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Family Dollar Stores (NYSE:FDO)

F1Q07 Earnings Call

December 20, 2006 10:00 am ET

Executives

Howard Levine - Chairman, CEO

Jim Kelly - President, COO, Interim CFO

Kiley Rawlins - IR

Analysts

Mr. Smith - Banc of America Securities

David Mann - Johnson Rice

Christine Augustine - Bear Stearns

Charles Grom – JP Morgan

Meredith Adler - Lehman Brothers

Scott Malat - Goldman Sachs

Dan Wewer - Raymond James

Mark Miller - William Blair

David Cumberland - Robert W. Baird

Presentation

Operator

At this time, I would like to welcome everyone to the Family Dollar first quarter earnings conference call. (Operator Instructions) I would now like to introduce Ms. Kiley Rawlins, Divisional Vice President of Investor Relations. Ms. Rawlins, you may begin your conference.

Kiley Rawlins

Thank you, Bridget. Good morning, everyone and thank you for joining us today. We appreciate your continued interest in Family Dollar. With me this morning are Howard Levine, Chairman and CEO; and Jim Kelly, President, COO and interim CFO.

Before we begin, you should note that our comments today will include forward-looking statements which are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act. These statements address company plans and activities or events which we expect will or may occur in the future. However, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ from our plans. We refer you to and specifically incorporate the cautionary statements contained in today's press release and in our other SEC filings.

You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this call. The Company does not undertake to publicly update or revise its forward-looking statements.

As a reminder, the financial results reported today are preliminary, due to the previously announced review of the company's stock option grant practices. The results reported today do not take into account any adjustments that may be required upon completion of the review, and therefore should be considered preliminary until the company files its annual report on Form 10-K for fiscal 2006 and its Form 10-Q for the first quarter of fiscal 2007.

We are unable to comment today on any aspect of this review or its potential outcome. We will begin our discussion this morning with some comments on our preliminary first quarter operating results from Jim, and then Howard will share some of his thoughts with you.

Jim Kelly

Thank you, Kiley. Good morning and Happy Holidays. We reported this morning that net income per diluted share for the first quarter of fiscal 2007 increased 13% to $0.36 compared to $0.32 for the first quarter of fiscal 2006. Despite lower than expected comp sales in the quarter, we achieved our expected results, largely due to some favorable trends in gross margin and well-controlled expenses. We are particularly pleased that our inventory productivity continues to improve as we work to reduce inventories. This makes our stores easier to shop and easier to operate.

We began this quarter recording only the markup on sales of prepaid cellular services as opposed to the gross sales to the customer. Last fall, we began offering prepaid cell phones and minutes in our stores, and customer response has been tremendous. As a consequence of recording just our markup, previously disclosed comp sales for the quarter of 1.9% was reduced about 1% to 0.9%; and comp store guidance for December was lowered from 1% to 3% to zero to 2%. Importantly, this has no impact on operating results, and we believe that the impact on comps will diminish as we cycle the ramp up of these sales.

Notwithstanding how prepaid cellular services are recorded, our comp sales performance for the quarter was lower than planned and lower than we desire. We mentioned in previous sales releases that we estimate that the cycling of Katrina and other hurricane-driven sales during the first quarter of last year negatively impacted this year's first quarter comp performance by about 1%.

On a positive note, sales growth was more evenly balanced among high margin and lower margin products, setting a foundation for better gross margin performance. Indeed, gross margin as a percent of sales increased 90 basis points this quarter. About half of this increase relates to the growth in prepaid cellular services, with the other half relating to improved markdown and shrink performance.

On the other hand, SG&A expenses increased as a percent of sales by approximately 70 basis points. This was driven by low comp sales growth and expenses associated with a review of stock options.

Workers' compensation expense trends continued to improve as a result of better processes, lower inventories and higher associate retention rates.

Some of you may have noticed that interest expense increased by a little more than $3 million. This was primarily a result of income tax related interest. Our income tax rate for the first quarter this year was 37.8% versus 37% for the first quarter last year. This increase primarily resulted from the phase out of tax credits and adverse state tax trends. We have received the preliminary results of an IRS audit of the three years ended fiscal 2005. Proposed adjustments were primarily timing in nature, and therefore the major impact was the interest charge that I previously noted.

