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Executives

Pat Watson

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

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

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

Rick A. Chambers - Executive Vice President of Pharmacy Operation

Analysts

Matthew Siler - Deutsche Bank AG, Research Division

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

John R. Lawrence - Stephens Inc., Research Division

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

David G. Magee - SunTrust Robinson Humphrey, Inc., Research Division

Cristan Blackman

Fred's (FRED) Q3 2013 Earnings Call November 26, 2013 10:00 AM ET

Operator

Good day, and welcome to the Fred's Third 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.

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 third fiscal quarter and first 9 months of the year, that ended on November 2, 2013.

Before we begin, I would like to remind everyone, that management's comments in this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and are subject to uncertainties and risks. It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued earlier today, 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 believed accurate as of today's date, November 26, 2013. 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 expressed written consent of the company is prohibited. With those announcements, I'll turn the call over to Jerry Shore, the company's Chief Financial Officer. Good morning, Jerry.

Jerry A. Shore

Good morning, Pat, and good morning to everyone on the call. Thank you for joining us this morning, for our discussion of third quarter results for 2013.

With me, this morning, and available for questions are Michael Hayes, Chairman; Bruce Efird, Chief Executive Officer; Rick Chambers, EVP of Pharmacy Operations; and Alan Crockett, EVP and Chief Merchandising Officer.

As the company reported in its press release this morning, total sales for the third quarter were $460.5 million compared with $450.6 million last year, a 2% increase in the quarter. On a comparable store basis, sales increased 1.4% for the quarter compared with a decline of 2.5%, in the same quarter last year. The quarterly sales mix comparison was as follows: Household goods were 19.4%, a decrease from 19.9% last year; apparel and linens were 5.2%, decrease from 5.9%; health and beauty were 7%, decreased from 7.7%; paper and chemical were 8.8%, decreased from 9.4%; food and tobacco was 17.8%, increase from 17.3%; pharmaceuticals were 40.1%, increase from 37.9%; and franchise were 1.7%, decrease from 1.9%.

For the quarter, comparable store customer traffic decreased 1% from last year, while the average customer ticket increased 2.4% to $20.76.

For the first 9 months, total sales increased 2% to $1.444 billion compared with $1.422 billion in the year-earlier period. And on a comparable store basis, sales increased 1.1% this year, compared with a decline of 0.8% last year.

The year-to-date sales mix was as follows: Household goods, 21.6%, decrease from 22.3% last year; apparel and linens were 5.8%, decreased from 6.3%; health and beauty were 7.1%, decreased from 7.5%; paper and chemical were 8.7%, decrease from 9%; food and tobacco were at 17.7%, increased from 16.7%; pharmaceuticals were 37.4%, increased from 36.4%; and franchise were 1.7%, decrease from 1.8%.

On a year-to-date basis, comparable store customer traffic increased 0.1%, while the average customer ticket increased 1% to $20.79.

Total company sales per selling square foot for the past 12 months are $209 compared to $203 a year ago, a 3% improvement.

For the third quarter, Fred's net income increased 11% to $7.3 million or $0.20 per diluted share, compared with net income of $6.6 million or $0.20 per diluted share in the year-earlier period. The primary drivers of the 11% -- correction, the $6.6 million was $0.18 in the year-earlier period. The primary drivers of the 11% increase in earnings for the third quarter were the pharmacy department growth and company-wide expense management. For the first 3 quarters of 2013, net income was $22 million or $0.60 per diluted share versus net income of $23.1 million or $0.63 per diluted share in the first 3 quarters of 2012. As a reminder, 2012 included the benefit of approximately $4.2 million or $0.12 per diluted share of favorable tax credits. Primarily related to a state income tax settlement in the second quarter, as well as adjustments for other tax-related assumptions and estimates. Excluding the benefit of this onetime settlement, the year-to-date 2012 net income was $18.9 million or $0.51 per diluted share. Compared to the adjusted 2012 results, the year-to-date 2013 net income increased 17%, and earnings per share increased 18%.

