Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Pat Watson – Corporate Communications

Jerry A. Shore – Chief Financial Officer

Michael J. Hayes – Chairman

Bruce A. Efird – Chief Executive Officer

Rick A. Chambers – Executive Vice President of Pharmacy Operations

Dennis Keith Curtis – Executive Vice President and General Merchandise Manager

David B. Mueller – Senior Vice President of Sales and Marketing

Analysts

Mark Miller - William Blair & Company, LLC

Paul Trussell - J.P. Morgan

David Magee - Suntrust Robinson Humphrey

Jillian Caruthers - Johnson Rice & Company

Patrick McKeever - MKM Partners LLC

John Lawrence - Morgan Keegan & Company

Andrew Wolf - BB&T Capital Markets

Fred’s Inc. (FRED) Q2 2009 Earnings Call August 27, 2009 10:00 AM ET

Operator

Good day and welcome to the Fred’s second quarter conference call. Today’s call is being recorded. At this time for opening remarks I would like to turn the call over to Mr. Pat Watson. Please go ahead, sir.

Pat Watson

Good morning everyone. This is Pat Watson with Corporate Communications. Thank you for joining Fred’s to review the company’s financial and operating results for the second fiscal quarter and first half of 2009 ended August 1, 2009.

Before we begin I would like to remind everyone that management’s comments in this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks. It should be noted that the company’s future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued earlier today, in the company’s annual report on Form 10-K and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information.

Lastly I would like to point out that management’s remarks during this conference call are based on information and understandings that are believed accurate as of today’s date, August 27, 2009. Because of the time sensitive nature of this information it is Fred’s policy to limit the archived replay of this conference call webcast to a period of 30 days. This call is the property of Fred’s. Any distribution, transmission, broadcast or rebroadcast of this call for commercial purposes in any form without the express consent of the company is prohibited.

With that announcement I’ll turn the call over to Jerry Shore, the company’s Chief Financial Officer. Good morning, Jerry.

Jerry A. Shore

Good morning, Pat, and thanks. And thanks to all of you for joining us this morning for our discussion of second quarter results for fiscal 2009. With me this morning and available for questions are Michael Hayes, Chairman, Bruce Efird, Chief Executive Officer, Rick Chambers, EVP of Pharmacy Operations, Keith Curtis, EVP and General Merchandise Manager and Dave Mueller, Senior Vice President of Sales and Marketing.

As the company reported in its press release this morning, Fred’s total sales for the second quarter of fiscal 2009 declined 3% to $434.2 million from $447.1 million for the same period last year. Included in the sales for last year are those 74 stores and 23 pharmacies that were closed during 2008. Excluding those stores closed last year, total sales from ongoing stores were flat in the second quarter 2009 with the year earlier period. And on a comparable store basis second quarter sales declined 1.3% compared with a 4.9% increase in the same period last year. Within the quarter, comparable store sales were a positive 0.2% in the first two months of the quarter but negative 4.6 in July.

The sales mix for the period was 23.6% household goods, 16.7% food and tobacco, 7.5% health and beauty aids, 9.5% paper and chemical, 7.8% apparel and linen, 32.8% pharmacy and 2.1% franchise. This compares with the following mix in the same quarter of last year, 25.5% household goods, 15.3% food and tobacco, 7.9% health and beauty aids, 9.3% paper and chemical, 9.1% apparel and linen, 30.7% pharmacy and 2.2% franchise. And for the quarter, comparable store customer traffic decreased 0.4% from last year while the average customer ticket decreased 0.9% to $18.68.

For the first six months of 2009, total sales declined 2% to $892.6 million from $911.4 million in the year earlier period. Again excluding those stores closed last year, total sales from ongoing stores increased 2% in the first half of 2009 versus the year earlier period. And comparable store sales for the year-to-date period in 2009 increased 0.8% versus a 3.5% increase in the prior year period.

The sales mix for the year-to-date period was 23.5% for household goods, 16.4% food and tobacco, 7.7% health and beauty aids, 9.3% paper and chemical, 7.8% apparel, 33.1% pharmacy and 2.2% franchise. And this compares with the following mix in the same period last year, 24.9% household goods, 15.4% food and tobacco, 8.1% health and beauty aids, 9.2% paper and chemical, 8.9% apparel, 31.3% pharmacy and 2.2% franchise. And on the year-to-date basis, comparable store customer traffic increased 0.6% over last year while the average customer ticket increased 0.2% to $19.05.

