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Family Dollar Stores, Inc. (NYSE:FDO)

F2Q2014 Results Earnings Conference Call

April 10, 2014, 10:00 am ET

Executives

Kiley Rawlins - Vice President of Investor Relations and Communications

Howard Levine - Chairman of the Board, Chief Executive Officer

Mary Winston - Chief Financial Officer, Executive Vice President

Analysts

Dan Wewer - Raymond James

John Heinbockel - Guggenheim Securities

Scott Mushkin - Wolfe Research

Stephen Grambling - Goldman Sachs

Mark Montagna - Avondale Partners

Patrick McKeever - MKM Partners

Anthony Chukumba - BB&T Capital Markets

Peter Keith - Piper Jaffray

Laura Champinehank - Canaccord

Meredith Adler - Barclays

Operator

Good morning. My name is Rebecca and I will be your conference facilitator today. I would like to welcome everyone to the Family Dollar earnings conference call. All lines have been placed on mute to prevent any background noise. After the company's prepared remarks, there will be a brief question-and-answer period. The question-and-answer queue will not be available until after the company has concluded their prepared remarks. So please wait until after the speakers have finished their remarks before attempting to enter the queue.

I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin your conference.

Kiley Rawlins

Thank you, Rebecca, and good morning, everyone. Thank you for joining us today. Hopefully you have had a chance to review the press release that we issued this morning. Before we begin, you should know that our comments today will include forward-looking statements regarding various operating initiatives, sales and profitability metrics, store closings and capital expenditure as well as our expectations for future financial performance. While these statements address plans or events which we expect will or may occur in the future, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ from our expectations.

We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, April 10, 2014. We have no obligation to update or revise our forward-looking statements except as required by law and you should not expect us to do so.

In addition, the amounts and timing of all estimates we discuss today are subject to change. The actual amounts and timing may vary materially based on various factors, including the timing of store closings, the timing and amount of sublease income and other lease expenses, factors relating to real estate including sale proceeds, asset write-downs and other factors affecting inventory value, changes in management's assumptions and other factors.

We will begin our call today with some opening comments from Howard Levine, Chairman and CEO. Then Mary Winston, CFO, will review our financial results for the second quarter of fiscal 2014 and our outlook for the rest of the year. Following our prepared comments, you will have an opportunity to ask questions. Remember that the queue for the question-and-answer session will not be available until after we have finished our prepared remarks.

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

Howard Levine

Thanks, Kiley, and good morning, everyone. Today we reported our second quarter results and also announced a number of key strategic initiatives that we are implementing to improve profitability and shareholder returns. I will begin my discussion today with a brief overview of the second quarter and then I will discuss these actions in further detail.

This morning we reported the second quarter earnings per diluted share were $0.80 and the comp store sales declined 3.8%. Mary will provide more details about the quarter in a moment, but clearly these results did not meet our expectations. As we discussed in January, this holiday season was challenged by more promotional environment and a more financially constrained consumer. While there were certainly external factors that impacted of our holiday performance, we believe that we have opportunities to improve our execution, increase our relevance and strengthen our value proposition during this critical selling season.

To that end, we have evaluated the holiday results and have identified areas where we know we can improve next holiday season. As many other retailers have reported, the disruption from winter weather this quarter was severe and had an unanticipated impact on our sales and expenses. While difficult to quantify absolutely, we estimate that the store closings and shortened operating hours, combined with higher than expected utility and store maintenance expenses impacted EPS in the quarter by at least $0.05.

The last few quarters has been challenging. Our long-term position in growth prospects remain strong and we must improve our execution. We must reaccelerate traffic, drive stronger revenue growth and generate operating leverage. To that end, we have initiated an in-depth business review to identify opportunities to strengthen our value proposition, increase operational efficiencies and improve financial performance.

Before I go into the new actions resulting from our business review, I want to provide an update on the merchandising changes we discussed on our last call. Building on the significant food expansion, we implemented in 2012, we have continued to refine our food assortment. We expanded categories where customer demand has been very strong and added approximately 400 new items with the significant focus on key national brands to drive traffic, increase awareness and build shopper loyalty. To make room for these new items and drive greater profitability and productivity, we have reduced space in categories where the customer response has not met our expectations. We also improved adjacencies and made it easier for our customers to shop. We completed these changes last month and while it is still early, our customer's response to our enhanced assortment has been very positive.

In addition to food, we made key changes in our household area to provide our customers with new items, greater value and more convenience. We expanded space and introduced new formulations in sizes of both national and private brands. I am particularly pleased to share that we were the first in a discount channel to introduce compelling innovation that drove air care and laundry care market share. Early customer response has been encouraging. Our sales trends are improving and we are gaining share in a contracting market.

Now regarding our in-depth business review. While this work is ongoing, we are implementing a number of immediate strategic actions to improve our performance. First, we are investing significantly to lower prices to provide more compelling values for our customers. Second, we are optimizing our workforce to improve execution and better align resources. Third, we intend to close approximately 370 underperforming stores. And lastly, we plan to slow square footage growth beginning in fiscal 2015.

Let me share a little bit more detail about each of these. Let's begin with pricing. While our customers satisfaction scores continue to improve, we believe that we have an opportunity to improve our everyday value proposition. Over the last several years, as our use of discounts and promotions increased, our value proposition and perception has deteriorated. To reverse this trend, we have renewed our commitment to providing customers with great values everyday.

