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Fred's, Inc. (NASDAQ:FRED)

Q4 2013 Earnings Conference Call

March 27, 2014 10:00 ET

Executives

Pat Watson - Corporate Communications

Jerry Shore - Chief Financial Officer

Michael Hayes - Chairman

Bruce Efird - Chief Executive Officer

Rick Chambers - Executive Vice President, Pharmacy Operations

Analysts

Andrew Wolf - BB&T Capital Markets

Paul Trussell - Deutsche Bank

Jill Nelson - Johnson Rice

Mike Richardson - Sidoti

Operator

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

Pat Watson

Good morning, everyone. This is Pat Watson with Corporate Communications. Thank you for joining Fred’s to review the company’s financial and operating results for the fourth fiscal quarter and fiscal year ended February 1, 2014.

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 this morning 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, March 27, 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 will turn the call over to Jerry Shore, the company’s Chief Financial Officer. Good morning, Jerry.

Jerry Shore

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

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

As council has reminded me, the company announced on January 9, 2014 that it hired financial advisors to review strategic opportunities to enhance shareholder value. The company does not intend to comment further regarding this process until such time as it’s Board of Directors has determined the outcome of the process or otherwise determined that disclosure is required or appropriate. Therefore, I will not be making any comments regarding the process.

As the company reported in its press release earlier this morning, for the fourth quarter of 2013 total sales decreased 7% to $495 million compared with $533.4 million for the same quarter last year. Total sales for fiscal 2013 decreased 1% to $1.939 billion from $1.955 billion for fiscal 2012. I will remind you that the fourth quarter of 2013 consisted of 13 weeks compared to 14 weeks last year and the 2013 year at 52 weeks compared with 53 weeks. To adjust the prior year results, the comparable 13-week and 52-week periods, we eliminated the first week of the quarter and the year in 2012. On the adjusted basis, sales for the fourth quarter of 2013 increased 0.5% over the prior year and sales for fiscal 2013 increased 1.4% over last year.

The fourth quarter comparable store sales on an adjusted basis increased 10 basis points compared to a decrease of 2.8% in the same quarter last year. During January, sales were heavily impacted by poor weather, which included over 120 store closings and additional reduced hours of operations in many other stores. We estimate the impact of weather to be approximately 100 basis points during the quarter. Fiscal 2013 comparable store sales on an adjusted basis increased 60 basis points compared with a decrease of 1.4% for fiscal 2012.

The sales mix for the quarter was as follows: household goods were 22.4% in the fourth quarter, which decreased from 23.2% last year; apparel and linens was 5.6% in this quarter decreased from 6.3%; health and beauty 6.7% decreased from 7.5%; paper and chemical 7.9% decreased from 8.5%; food and tobacco 17.2% increased from 16.7%; pharmaceuticals 38.6% increased from 36.2%; and franchise 1.6% flat with the same quarter last year. For the quarter, comparable store customer traffic decreased 2% from last year, while the average customer transaction increased 2.1% to $21.75.

The sales mix for the full year was as follows: household goods were 21.8% this fourth quarter, which decreased from 22.6% last year; apparel and linens 5.8% this quarter decreased from 6.3%; health and beauty 7% decreased from 7.5%; paper and chemical 8.4% decreased from 8.8%; food and tobacco 17.6% increased from 16.7%; pharmaceuticals 37.7% increased from 36.3%; and franchise 1.7% increased from 1.8%. For the full year, comparable store customer traffic increased 0.7%, while the average customer ticket increased 1.3% to $21.03. Sales per selling square foot in 2013 increased slightly, but both this year and the last rounded to $204 per foot.

For the fourth quarter of 2013 Fred’s net income totaled $4 million or $0.11 per diluted share, which includes an impact of $0.06 per share in the quarter. The LIFO index adjustment at year end was significantly higher than ever experienced and resulted in additional non-cash expense of $1.6 million or $0.03 per share. Also the company recorded inventory reserves totaling $1.7 million or $0.03 per share for product lines of business that we will be exiting as part of our reconfiguration plan in 2014. The lines of business include footwear, televisions and home theater and select products of home furnishings. The space made available by exiting these categories will be used to expand seasonal health and beauty pharmacy OTC, all of which is in line with our reconfiguration plan strategies.