For the second quarter of 2009, Fred’s net income increased to $4.2 million or $0.11 per diluted share from $1.0 million or $0.03 per diluted share in the same quarter of last year. Included in the results of the second quarter are expenses of $864,000 or $0.02 per diluted share relating to tax audits of the years 2004 through 2007. These audits were completed and settled during the second quarter. Excluding the effects of these tax audits and the year earlier net cost of $4.7 million on a pretax basis or $3.1 million on an after tax basis incurred with the company’s store closing program, net income increased 23% to $5.1 million or $0.13 per diluted share from $4.2 million or $0.10 per diluted share in the second quarter last year. The adjusted earnings per diluted share increased 30% quarter over quarter.

For the six months ended August 1, 2009, net income increased 54% to $12.8 million or $0.32 per diluted share compared with net income of $8.3 million or $0.21 per diluted share for the first six months of 2008. Excluding the effects of the tax audit in the current year and the net costs incurred from the company’s store closing program in the first six months of 2008, net income increased 19% to $13.7 million or $0.34 per diluted share from $11.5 million or $0.29 per diluted share last year.

Operating income for the second quarter of 2009 increased to $8.2 million or 1.9% of sales from $1.9 million or 0.4% of sales in the prior year period. Adjusting to exclude the effects of the year earlier net costs incurred with the company’s stores closing program, operating income increased 22% to $8.2 million from $6.7 million in the second quarter of last year. As a percent of sales, operating income improved to 1.9% of sales as compared to 1.5% in the year earlier period. And on a year-to-date basis, operating income increased to $21.8 million or 2.4% of sales from $13.7 million or 1.5% of sales a year ago. Again excluding the effects of the tax audit and the year earlier net costs incurred with the company’s store closing program, operating income increased 18% to $21.8 million or 2.4% of sales from $18.5 million or 2.1% of sales in the same period last year. This improvement is primarily a result of our strategic initiatives to control costs throughout the organization.

Fred’s gross profit for the second quarter of 2009 declined 3% to $120.7 million from $123.9 million in the prior year period. Gross margin for the quarter improved 10 basis points to 27.8% compared with 27.7% in the same quarter last year. The overall improvement in gross margin results primarily from controlling clearance markdowns and lower freight costs. The improvement in general merchandise departments was partially offset by the continued competitive pricing on pharmacy department sales.

Gross profit for the first half of 2009 also declined 3% to $249.7 million from $256.3 million last year. Gross margin for the year-to-date period in 2009 was 28.0% compared with 28.1% last year. On a year-to-date basis the 10 basis point decrease in gross margin is attributable to the basic and consumable product mix shift.

SG&A expenses including depreciation and amortization trended favorably in the second quarter of 2009, declining to 25.9% of sales versus 27.3% of sales in the year earlier period. Operating expenses were $9.3 million lower in the second quarter than the same period last year. A breakdown of this significant dollar reduction and the 140 basis point expense leverage are as follows, $7.3 million were costs associated with closing of 50 stores that took place in the second quarter of last year, $1.5 million reduction in distribution and transportation costs from the previous year where we have seen significant savings in fuel costs that also made productivity improvements through managing freight flow throughout each of the months of the quarter, and then $0.5 million reduction relates to ongoing store costs reduction efforts in productivity improvement. For the first half of 2009 SG&A expenses improved by 100 basis points to 25.6% of sales compared with 26.6% of sales in the first six months of last year.

Depreciation and amortization expense totaled $6.5 million in the second quarter and $12.9 million for the year-to-date period.

Net interest expense for the second quarter of 2009 was $78,000 versus $77,000 in 2008. We continued to experience only minimal interest expense on outstanding real estate loans and there were no borrowings in the quarter under the company’s revolving line of credit. On a year-to-date basis net interest expense totaled $187,000 in 2009 compared with $250,000 in 2008.

As stated earlier, income tax expense included $864,000 related to the completion and settlement of income tax audits of the years 2004 through 2007. Excluding this amount, income taxes in the second quarter were 36.8% of pretax income. For the year-to-date 2009 period the tax rate excluding the tax cost is 36.9 and we anticipate the tax rate for the remaining two quarters of 2009 to be in the range of 35 to 37%.

Moving to the balance sheet, we improved our performance in several key areas and continued to drive the strength of the financial position. Cash and cash equivalents increased to $51.4 million from $9.6 million in the year earlier period. Total inventories decreased 7.9% to $308.9 million at the end of the quarter compared with $335.3 million in the second quarter of 2008. This 7.9% decrease in inventory has been accomplished even with two additional stores and 14 additional pharmacies as well as our initiatives to improve in stock levels per the in-stock performance at our stores.