Today our team is more focused than ever on making sure that providing great value is the cornerstone of all decision-making. Our goals are to build customer loyalty, sell more units and capture more market share. Reflecting this commitment, we are investing more than $50 million on an annualized basis to permanently lower prices on nearly 1,000 basic SKUs. These investments will make us more competitive, enable us to deliver more value to our customers.

Two weeks ago, we implemented most of these price reductions and our team did a great job quickly executing the changes. We are pleased with the early customer response but we know that it will take time for customers to recognize and appreciate the changes.

To support our EDLP strategy and increase customer traffic, we are simplifying our marketing approach. We want our customers to know that they can depend on us to help them save money and take care of their families every day. But in this environment, we still need to tell customers about what is new and different in our stores and we know that periodic promotions can drive excitement and traffic.

Like many retailers, we will continue to leverage a hybrid approach to drive awareness. We will focus on driving more awareness of our great everyday values on both national and private brands, while also leveraging periodic promotions to drive traffic. Going forward, we will increase our emphasis on everyday values and also reduce promotional markdowns. We aren't eliminating our use of circulars, but intend to reduce the frequency to one to two times a month when our customers are most responsive.

We also intend to be more targeted in our events and we use multiple advertising tools to focus on our core customer. A few years ago, we shifted our circular distribution to the Sunday newspaper. Unfortunately, we haven't seen consistent returns from this approach. So we are returning to distributing our circulars via mail, which will allow us to target our core customer, when and where she is most receptive. We also intend to increase our use of radio, email and digital marketing to drive traffic and reinforce our value proposition.

Now let's talk about our decision to reduce our workforce and improve our cost structure. We are focused on generating operating leverage and improving our operating margin. This has led us to take a deeper look at our organization and we are taking necessary steps to improve productivity, execution and financial returns. Last week we made a number of organizational changes, which included the difficult but necessary decision to eliminate a number of corporate positions. We are fully committed to treating impacted team members respectively, and helping them through this transition.

As part of our strategic review, we also completed a thorough analysis of our store portfolio and have decided to close approximately 370 underperforming stores. Generally these stores are older and have lower sales volumes. Obviously the closing of these stores will improve the productivity metrics of the remaining chain.

With regard to new store openings, we have decided to slow down new store growth beginning in fiscal 2015. New stores have always delivered the highest return on investment for Family Dollar, but as our operating margin has contracted and our capital investment has increased, our return on investment trends have been pressured. To improve these trends, we have reevaluated our site selection criteria and refined our real estate models to reflect the current sales environment and sales insights from store openings over the last three years.

We have substantial data on returns by location, competitive dynamics and cost structure and we will use this data to eliminate higher risk situations. We are on track to open approximately 525 new stores this year, but next year, we will reduce new store openings to 350 to 400 stores and focus on opening stores that will deliver us the highest ROIC.

Our renovation program is critical to improving the shopping experience for customers and we remain committed to renovating our entire chain. Renovated stores continue to outperform stores that have not been renovated. We plan to continue to renovate, relocate or expand about 800 stores a year.

I will now turn it over to Mary to provide more color on our second quarter results, as well as the expected financial impact from these decisions. Mary?

Mary Winston

Thank you, Howard, and good morning, everyone. This morning I will review our second quarter results and then discuss our revised outlook for the remainder of the year.

As Howard mentioned, our second quarter was particularly challenging, especially considering the significant impact that the severe weather had on our result. There were 18 named storms in the quarter, which resulted in more than 60 days being negatively impacted by winter weather. In addition, winter conditions disrupted merchandise deliveries and snow accumulation and very cold temperatures resulted in higher than expected store maintenance and utility expenses. We estimate that the financial impact in the quarter related to adverse weather was at least $0.05 of earnings per diluted share.

Total sales decreased 6.1% to $2.7 billion and comparable store sales decreased 3.8%. As a reminder, we estimate the extra week last year contributed approximately $189 million in sales. Excluding the impact of the extra week, total sales in the quarter would have increased 0.4% compared to the second quarter of fiscal 2013. Sales in the quarter were strongest in the consumables category. The decrease in comp sales was primarily due to fewer customer transactions, which was partially offset by an increase in the average transaction value.

For the quarter, gross margin declined 21 basis point as compared with the second quarter of fiscal 2013. Strong sales of lower margin consumables, combined with soft discretionary sales resulted in 163 basis points of mix shift during the quarter. In addition, markdowns increased as a percentage of sales. This increase was as a result of clearing slow-moving seasonal merchandise during the holiday season and markdowns of discontinued items in anticipation of our merchandising schematic reset. These factors were partially offset by improved merchandise markups, lower freight cost and lower shrink.

Our global sourcing and private brand programs continue to improve our merchandising margins. The decrease in freight expense was mainly due to our supply chain relationship with McLane, which resulted in less merchandise being handled through our own distribution network. Shrink improved for the first time in three years as our inventory levels and store manager turnover metrics continue to stabilize. This has been a strong area focus our teams and I am pleased that we are beginning to see the result of these efforts.

SG&A expenses increased 1.6% compared to the second quarter last year and as a percentage of sales increased 213 basis points to 28.1%. SG&A deleverage in the quarter was mainly the result of the decrease in sales.

As a percentage of net sales, store occupancy and store labor cost increased as compared to last year. Partially offsetting these increases were reductions in advertising expenses and incentive compensation.