Asset management efforts continue to drive improvements. Inventories at quarter end were approximately 8% lower on a per-store basis than first quarter last year. We believe that lower inventories are contributing to the positive trends we are seeing in shrink, store manager retention and workers' comp.

We are also more disciplined in our capital expenditures. We now expect current year capital expenditures to be approximately $170 million to $180 million. First quarter capital expenditures were approximately $21 million, versus approximately $49 million for the first quarter of last year. Narrowing our focus and more aggressively measuring related benefits from proposed expenditures are leading to wiser capital decisions.

We are, however, continuing to aggressively invest in our business, with programs like Store of the Future and Project Accelerate holding great potential for supporting much-improved performance. Howard will give you an update on these and other initiatives in a moment.

From a liquidity perspective, cash and short-term investments aggregated approximately $236 million at quarter end, an increase of approximately $90 million, or 62% over the end of the first quarter last year.

Now let's talk about the outlook for the rest of the year. Our annual earnings per share guidance of between $1.57 and $1.69 is unchanged from earlier guidance. We believe that comparable store sales will modestly improve during the remainder of this fiscal year, and are excited about the various sales driving initiatives planned for this spring and summer.

Operating margin pressure is expected to continue as we expand our food strategy and in particular, if comp store sales remain in the low single-digits. On the other hand, we are confident that sales of prepaid services, better purchase markups, lower inventory shrinkage, lower freight expense and the benefits of continued refinement of operational and administrative processes can largely offset these pressures.

I would remind you that our second quarter contains 14 weeks versus 13 weeks last year. We are expecting December comps of between zero and 2%; this is consistent with earlier guidance, after adjustment for prepaid wireless services. The biggest shopping days of the holiday season are in front of us and the results will significantly impact results for the month. We expect comparable sales to increase 1% to 3% for the second quarter, and expect earnings per share to be between $0.58 and $0.64.

Now Howard will share his perspectives.

Howard Levine

Thank you, Jim. Good morning and Happy Holidays. More than five years ago, we began investing to create a more compelling place to shop, work and invest. I am pleased with the progress we have made, especially in increasing inventory productivity, improving manager retention and in building our management team.

We have reduced inventory appreciably in our stores. I cannot emphasize enough the impact that lower inventory has in our stores, and we continue to work to make sure that our stores have the right amount of inventory at the right time. With the implementation of our replenishment system, we have improved in-stocks of basic merchandise, while reducing excess safety stock. We have also improved the flow of fashion inventory to our stores, working to smooth peaks of seasonal freight.

For our customers, lower inventories result in less cluttered, more organized stores with more attractive merchandise presentation. For our associates, the results are stores that are easier to operate. For our investors, the results are better returns on our most significant financial assets.

Improving associate retention is not easy to do, nor does it happen overnight. Having less inventory has had an impact, but we have also invested in better selection and training processes to ensure that our people have the tools they need to be successful. Our urban initiative has also had a meaningful impact on improving store manager retention. Our store manager turnover during the first quarter this year was approximately 20% lower than the first quarter last year, and it is lower today than it has been in several years. In a business that is dependent upon thousands of managers to lead small teams of associates, serve customers and run a million dollar business, increasing our retention of experienced managers has a significant impact on our ability to execute well.

In addition to reinforcing our store teams, we have also strengthened our leadership team, complementing our experienced team with specific expertise to fill identified gaps. Over the last 18 months, we have added new talent in merchandising, supply chain, human resources, facilities management, real estate, information technology and business development. These new folks are partnering with our experienced veterans to improve our performance.

While I am proud of what we have accomplished, we are not satisfied. We also recognize that there is still much opportunity to improve. Today, Family Dollar captures approximately 1% of our customers' discretionary spend, and we think that there is a significant opportunity to increase our share. That is why several years ago we began to develop our Enhanced Food Strategy and our Treasure Hunt program. We have made important progress in both, but we can do better.

As we have discussed, food purchases are a large percentage of our customers' discretionary spend. For low-income customers, smaller home storage capacity and a limited income result in more frequent fill-in shops for basic necessities. Our Food Strategy is intended to position Family Dollar to capture these frequent trips. Today, approximately two-thirds of our stores have coolers for the sale of refrigerated food, enabling us to offer more convenience and value for the fill-in food trips that our customers make. We expect to have coolers in about 5,000 stores by year end.