Inventory turns are at 3.9 at the end of the quarter and we anticipate we will end the year at 4 or above turns.

Capital expenditures for the second quarter totaled $7.6 million compared with $3.8 million in the second quarter of 2008. On a year-to-date basis, capital expenditures totaled $11.9 million compared with $9.3 million in the first half of 2008. The breakdown of capital expenditures includes $1 million for new stores and pharmacies, $9 million for existing and remodeled stores, $0.8 million for DC equipment and $1.1 million for corporate and technology upgrades. Additionally there was $3.2 million related to the acquisitions of pharmacies as compared to $1.4 million in the second quarter of last year. And on a year-to-date basis for acquisitions and pharmacies we’ve spent $3.6 million compared to $1.4 million last year.

At the end of the second quarter accounts payable increased $3.2 million to $90.3 million as compared to $87.1 million at the end of the year earlier period and this was accomplished despite a $26 million reduction in total inventory.

Total debt at the end of the quarter was $5 million compared to $5.5 million last year and again there were no borrowings under our revolving line of credit at the end of the quarter.

Through the end of the second quarter cash provided by operating activities was $33.6 million. Free cash flow which we define as cash provided by operating activities less capital expenditures and dividends was $16.2 million for the first half of the year.

The company operates 669 discount general merchandise stores including 24 franchise Fred’s stores. During the second quarter the company opened three Pharmacy Express locations and seven additional new pharmacies. On a year-to-date basis, the company has opened three stores, three Pharmacy Express locations and seven additional new pharmacies. The company’s total selling space of 9.4 million square feet is approximately the same as at the end of the second quarter of last year as well as at the end of last year. The company anticipates that in 2009 it will open ten to 14 new stores and five to ten pharmacies and that selling space will be flat to an increase of 2% in 2009.

Our financial guidance for the remainder of the year is as follows. In the third quarter the company expects total sales to be up 1 to 3% over last year, reflecting conservative store growth but the impact of new pharmacies opened year-over-year. Comparable store sales are expected to increase in the range of flat to up 2% in the third quarter. We now anticipate August sales to be flat to down 1%. The month of August started off stronger with the shift of tax-free holidays in several states from July to August. However, sales dropped off in the past week and with a negative shift in pre-Labor Day holiday shopping which occurred last year, we expect the remaining days of the month to be negative in sales. We anticipate comparable store sales results improving in September and October with additional marketing and merchandising initiatives.

Earnings per share are forecasted to be in the range of $0.18 to $0.21 for the third quarter, representing an increase of 12 to 30% increase over the same period last year. And looking ahead, the company continues to expect total earnings per share for 2009 to be in the range of $0.73 to $0.80.

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

Bruce A. Efird

Thank you, Jerry. Good morning everyone. We appreciate you joining us this morning and thank you for your continued interest in Fred’s. I want to start out by saying that we believe our performance in the second quarter was solid given the challenging competitive and economic environment. We are pleased that our earnings per diluted share on an ongoing basis came in at $0.13 or 30% above second quarter last year, which matched the analysts mean which was also in the mid-range of our own guidance.

Much of our progress in the second quarter was attributable to the diligent efforts of our leadership team which managed operations in a disciplined manner and continued to focus intently on improving productivity and operational efficiencies. These efforts enabled us to deliver another quarter of solid earnings growth and helped Fred’s maintain a strong balance sheet, which in turn contributed to our continued progress toward our plan to generate over $100 million in free cash flow over our next three year strategic plan period.

As previously noted, our sales for the quarter were lower than expected, especially in July. Sales in July were negatively affected by the continued change in pharmacy mix toward lower cost generics, a shift in tax-free holidays affecting back-to-school sales as well as heightened competitive promotional activity. With respect to sales, let me add a quick note on our back-to-school performance. We were pleased with our school supply and stationery related sales overall and our product sales group, both of which ran above plans. However we did not perform up to expectations in other back-to-school related departments such as home furnishings and apparel, which continue to be tough areas for our consumers in this environment.

To address the continued economic challenges and our anticipation of increasingly competitive promotional activity in the near term, our team has reviewed our second half promotional and advertising programs. We will make adjustment to our print, radio, TV plans and also other promotional activities to strengthen customer perceptions of Fred’s value, service and selections. Our objective in these adjustments is to extend the positive trends seen in our operating performance while regaining sales momentum.

Other achievements for the second quarter include continued pharmacy scrip growth, further improvement in the quality of our inventory, extremely strong own brand and private label growth. Elsewhere our team delivered ongoing expense leverage and continued to improve in payables as a percent of inventories.