The effective income tax rate in the second quarter of fiscal 2014 was 35.3% as compared to 35.6% in the second quarter of fiscal 2013.

Net income for the quarter was $90.9 million compared to $140.1 million in the second quarter of fiscal 2013 and earnings per diluted share were $0.80 compared to a $1.21 last year. As a reminder, we estimate that the extra week last year contributed approximately $0.07 of earnings per diluted share.

Merchandise inventories at the end of the quarter increased 8.3% to $1.7 billion compared with $1.5 billion last year. Average inventory per store increased 2.1% versus last year, driven by consumables as we prepared to implement certain schematic changes. Despite the softness in discretionary sales, inventories in these categories were well controlled at the end of the quarter.

Capital expenditures in the quarter were $107.2 million as compared to $213.3 million in the second quarter of fiscal 2013. The decrease in capital expenditures was primarily the result of lower new store investments as we continue to diversify our financing vehicles and as we anniversary investments related to the construction of our 11th distribution center, which opened in the fourth quarter of fiscal 2013.

During the quarter we opened 118 new stores and closed 21 stores, compared to 126 openings and 17 closings in the second quarter last year. In addition, we expanded, relocated or renovated 140 stores in the quarter.

Reflecting our commitment to returning excess capital to shareholders, in the second quarter of fiscal 2014 we paid $29.6 million in dividends.

Now let's turn to our expectations for the remainder of fiscal 2014. I will start with additional color on some of the strategic actions that Howard discussed earlier, and that we outlined in our press release this morning.

Our leadership team has completed an in-depth workforce optimization effort to right size our corporate overhead to reflect the current operating environment. Last week we implemented a number of organizational changes, which included the reduction of about 10% of our corporate workforce. Reflecting these changes, we expect to incur a charge in the third quarter of about $4 million related to employee severance cost.

We also intend to close approximately 370 underperforming stores in the second half of fiscal 2014. On average these store have generated sales and profits well below the company's average and have continued to deteriorate in the current environment. Year-to-date, the average comps for these stores is a negative 8%. We expect to complete store closings by the end of fiscal 2014 and expect to incur a charge related to the closings of between $81 million and $91 million in the second half of fiscal 2014. Although the timing and actual amounts will depend on the cadence of the closing, we expect that most of the impact from the charge will be in the fourth quarter.

Between our workforce reduction and the impact from store closings, the collective annualized operating profit benefit is expected to be between $40 million and $45 million.

Now let's talk about our sales and earnings expectations for the rest of the year. For the third quarter, we expect that comp sales will decrease in the low single-digit range. For March, results were adversely impacted by winter weather and the Easter shift, and are not indicative of our comp expectations for the full quarter. It is worth noting that our comp performance has improved in April.

We also expect that gross margin in the third quarter will be consistent with the trends we saw in the second quarter. Based on these expectations and the impact of our strategic actions, we now expect that earnings per diluted share will be between $0.85 and $0.95, excluding approximately $0.13 related to restructuring expense charges.

For the fourth quarter, we expect that comp sales will be flat to up slightly and that earnings per diluted share will be between $0.75 and $0.85 excluding approximately $0.37 related to restructuring charges. We now expect that net sales for the full year, excluding the impact of the extra week will increase in the low single-digit range and that comp store sales will decline in the low single-digit range. We expect that gross margin will be pressured, and we expect SG&A will deleverage for the year given our current expectations for comp store sales. As a result, we now expect earnings per diluted share for the full year to be between $3.05 and $3.25. This range reflects approximately $0.50 of restructuring charges.

Now I would like to turn the call back over to Howard for some final remarks. Howard?

Howard Levine

Before we take your questions, I would like to leave you with a few closing thoughts. Family Dollar's growth over the past 54 years has been rooted in the core principle of providing compelling values to our customer. Over the past 90 days, the team and I have been focused on strengthening our value proposition, increasing operational efficiency and improving our financial performance. Throughout this process, I have had the opportunity to work more directly with our teams to gauge our talent, assess our organizational capabilities and provide clear direction and focus. I am confident in the leadership team we have in place.

Jason Reiser, who we promoted to Chief Merchandising Officer in January has been doing some great work to align our team with our value proposition and merchandising strategy. And I am very pleased to welcome our newest addition, Brian Hancock, Senior Vice President of Supply Chain. Brian joined our team last month and we look forward to his contributions.

Lastly the search for a President and COO is underway and we are taking steps to ensure that we identify the right candidate who possesses the necessary experience and qualifications. We will provide an update when we have made a decision.

We have covered a lot of ground today. As we go forward, our senior leadership team and our Board are aligned and keenly focused on effectively executing the initiatives we have outlined. While our review is ongoing, these strategic actions are a great starting point from which we will build momentum. In the coming months, we will continue to take steps to improve our performance and I look forward to updating you to our progress.

And now operator, we would be happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from Dan Wewer with Raymond James.

Dan Wewer - Raymond James

Thanks. Howard, can you give us some more insight into the 200 fewer stores that you will likely open next year? Any type of characteristics in terms of market size, competitive overlap? And also with your comments on declining return on investment from new stores, do you think we are getting closer to the saturation point for the concept?

Howard Levine

Sure, Dan, and good morning. As part of this in-depth business review, one of the significant undertakings that we went through was a deep analysis of our store portfolio and it was very thorough. I told the team to go in unencumbered with anything other than going through there and looking at our store base and seeing where we had issues and what kind of decisions we need to make.