Earnings before interest and taxes, or EBIT, was $10.6 million or 2.3% of sales in the third quarter, up 5% from $10.1 million or 2.2% of sales in the year-earlier period. For the first 3 quarters of 2013, EBIT increased 10% to $33.6 million or 2.3% of sales compared with $30.6 million or 2.2% of sales last year. EBITDA, or earnings before interest, taxes, depreciation and amortization, during the third quarter increased 6% to $21.3 million or 4.6% of sales compared with $20 million or 4.4% last year. EBITDA for the 9 months ended in October, increased 10% to $65.1 million or 4.5% of sales compared with $59.3 million or 4.2% last year. Gross profit for the third quarter increased 2% to $140.2 million compared with $138.1 million, in the same period last year. Gross margins for the quarter decreased 20 basis points to 30.5% compared with 37 -- 30.7%. The decrease in gross margin was primarily driven by higher general merchandise markdowns and general merchandise shrinkage. LIFO expense on pharmacy department inventory was favorable in the quarter by $0.6 million, and favorably impacted gross margin by 13 basis points and earnings per share by $0.01.

Gross profit for the first 3 quarters of 2013 increased 2% to $427.2 million from the $417.7 million, in the same period of 2012. Gross margin for the year-to-date period increased 20 basis points to 29.6% compared with 29.4% last year. The increase in gross margin was primarily driven by higher pharmacy department volume rebates. LIFO expense was unfavorable for the first 9 months of the year by $1.9 million, and unfavorably impacted gross margin by 10 basis points and earnings per share by $0.03.

Selling, general and administrative expenses for the quarter improved 30 basis points to 28.2% of sales, compared with 28.5% of sales last year. The leveraging is attributable to decreases in labor expense and insurance expenses. This favorability was offset by increased store occupancy costs and depreciation expense, primarily a result of the investments in new store and pharmacy department growth. On a year-to-date basis, SG&A expenses are 27.3% of sales in 2013 compared with 27.2% of sales in 2012. The 10 basis point deleverage for the year-to-date period is primarily attributable to an increase in depreciation as a result of the investments in new store and pharmacy growth.

Depreciation and amortization totaled $10.6 million in the third quarter, and $31.5 million for the year-to-date period. This compares to $9.9 million in the quarter and $28.7 million in the year-to-date period in 2012. For the third quarter of 2013, net interest expense was $113,000 compared to $129,000 in the same quarter last year. On a year-to-date basis, net interest expense totaled $377,000 in 2013 compared with $402,000 in 2012.

Income tax expense was 30.6% of pretax earnings in the third quarter, compared with 34.3% in the third quarter last year. On a year-to-date basis, the income tax rate was 33.7% as compared to 23.6% last year. Again, as a reminder, the 2012 included the benefit of approximately $4.2 million or $0.12 per diluted share of favorable tax credits related to a state income tax settlement in the second quarter, as well as adjustments for other tax-related assumptions and estimates. Excluding the benefit of this onetime settlement, the 2012 year-to-date income tax rate was 37.5%. The lower effective tax rate for the quarter and year-to-date periods reflect the impact of the Work Opportunity Tax Credits, which have congressional approval this year, but were not approved last year, until late in the fourth quarter. We expect to end the year at a tax rate of 34% to 35%.

Moving to the balance sheet. Cash and cash equivalents were $21.6 million compared to $16.2 million in the year-earlier period. The increase from last year is primarily attributed to the year-over-year sales growth of 2%, coupled with an inventory decrease. Total inventories decreased 1.8% to $385.6 million, compared with $392.5 million in the third quarter of 2012. The decrease in inventory reflects the focus on managing our inventory levels. We continue to believe the quality of our inventory is strong, and we are well stocked for the upcoming holiday season. Inventory turns remained at 3.8 turns, the same as last year. And we intend to end the year at approximately 3.9 turns.

Total capital expenditures for the third quarter totaled $6.2 million compared with $7 million in the third quarter of 2012. The breakdown of capital expenditures in the quarter were: $3.8 million for existing stores and pharmacies; $1 million for new stores and pharmacies; $0.8 million for corporate and technology upgrades and $0.6 million for DC equipment. Additionally, during the third quarter, there was $5.3 million related to acquisitions of pharmacies as compared to $5.1 million in the third quarter of last year. On a year-to-date basis, capital expenditures totaled $20.2 million compared with $19.1 million for the first 3 quarters of 2012. The breakdown of year-to-date capital expenditures were: $13.4 million for existing stores and pharmacies; $2.2 million for new stores and pharmacies; $2.5 million for corporate and technology upgrades and $2.1 million for DC equipment. Year-to-date expenditures for acquisitions of pharmacies were $13.1 million, the same as last year.