This spring, we will build upon the cooler assortment by expanding our selection of shelf stable food, focusing on quick-prep and ready-to-eat products. We expect to have this enhanced assortment in about 2,000 stores by the end of our fiscal year. In addition, we will begin accepting food stamps in about 10% of the chain by the end of our fiscal year.

When we launched our Treasure Hunt program several years ago, our objective was to offer exciting, unexpected merchandise for our customers and to utilize circulars to communicate these values directly to our customers. Since launching the program during the holiday season of 2004 we have learned much, and today our Treasure Hunt program has evolved from an item-based program into a more event-based strategy. Our goal is to create store events that differentiate us from our competition, create customer excitement and integrate merchandise presentation and marketing.

An example of how we are executing upon this strategy is our toy business. In November, we initiated an in-store event around toys for the holidays. We created a toy book that highlighted the toy selection of many national brands priced at $10 or less. With less overall inventory to manage in our stores, we have executed our merchandising plan better. In addition, because we have done a better job this year of flowing inventory in our stores, we have reduced the multiple handling of product, making it easier on our store associates. Our customers have responded enthusiastically and our toy business so far this holiday season has performed very well.

Another element of our Treasure Hunt program is our apparel assortment. With the support of new leadership in this area, we are working to improve the appeal and the productivity of our apparel offering. We have identified several key objectives in this area, and this spring you will begin to see some of the results of our effort.

First, to drive higher inventory productivity, we are focused on taking timely, effective markdowns to clear residual inventory. As you may recall, last summer we tried a new approach with a spring/summer clearance event and we were very pleased with the results. We will take a similar approach this quarter, as we work to clear out our fall, winter and holiday merchandise.

Second, we are working to narrow our assortments to create better presentations and to improve profitability. We are also working to improve the quality of our apparel offering and have recently established a more rigorous quality testing program. As we move into spring, I am confident that our customers will notice the improvements.

With all seasonal and fashion merchandise, we are working to manage inventory flow better and to coordinate our merchandising efforts so that our store teams can manage their workload more efficiently.

In addition to investing to increase our relevancy to the customer, we are working to deliver a better shopping experience. Lower inventory levels, more experienced store managers and the changes we are making in our assortment will all coordinate for a more pleasant shopping experience. Through our constant renewal program, which is driving more fundamental change, we have created a more appealing store layout with improved design elements and more intuitive adjacencies. Today, we have three concept renewal stores in Charlotte, and we are using these stores to test new ideas and evaluate customer reaction. By the end of the fiscal year, we plan to have about ten test stores.

However, beginning in January, we will begin to incorporate many of these designs and layout elements into most of our new stores. Based on the feedback we have received from our stores in Charlotte, I am confident that our customers will appreciate our new look.

Execution is the key to success, and we have several significant multi-year projects underway which will help us to execute better. We began working on our Store of the Future initiative several years ago and are now ready to begin deploying the new system in stores. Our Store of the Future project is an initiative designed to enhance customer service and to make our stores easier to operate. In addition to providing a more efficient platform to process multiple tender types, including food stamps, our Store of the Future project will enable us to process customers faster, making trips to Family Dollar even more convenient.

In addition, the Store of the Future platform, through a customized store portal, provides store managers with actionable, exception-based information, enabling them to manage their time and the time of their associates more effectively. Ultimately, we intend to refresh the technology in all of our stores, but this year we will focus our Store of the Future project in approximately 750 urban initiative stores, providing store managers in these challenging markets with better tools to manage their business.

As we have discussed this morning, we have made significant progress in lowering our inventory levels, which in turn has made our stores more shoppable. However, we believe there is an opportunity to improve further, and we have a clear vision of where we want to be. This year, we are initiating a strategic multi-year effort designed to optimize our merchandising and supply chain processes. We call this ambitious effort Project Accelerate, and our focus will include price optimization, category management, space management and assortment planning. In essence, we are developing a more strategic approach to how we meet the needs and wants of our customers, while improving the productivity and profitability of our inventory investments. We believe the long-term benefits of these efforts will have tremendous impact on our ability to serve our customers, associates and shareholders.