Our team continues to make good progress on our previously announced transformation plan and strategic initiatives. I will highlight a few of these starting with our focus on fundamentals. We made solid progress on our product in stock initiatives as our service level to our stores exceeded our internal plan and averaged 270 basis points above last year. We maintained a disciplined approach to managing expenses in our stores, distribution centers and corporate departments which resulted in strong overall expense leverage. I want to point out, however, that we continue to focus on cost reductions in a prudent manner to insure that we don’t sacrifice the Fred’s brand in the process.

With a similar disciplined approach to managing our inventory, we achieved a 7.9% decrease in total inventory as inventory per store declined, inventory turns increased and the overall quality of inventory improved. One area of focus has been upgrading our systems and technology. We are near completion and roll out of our new direct to store delivery system that will begin to deliver additional gross margin benefit going forward.

I will now turn to the second platform of our transformation plan which is to create a unique and differentiated store experience. One of our top priorities continues to be leveraging pharmacy operations as a competitive advantage over our small box, discount competitors. Our pharmacy team delivered solid scrip comp growth in the quarter. We will continue to invest in pharmacy file buys and acquisitions to augment organic growth.

In the second quarter we continued to roll out our Prescription Plus card program to all stores and saw an 86% increase in enrollment. We now have more than 75,000 customers as members of this program. Our marketing launch of Prescription Plus begins in September with in store marketing, radio and outdoor media.

Our own brand or private label initiatives exceeded our expectations with a year-over-year increase of 515 basis points as a percentage of consumable sales. This growth reflected the addition of new items, revamped labels and packaging, as well as increased advertising. I would like to congratulate our marketing and merchandising teams for being recognized by Private Label Magazine as the 2009 Store Brand Leadership Award recipient for the discount class of trade.

The third key component of our transformation plan is to position Fred’s for profitable and sustainable growth. One of our key strategic initiatives to drive future growth is to retool our real estate process and improve our store model. In the upcoming months we will open our first two stores utilizing this new process. These stores will also serve as our pilot store or our store of the future which includes a significantly improved and differentiated customer service, new graphics, improved product adjacencies, store layout, enhanced pharmacy and seasonal exposure as well as wider aisles, lower product profiles and a more value appeal apparel layout.

Moving to the chain growth for the second quarter, we opened six new pharmacies and have plans to open nine to 15 more pharmacies in 2009, with an emphasis on acquisitions and scrip file buys. We are on track with our store remodel program to complete 30 major remodels in 2009. Our new anchor format prototype continues to perform solidly and we also plan to open six to ten new stores in the second half of 2009.

Looking forward, we are confident in Fred’s long term future and are well positioned to provide our customers with better value, service and convenience. As we said in our press release this morning, we expect the retail climate to remain very challenging but with our momentum on initiatives and strong financial position we are very excited about the remainder of 2009 and beyond.

Again, thank you for your interest in Fred’s and I will now turn it over to [Shay] our operator for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Miller - William Blair & Company, LLC.

Mark Miller - William Blair & Company, LLC

Was hoping you could expand on your comments about the tighter competitive pricing as it relates to pharmacy. And what type of impact did this have on the pharmacy margins in the second quarter? And how much greater was that than in the first quarter? And is this coming more through moves of competitors or how much of that is caused by the roll out of the RX Plus card?

Rick A. Chambers

Good morning, Mark. This is Rick Chambers. In regards to that what we’re seeing when we make those comments, what we’re really getting on there is you know we’re still seeing the same pressures from the Wal-Mart, Kroger and grocery industry in terms of the $4 programs. We are as Bruce mentioned earlier aggressively rolling that out and we’ll have our marketing support behind that beginning in September. And it’s been more of some impact as we talked about on margins but we’re looking at it more on a broader scale as an overall investment into the entire store experience for the customer, not just on the individual pharmacy margin alone. But yes there has been a pressure put on that but not again that’s something that we did not expect. It was something that was in line with our plans. But we would expect that to continue to support our strong scrip growth as we go forward and the comps that Bruce mentioned earlier, so.

Bruce A. Efird

And Mark, just in emphasis, we have seen the benefit of that driving scrip comp throughout the year.

Mark Miller - William Blair & Company, LLC

Sticking with the gross margin from on the positive side, very impressive increase in private label as a percent of consumable, you didn’t mention that in the text or I guess that I heard in the commentary about that being an uplift to gross margin. Was that something that did impact the business positively, you know in a meaningful fashion? Or are you pricing it such that really it doesn’t have a positive contribution to the margin percentage?