At the end of the third quarter, accounts payable was $145.3 million or 38% of inventory, compared to $153.5 million or 39% of inventory in the same quarter last year. The lower percent of inventory this year reflects our earlier receipts of seasonal merchandise.

Total debt at the end of the quarter was $5.3 million as compared to $6.7 million last year. There was no debt at quarter end on the company's revolving line of credit.

For the first 3 quarters of 2013, net cash provided by operating activities was $57.5 million. And free cash flow, which we identify as net cash provided by operating activities minus capital expenditures and pharmacy acquisitions, totaled $23.9 million.

At the end of the third quarter, there were 630 company-owned full-size stores, 50 company-owned express stores, 21 franchise stores, for a total of 701 discount general merchandise stores and 354 pharmacies.

In the third quarter, there was a net increase of 4 locations. Fred's opened 4 full-size stores, 4 Xpress pharmacy locations and closed 1 full store, and 3 Xpress pharmacy locations. For the third quarter 2013, (audio gap) Fred's opened a net of 4 new pharmacy locations. For the first 3 quarters, Fred's had a net decrease of 11 locations. The net decrease consisted of opening 7 new stores, and 10 Xpress pharmacy locations, and the closure of 21 full stores and 7 Xpress pharmacy locations. We've opened 8 net new pharmacy locations during the year. The company's selling square footage was approximately 9.4 million square feet, compared to 9.6 million square feet in the same period last year. The reduction in square footage is primarily the result of the store closures that took place in the second quarter. We now expect to open a range of 10 to 14 stores and 20 to -- and 25 to 30 new pharmacies in 2013. Closings for 2013 are expected to be approximately 25 stores and 10 pharmacies. Year-end selling square footage is projected to be 2% below year-end 2012.

Our financial guidance for the remainder of the year is as follows: For the month of November, total sales are projected to be flat to up 1.5% as compared to last year. Comparable store sales are projected to be in the range of down 1% to positive 1%. The month got off to a slow sales start with the calendar shift of Thanksgiving moving from the third week to the fourth. With this being the Thanksgiving Black Friday and first of the month week, we are expecting strong sales this week. Our stores are open Thanksgiving Day, and our Black Friday specials are very strong.

In the fourth quarter of 2013, the company expects total sales to increase in the range of 1% to 3%. Comparable store sales are expected to increase between flat and up 2% versus a decrease of 2.8% in the comparable 13-week fourth quarter last year. Earnings per diluted share are projected to be in the range of $0.18 to $0.23 in the fourth quarter. Last year, earnings per share in the 14-week quarter were $0.18 and $0.15 in the comparable 13-week quarter. As projected -- as compared to the 13-week quarter last year, earnings per share are projected to increase in the range of 20% to 53%.

Total 2013 earnings per diluted share are now projected at $0.78 to $0.83. Comparing to 2000 results, excluding the onetime tax benefits, earnings per share is projected to increase in the range of 13% to 20%.

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

Bruce A. Efird

Thank you, Jerry. Good morning, everyone. We appreciate you joining us this morning, on this busy Thanksgiving week. And to follow up on Jerry's comments, this morning I would share with you, a summary of what we saw in the third quarter performance, as well as how we're thinking about our near-term and long-term opportunities. After reading and listening to a number of recent retail company earnings releases, I don't need to spend much time on the challenges on our customers, resulting from increased payroll taxes, the government shutdown, SNAP or EBT benefit reductions and the unusual holiday calendar. Overall, the economy in the Southeast continues to be challenged with higher unemployment and wavering consumer confidence. I'd rather spend time more positively, by turning inward, to areas that are more controllable and how we plan to leverage future opportunities.

Starting with our overall financial performance for the quarter, we are pleased to report an 11% increase in earnings for the third quarter.

Moving to healthcare services. Our pharmacy department continues to grow and outperform our expectations. We excelled in most areas of the Pharmacy business. Our team drove traffic, in the pharmacy department, with a total script increase of 4.4% and sales increase of over 8.2% during the quarter, while maintaining our track record of positive script comps. Combination of script and new pharmacy acquisitions growth has contributed to improving overall Pharmacy gross profit. The gross margin improvement in the pharmacy department has continued despite significant third party reimbursement pressures. We estimate public and private third party reimbursement reductions to be approximately $3.6 million or $0.06 per share in Q3 and $8 million, or $0.14 per share, during the first 3 quarters of 2013.