In these stores and the characteristics of these stores that we are closing where sales about half of what the average is. So around $650,000. These stores are older stores. Generally a little bit smaller and given the slowdown in the economy, the erosion of some of our gross margin over the last few years, it really did not make sense to continue to operate these stores and make continued investments in these stores and it looked to make sense to go ahead and close those and put our focus on the remaining chain.

Dan Wewer - Raymond James

But I was thinking more going forward? You talked about opening 350 or 400 stores next year. At one point whereas probably looking something around 600. What kind of characteristic are there in these stores that you are not opening?

Howard Levine

Yes, and I will get to that. In fact, I am going to let Mary go into that, but I just wanted to make sure that you understand what the process that we went through on the underperforming stores and then so let me go ahead and turn it over to Mary and talk about that.

Mary Winston

Yes. So let me just comment on it form a financial perspective. A lot of the work that we did on the underperforming stores that Howard just talked about mirrors how we looked at stories that we want to open going forward. So while we were looking for what were the characteristics that are acceptable from a performance standpoint, we were also looking at what are the best in our portfolio and what's going to make for a successful store.

So we looked at our sales expectations for the year going forward. We looked at profitability within a reasonable period of time, both on a four-wall basis and on a fully loaded basis. We looked at metrics around when we expect the store to deliver ROIC above our weighted average cost of capital.

And taking all of those things into consideration, we then went back and worked with our real estate team to look at our site selection models and made some refinements based on the key financial metrics that we would like to achieve as well as the demographics in the marketplace that work best for us, the competitive environment in the marketplace. And on that basis, we tried to pick what was the best of the best of the opportunities that we have in the marketplace and really focus on opening stores that are going to deliver the highest return for us.

So I would say it doesn't necessarily suggest that we are worried at this point about saturation in the marketplace. We still think that we have plenty of opportunities out there to open new stores, but as we adjust our financial performance in the business and think hard about our capital allocation, we want to make sure that we are refocusing our store investment on those that are going to deliver the highest return. So that's how we got to the lower store number.

Dan Wewer - Raymond James

Okay, and just one other quick question. Howard, your largest public competitors are all on record stating that market share is more important than margin. Given your chains and pricing strategies, what do you contemplate your biggest competitors like how they are going to respond to your price fallback on these 1,000 items?

Howard Levine

Sure, Dan. So we are focused on driving market share and margin. And the price investments is all about us getting back to what I think is just so important to the Dollar channel and having competitive prices every day. As I talked about in January, we felt we lost out way there with our price perception and these price investments, I think, help to go a long way and win back that. It's not necessarily one where we are undercutting competition. It is really coming down and meeting the market on about 1,000 items in our assortment today.

So we are excited about that. We are notifying our customers. We just kicked it off with our April event just last weekend. We are excited to review those results. But when thinking about our business over the long term, which is really the basis behind that decision, we felt we had to make these investments to drive that value proposition and feel confident that over the next several quarters that we will begin to see the benefit of that.

And clearly there is a different focus and that focus is on driving units. That was lost in the last couple of quarters. And I think that's critically important to our success as we go forward.

Dan Wewer - Raymond James

Okay, right. Good luck.

Howard Levine

Thanks, Dan.

Operator

And next we will go to John Heinbockel with Guggenheim Securities.

John Heinbockel - Guggenheim Securities

Well, Howard, a couple of things. The process or the review that is in process. What other things might you be looking at? And is the $40 million to $45 million you talked about, are we all going to see much higher number than that or you are really tackling the big items today?

Howard Levine

Sure. John, good morning. As I said in my comments, we think that these are some major chunks of the strategic review that really give us a good kickstart on the process. And to your point, it is ongoing and specifically when we think about what some of these opportunities are, it's both on the assortment size as well as on the expense side.

And as an example, one of the big pieces of the puzzle which we are not prepared to discuss yet, because we are still going through the analysis and so on, but as you can appreciate with 8,000 stores we are really a chain of chains and these stores across the country have different demand characteristics and different demographics and just completely different characteristics. And think that as we fully digest the information and process that, we think we will be able to tailor and cluster some of these stores with the merchandise assortment that is more relevant to the neighborhoods where these stores are located.

Just as an example, I know we talked about how soft our discretionary business has been and one of the things that we think will help drive our discretionary business is getting those inventories in the right stores. So believe it or not, we have some very good apparel stores. We have some very good home stores that we have actually taken space out of those categories. As we look at this clustering opportunity, those stores would probably get some more space to apparel.

Conversely, we have a number of stores that are great food stores, almost acting as a small grocery store in some of the communities and are probably under spaced in what we offer in terms of food. So we will be able to tailor a mix that's more appropriate for those stores.

That's a huge undertaking for us. And one that we are going to be very careful about approaching to make sure we have a project planned that's documented well and tested well and ready to go before we roll it out. But that is certainly something that's a major part of our plan.

In addition to that, these food and household sets in the near-term, we are going to want to leverage and make sure we continue to execute well there. They have gotten off to some good starts and between those two businesses represent over half of our company sales today. So driving the improvements there and continuing to see that grow is also important.

And the price investments are critical to us. That's not a one and done sort of thing. It's going to take some time for the word to get out across our customer base. But we are excited about what that means to our customers and what that will do to us over the next few years.