Jerry A. Shore

No, Mark, it did. We didn’t see the positive initial mark up that came from brand, own brand. It was in terms of the overall impact as related to the markdowns and the freight it wasn’t in that range, but certainly is growing through month-by-month.

Mark Miller - William Blair & Company, LLC

And just a final question from me, I’m sure others will be interested as well in the changes in the promotional programs for the second half. Can you just elaborate on the things again what you talked about, Bruce and what confidence do you have that it’ll begin to drive the top line? Are these things you’ve already tested in some markets?

Bruce A. Efird

Yes, Mark, we will comment at a high level on the revamped promotional activity due to competitive reasons but as we’ve seen the market heighten in promotional activity we are adjusting our plan accordingly. Coupled with the need to or our desire and plan to regain our sales momentum, we’ve really focused on our advertising. We have ramped up our spend on radio and TV as well as our print and added additional pages to the likes of TV, radio. And we also have additional vendor funded mid-month and print ad pages as well. And I’ll turn it over to Dave if he has some more comments.

David B. Mueller

Yes, as Bruce said some of the electronic that we’re going to invest in will focus around the first of the month. We’re going to focus on driving our low price proposition and making sure we have the right products at the right price for the customer. In addition we’re also going to make sure we merchandise those projects and those special offers in our store, putting them right in front of the customers. For the November, December period we have improved our entire marketing and promotional plans and this was based on a deep dive analysis of the past three years performance plus historical competitive activity. We continue to monitor current activity and adjusting as needed as we plan for what we believe is increased competition for the 2009 holiday consumer dollar. And last but not least I will tell you that we are also developing internal tools to help us analyze and understand the consumers’ responses to our promotional offers on an ongoing basis.

Operator

Your next question comes from Paul Trussell - J.P. Morgan.

Paul Trussell - J.P. Morgan

Just a follow up on the top line commentary and the strategy for the second half. It sounds very marketing and promotional driven. I just want to get your comments on what your plans are from an everyday pricing standpoint.

Dennis Keith Curtis

Paul, this is Keith. We continue to maintain our low price image with the customer and at the same time are responsibly managing our margin goals through our tiered pricing strategy. We developed a tiered pricing strategy last year which we continue to maintain and monitor and we have all our merchandising personnel geared toward that. And we will continue to maintain our low price leader image. And we do have some good initiatives in the second half as Dave had alluded to with our promotional pricing strategies also.

Bruce A. Efird

Yes, just to add to that. Since we over the past nine months have rolled out our pricing strategy and a more structured approach to pricing, we have a much better handle on where we stand versus our key competitors that we benchmark against. And our goal is to continue to be very competitive on price, to drive the sales longer term.

Paul Trussell - J.P. Morgan

And then also just from an expense standpoint obviously you’ve benefited over the past few quarters from closing the under performing stores and some of the other strategic initiatives. Could you just tell us what to expect going forward on the expense line, that should begin to lap those reductions from the year prior.

Jerry A. Shore

Yes, Paul, this is Jerry and we have you know achieved and retained the savings that came with not only the closing of the store but the changes that we made in our corporate expenses as well. So we’ve accomplished that. We will get some benefit in the third quarter as compared to last year because there was still some. We are anticipating considerable leverage still in operating expenses and a lot of those efforts that we’ve gone through to control distribution, freight flow will continue. We’ve balanced the freight flow extremely well. That’s had a positive effect on distribution labor. And our stores are putting a much more structured labor plan in place. We’ve built tools there.

And ongoing we have a store simplification project that runs throughout the company to help support our store associates and make their jobs easier. So we expect continued leverage in SG&A.

Operator

Your next question comes from David Magee - Suntrust Robinson Humphrey.

David Magee - Suntrust Robinson Humphrey

Just a couple of questions, one is a quick one. Can you remind us what percentage of the pharmacy business is cash at this point in time versus third party pay?

Rick A. Chambers

Yes, David, on a scrip basis it’s around 14% is cash and on a sales basis about 8% cash.

David Magee - Suntrust Robinson Humphrey

I guess with those numbers being relatively low I’m surprised that you’d feel so much of the competition from Wal-Mart with regard to generics. Is that?

Rick A. Chambers

When we look out and compare to our industry peers, we’re probably more cash driven than a lot of our especially larger box retailers are. So we typically see that number as being somewhat higher, so that’s why the pressure is a little bit more maybe than some of the other folks are feeling on that front.