The pharmacy department margin improvement continues to come from the increased in generic penetration rate and purchasing productivity. As Jerry noted, the Pharmacy sales mix increased to over 40% of our total sales mix during the quarter. This is the first time in the history of the company, that Pharmacy sales have exceeded the 40% mark. This has been accomplished despite the top line pressures from ongoing brand-to-generic conversions. We are exceptionally pleased with the growth of our immunizations in the pharmacy department. So far this year, we have expanded immunizations given by over 78% during a delayed flu season, on top of a 43% increase during Q3 of last year. Our Pharmacy team has done an excellent job, communicating with customers regarding the immunizations available beyond the typical flu shots. We anticipate strong immunizations growth to continue in the future.

We're also pleased with the Pharmacy acquisition opportunities and growth in new pharmacy departments. The team has completed 19 acquisitions through the third quarter, consisting of 12 new locations and 7 incremental acquisitions. We've also opened 4 cold start pharmacies through the third quarter. The pharmacy acquisition opportunities continue to look favorable for the foreseeable future and we remain committed to allocate capital to leverage these growth opportunities. I'll remind you that stores with pharmacy departments perform at levels higher than our overall 4% operating margin goal. Strategically, one of the most notable accomplishments in the third quarter was the opening of our specialty Pharmacy operation, EIRIS, E-I-R-I-S Health Services. And if you're wondering where we got the name EIRIS, it comes from the Norse God of healing. EIRIS is a stand-alone specialty pharmacy that will support our ongoing relationship with Diplomat Specialty Pharmacy, which began in the first quarter of this year. Specialty scripts are the fastest-growing segment within the pharmacy industry, with specialty drug spend anticipated to increase by almost 20% in both 2014 and 2015. Specialty scripts are projected to quadruple and exceed $400 billion by 2020. With 2013 being our initial entry into the Specialty Pharmacy segment, we are experiencing an 8% increase in specialty scripts, and a 13% increase in sales associated with those scripts.

Shifting to general merchandise, we made progress in several areas, including driving sales in the reconfiguration program departments, expanding our marketing programs and managing inventory. I'll also comment on our concept stores that are still in design stage and test phase, Getwell Drug & Dollar and Yazoo Trading Company stores.

First, we completed phase 3 of our Hometown Automotive and Hardware expansion program, in approximately 150 stores during the quarter. Bringing the total number of stores with expanded automotive and hardware to 323, or 46% of the chain. The expanded automotive and hardware categories continued to show strong performance, posting comp gains on a year-to-date basis of 18% and 40%, respectively. Additionally, in stores with expanded automotive and hardware, comp sales and traffic are outpacing the remainder of the chain. Comp sales for the third quarter in stores with Hometown and automotive -- Hometown, Automotive & Hardware outperformed the remainder of the chain by over 300 basis points, and by approximately 180 basis points on a year-to-date basis. Also, during the quarter, in 75 of the reconfigured stores, we expanded health and beauty aids, as well as seasonal space. Categories expanded in health and beauty aids include vitamins, cosmetics and adult nutrition, just to name a few. The initial read, although still very early, as these stores are completed by the end of the third quarter, is very positive. We have identified an additional 150 to 175 stores, that will be reconfigured in 2014 with our expanded Hometown, Auto & Hardware, expanded health and beauty aids and added seasonal space, where allowed.

Moving ahead to our marketing efforts. Throughout 2013, we have continued to expand our loyalty card, the Fred's smartcard.

The smartcard is being used as a reward -- to reward loyal shoppers while gaining insight into the behaviors and shopping patterns of these customers. Through the third quarter, we have approximately 2.1 million activated cards with approximately 21% having enrolled accounts. Sales from activated smartcard customers are approximately 12% of total general merchandise during the quarter. Enrolled smartcard customers are generating basket sizes that are approximately 41% higher than non-card transactions and are visiting the store twice as often. The information gained from the smartcard allows us to communicate directly via email to these customers. And in the future, we'll target our promotions toward these more loyal customers that are higher purchasers. So far, the customer response to our loyalty program has been very favorable.