The earnings from operations of $6.4 million or $0.17 per share, compared with $5.6 million or $0.15 per share in the comparable year earlier period which includes $1 million or $0.03 per diluted share related to the extra week in the fourth quarter of last year. For fiscal 2013 Fred’s net income was $26 million compared with net income of $29.6 million for last year. Earnings per diluted share were $0.71, down from $0.78 last year or $0.81 on adjusted. In addition to the impact on earnings from the additional week in fiscal 2012, the settlement with the state of Tennessee of an outstanding tax matter in the second quarter of 2012 as well as other tax related assumptions and estimates had a favorable impact on earnings per share of $0.12 during 2012. Excluding these favorable tax credits and the additional sales week, earnings per share in 2012 would have been $0.66. With these adjustments fiscal 2013 earnings per share increased 7.6% over the prior year.

EBITDA or earnings before interest taxes, depreciation and amortization during the fourth quarter totaled $15.2 million or 3.1% of sales compared with $19.3 million or 3.6% of sales in the same quarter last year. EBITDA for the full year totaled $80.2 million or 4.1% of sales from $78.6 million or 4% of sales in the prior year. Adjusted EBITDA which includes the non-cash impact of LIFO and stock based compensation expenses during the fourth quarter totaled $17.6 million or 3.6% of sales compared with $20.9 million or 3.9% of sales in the same quarter last year. Adjusted EBITDA for the full year totaled $86.6 million or 4.5% of sales from $84.6 million or 4.3% of sales in the prior year.

Earnings before interest and taxes or EBIT for the fourth quarter of 2013 totaled $5.6 million or 1.1% of sales, down from $8.5 million unadjusted or 1.6% of sales in the same quarter last year. EBIT for the full year of 2013 was $39.2 million or 2% of sales, up from $39.1 million or 2% of sales in the prior year.

Fred’s gross profit for the fourth quarter decreased 10% to $133.6 million from $148.6 million on an unadjusted basis in the prior year period. Gross margin for the quarter was 27%, a decrease of 90 basis points from 27.9% in the same quarter last year. The 90 basis point reduction in gross margin is attributed to the following; General merchandise sales mix towards lower margin consumable goods, the inventory markdown reserves for merchandise categories that will be exited in 2014, which had an impact of approximately 35 basis points and pressure on pharmacy initial markups driven by historically large generic inflation coupled with the continued pressure on the generic reimbursement rates. The reimbursement adjustments from third-parties have not yet been made at the speed of the manufacturers’ rate of generic price increases.

Also during the fourth quarter, LIFO expense on pharmacy department inventory increased 172% over last year and adversely affected overall gross margin by approximately 30 basis points as a result of the large inflationary impact on generic drugs during the final month. Positively, shrink control and vendor rebates were favorable in the quarter.

Gross profit for 2013 decreased 1% to $560.8 million from the unadjusted $566.3 million last year. Gross margin for 2013 decreased 10 basis points to 28.9% versus 29% last year. SG&A expenses for the fourth quarter were 25.9% of sales, 40 basis points better than the 26.3% last year. For the quarter, the 40 basis point leverage of expenses was primarily attributed to controlling advertising expenses and leveraging pharmacy department partially offsetting increasing occupancy costs. For the full year of 2013, SG&A expenses were 26.9% of sales, 10 basis points better than the 27% in 2012.

Depreciation and amortization expense totaled $9.6 million in the fourth quarter of 2013 and $41 million for the year-to-date period. This compares to $10.8 million in the fourth quarter of 2012 and $39.5 million for the year earlier period. For the fourth quarter of 2013, net interest expense totaled $110,000 versus $147,000 last year. And for the year, net interest expense totaled $487,000 versus $549,000 in 2012.

The income tax expense in the fourth quarter was 27.3% of pre-tax income compared with 21.4% in the same quarter last year. The lower freight in 2012 reflects the recognition of available work opportunity tax credit following congressional approval received during the fourth quarter in 2012. For the year of 2013, the tax rate was 32.8% of pre-tax as compared to 23.1% last year. The lower tax rate in the prior year resulted from the Tennessee state tax settlement and other related adjustments totaling $4.2 million or $0.12 per share.