David Magee - Suntrust Robinson Humphrey

Do you anticipate much benefit from the H1N1 virus this fall?

Rick A. Chambers

Yes, we are set up strategically with that. We are currently working right now with a lot of the health departments, both at the state level as well as down to the community level. As you know the distribution is still being finalized on how that vaccine will be disseminated across the country but with our rural footprint we fit a very good niche or need there with that distribution channel, and have already had very positive conversations both with the health departments you know as I said both state and local to be able to facilitate that. And we do see a lift on that. We’re also working to increase the number of immunizers that we have in our pharmacies. And then if we have areas where we don’t have a certified immunizer we’re looking to contract with outside services to fill that need and be there for those patients.

Dennis Keith Curtis

This is Keith. We’ve worked very closely with our vendor base on the over-the-counter products such as hand sanitizers and most of the over-the-counter products in our health aids offerings, worked very closely with our vendor base in regards to planning our inventory levels and we’ve had meetings as early as this week. And we feel like we’re very well prepared in regards to the over-the-counter side of that need also.

David Magee - Suntrust Robinson Humphrey

Are you seeing any impact yet? It seems like around here anyway there’s already some hysteria in the press and whatnot. Are you seeing any of that in your markets in terms of you know OTC at this point?

Rick A. Chambers

We have seen a small spike, not a significant number. And it’s been more in the right south of Memphis area, north Mississippi, that area where we’re seeing some reported cases of it. But again not on a major scale that we anticipate or expect on a go forward basis.

David Magee - Suntrust Robinson Humphrey

The last question I have is with regard to the non-pharmacy, the balance of the store, can you describe the promotional environment that you’re seeing now versus what you’ve been seeing so far this year? You know is it getting worse, that part of the store, incrementally?

David B. Mueller

I won’t say it’s getting any worse. It’s no secret that things have certainly gotten more competitive over the last few months and will continue to do so, so I think we’re in a great position to be able to take advantage of those and keep our position and offer programs and product to our customers at aggressive prices that will continue to bring them in our stores. So we’ve been studying it. We’ve been monitoring it and we’re continually adjusting our go forward offers to compete aggressively against the other competition out there.

David Magee - Suntrust Robinson Humphrey

Are you surprised that it’s getting tighter here because it you know just it seems like the consumer’s trying to feel better, I guess, you know sequentially. And I’m a little surprised that maybe you saw it got more promotional at this point.

Bruce A. Efird

Well I think the real key is really you know I think that you can’t eat it, you don’t need it type of phrase is still out there. It’s really that they’re looking for product that they you know current consumption, but we are seeing a few trends into some other areas. But again the consumer confidence levels, we are seeing some slow growth increased consumer confidence in some of the reports we’re getting so that does bode somewhat well for the upcoming months.

Operator

Your next question comes from Jillian Caruthers - Johnson Rice & Company.

Jillian Caruthers - Johnson Rice & Company

If you could talk about the ability to offset the higher marketing spend given you’ve maintained your annual guidance for the year?

Bruce A. Efird

Yes, Jill, I’ll start with that one and then we can move on to Dave. But yes we did add our marketing items in there but with the initiatives that we’re seeing, the results that we’re seeing from our initiatives in some of the expense areas, being able to control our store costs and then getting into the distribution and merchandising costs as well as some of the improve margins we’ve seen we were able to take that and put that into the advertising dollars to drive the sales then to go forward. So we did quite a bit of reallocating to do that but feel comfortable that’s the right answer.

David B. Mueller

And we do anticipate the additional incremental sales from those investments, plus we also have partnered with our suppliers to put some additional marketing efforts out on the street that they have supported us with.

Jillian Caruthers - Johnson Rice & Company

And then inventory down 8% is impressive at the end of the quarter. If you could talk about where those reductions are coming from? Is it more on the consumables days or the discretionary categories? And then what’s your planned kind of inventory going into the back half?

Bruce A. Efird

Jill, starting out on that one where we really saw it was that we’ve been able to control the quality of the inventory in those areas such as soft lines and home lines. We made a strong effort this year to maintain portion of the open to buy that allows us to flex towards sales levels, so we’ve improved the quality of the inventory greatly in those areas. And then Keith has done a good job and I’ll let you comment in terms of the consumables and all the other types of inventory that we carry.