In summary, we have worked hard to get where we are today and I am pleased with what we have accomplished. But I am determined that we will not allow ourselves to be complacent. There is significant opportunity for Family Dollar, and I remain excited about our future as we work to become a more compelling place to shop, work and invest.

Now, operator, we would be pleased to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mr. Smith - Banc of America Securities.

Mr. Smith - Banc of America Securities

Just two quick questions. Obviously, you guys have built up some cash in the quarter. We are expecting that to continue going forward with lower CapEx. What are your plans for your cash, especially with your enhanced inventory performance?

Jim Kelly

I think at this point in time, we are certainly going to accumulate and stay focused on making those investments back into our company that can give us the targeted returns. At such point in time as we file all of our various SEC filings, then we are likely to resume our historic pattern relative to stock repurchases.

Mr. Smith - Banc of America Securities

Thanks so much. I was a little unclear on the interest expense. I understand it was related to some changes in taxes. Is this something that we're going to expect going forward for the rest of the year, or is this sort of one-time in nature?

Jim Kelly

I think the largest portion of it will be one-time in nature. There was a three-year audit that was completed, so it reflects the cumulative effect over that three-year period of the proposed adjustments.

Mr. Smith - Banc of America Securities

Thanks so much and congratulations on the nice quarter.

Operator

Your next question comes from David Mann - Johnson Rice.

David Mann - Johnson Rice

First of all, can you just elaborate a little more in terms of the shrink benefits that you are getting? Is that something you are seeing in all stores or is it just a certain group of stores where you have some targeted focus?

Jim Kelly

I think the shrink program has been somewhat widespread. If you look at the major contributing factors, it would include clearly a reduction of inventory, clearly some very much improved processes on the part of our risk management folks, as well as our distribution and store operations people. The introduction of new shrink technology a couple of years ago is also very helpful. So it's a cumulative effect of about a three-year intense effort that is beginning to show some meaningful traction.

It is widespread in terms of the store base. The special focus that we've had on the urban environment is perhaps leading a slightly higher proportionate impact than other stores, but we are seeing a favorable impact throughout the organization.

David Mann - Johnson Rice

A second question, just in general, on the competitive landscape. Dollar Generals looks a little more active in terms of their pre-Christmas clearance activities and toy sale. Can you just talk about what you are seeing out there and if you feel like you need to do anything to respond to that?

Howard Levine

Yes, David. It seems like every December it gets more and more competitive. And as we've said earlier in some of our prior conference calls that we did anticipate a very competitive holiday season, and think that we made the appropriate plans to be competitive ourselves during that time period. As I commented, our toy business has been very good.

On the other hand, we've had some negative impacts on the apparel side this December with all the warm weather. Other hard-line seasonal categories have performed well, and we are very pleased with the performance thus far. We've still got some big days ahead of us, we've got some exciting post-holiday plans as well. And as we've talked about, we kick off the major initiatives going into the second half of next year.

David Mann - Johnson Rice

If you could clarify one other thing: in the first quarter, you did not comment on mix shift, but you do expect that to have some impact on gross margin for the rest of the year. Is that correct?

Jim Kelly

Well, I think my comment was that we actually had relatively consistent growth between high-margin and low-margin items. So there wasn't a tremendous amount of negative mix shift impacting the first quarter. As we roll out the Food Strategy, that will drive core consumable sales to a higher degree, perhaps, than higher margin items. So I caution that that may have and our guidance expects that the Food Initiative, in essence, will result in a slight adverse mix shift.

David Mann - Johnson Rice

Okay, great. Good luck. Happy Holidays. Thank you.

Operator

Your next question comes from Christine Augustine - Bear Stearns.

Christine Augustine - Bear Stearns

Thank you. My first question is on your 70 basis point increase in SG&A. How much of that, if you could give us even within a range, was from the costs incurred to do the internal investigation on stock options?

Jim Kelly

Let me break that 70 points down a little bit, and I will answer your question and probably give you a little more. I think there are a couple of things there, Christine. First is the indirect impact that recording wireless at net had. That is roughly 40 of the 70 basis points. In other words, if we had 2% comp as opposed to 1% comp, we would have had roughly a 30 basis point impact on deleverage of expenses.