Also as part of our expanded marketing efforts in 2013, we distributed 3 additional midmonth ads during the quarter with favorable results. Third, during the quarter, we opened one additional Getwell Drug & Dollar store, bringing the total to 6 stores, and we added 4 Yazoo Trading Company stores, bringing the total to 5. Both of these concept stores are still in the test phase with continuous refinement taking place. We will continue to improve upon these concepts and incorporate key wins into the existing Fred's chain. Although both of these projects are in early test phase, we expect these new concept stores to expand growth opportunities for Fred's in the future. As we look forward beyond this year, we expect our new concept stores, specialty pharmacy expansion and our Hometown Auto & Hardware program and the future reconfiguration program initiatives to be key drivers of future success.

Also, I'm pleased to note that our customer satisfaction scores are tracking well above last year's record performance. We are especially pleased with Fred's balance sheet and cash flow. At the end of the third quarter, cash ended the quarter above our internal forecast as we managed key assets, areas of inventory, accounts receivable and capital expenditures. We ended the quarter with no borrowings under our revolving line of credit, with only minimal debt for real estate loans. The 1.8% increase in total inventory was in line with our projections, and our stores are well merchandised for the upcoming holiday season. The general merchandise department inventories were 2.5% below last year, and pharmacy department inventories were in line with growth and inflation. Our merchandising team accomplished this inventory reduction while maintaining our in-stock and service-level goals. Through the end of the quarter, we have produced approximately $65 million in EBITDA, while generating almost $24 million in free cash flow. We expect to end the year with EBITDA in the range of $87 million to $89 million, a 10% to 14% increase over last year, and free cash flow in the range of $20 million to $30 million.

Moving to future growth, Pharmacy expansion will be an ongoing priority for Fred's, and we continue our reconfiguration objective of attaining 65% to 75% penetration of pharmacies in our base of company-owned stores by the end of 2015. At the end of the third quarter, we had 354 pharmacies with a base of 680 total locations, or 52%. We expect our year end Pharmacy penetration to be in the range of 53% to 54%. We will open 10 to 14 new stores and 25 to 30 new pharmacies during the year. The growth of new pharmacies is in line with our original 2013 expectations. Our focus for the remainder of 2013 and moving into 2014 will be to identify and acquire pharmacies that will move into an existing store without a pharmacy today.

So summing up, the foundation of the company is strong, and the team has built a solid merchandising and operational plan to drive a successful fourth quarter. Our store is in great shape for the next few days and beyond from a merchandising and operational execution standpoint. We've enhanced our marketing program during the fourth quarter, including Wild Wednesday specials before Thanksgiving, Expanded Thanksgiving Day specials and Hours, and over 40 new items for Black Friday and a more basic approach to December with broad category statement and value messaging.

The team is confident that the work and the success of the first 3 quarters will continue to drive stronger results into the fourth quarter. As Jerry noted, earnings per share growth over a comparable 13-week quarter will be in the range of $0.18 to $0.23 EPS, which represents a 20% to 53% increase in the fourth quarter when excluding the benefit of the 53rd week last year. Again, I want to thank you for joining us today. We wish you all a very happy Thanksgiving. And now, I will turn the call over to our operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Paul Trussell with Deutsche Bank.

Matthew Siler - Deutsche Bank AG, Research Division

It's actually Matt for Paul, sorry about that. I was just hoping you could talk a little bit more about the 2 concept stores. I mean, obviously, you've opened a few more of each this past quarter. Just kind of, what you're doing in terms of where you're targeting the stores, where you're placing them and what you're seeing within the box that's got you excited about each concept.

Alan C. Crockett

Paul, this is Alan, I'm sorry, Matt. The 2 concept stores are, as Bruce said, we opened 1 additional Getwell in the quarter and 4 additional Yazoo Trading Companies in the quarter. Both of the stores are in the early phases, but certainly both have different purposes. The Getwell Drug & Dollar really targets smaller communities where we might not have had the opportunity to put a full-on Fred's store, but had a great opportunity for an acquisition of a pharmacy. So we created a smaller store to take advantage of that situation and we are, as I said, still early in the test phase but doing well with those. And then Yazoo Trading Company really is a different kind of store in terms of the mix being primarily driven by 3 main categories of hardware, automotive and pets, in addition to a heavy seasonal emphasis and then the original sort of concept of Fred's of heavy consumables such as paper, ink and those kinds of things. And we're targeting those stores really to -- we really looked at sort of a cross section of small towns to more medium-sized towns to look at the performance in each of those and how those would react. So again, early in the test phase of both of those stores, but learning things from them and applying those learnings to the Fred's chain and we'll be looking to refine those as we go forward.

Bruce A. Efird

And Matt, just to add to that, we see both of these concepts as an investment in our future growth. Again, as Alan noted with the Getwell Drug & Dollar, we see opportunities for further expansion in pharmacies in towns that are not big enough to support a 16,000 square foot Fred's store. And then we see leveraging the Yazoo Trading Company, both from a potential growth standpoint in the future, but one of the residual benefits that we are seeing is we're finding items in categories in certain departments that are performing exceptionally well in the Yazoo Trading Company stores that we're bringing some of that learning and some of those items -- stronger items into our existing Fred's stores to bolster the overall performance of our existing Fred's stores without pharmacies.

Operator

We'll go to our next question from Andrew Wolf with BB&T Capital Markets.

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

Wanted to ask on the Pharmacy, with the jump to 40% of sales, is that to do more with the new units or is that also sort of coming from the specialty drugs increasing as a percent of that?

Jerry A. Shore

Andy, this is Jerry. I will comment first, and then we can turn over to Rick, but the -- we had a good total sales increase on the comp side, but then we also had the growth in pharmacies. So it's really coming from both. It's not as much so far in the specialty, it's more on the growth in retail scripts and new locations.

Rick A. Chambers

Yes, this is Rick. And on the specialty portion of that, it's around 50 basis points of our sales comp that we're seeing -- on a comp basis that we're seeing, and Bruce and Jerry both had alluded earlier to, we're up around 13% on total specialty sales year-over-year or a year-to-date basis. So we are seeing some lift through specialty, but as Jerry noted, it's not to the level, but obviously, we'd anticipate going forward, but it's a combination of several moving parts.

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

Okay. And as the new organization you announced, the specialty drug business, can that in and of itself get -- move that up either through greater resources or other means, or what's your outlook on specialty going forward?

Rick A. Chambers

Really, they're similar to what we've outlined in the past, but we're leveraging our relationship with Diplomat, that's still in place today, looking to leverage the rural footprint of our Pharmacy stores and then being able to use that in terms of our relationship with Diplomat, then also the organic growth through EIRIS Health Services that we'd look to do with commitment of resources both in headcount, sales teams and so forth. And then, obviously, as we've talked in past quarters about the acquisition opportunities that exist out there in that space and looking to capitalize on those when those become available.

Bruce A. Efird

Yes. Andy it's aligned with the three-pronged approach into growing specialty that we outlined earlier this year. One is through an internal buildout, which that internal buildout is EIRIS. And then the second is continuing to leverage our relationship with Diplomat Specialty Pharmacy and then the third being identifying or seeking an acquisition opportunity. So it's very much aligned with our internal strategy communicated earlier this year.

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

Got it. And Rick, the numbers that were given out, it sounds like the third quarter had an acceleration in reimbursement rate pressure. And trying to get into that, is that -- are you counting -- macking [ph] down sort of recently introduced generics in there? Or is that just more of a pure number on the book of business x the newer generics, just lower rates from the parties you mentioned, public or private?

Rick A. Chambers

It's actually a combination of both, because the way we model that number, it has to do with -- it's really hard to break -- we don't really break it out into separate segments, we look at it overall in terms of year-over-year change both from a private and public payer. Obviously, which -- those branded-to-generic conversions are in those numbers. So it's not exclusive of the brand-to-generic impact, so those are in our numbers as well. And it did accelerate, to your point, and obviously, going into 2014, as we're preparing for budgets and finalizing that number, obviously, is bigger going into '14 than we anticipated coming out of '13.

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

And just one follow-up and then I'll get into queue. So are you able to tell us is the acceleration coming from increased macking [ph] down of previously more profitable generics? Is that -- why it accelerated in Q3?

Rick A. Chambers

That -- and more so with the class of 2012 because '13 -- the 2013 class was not really that heavily weighted in terms of conversions in so many of the bigger drugs are actually occurring in the fourth quarter. So to answer your question, I would say, yes. It has to do with that maturing and that's somewhat how we referred to it of those earlier brand-to-generic conversions. And, obviously, the market responds fairly quickly on taking the price down, and not going the other way, as you know.

Operator

We'll go to our next question from John Lawrence with Stephens.

John R. Lawrence - Stephens Inc., Research Division

Bruce, would you start off a little bit. It appears the ad, as you mentioned, expanded items. Would you just touch a little bit on that as far as it looks like there's a lot more items in the ad, can you just touch on that a little bit and the categories you are trying to hit?

Alan C. Crockett

You're talking about, John, the existing ad that we have out right now?

John R. Lawrence - Stephens Inc., Research Division

That's right, the existing ad for this week.

Bruce A. Efird

Yes. John, a couple of things that -- we made changes relative to having broader value statements, #1. #2, we did add some additional items to the ad, Black Friday this year. We do have more items, but more specifically we've identified unique items that customers come to Fred's for. And we're leveraging that versus trying to -- as we've done in the past, going head to head on a television or some of the top electronic items, but we have unique items in the ad. So some of the changes, we do have an aggressive, as I noted in my comments, Wild Wednesday specials to -- as everyone, a number of retailers are pulling Black Friday further into Thanksgiving even into this past weekend, we see an opportunity to pull forward, not only with better specials on Thursday, but driving that traffic on Wednesday, and all of the promotional markdowns are in our current projections.

John R. Lawrence - Stephens Inc., Research Division

Great. And is there anything -- so overall, on that sort of format, you feel better that -- you've sort of the range of fourth quarter earnings, you feel better about sales because of the lineup and even though the major discounter is more aggressive, you feel like you're less in their headlights than you have been?

Rick A. Chambers

Well, John, we absolutely anticipate one of the most intensely competitive promotional selling periods that we've seen in recent years. However, we're confident in the changes that we've made in our program that we'll be able to drive sales, our service level at store level or in-stock position is actually better than last year. Our operations team just finished their operational execution readiness checks this year, and our scores overall were above last year. So we have a lot of confidence based on the executed changes in the merchandising and advertising and marketing, as well as the execution levels. Alan, I want to know if you have anything else to add?

Alan C. Crockett

I think you covered everything, Rick.

John R. Lawrence - Stephens Inc., Research Division

Yes. And just to go back to general merchandise, you quoted a couple of stats regarding the auto and hardware stores. So the trick has been in those stores traffic is a little better driving that comp. So ideally, you're getting more people to come into that auto hardware renovation.

Bruce A. Efird

We're seeing both the traffic and ticket increase in the reconfigured stores because a number of the category -- automotive hardware category expansions do include items that are at a higher dollar range, such as expanded tools and some plumbing and some electrical and some of the departments that we've expanded are a little bit higher dollar range.

Alan C. Crockett

John, this is Alan. As I mentioned on the last call, we are attracting a different customer with a different shopping trip, that needs based, fix it up trip and we're seeing that sort of spill over into the home area with improved results in home and those stores as well. So in addition to our current customer seeing the newness we are attracting a different customer, which is helping traffic in those stores as well.

Jerry A. Shore

This is Jerry, I was just going to give you one more number. The auto and hardware departments in the quarter, just those departments by themselves comped positive by 7%, and were really 2 of the strongest departments in the whole chain during the quarter.

John R. Lawrence - Stephens Inc., Research Division

Okay. On the cost side, Jerry, you mentioned, I guess, insurance and also labor. How do we think about that as far as --you line up those items that shrink and insurance and your outlook for the quarter?

Jerry A. Shore

John, in the fourth quarter, we're really expecting a small amount of leverage. It's very difficult to project the insurance expense. We've been very fortunate this year with lower group medical and fewer property and casualty claims, but it's very difficult to project that going forward. We are projecting -- our projections are based on higher insurance expense in the fourth quarter. We are and will continue to do a good job of managing our labor in the stores.

Bruce A. Efird

And one of the adjustments, John, that we've made this year is recognizing the shift to more direct store delivery product and consumables. Our team has done a very good job of making adjustments in labor because, obviously, it takes less labor to process those transactions DSD product versus warehouse shipments. So it's something we did not do as well at last year, that we learned from and have made adjustments and improved on this year.

Operator

[Operator Instructions] We'll take our next question from Jill Nelson with Johnson Rice.