Dennis Keith Curtis

Well, Jill, I would add that you know a disciplined performance to our budget which included the realization of what was happening in the marketplace. Everything begins with a good budget so the control of those inventories has been due to a discipline to our established budget, and better execution of our clearance programs as Bruce alluded to to reduce our aged inventory in the stores also has been a key. We continue to give the customers what they’re wanting in our basic consumable areas and our inventory positions are good. As Bruce also alluded to, we feel that the focus on the basic fundamentals and the inventory in stock position will continue to give us continued improvement there.

Bruce A. Efird

Jill, just to add one more point, the team has done a very good job with improving the allocations process as well as more disciplined around managing to the open to buy. And I guess the third point I would make is relative to the in store shopping experience where we have taken a lot of merchandise down off the risers and lowered the profile in the store to improve the overall shopping experience. That has had an impact on our ability to better manage our in store inventory to the sales.

Jillian Caruthers - Johnson Rice & Company

And are you expecting these declines to continue throughout the back half?

Dennis Keith Curtis

Jill, they will level off. I would not expect to see continued decreases.

Operator

Your next question comes from Patrick McKeever - MKM Partners LLC.

Patrick McKeever - MKM Partners LLC

I was just wondering if you could give us some thoughts on I was looking at that Walgreen’s deal that was announced I think this morning with Caterpillar to supply prescription drugs to Caterpillar employees and publish their pricing and that kind of thing. Just that general dynamic, I think Wal-Mart’s involved with Caterpillar as well. I mean how do you see that basic dynamic unfolding as it relates to your pharmacy business? Kind of the big players in the retail pharmacy business putting together these agreements with big employers and so forth. How do you see that unfolding?

Rick A. Chambers

Patrick I mean obviously when we hear those, those are obvious areas of concern as you were pretty obvious there with that statement I guess but it’s a situation that we look at. But if we go back and see where we’re located rurally in the markets that we’re in with the majority of our pharmacy stores, we believe that we still serve a need in a niche there and in several of the communities that we’re in we may be the only provider within a county for example. And there’s still access issues when they roll these plans out for these individual contracts, but obviously it is something that we’re aware of. We’re watching. We’re putting plans in place as well on our side to develop a program on a go forward basis to be able to counteract that. Again going back, playing to the strength of our rural markets. And we see that as a very big opportunity and upside for us as well.

Patrick McKeever - MKM Partners LLC

And I mean just on that basic question or theme, how are your pharmacy stores doing? How are the stores that compete that are located in areas where there has been a new Walgreen’s or CVS open within the past year or so? How do those stores do versus the stores that are more insulated from the national drug store chains?

Jerry A. Shore

Patrick, I’ll take that first and then Rick can. We’ve consistently seen our pharmacy comp scrips and comp store performance increase and it’s been extremely consistent. So there’s not been major changes in that area and you know pharmacy has always been a little bit different business in that pharmacy customers are very loyal. So you know from my point of view and effect on comps we haven’t seen that. Rick?

Rick A. Chambers

I would agree with that as well. Again so much of our business as Jerry said is driven by the people behind that counter so many times. And I hate to keep over playing the rural presence of our store footprint but it really plays to one of our strengths that we’re able to go in even with a Walgreen’s, CVS coming into our market and still hold market share and even grow market share. And obviously as we go forward with our new growth strategy in pharmacy as Bruce alluded to earlier our file buy acquisition program will be a core tenet of that growth but also looking for cold start opportunities where we can identify key individuals and use that as a strength as well. Because it’s so much tied to the person behind that counter and we again it’s been very successful for us on a go forward basis.

Operator

Your next question comes from John Lawrence - Morgan Keegan & Company.

John Lawrence - Morgan Keegan & Company

Bruce, would you start off by just when you really put the initiatives in place you really started with those battleship stores and how many of the stores now do you believe have sort of been fully implemented with all the programs that are at least out there at this point?

Bruce A. Efird

John, let me just start out by some general battleship program comments. Overall we are seeing our battleship stores exceed the balance of the store chain on sales comps at about 200 basis points improvement, began over the balance of the residual stores. Contribution as well is one of the measures that we look at in the battleships and they are tracking to our plan. Some of the initiatives, we have a number of initiatives one of which is better shrink control and we’re seeing favorable results versus expectations. Our audit process we’re seeing improved audit pass percentages relative to the balance of the fleet.

And one key indicator that we evaluate as well is our customer service scores and our battleships are running at 91% positive customer service or SWAN scores versus the balance of the chain at 84.3%. We also have John some additional Saturday specials. One of the challenging areas that we’ve seen is our Saturday sales and we put in place the Saturday Special Sales program. That’s showing positive results within the battleships that we see and we’re actually carrying that forward into additional high volume stores. So we’re pleased with some of the results and that the battleship stores are garnering.