In terms of expenses, there is a number of things we continue to look on the expense side to try to take cost out. Clearly we have realized we are in a very competitive business and the best way to fund these price investments is to take unnecessary cost out of the business. So there is a real good emphasis on work being done there. So as we finalize and get more rigor around some of these things we certainly will communicate that with you all in due course.

John Heinbockel - Guggenheim Securities

And let me just follow up on pricing. When you think about the $50 million investment, so I assume a lot of that is consumables, but how much of that might be discretionary? Is that fairly broad-based approach stores? I found some inconsistencies as we have done pricing from store to store. How satisfied are you that the zones are what they should be and they are being executed effectively?

Howard Levine

Sure. John, and let me start with the last part of the question first. In terms of our zone pricing, as part of our price investments, we will continue to evaluate our zones. Generally we feel pretty good about that, but there will also be corresponding reductions in price in some of the higher zones as well to help enhance the value proposition in those stores as well. So they are also a part of this work in terms of terms of some of the price reductions.

So in terms of your question about the discretionary side of the business, when I talk about our value proposition the discretionary side of our business is critical to that, and particularly as we took a step back and looked at some of our holiday results. We own a lot of that. We felt again that we did not have great value and just as some examples, that magical $1 price point that has been so important to us over the years is hard to find sometimes. We will be getting back to try to drive that more in to our stores, not just during the holiday but year round.

Getting back to the holiday, another big area of opportunity as we have always been strong in $5 toys. We didn't have a presence this year that we wanted to have. We are going to look at that more effectively. But there is clearly opportunity from the value side on the discretionary piece of our business just as there is on the basic side of the business. So we think the total company is now getting refocused on driving that value proposition and letting our customer know what we stand for.

John Heinbockel - Guggenheim Securities

Thank you.

Operator

And from Wolfe Research, we will go to Scott Mushkin.

Scott Mushkin - Wolfe Research

Hi, guys. Thanks for taking my questions. Two, one follow-up on the pricing. Howard, you said, you need to continue to invest and we show that the $50 million maybe just a start, maybe it's more like $150 million to $200 million to get you guys back to parity to down to Walmart. How quickly could you implement something like that? Is it going to be in stages where you gradually take pricing down? Or how do you have envision this will work overtime?

Howard Levine

Yes. So Scott, I am not sure what your starting point was because most of these price reductions were just done last week. So I don't see the kind of numbers that you do. And frankly, we are not looking to undercut competition in this thing. In most cases, it is coming down to the competition, but clearly this is an ongoing process and there will be more opportunities for us to invest in price, but I think your number is elevated.

Scott Mushkin - Wolfe Research

Okay, then my second question goes to the ROIC comments you had and the real estate comments. You guys changed the way you develop stores. As you went back five, six, seven years ago, you were much more doing five-year leases, you were going to be in fee locations to really drive down the rental expense. That's changed a lot over time. As you look at store development, do you think you can go back to the old model where you were really kind of trying to get very low rents in BC locations, but to drive very higher ROIC or are we not yet to that point where we are going to revert to the old strategy?

Howard Levine

No, Scott. That's a very good question. Let me start off by saying the world has changed over the last several years. Existing shopping centers don't offer us what we need and our assortment what we want to do with the store today. Often times, very regular, not a regular shapes not the right sizes, there is grocery competition that doesn't want us in their shopping centers. And this has been ongoing for a number of years and it has actually been a real positive for us that developing our own sites with freestanding locations where we have plenty of parking, really emphasizing the convenience component of our business with easy in, easy out, it is critically important to us.

In fact, those stores are doing better than some of these old shopping centers that you are talking about. But clearly that creates a different lease structure and a different dynamic, to your point that you cannot build a store with a five-year deal. It's a little longer term. Rents are up a little bit, because it is a brand-new building, but when we do that properly and we put in the right spot, we have seen a lot of success.

So that will be the way that we have grown and frankly, the way a lot of our competitors have grown over the last few years. So I suspect that that will continue. But one thing that has not been lost through this while rents are up, we are keenly focused on driving the lowest possible rents and lease structure that we possibly can. Again, that is part of our long-term culture and part of what will stick with us and something that I continue to believe we have opportunity on.

Scott Mushkin - Wolfe Research

Thanks, Howard. That's a really good answer. Just one comment. If you look at the return on invested capital and the consumable mix and what you have done with your store base, it looks like you have gone from 18 level down to 15. So a real big drop, given the change of strategy. That's the only comment. But I really appreciate your comments. Thanks.

Howard Levine

No, sure. I will just tell you. I don't think that has to do with the real estate strategy as much as what we have done with our assortment. Once we get that settled down, we get the price investments back in there. We settled down our marketing strategy. We get the customer focused and our teams focused on value. We think that we will be properly placing. We will start to see those returns improve.

Mary Winston

And let me just add one more thing to that. I would say the other thing that we are looking at obviously, as we said before, is controlling our cost. So not necessarily through the lease costs, although as Howard said, we certainly are focused on that as well in keeping those costs low. But we are looking for every opportunity to improve efficiency in our stores and bring some cost savings through that, improve our distribution and supply chain network and bring some cost savings through that. So we are looking at every element of cost in order to keep the profitability up and keep the returns up.

Scott Mushkin - Wolfe Research

Perfect. Thanks, guys. I appreciate your comments.

Mary Winston

Okay, Rebecca, we will take the next question.

Operator

And that will come from Stephen Grambling with Goldman Sachs.

Stephen Grambling - Goldman Sachs

Hi, good morning. Thanks for taking my questions. I just have two follow-ups. The first is just to John's question on the business review. Clearly there seems to be a lot of opportunity on the operational fronts but you are also considering changes to either capital allocation or even other ways to create shareholder value?

Mary Winston

No, at that point we are not changing our capital allocation philosophy. So our priorities are remaining the same. Our first priority is to continue to invest back in the business and you can see that reflected in the investments that we are continuing to make in the new stores, even at a lower level next year. And we are continuing to renovate the chain and all that and we continue to be happy with those returns.

I would say, our new stores continue to deliver returns that are higher than the rest of the base business and our renovations continue to get a great lift when we do that. So that continues to be our top priority.

Second priority is to maintain our dividend program. And as you know, we have done that for 37 straight years and have increased the dividend every year. So those are our continued priorities. On share buybacks, we continue to be opportunistic in how we look at that and that's gong to continue to be our stance as well.

Stephen Grambling - Goldman Sachs

But I guess, is the strategic review all encompassing? Is there other ways that you are looking at either a leverage point or other things to think about creating shareholder value?

Mary Winston

Well, yes. It is certainly all encompassing. So we have definitely looked at our balance sheet as well and our leverage ratios and thought hard and long about how we return value to shareholders. And as Howard mentioned, while the review has been going on and we have accomplished a lot and we feel that we have announced a lot today, it is still ongoing and so there are still a number of things that we are still sort sorting out and finalizing. But yes, it has been all encompassing.

Stephen Grambling - Goldman Sachs

Great, thanks, and then the other follow-up was really on the closed stores. I appreciate all the color that you gave on those. But a couple of outstanding things. One, were these stores losing money out of four-wall EBIT or cash flow basis? And why do you believe that renovations weren't going to help improve the results or weren't going to be an appropriate use of capital? Is there something specific about those demographics or the competition that just made it seem like the renovations weren't going to be as impactful? Thank you.

Mary Winston

Yes. So that group of stores, yes. They were losing money on a four-wall basis. We looked at the performance back over the past three years. So we didn't just make a knee-jerk reaction based on their performance in one year or something like that. It's always our first preference to look for ways to improve the performance of our stores and so we do that every year. We look at stores that may have dropped below our expectations and we look for opportunities to improve their performance. But in the case of this group of stores, we had exhausted those opportunities, their performance had been subpar, I would say over the past few years and had deteriorated with the recent pressure under the business. Our real estate folks did get involved and looked at the site and looked at whether or not they were candidates for renovations or relocations and we came to the conclusion that those stores really should be closed.

Stephen Grambling - Goldman Sachs

Okay. Thank you.

Operator

And from Avondale Partners, we will go to Mark Montagna next.

Mark Montagna - Avondale Partners

Hi, it's actually Mark Montagna. The EDLP reductions, were those all in consumables or did some of that breakdown into non-consumables? And then, just looking at if they were all in consumables, how did that breakdown in terms of food versus non-food? Did you take any private brands down to a lower level?

And then is your expectation that this takes your pricing equal to Dollar General and Walmart?

Howard Levine

Thanks, Mark, and we know how to pronounce your last name but thanks for restating that because not that we wouldn't want have to happen. But in terms of your question about the pricing, the 1,000 or so SKUs that we talked about reducing pricing on were basic everyday SKUs that we carry in our assortment and the evaluation process there was to come down to competition. So we feel that as a result of these changes, we have become absolutely more competitive. I am not going to comment on the specifics of each of those, but it was across the board.

But your point about discretionary, and I had indicated this on an earlier question, discretionary is also about value and ensuring that we are priced right there. So as we go through the seasons, whether it's holiday or whether it's our spring and summer apparel, there has been a hard look at our price points in those areas to also incorporate great value and make sure that we are offering great value on those pieces of our assortment as well.

Mark Montagna - Avondale Partners:

Okay, and so within consumables, did you just have to roll back on private brands or are you really just focused on the national brands?

Howard Levine

There was a combination of both. It's primarily national brands, but there was a combination of both.

Mark Montagna - Avondale Partners:

Okay, and then just lastly a follow-up with EDLP. Is it fair to say that IMU would likely be down for the next four quarters because of this?

Howard Levine

We are working very hard on that. We have incorporated, at least for the remainder of this year, the impact of the price investments. But I also want to emphasize that we are still building out opportunities in global sourcing and think that that's an opportunity to help offset some of that.

Our private brand business is also about our margin play too in determining how we can continue to get traction there, which has actually been very good for us. Our private brand program continues to grow. Our customer satisfaction on those categories continue to improve. So we are looking at that.

We are also looking at every other aspect of the business in terms to fund this, another positive, which helps all around as our shrink improvement. The first time in a few years, our shrink is actually improving and I have to recognize the great work that our store teams have done as well as the great work our merchandising teams have done on some of those high, proliferated SKUs in getting them out of our assortment as they have not been productive sales for us.

And as I have talked about early on the expense front, taking expense out of the business is necessary to help position us better to continue to fund and support these price investments is a critical part of the formula and has always been important to us, but you will see renewed emphasis there as well.

Mark Montagna - Avondale Partners:

Okay, that sounds great. Thank you for your help.

Howard Levine

Sure.

Operator

From MKM Partners, we will hear from Patrick McKeever.

Patrick McKeever - MKM Partners

Thanks. Good morning, everyone. So my question is on the pallet delivery program that you talked about on the last call and were planning to roll out to a total of four distribution centers this year. So the question is, you didn't mention that this morning, it seems like that would be a pretty big deal as it relates to just truck unloading and store replenishment? So why not work that into the plan here, the immediate actions? Why not, let's say, accelerate that particular initiative?

Howard Levine

Sure, Patrick, and you got it. It's on the list now because it is critically important to us. We were assuming that we would get a question about that and so thank you. The pallet delivery process is going quite well. We have guided and we completed our Charlotte, our Matthews Distribution Center and we have rolled it out to our second one and it's going quite well.

Our store teams just love it. The lack of wear and tear and so on from unloading it case-by-case is behind us in those stores. I walked into some of those stores and they are about ready to hug me and give me a big kiss from what it's done to change their lives.

All that being said, one of the things that we have looked at very closely is to not outrun what we think our capabilities are. This is a perfect example of this. Converting the DCs, getting the equipment purchased, getting the equipment installed, getting the distribution centers trained and getting the productivity back up just takes time. We wanted to make sure we pace that properly. So our plans are still to do four this year and we will do the rest of them next fiscal year and we are very excited about getting it through.

Patrick McKeever - MKM Partners

Okay and then a second one on your tobacco business. With CVS just getting out of that business, I think as of the early fall or sometime in October. The question is, how much overlap do you think there might be there, not just with CVS, but let's say the drugstores in general, in tobacco? Is your core customer buying cigarettes there? Is it more of a convenience store trip for that customer? Do you see a market share opportunity as CVS exits the tobacco business?

Howard Levine

Sure, Patrick. First we continue to be pleased with our tobacco sales. They continue to grow and we are very pleased with that and we have some other plans to continue to keep that growing even prior to, as you have pointed out, the CVS situation. CVS is a competitor of us, not the kind to overlap with some of our other key competitors, but clearly, I think it's a win for us if you have a major retailer such as CVS getting out of the business.

So we look forward to getting our fair share of that chunk of the business. But to your point, the majority of tobacco sales occur at convenience stores, and I think they will also gain some benefit from that. But we are well-positioned there as well and look forward to taking advantage of that.

As part of our McLane relationship, we are in a great position to make these kind of changes and we are excited about what they bring in terms of the trip. Just further to that, the (inaudible) characteristics remain consistent to what they have been going through and as I say, it's been a nice addition to our business, albeit a lower margin piece of it, but it's been critical to our comps in the last few years.

Patrick McKeever - MKM Partners

Got it. Thank you, Howard.

Operator

From BB&T Capital Markets, we will hear from Anthony Chukumba.

Anthony Chukumba - BB&T Capital Markets

Thanks for taking the question. Just had a couple of questions. Just more clarification than anything else. In terms of gross margins, is that consistent with Q2? You are talking about, I am assuming that you meant the year-over-year decline in gross margin and not the absolute gross margin rate?

Mary Winston

Yes, that's absolutely right. Thanks for the clarification. That was a good question.

Anthony Chukumba - BB&T Capital Markets

Okay and then just one other question. So in the first quarter, your comp store sales were down 2.8% and you delevered SG&A 60 basis points. Now the comp was slightly worse, 100 basis point worse, but you delevered SG&A 210 basis points. I am just wondering, why was there so much more SG&A deleverage in the second quarter, given that the comp was worse, but not significantly worse.

Mary Winston

Yes, and I think it really is all the math around the negative sales comp. So I think that's really what it is. And then in the first quarter, I think we did indicate that first quarter SG&A was lighter than it otherwise would have been due to some changes we made in our incentive comp and some other things. So SG&A would have been slightly higher than it was in the first quarter. So I think that's where the aberration was as opposed in the second quarter.

We continue to view our base expenses as being very well-controlled. Our base expenses we target at around 2% to 3% increase and we did have, in the second quarter, an extra week, or the comparison year-over-year, had an extra week last year. So all those factors play into it and so it's just the math of it.

So, Anthony, just to clarify, the comp does not have an extra week. The comp is a comparable period, but the income statement where we get the deleverage, does, right?

Anthony Chukumba - BB&T Capital Markets

Got it. That's helpful. Thank you.

Operator

From Piper Jaffray, we will hear from Peter Keith.

Peter Keith - Piper Jaffray

Hi. Good morning, everyone. I wanted to ask about the reduction in SNAP benefits that we saw late last year. I am wondering now because we are couple of months into that, if you have seen some impact on your business, perhaps little bit of traffic trends falling off late in the month as some of those SNAP benefit cards run out? Any observations there would be helpful.

Howard Levine

Sure, Peter, and good morning. We certainly think there is some impact from the reduction. It's difficult to quantify but I would certainly tell you that it's not a positive for our customers.

Peter Keith - Piper Jaffray

Okay, and anything on and maybe a little more tangible regarding to traffic or your comp within the month at all?

Howard Levine

No. It's hard to tease out the specifics from each of the things that have been happening out there. So no, not really.

Peter Keith - Piper Jaffray

Okay, fair enough. Then I just had a separate question on the second half of your guidance. I was trying to make an adjustment on Q2 to add back the weather impact to adjust for the extra week last year. So kind of apples-to-apples, it looks like your EPS declined 25% year-on-year. And looking at the guidance now for the back half, it looks to be more like, call it a 7% to 18% decline. So certainly some improvement. I am wondering what's giving you the confidence there or why not just guide in line with the current trends?

Mary Winston

Yes. So I would say, there are a number of things that are causing us to expect an improving trend as we get into the back half of the year. First is the actions that we took during the second quarter around our assortment. So we did resets in our household area that started in January through February and then we reset our food assortment in February through March. We have rolled out most of the pricing that we have been talking about towards the end of March.

So we have already taken a number of actions that we expect to take hold and have some benefit in the back half of the year. And then when you look at the actions that we have announced today that are new, we will obviously have some SG&A benefit from the reduction in our workforce here at the corporate headquarters and we will also have some benefits from the closure of the stores. Although that will be towards the fourth quarter as we roll through that process because it does take a couple of months to actually get through the process of closing the stores.

So all of those things are impacting the business and in every line item. So we are expecting, as I mentioned in my guidance comps to stabilize a little bit. So we are expecting some improvement overall.

Peter Keith - Piper Jaffray

Okay. Thank you for that feedback. And good luck in the back half of the year.

Mary Winston

Thank you.

Operator

And next we will hear from Laura Champinehank with Canaccord.

Laura Champinehank - Canaccord

All right. So Mary, in your comments on why the inventory is growing faster than projected sales growth, you mentioned that it's happening in consumables because of a change in schematics. Can you give us a little more color on that?

Mary Winston

Yes. That is exactly the food resets and everything that we have been talking about all along. So it's the things that I just commented on. We were building inventory in advance of resetting our household category which is mostly cleaning products, laundry, air care, those products and we did start rolling that out in January. Then we have been building inventory in advance of our food reset which was mostly every category across food and actually changing some SKUs out and adding some new SKUs. So building inventory in relation to that.

Laura Champinehank - Canaccord

And how long do you think it will take to get those levels back in line with sales growth?

Mary Winston

Well, first of all, let me say we do continue to be happy with our inventory metrics because we think that building inventory in advance of a major reset makes sense. We are doing a lot to get the message out to the customers so that the customer is aware of that and we start to build some momentum behind those new items. So I would expect the inventory levels to continue to stabilize and the metrics to continue to improve as we move towards the end of the year.

Laura Champinehank - Canaccord

Thank you.

Mary Winston

Rebecca, I think we have time for one more question.

Operator

And the final question will come from Meredith Adler with Barclays.

Meredith Adler - Barclays

Hello. Thanks for taking my question. I would like to start by talking about the stores that will be opened this year. You are still opening quite a large number. Obviously you had signed leases and you had commitments but did you consider, I mean, did you go through the same exercise of looking at those stores and saying, gee, maybe we should try to not open these stores, pay the landlords or do something else?

Howard Levine

Yes. Meredith, at the beginning of the year, actually before the beginning of the year, we did a deep dive on the stores that were on the plans to open this year and did make some adjustments there but we feel very good about the remaining stores in the pipeline. As you have mentioned, a number of those are under construction as we speak but we feel very good about the pipeline in the stores that we have opening for the remainder of our year here.

Meredith Adler - Barclays

Okay, and then I have just a follow-up question about the 10% reduction in the corporate office. Can you just talk a little bit about whether that was an across the board reduction or did you focus on certain areas? Was there also, I think you used the word reorganization, was there a detailed reorganization plan so that you didn't have people doing twice as much work as they used to do which is kind of situation here at Barclays right now.

Howard Levine

Well, I can't promise you that everywhere. Speaking for myself, it feels like I am doing quite same the work as I used to. But candidly, Meredith, this process began several months ago. This wasn't something that we just came up with. Our senior leadership teams had a number of conversations in detail about each line of business to try to make sure that we were positioned right.

We knew we needed to take some actions there to position the expense portfolio, the expense structure, I am sorry, of our business but it was different cases and different lines of businesses. Each one had its nuance, but one of key results of this is it wasn't just to eliminate heads without understanding who was going to be picking up the responsibilities there.

So I feel very comfortable and confident about the process we went through and think that there may be some people that had some bandwidth that will now not have a little extra time on their hands but we did our best to ensure that we didn't overburden our workforce here.

Mary Winston

Meredith, this is Mary. I am just going to add one more quick comment to that. As Howard indicated, we did do a deep dive on every area and we focused on where we could improve our processes to help us make those decisions. We also looked at the actions that we were about to announce like fewer store openings in the coming year and things like that and other changes in the business that would impact the level of resource that we needed here at our store support center.

Meredith Adler - Barclays

Okay and I am just going to squeeze in one more question. You talked about, this is totally different, but talking about using digital as part of your marketing. Can you just talk about what research you might have done? Do you think your customer is likely to respond to digital messages? Is that a good direction or an important direction to be going in?

Howard Levine

Yes, Meredith. And we have been doing digital, email blast, et cetera for a few years now and it just continues to grow. You would be surprised how highly our customer index is to smartphones today. Well over 50% and climbing every day. So it is a very effective and efficient way to reach customers to notify them of things. What we are talking about doing is just continuing to grow what has already been set up as part of our marketing effort.

Meredith Adler - Barclays

Okay, great. Thank you very much.

Mary Winston

So it is a little bit past the top of the hour and unfortunately, we didn't get through all of the questions in the queue. So as always, Kevin and I will be available for any follow-up calls that you may have. Thank you for your continued interest in Family Dollar and have a good day.

Operator

So with that, ladies and gentlemen, that does conclude today's presentation. We do thank everyone for your participation.

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