Moving to the balance sheet, cash and equivalents were $6.7 million, down from $8.1 million in the year earlier period. The reduction in cash is primarily due to the increase in inventory, which is being driven by pharmacy department inflation in growth as well as other working capital needs. Total inventories at year end increased 2.5% to $362 million compared with $353 million at the end of 2012. The increase in inventory is attributed to the inflation experienced in the pharmacy department as well as the accelerated growth of our pharmacy department in line with our reconfiguration plan. Inventory turns at the end of 2013 were 3.7 turns compared to 3.8 turns at the same time last year.

Capital expenditures for the fourth quarter of 2013 totaled $5.3 million compared with $8.1 million in the last quarter of 2012. Capital expenditures for the quarter were spent as follows: $2.9 million for existing store improvement, $1.7 million for new stores and pharmacies and $700,000 for technology distribution and corporate expenditures combined. For the full year of 2013 capital expenditures totaled $25.9 million compared with $27.2 million for 2012. Additionally $25.1 million was spent on acquisitions of pharmacies during 2013 as compared to $20.2 million in 2012.

Total indebtedness was $5.2 million compared with $13.5 million at the end of 2012. At the end of 2013 there were no borrowings under the company’s revolving line of credit compared to $6.9 million at the end of 2012.

Net cash provided by operating activities was approximately $59.2 million for fiscal 2013. Free cash flow which we identify as net cash provided by operating activities minus capital expenditures and pharmacy acquisitions plus proceeds from asset dispositions totaled $14.1 million. At the end of the fourth quarter, there were 630 company-owned full size stores, 53 company-owned express stores and 21 franchise stores for a total of 704 discount general merchandise stores, which includes 355 pharmacies.

For the full year, we opened 26 pharmacies and closed 17. The 2013 ending store count of 704 is 1% lower than the same period last year. At year end there were 355 pharmacies which is a 2.6% increase over the prior year. The company’s total selling space was approximately $9.4 million compared to 9.6 million square feet – excuse me 9.4 million square feet compared to 9.6 million square feet in the same period last year, a reduction of 2.8%. The reduction in square footage is primarily the result of the store closures that took place during the year.

Moving to guidance for 2014, in the first quarter the company expects total sales to be flat to up 2% as compared to last year. Comparable store sales are expected to be flat to down 2%, which compares to a negative 1.3% in the first quarter of last year. February and March sales have been negatively impacted by cold weathers throughout our regions heavily impacting general merchandise sales. Earnings per diluted share are forecasted to be in the range of $0.23 to $0.27 for the first quarter compared with $0.31 in the same quarter last year. And reconciling these lower earnings to last year, the major reductions are the sales missed due to weather resulting in $0.03 reduction and the continued impact in the first quarter of the large generic gross margin inflation which has impacted the overall gross margin by 50 basis points or $0.04 per share.

Looking ahead for the full year, the company expects total sales to increase 1% to 3%. Comparable store sales for 2014 are expected to be flat to an increase of 2% in 2014. We anticipate general merchandise and pharmacy – general merchandise department to turn positive in the back half of the year as we implement new programs throughout the stores. The pharmacy department comp store sales will continue to be positive throughout the year.

Based on this outlook the company expects total earnings per diluted share for 2014 to be in the range of $0.74 to $0.80 with the midpoint of the range representing an 8% increase over 2013. We project EBITDA to improve to a range of $82 million to $89 million with the midpoint of the range representing a 7% increase. Adjusted EBITDA, which adds back non-cash LIFO and stock compensation expense for the full year, as this expected to be in the range of $88 million to $95 million compared with $86.6 million in 2013. We are projecting a normalized income tax rate for 2014 of 36% to 37%.

At the end of the first quarter of 2014, we expect inventory to be 2% to 3% above year end 2013 balance as a result of our focus on pharmacy department growth and the continued inflation impact on inventory. In addition, the expanded Hometown Auto and Hardware program will be rolled out to approximately 80 additional stores by the end of the first quarter of 2014.

Capital expenditures for 2014 are expected to be in the range of $22 million to $27 million additionally $28 million to $32 million is planned related to acquisitions of pharmacies during 2014. We plan to open in the range of 15 to 20 new stores and 30 to 40 new pharmacies in 2014. Closings in 2014 are anticipated to be approximately 20 stores and 3 pharmacies. Free cash flow, which we identified as net cash provided by operating activities minus capital expenditures and pharmacy acquisitions, is expected be in the range of $12 million to $15 million in 2014.

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

Bruce Efird

Thank you, Jerry and good morning everyone. I appreciate you joining us this morning for our fourth quarter and fiscal 2013 conference call. I will begin this morning with a review of 2013 and then update you on our 2014 outlook. Starting with the 2013 fourth quarter recap, operationally, our team delivered earnings per share at the high end of our revised guidance in the face of significant challenges, which was mirrored throughout the retail industry. Specifically, the company was impacted by unusually harsh weather and an unprecedented generic drug cost increases.

As noted in the press release, the cost increase resulted in 100 basis points reduction in pharmacy gross margin. In the fourth quarter, the LIFO inventory adjustment increased 172% over last year as well. We incurred a year end inventory reserve of $0.03 earnings per share in the fourth quarter for businesses that we will exit that do not fit with our long-term strategic plan. By exiting these product lines, the company will better tailor its health and beauty care products to be more reflective of a pharmacy’s product offering. In stores without pharmacy exiting these product lines will make much needed space available for ongoing automotive and hardware expansion plans.

The inventory reserve allows us to speed up our implementation process of our long-term strategy, which will in turn improve our inventory turns and margins in quarters three and four. Furthermore, given the unusual sales challenges the team faced in the fourth quarter, the team did a yeoman’s job of keeping their focus as reflected in the leveraging SG&A expenses by 40 basis points.

As I look back to last year, there were several areas of improvement in Fred’s business. The company produced adjusted EBITDA of $86.6 million and once again ended the year with no borrowing under our revolving line of credit by producing $14.1 million in free cash flow after spending $25.9 million on CapEx and $25 million on pharmacy file buys. We were able to continue expanding our reconfiguration program by reconfiguring 322 stores along with increasing total pharmacies year-over-year from 346 to 355.

One of our most exciting opportunities for the future was opening our specialty pharmacy division, EIRIS in October 2013. EIRIS provides us an opportunity to accelerate our penetration into the fastest growing segment of the pharmacy industry specialty drugs. We believe Fred’s is uniquely positioned to participate in this segment by leveraging our network of rural and local pharmacies. We are exceptionally pleased with our early results from our specialty pharmacy department which has exceeded plan every month since opening. We are excited also about the quality of the health services team we have rapidly assembled and the reaction by the community and our pharmacies with this new opportunity.

Moving to the first quarter, the unusually harsh weather conditions experienced and the margin impact due to the generic drug inflation is reflected in Jerry’s guidance that he previously outlined. In February alone due to unusual weather conditions, over 200 stores were closed or experienced a reduction in hours of operation having a material impact on our first quarter results. We project an ongoing impact of cold weather due to the extraordinary increases in utility bills and we believe this will have a lingering effect on disposable income for our customers throughout the Southeast.

As mentioned by Jerry the impact of increased cost of goods for generic drugs that began in the fourth quarter will persist throughout the first half of 2014 due to the delayed adjustments in reimbursement rates. This impact has been greater to Fred’s than other pharmacies due to our industry leading penetration in generics. I am confident in the plans and the programs that are being implemented to mitigate these generic drug cost increases. We expect the cost impact to moderate in the third and fourth quarter as we work with payers to restore reimbursement rates to more normalized levels.

Looking ahead we continue to push forward with our long-term strategy in 2014, our penetration of stores with pharmacies is anticipated to be at 53% by the end of the first quarter and 56% by the end of this year. As we continued to accelerate our pharmacy presence, we are further leveraging our pharmacy department by tailoring our general merchandise mix towards our pharmacy customers in stores with pharmacies. We will be retrofitting 80 stores in the first half of 2014 with the reconfiguration program as well. The results of reconfiguration continues to be positive with comparative sales of retrofitted stores realizing a 1.6% comp gain over the chain store average.

Moving on to our marketing efforts, we are expanding our smartcard loyalty program. We currently have over 2.5 million active cards in circulation. On average enrolled smartcard customers have baskets that are 35% higher versus non-card transactions. For 2014, we will accelerate our in-store efforts and marketing programs to increase enrollment in Fred’s smartcard program. An additional benefit of the smartcard program is our ability to obtain the valuable information and insights into the shopping patterns and desires of our customers. This allows us to further refine our product mix and meet our customers need.

In summary we have opportunities for growth in 2014 and the capital to support that growth for the benefit of our shareholders. We expect challenges in the near-term but remain confident in our ability to achieve improved performance in 2014 with a projected adjusted EBITDA of $92.3 million. One additional comment before taking questions based on the council’s guidance the company does not intend to comment further regarding the process of reviewing strategic opportunities. Therefore I will not be making any comments regarding this process.

Again, thank you for joining us today. And I will now turn it over to the operator for questions.

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions) And we will take our first question from Andrew Wolf with BB&T Capital Markets. Mr. Wolf your line is open.

Andrew Wolf - BB&T Capital Markets

Sorry about that, mute. Thanks. Good morning. Just want to start on the pharmacy, I want to understand what’s more – what’s unusual for Fred’s is it we are hearing from drug store retailers that it’s really the generic drug cycle, there is and ebb and a flow in new generics which are far more profitable. So it sounds more like a mix issue between all the new generics, where it sounds like for Fred’s, it’s a little different, it’s more about inflation rate in the cost of all generics and how that is – how that flows through in terms of reimbursement rate. So could you help me kind of think through those differences?

Rick Chambers

Yes, Andy. This is Rick Chambers. When we looked at that impact and saw that impact in the fourth quarter there was basically two different components and the majority of that impact came from the generic cost increase that has already been commented on earlier. It was a very few – a very select list of generic products with very high velocity items for us. And as Jerry had pointed out earlier in his comments with our generic penetration and also Bruce as well, it is a very big issue for us. Anytime we see any type of movement within a small group of products that have that type of velocity, I will touch back on what you had referenced with the brand – cycling the brand to generic that other retailers are discussing. We had that same impact in our plan. We cycled through that. It basically met our expectations for 2013 in terms of what we expected from that change. Unfortunately, that was more than offset by these cost increases especially in the fourth quarter coupled with the fact that the payer community was somewhat lagging in the adjustment of the top line, change in the market to those cost increases.

In terms of mitigation, we do have plans in place. I am very confident with what the team has in place now to mitigate that go forward. And as commented earlier, we do anticipate that to rebound later in the year, especially in the third and fourth quarter and going back to how we were attacking that, there is two ways, one being the top line working much closer with our payers to get much more quicker response in terms of the ASP changes and then secondly which is the bigger nut for us to crack is that cost of goods increase and that we have plans in place to go after that. I am sure you will understand and respect the confidential nature of those plans. So therefore, I can’t go into the details around what we will be seeing on the cost of goods side, but are very confident with what the team has in place to rebound on that side.

Andrew Wolf - BB&T Capital Markets

Yes, thanks. Just one quick follow-up, can you comment on was there any difference in the class of payers in terms of not seeing increased reimbursement and by that I mean PBMs versus government payers?

Rick Chambers

Yes, that’s a very good question and it was more aggressive on the federal government side, the Medicare Part D particularly. And of course you know those are managed by the private PBMs, but it was much more aggressive on the Medicare Part D side of our business. And I will add to that, we skew much higher than our retail competition in both Medicare and Medicaid, Medicaid being different in this discussion, but with the Medicare Part D part of our business, we do skew higher than our retail competitors, which does have a bigger impact on us across the board.

Andrew Wolf - BB&T Capital Markets

Yes. If I can just squeeze one more in, on the – Jerry, you gave some numbers for adjusted EBITDA, I just want to try to normalize that and then ask what the implications are for profitability between the general merchandise and pharmacy? But if I normalize it I take the extra week out of last year’s $20.9 million and I add in the inventory write-downs to this year’s number, you get pretty much the same number in EBITDA, $19.3 million versus $19.4 million, I want to make sure that our definitions are the same. And if they are, could you kind of comment on how the profitability trends were? Were both segments essentially flat this year the front end versus the pharmacy or was there some change going on due to what we are talking about in pharmacy?

Jerry Shore

Yes. Andy, I am not going to break those down. Your modeling is real close, but I am not going to – I can’t really breakdown the differences between general merchandise and pharmacy profitability. We account for pharmacy as a department just as we would any other general merchandise department.

Andrew Wolf - BB&T Capital Markets

Okay. Well I am just trying to – I mean the way I would look at it just from what you are saying, if the pharmacy had a big unanticipated negative impact which you sized out around I think $1.5 million or $2 million. And obviously the swing looks like it’s worst there at least the delta, it may still be up but it would be up by less than that and that’s all I am getting to?

Jerry Shore

Yes, your assumptions were relatively close on that.

Andrew Wolf - BB&T Capital Markets

Okay. Alright, well, thank you.

Jerry Shore

Thank you.

Operator

And we will move to our next question. Next we have Paul Trussell with Deutsche Bank.

Paul Trussell - Deutsche Bank

Good morning.

Jerry Shore

Good morning.

Paul Trussell - Deutsche Bank

I have a question on some of the reconfigurations happening with the stores, if you can just maybe give a little bit more detail about the categories that are being exited in terms of were these below company averages on sales per square foot and margins in your expanding categories that have are higher on those metrics or is it just a matter of them not really fitting into the model quite as well anymore and just trying to gauge what the overall P&L impact will be of these changes. And just to add to that if you can just specifically kind of describe your overall consumable strategy and what role that will play in the store, so ex-pharmacy how should we think about food and HBA, how are you coming to market on that, that would be helpful? Thank you.

Jerry Shore

Okay Paul, I am going to comment first on the decisions, the evaluation and the decisions to exit those areas. Those decisions were based on a combination of traffic into the stores as well as then the financial impact which included the sales margin and especially inventory turn. Those areas had a large investment without an adequate return. Whereas as we have talked about extensively the areas in the reconfiguration programs such as Hometown Auto and Hardware, health and beauty and the other pharmacy OTC areas have really done much better and especially in the traffic and inventory turn category aspects of it.

Bruce Efird

So Paul let me add some color to your question. And let me start off by stepping back and just reminding everyone that the reconfiguration plan is the three year plan that’s centered around two fundamental principles. One is to aggressively accelerate our pharmacy presence to further leverage the strength of pharmacy while tailoring our general merchandise mix to our pharmacy customers.

And the second component of reconfiguration within general merchandise is centered around expanding the space in our discretionary product lines aimed towards driving it to higher turns and more productive inventory within the store. So to enable us to further expand, we made the decision to exit the product line that Jerry had outlined in select indoor furniture TVs and some of the shoe business as well. So we see those product classes not being as productive while we are replacing it with automotive hardware expansion as well as HBC expansion within stores with pharmacies that are typically more productive. Also I would add that this is all aligned with a long-term strategy which is focused on growing and building our product base around items that are less susceptible to internet or online purchasing and in our stores which are much more need it now type products as you know automotive and hardware is more immediate need type products that people don’t always go to the internet to purchase.

And then last going back to the HBC expansion, we do have again one of the opportunities for us is to ensure that our product mix in our stores with pharmacy is more reflective of a pharmacy operation. Last point I would make relative to food expansion we have continued to expand in food it’s not technically part of our reconfiguration plan per se. However, as you know food is a strong traffic generator we did expand our coolers last year. We are seeing the benefit from that as well. So I think I have touched on all points of your question, Paul.

Paul Trussell - Deutsche Bank

You did, you did. That’s very helpful. My follow-up is just on the recent trends, top line trends that have been experienced. If you can just outline for us what you have seen during periods of time where the weather hasn’t been as much of an impact, how should we think about the upcoming months, particularly April with the Easter shift and hopefully a little bit warmer temperatures? And just wondering is there anything from a competition standpoint perhaps that you have seen that might have had an impact on some of the recent trends? Has anyone been much more aggressive than expected on certain parts or certain categories, just if you can just highlight those factors relative to how they have come to fruition in your results?

Jerry Shore

Paul, this is Jerry. And I will comment before Bruce gets into the specifics, but this week it was still in the 20s in the morning as we are coming to work. So in terms of how we have seen after the temperatures have changed, we are still not seeing a huge shift in our weather patterns in the first quarter.

Bruce Efird

So just to touch on some of the departmental sales items, we continue to see strong results in our tobacco sales, which is bucking most trends across the industry. Pets is performing better than our overall trend. Again, that’s part of our ongoing expansion within pets. And we are seeing even with our expansion within HBC some challenges due to a slower flu season this year. We are pleased as we pointed out with the sales in our Automotive and Hardware expansions. And then lawn and garden, even though it’s down significantly due to weather-related issues on the day that we have had decent weather, we have seen very immediate response to that. Unfortunately, as Jerry pointed, it’s hard to sell lawn and garden in Southeast when it’s 26 degrees. We are seeing just to touch on another area, our toys and sporting goods have been better than historical trends over the past few months. So we are seeing some of those areas particularly related to our long-term strategy of reconfiguration that are working.

Paul Trussell - Deutsche Bank

Thank you.

Operator

And we will move to our next question to Jill Nelson with Johnson Rice.

Jill Nelson - Johnson Rice

Good morning. If you could talk about I believe in early January, you announced some management changes, the Chief Merchant left and Bruce you seemed to take over that role, could you just talk about it if you are looking for a search to replace that position and just some of the other management changes possibly if you have made any big changes on the buying team?

Bruce Efird

Yes. We are in the process of a search for a new Chief Merchant and that is moving forward at this point in time as far as we have made some internal changes relative to product categories that are our merchants or buyers are aligned with. And then from the other changes that we have made at a high level obviously with Jerry stepping into his role as Chief Operating Officer, he is seeing opportunities to leverage within our operations in different areas of that company. So, we are pleased so far with the changes that have been made, but still on the search for a Chief Merchant at this point in time.

Jill Nelson - Johnson Rice

Alright. And maybe just on that point of leverage, I mean you saw nice expense leverage in the fourth quarter despite some weaker sales, could you talk about maybe what’s your new leverage point if you look at 2014?

Jerry Shore

Jill, this is Jerry. We do anticipate leveraging expenses again this year. And as you know, our comps are flat to up slightly. So, we are now at a point where we can leverage expenses at a flat comp and we will continue to evaluate expenses as we go forward and expect to do even better on our expense controls in 2014.

Jill Nelson - Johnson Rice

Okay. And then last question just a broader question I guess. First year of the three year reconfiguration process I guess your EBIT margins were flat with last year, could you talk about maybe some big callouts of your – the major disappointments versus your plan would be helpful. Thank you.

Jerry Shore

Yes, Jill, this is Jerry. I will go first on that one. The obviously in the fourth quarter the margins on the pharmacy impacted us adversely, however, during the year pharmacy did extremely well until that point. The sales mix shift was the largest impact item on the gross margin and then the mark down rate during the third and fourth quarters were higher than we anticipated as which would really related more to the sales mix shift then changing marketing and advertising strategies, so at the high level of the sales mix shift as well as additional markdowns during the last two quarters?

Bruce Efird

If you look back at the full year we were on plan through the first three quarters and then we were impacted in the fourth quarter specifically around those areas that we outlined in our previous comments.

Jill Nelson - Johnson Rice

Thank you.

Operator

(Operator Instructions) Next we will go to Mike Richardson with Sidoti.

Mike Richardson - Sidoti

Yes, good morning and thanks for taking my call. You guys said that you are going to reconfigure Hometown Auto and Hardware in additional 80 stores by the end of the first quarter, if you can just remind us how many stores are reconfigured in fiscal ‘13 and what the overall goal is for auto and hardware reconfiguration in fiscal ‘14? Thanks.

Bruce Efird

Yes, we do have an additional 80 planned for this year which will take us over 400, I believe around 420 stores that we would have.

Jerry Shore

And we started the year with 75 so the difference is what we added in 2013.

Mike Richardson - Sidoti

And 80 is going to be the total number for this year or what the total number is going to be?

Jerry Shore

No, we will continue to evaluate and do more during the year.

Bruce Efird

We have 80 currently in the pipeline for the first half and then we are evaluating additional stores in the back half.

Jerry Shore

We have estimated that for the full year and in all of the reconfigurations approximately 150 more.

Mike Richardson - Sidoti

Great, thank you very much. Good luck guys.

Jerry Shore

Thank you.

Operator

I show we have no further questions in queue at this time. I will now turn the call back over to Mr. Efird for any additional comments or closing remarks.

Bruce Efird

Again, I would like to thank you for participating in today’s call. Hope everyone has a great day.

Operator

And that does conclude today’s conference and we thank you for participating.

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