John Lawrence - Morgan Keegan & Company

And the number of the battleships now? What is it, 75, 80? Or is it closer to 100?

Bruce A. Efird

No, John, it’s still 50.

John Lawrence - Morgan Keegan & Company

Okay. Just 50. Okay.

Bruce A. Efird

Yes. We discussed moving that number up but our goal as a team is to insure that we’re executing with excellence in those 50 stores prior to moving those initiatives out into other stores. We did evaluate the stores at the end of 2008 and some new stores went on. Some stores that did not perform at the expectations fell off the program. So again it’s something that we constantly monitor and again the true bellwether is the improved corporate contribution versus the budget and that is on plan year-to-date.

John Lawrence - Morgan Keegan & Company

And would that contribution be higher than the 200 bips?

Bruce A. Efird

Yes.

John Lawrence - Morgan Keegan & Company

Back on the inventory question, if you look at having more open to buy does that give you more flexibility in say end of life product and some of those treasure hunt items for the second half?

David B. Mueller

Yes. Definitely. And this was really a time when we wanted to lead into that point and Keith you may want to address how that’s helped you.

Dennis Keith Curtis

Okay. Sure. Yes, John, it has. Again in our budget we did make room to make sure we could fund our surprise in line initiative and our treasure hunt opportunity buy. We’ve actually purchased almost four times as much in this market as we did during the same period in 2008 year-to-date in 2009. And we continue to increase our presence in the opportunity market out there and we’ve recently been able to take advantage of some key offerings for the third and fourth quarter. And they will definitely contribute to both our sales and margin performance in the second half. And we do find that that opportunity market is still strong for us and we now have many of the key players out there that are looking specifically for buys that will fit Fred’s strategy and Fred’s needs.

And our smaller store count actually puts us in a very good position to take advantage of those great buys that may not be in huge quantities. So overall we’re pleased with the sell throughs that we’ve had on the purchases that we’ve made and we’re very committed to grow this piece of our business in a controlled and responsible manner. And also we’ve had some great customer feedback. They’ve indicated that this is something that enhances their shopping experience at Fred’s and we definitely want to continue that.

John Lawrence - Morgan Keegan & Company

And just the last question there is that different type of product or different sourcing of the product? What would be different this time around?

Dennis Keith Curtis

We have added to our sourcing. You know as we got more active in the market obviously we’ve had more people seeking us out as they knew we were more involved in the market. So we do have many more suppliers that we’re dealing with on opportunity buys. And as far as the types of merchandise we’ve really been able to find some very good buys throughout the year in our toys and electronics and appliances, and some of the more discretionary areas where customers definitely will be looking for off price and value.

Operator

Your next question comes from Andrew Wolf - BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

I just wanted to ask on the food and tobacco which you all combine, it’s growing and actually grew better in the second quarter than the first despite you know disinflation or maybe outright deflation in some food items and you know your traffic wasn’t up, it was relatively flat. So was it really just a function of a lot of the inflation we’re seeing in the tobacco category or is it something in the merchandising as well?

David B. Mueller

Yes, Andy, you’ve hit it well that they’re really combinations of cost changes and price changes on the general food side of it but then also the inflation on the tobacco side of it. But without getting into great detail on a lot of different items it really is that combination.

Andrew Wolf - BB&T Capital Markets

Do you feel like the food disinflation impacted your same-store sales somewhat as Wal-Mart talked about or is it not enough of your mix? Or did you have good enough results on the unit side in food that that really wasn’t the case?

Bruce A. Efird

Yes, we’ve seen minimal impact overall. Keep in mind our food mix relative to a Wal-Mart is smaller and we obviously don’t have the perishable, the meat, produce, deli, bakery where there is deflation in those departments as well. There is some deflation but nothing of a major impact.

Andrew Wolf - BB&T Capital Markets

And just sort of housekeeping, Jerry, but on the $0.73 to $0.80 on the EPS guidance are you including or excluding the $0.02 for the audit costs this quarter?

Jerry A. Shore

I have that in there. So you know ex the tax we would be $0.02 higher in the low end and the high end. We’d be $0.75 to $0.82.

Operator

And are you ready for me to turn the call back over to management?

Jerry A. Shore

Yes, please.

Bruce A. Efird

Yes. Thank you for your interest and your questions and we look forward to continuing the positive momentum of these initiatives and things that we’ve talked about through the balance of the year. Have a great day.

Operator

That concludes today’s conference.

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

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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

Source: Fred’s Inc. Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts