions, what I'm really looking for is to start looking at succession. One of the things that I think myself and our board particularly looks at is making sure that we have a good bench. Clearly, we have a great opportunity to offer somebody that opportunity at Family Dollar, but we've made substantial progress there. We brought in some really good folks with expertise across industry type from grocery to drug to general merchandise, to Sam's Club more recently with Jason. And I think the effort that we're going through right now, and we haven't really talked about it a lot. When you look back, clearly, we've added a lot of items to our assortment. We've done a lot to our inventory and merchandise, and we have a ton of initiatives. And at the same time we've really gone through a rebuilding of our team over the last year or so. And we'll continue to look at that and continue to improve upon that. But I think that we will be able to attract some top talent here. Family Dollar is a great company, a great future and a great business model. And I'm really looking forward to seeing who we can add to help grow that. But from my perspective, we've made tremendous progress in rebuilding the team. The effort now is getting everybody to understand the Family Dollar customer, the industry competition and getting everybody on the same page. And again, I think we've made some great progress there and are in the process of finishing some of that out. So I hope that helps a little bit.

Meredith Adler - Barclays Capital, Research Division

Yes, I guess I would then ask how long do you think it takes? And a question for Mike, you're obviously very focused on operations. But is it going to be a distraction for you to be the Chief Merchant? And then along with that, how are you running the store simplification process? Is it a real project? Is there one person who's a Project Manager and they've got a list of to-dos, so that you really don't have to be on top of it?

Michael K. R. Bloom

Yes, yes, and yes. So it will not be a distraction, and I'll tell you why. We have a great team down there today. The 3 Senior Vice Presidents, I'm real happy. Tammy DeBoer came in from Food Lion, hit the ground running, managing all of our food businesses and private brand businesses. I've got Holly, who is taking over discretionary business, has just done a fabulous job stabilizing it with her team. And now Jason coming in to run health care and household. So I've got to tell you something. I feel very comfortable with the immediate merchandising team taking the lead, taking charge, working collaboratively together along with Jocelyn, who's my lead Chief Marketing Officer. And Kevin Boyanowski has been here for quite some time running global sourcing. So I actually feel really good about the team and how they will collaborate and lead and drive this. Certainly, I'll be there for oversight. But my expectation is they're going to take the ball and run with it, so I feel really good about that. The second question you had was stable -- simplification of the store. It is a project. It is a very cross-functional collaborative project, working -- the merchants are working with the operators, working with distribution, working with allocation and doing -- and again, it's a really deep dive. Just like we deep-dive on a customer, we're deep-diving on our stores to understand non-value-added work. And we've -- there's a lot of work there. The team has done a great job so far. We report out. I'm involved in it. They report out all the time. We've already executed some changes that are helping our stores reallocate their time to doing more productive tasks in the store and taking care of customers. So it is a project, and it's a big one and it's one that we expect some big things out of.

Operator

We'll go next to Stephen Grambling with Goldman Sachs.

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

You noted that there's been pressure on the core customer, but you've also been able to offset this headwind by gaining share. Can you maybe address what you're seeing in the overall spend and your market share in the trade-down customer?

Howard R. Levine

Sure, Steve. We continue to view that trade-down customer as a great opportunity at Family Dollar. All the things that we're doing to improve our business from the renovation program to the focus on improving our quality to the way we're running our stores, I think that, that really positions us nicely for that trade-down customer. Additionally, as indicated on the last conference call that one of the benefits of the added assortment in food and HBA particularly is that we're able to locate stores in a little better income area than we have traditionally. And that also is driving some slight rent expense. But today, what you see with our Fee Development Program and building freestanding locations that are very convenient for consumer access has been very important to that trade-down customer. I hear about that all the time. The fact that we've added to our assortment with an improved cooler program, food and HBA additionally to that, has also positioned us very nicely for that trade-in customer as well as our core customers. So all the efforts that we're doing I think really position us well for that continued growth in that segment of our customer.

Stephen W. Grambling - Goldman Sachs Group Inc., Research Division

That's helpful. And then 2 quick follow-ups. One, just in relation to that consumer. Where do you think that's coming from? And two, just going back to Mary on the gross margin comment for next year. Did I hear that flat was a possibility?

Howard R. Levine

I'll let Mary take that one, but I -- on the growth that we're seeing out of the consumers is primarily coming out of grocery. There's some out of drug, some out of convenience. Those are the primary takers of share. Mary?

Mary A. Winston

On the gross margin, first, let me say we are still in the process of finalizing our budget and getting clear around exactly what we expect from our initiatives that are going to be ramping and everything else. So again, anything I'm saying right now is very preliminary until we finish that process. But yes. And I was talking about relative to the pressure that we're expecting in the fourth quarter with what we see as we go into fiscal '14. Then I would expect to see similar trends going into the year based on what we know now.

Howard R. Levine

And I would just add -- I would just add to that, Steve, that what we've been working on for the last several months is being able to make money in a slower sales environment. And we talked about sales moderating in the fourth quarter. We hope to see some improvement as we work through the fourth quarter and into fiscal '14. But what I'm very pleased with is that we're tweaking the model with improvements or stabilization and gross margin, better expense leverage, better inventory productivity to be able to show profitability and growth and profitability even in a slower sales environment. We'll talk more to that in our year-end call about some of the things that we are working on specifically in '14. But one of the things that I'd like to have take away from this call is the way the company is preparing for what could be a slower sales environment. Gosh, we certainly hope that we're doing some things that grow sales. But in addition to that, we're preparing for a more difficult environment out there, as we've talked about in what we've seen not only from Family Dollar and those in our channel. But we've seen it from other retailers that even have a smaller proportion of their customers that are low income, talking about challenges with the low-income customer. So we're ready for that. We're positioned for that and focused on driving profitability in that kind of environment, but still focused on driving additional sales.

Operator

We'll go last to John Heinbockel with Guggenheim Securities.

Steven Forbes - Guggenheim Securities, LLC, Research Division

It's actually Steve Forbes on for John today. One quick question, regarding new prototypes. I believe the biggest change was moving apparel back to the front of the stores. So can you just give some details on what you're seeing within those remodels relative to the rest of the chain and relative to the other remodel formats?

Michael K. R. Bloom

Yes, sure. You're right. The major change was bringing the apparel back up to the front of the store. And I believe we started that in February with our February remodels, so it's still very early. And without giving specifics, I'll tell you that we're pleased with the results. And of course, we tested this. So we tested it. We're pleased with the results. We're rolling it out and we're still pleased with the results. So it's working well for us.

Steven Forbes - Guggenheim Securities, LLC, Research Division

Okay. And then just quickly on the St. George DC. You should -- I think you're going to start shipping in the fourth quarter. Is that correct? And then how many stores will have served by year end?

Michael K. R. Bloom

Yes. The new DC in St. George, Utah is actually starting to ship. It started shipping last week, I think was the first ---

Howard R. Levine

Yes.

Mary A. Winston

Yes.

Michael K. R. Bloom

Yes. Last week was the first -- we're shipping at that DC now. And it will ramp up over the calendar or for our fiscal year '14. It's just shipping -- it might be like 100 stores right now. It's pretty small. But it will ramp up as we go through when we adjust the network, too, again. And you know what, we did that, of course, to reduce that model, so...

Mary A. Winston

So I think we are out of time today. Thank you, everyone, for joining us. Unfortunately, we didn't get to all of the questions in the queue. As always, Kevin and I will be available after the call for any follow-up questions that you may 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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