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

Can you address SG&A for the fourth quarter? Could you talk about gross margin. Previously, you expected for the fourth quarter you'd see a nice uptick in gross margin. I know you talked about, given the highly promotional environment you're expecting, you are including some higher markdowns, and also it looks as though you're getting some pharmacy pressure, if you could just talk about that -- that outlook for fourth quarter?

Jerry A. Shore

Yes, Jill, this is Jerry. We are expecting most of the margin improvement in the fourth quarter to come from the gross margin area. Last year was extremely tough in terms of the general merchandise margin. We are anticipating better because of a lower markdown rate. So even though it is highly competitive, as Bruce said, last year, we added a lot of incremental promotions and advertising that didn't really drive traffic in sales. So we're really more controlled this year, and that's the biggest reason, pharmacy margins, as they have been all year long, will continue to be strong.

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

Okay. And just one quick follow-up. Reconfiguration plan, kind of what's your focus heading into 2014 as kind of the top phases for that program?

Jerry A. Shore

Jill, this is Jerry. First thing I will say is we'll talk more about 2014 strategy later on, but, Alan, I don't know if you have anything.

Alan C. Crockett

Well, Jill, at a very high level it will be, the 2 core tenets of reconfiguration program is achieving our 65% to 70% penetration of our stores having pharmacies. So that will be a focus, as well as continuing to expand and reconfigure the stores with additional, or the added automotive and hardware products as well as the HBC. So we've identified the stores that will be part of that plan, but it will be very much aligned with those 2 principles.

Operator

We'll go to our next question from David Magee with SunTrust.

David G. Magee - SunTrust Robinson Humphrey, Inc., Research Division

Can you tell us what the contribution of the auto hardware additions, what the contribution of comps for this year or, I guess, asked a different way, the stores that did not have that department added to it, what was the comp rate at those locations roughly?

Jerry A. Shore

Yes. David, hold on I'm looking through. The comp sales in the third quarter outperformed the remainder of the chain by 304 basis points and 179 basis points on a year-to-date basis.

David G. Magee - SunTrust Robinson Humphrey, Inc., Research Division

Okay. Do you anticipate next year as having as much of an impact as you would go from 40%-- 46% up to, in the majority of the stores?

Jerry A. Shore

At this point, David, it's hard for us to say. We will get the benefit throughout most of the year of these stores that we did in the third quarter. So I would expect there to be a good benefit, quantifying that, I'm not able to do that right now.

Operator

We'll go to Cris Blackman with Empirical Capital.

Cristan Blackman

Would you comment on how many specialty drugs you are now dispensing? And the growth you're speaking of in that space, how much -- how many of that may come from new compounds or is it from acquiring of existing customers on the existing compounds you have?

Rick A. Chambers

Cris, this is Rick. Again looking at the 8% increase in our script count for the year, it's basically coming out of the 2 or 3 different categories, primarily the autoimmune arthritis type areas and in the anti-inflammatory, and that's been our focus right now because those typically are dispensed through more typical retail channels, as well as our new facility, EIRIS Health Services. So that's been our focus to start with as far as to date. We will look to expand that. Hepatitis C is going to be a very big category in 2014, as I'm sure you've seen or have read on that, with basically they're calling it almost a cure, I guess, for those that have Hepatitis C with some new drug entities that will be coming out in 2014. Obviously, the additional entities or drug entities that are going to be approved by the FDA, the majority of those will be coming through the specialty channel over the next 3 to 5 years. We've seen that in the last 2 to 3 years and expect that trend to continue. And, obviously, that's why we're very excited about, as Bruce mentioned earlier, the 3-pronged strategy that we have in place to be able to capitalize on that growth in that segment. I think we're very well positioned for that.

Cristan Blackman

So currently, you have how many compounds within those 2 categories?

Jerry A. Shore

It's hard to break that down per se. It's not going to be -- it's going to be less than a 100 in terms of the actual specific drug entities, Cris. We don't really -- not really prepared right now to break that out by individuals.

Bruce A. Efird

But your top therapies were focused on autoimmune, HIV and Oncology.

Operator

There are no more questions in the queue at this time.

Bruce A. Efird

Okay, Tiffany, thank you. And I hope everyone has a great Thanksgiving, and thank you for your continued interest in Fred's. Have a great day. Bye-bye.

Operator

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

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