Of the 30, roughly 25 related to the option expensing. So with a 2% comp, on historical standards we would have had about a 5 basis point expense deleverage, which is a lot better performance than we have traditionally realized. We still believe that in the long run, we need to target around a 3% comp in order to leverage expenses, but certainly the performance this quarter, but for the option review expenses, would have been much better than that.

Christine Augustine - Bear Stearns

Thank you. On Project Accelerate, you listed a number of different initiatives: price optimization, category management, space management, assortment planning. Could you talk about which one of those do you think will be the most meaningful this year and then what sort of additional costs do you have to incur to roll this program out? Thank you.

Howard Levine

Christine, as I've talked about, this is a project that will take a few years to complete. We have begun a pilot on the price optimization part of it, and based on the results of that, we will make further decisions as how to implement regarding the timing.

Some of the other parts of that category, management we've gotten a start on. In the planning assortment, space planning assortment, parts of it will be a little later on. But we've continued to make nice progress there and we have incorporated the costs and expenses into our plans as we go forward.

Christine Augustine - Bear Stearns

Finally, what is your philosophy with regard to pack away inventory? I was wondering this in light of the fact that Dollar Gen has decided to basically eliminate it, with some exceptions. Have you thought about revisiting that strategy at all?

Jim Kelly

We strongly believe in marking down and clearing out goods at the end of the season and have been executing a strategy to do so. In fact, we have probably gotten more aggressive, as we talked about this past summer, in liquidating some of our summer seasonal products, which we found to be very successful. So we continue to look on how we can be more effective in managing our inventory, in increasing inventory productivity, of which a significant part of that is the clear as you go. We've always said there are a few odds and ends and bits and pieces that may have some pack away to it, but our objective is to completely clean and move on to the next season at the end of a prior season.

Christine Augustine - Bear Stearns

Thank you very much and have a wonderful holiday season.

Jim Kelly

Thank you. You too.

Operator

Your next question comes from Charles Grom - JP Morgan.

Charles Grom - JP Morgan

Thanks. Good morning. Can you remind us of the rollout last year of the prepaid cell services and the expected merchandise margin benefit going forward? In other words, when do we start to anniversary the bulk of this rollout?

Jim Kelly

I think the bulk of it will be anniversaried in the fourth quarter. It should basically have the impact the next three quarters that are roughly the same as it had this quarter. So I would build into my model that it is going to have a positive influence on gross margin in that neighborhood of anywhere from 30 to 50 basis points.

On the other hand, the comp guidance that we will be giving will be the comp guidance recording the wireless net. So the comp guidance over the next quarter or so has been tempered a little bit to reflect this change already. So just in your model, note the adjustment or the temperance of the comp guidance, and it will have a positive impact related to the gross margin.

The lower comp guidance should also alert you to the fact that it is more challenging to leverage SG&A expenses at lower comp levels. So while at a 3% comp level, there is often no leverage or some positive results; at a 2%, it is far more challenging.

Charles Grom - JP Morgan

Okay, that is helpful. Another question on the margins here. The disclosure in the press release on product mix was very helpful, but the consumable portion at about 6% of sales was about 500 basis points higher than we were thinking. So could you touch on where directionally this could go in '07 in terms of where your budget is? I know Dollar General is close to 70%. Do you think that is where you guys get to eventually?

Jim Kelly

As I recall, our consumable business grew at roughly the same rate this past quarter as all other sections. I think it was less than a point spread between the two. I think consumables were at 6.4%, whereas apparel and seasonal were at 5.7%. So I think overall, the average is 5.9% so you had a few basis points, and those are tenths of a percent. That is so much better than our last ten-year history where we were having almost 200 points of shift each year. So I'm fairly well pleased and with that distribution I think we will be able to manage margin fairly effectively.

Do not see it, and I would remind you that one of the reasons that we have -- and again, for those of you that have followed us for the last five or six years, is we have had a tremendous emphasis on balance. And that emphasis was throughout the late '90s into the early ‘00s. It is what delayed in some ways the more aggressive pursuit of food. But we felt like we had to have a fully developed Treasure Hunt initiative that would enable us to effectively leverage the incremental food traffic in order to maintain the financial model that we were targeting.

Charles Grom - JP Morgan

Thanks. That is helpful. And then just to clarify the recalibrated December comp view of zero to 2%, which is down from 1% to 3%, is really solely from this accounting change, correct? It is not a reflection of the apparel weakness that you cited?

Jim Kelly

No. That is correct. It simply reflects the change in how we are accounting for wireless.

Charles Grom - JP Morgan

Thanks. Good luck. Have a nice holiday.

Operator

Your next question comes from Meredith Adler - Lehman Brothers.

Meredith Adler - Lehman Brothers

[Break-up in audio]

Kiley Rawlins

Meredith, we can't hear you very well. Can you repeat the question?

Meredith Adler - Lehman Brothers

Yes. I'm sorry. My question was just trying to understand the impact of accounting for prepaid phone cards on SG&A. I thought you said 25 basis points, but in the context of a different comp? I wasn't quite sure.

Jim Kelly

Yes. The point that I was trying to make, Meredith, is, as you know, how we account for wireless has no impact on the amount of SG&A. But with the lower reported sales, it does have an indirect impact. If I ran a pro forma that said let's record wireless sales at gross versus the net that is reflected in this release, SG&A expenses would be about 30 basis points less.

The SG&A breakdown starting from the top, we had 70 basis points. If on a comparable basis, we had reported wireless at gross, we would have had a deleverage of 30 basis points, not 70. So the impact of that change on SG&A was about 40 basis points. That leaves 30 basis points of deleveraging on a more consistent basis. Of that 30 basis points of deleverage, approximately 25 basis points related to the review of stock options.

Meredith Adler - Lehman Brothers

Okay, great. Another question I have is when you talk about expanding the food assortment in 2000 stores by year end, can you talk a little bit about whether you're actually replacing other items or just reconfiguring? When you roll out more food, do you have to take something else out of the store or are you just reconfiguring?

Howard Levine

We are doing several things, Meredith. In fact, our team has looked at each store where we are going to be putting the enhanced food strategy in and doing a specific evaluation of each store. In some cases, some categories may be removed from the store. In some cases, we have the room in the store and it is not necessary to do anything other than reposition some of the existing gondolas. In some stores, there is a combination of both of those things. But I think the key is we've looked at each store on an individual basis in trying to come up with what we think would be the best plan for each store.

Meredith Adler - Lehman Brothers

Another quick question: the apparel clearance that you will do for fall and winter merchandise, do you usually do that in January?

Howard Levine

We start the week after Christmas and we have events through January and February.

Meredith Adler - Lehman Brothers

My final question is, you did mention that turnover was looking better. I didn't know whether turnover is visible in many different groups of stores or is it most visible in the urban stores?

Jim Kelly

I think the results of our turnover initiatives and actually, we view it as associate retention programs, is widespread throughout our chain. Obviously, we've had some special efforts related to the urban markets and we're getting some significant performance improvement in those markets too.

Meredith Adler - Lehman Brothers

Great. Thank you very much and have a Happy Holiday.

Operator

Your next question comes from Scott Malat.

Scott Malat - Goldman Sachs

Good morning. Wondering if you can talk about the success you had in toys? It seems like the strategy has been maybe to add a bit more national brands. Just let me know how much that has changed and maybe the margins on some of those national brands toys and the sell-throughs that you've been seeing?

Howard Levine

Scott, I'm reluctant to give too much more color, other than what we've already given, as we still have a lot of business to do before the end of the month. Just to elaborate a little bit on what I already said is we took a very aggressive look at our toy business. I recall several years ago where there were thoughts that we were no longer a destination for toys as the electronics and some of the games were where all the action was.

We believe that there is a huge opportunity to serve low-income customers with tremendous values in toys, despite some of the challenges out there from the macro side. What we decided to do was group it together in a presentation in this toy book, to really allow the customers to see what some of our efforts have been. The positive feedback that we've gotten from our store associates and our customers has been very satisfying, and we look forward to completing the holiday season on an up note in that category.

Scott Malat - Goldman Sachs

Thanks. Really quickly then on shrink, just to turn back to that a little bit. Can you remind us of what the targets were for shrink and maybe give us an idea of where we are today?

Howard Levine

Our long-term goal is to try to get shrink down to the 3% area. We are still 40 or 50 basis points away from that today. We have had some tremendous improvements. When I look out into the future and see what the opportunity is, we remain very positive. As we've discussed before, one of the best leading indicators on improvement in the shrink area is store manager retention. We've seen very positive trends there and expect that to continue, and ultimately expect that to be a benefit to us in the shrink area.

Scott Malat - Goldman Sachs

Okay, thanks. Lastly, just on the Store of the Future, I know 750 stores for the year. Can you just give us an idea of what number of stores in the rollout in terms of following holiday, I guess we would start to see it first starting in the January/February timeframe?

Jim Kelly

I think the timeframe is really closer to March. But then you can take the rest of the months and you'll see a fairly consistent rollout from there, so 100 a month.

Scott Malat - Goldman Sachs

Okay, thanks.

Operator

Your next question comes from Dan Wewer - Raymond James.

Dan Wewer - Raymond James

Good morning. Jim, the change in the accounting for the prepaid cards puts you in line with most other retailers. I was curious to when you made the decision to make that change?

Jim Kelly

I think it puts us in line with some other retailers. I believe you will find practice a little bit diverse. Notwithstanding that, we believe it is the appropriate way in our circumstances to reflect it and we made that decision. Looking at the overall quarterly results and in considering that as we move forward from a strategic perspective, it is more likely that additional prepaid services will be offered. So what is of relatively minor significance today could have growing significance in the long run. So in anticipation of that, we thought it was appropriate to make the change.

Dan Wewer - Raymond James

The reason you are booking the spread is the fact that you do not have ownership or any risk on the cards until they are activated, is that correct?

Jim Kelly

That is correct, Dan. There is a series of considerations within the accounting literature on this, which is why I think you have a little bit of diversity in practice out there. You have to look through five or six different criteria and in the end, different people can look at similar situations and come up with slightly different results.

From our perspective, we are comfortable that the decision to record it at net is the most appropriate. Fundamentally, the impact you are seeing this quarter is more reflective of the growth that we've had this quarter, as reflected by the fact that half of our comp performance related to this single area, than it is the change itself.

Dan Wewer - Raymond James

Two other quick questions on this. It would be correct in assuming the gross margin rate on this is literally 100%? Second, there must be some reduction in your owned inventory, because I'm assuming under the old accounting if you were booking the revenues, you must have actually been buying the cards before you had activated them for your customers.

Jim Kelly

Dan, before it was recorded as a simultaneous event, because the plastic card itself is of insignificant in cost. But we were transmitting at the point of sales to the wireless provider, at which time we incurred a cost for the prepaid services. So it had no inventory impact before; it did have an impact on cost of sales, which would be recorded in connection with the recording of the sale.

Dan Wewer - Raymond James

Okay, so mathematically, this change will increase your inventory turns. Just under this standard because the definition is dividing average inventories into COGs?

Jim Kelly

No, because the inventory turn on that particular sliver of business, we have no inventory; it goes immediately to cost of sales at the point of sales under the old process. So cost of sales will be less.

Dan Wewer - Raymond James

Okay, that makes sense. Separate question. Howard, I know you have been working on these new real estate initiatives for a year now, or over a year. The new store productivity during the quarter looked terrific. Are we at the point now where you can say we are going to accelerate our new store growth rate, because these initiatives do appear to be working?

Howard Levine

Dan, you are right. We are making some progress in our new store area. We continue to believe that we still have opportunity to do better there. Our focus this year remains on the 6,000 stores, as opposed to talking about accelerating growth. But clearly, there are opportunities to continue the growth that we've had in the past. As we evaluate our plans in the future, we will be talking to you about that aspect of it.

Dan Wewer - Raymond James

Okay, thanks.

Operator

Your next question comes from Mark Miller - William Blair.

Mark Miller - William Blair

Good morning. I wanted to be clear, were either the option review expenses or the cumulative impact of the IRS audit contemplated in your original $0.34 to $0.38 guidance for the quarter?

Jim Kelly

No.

Mark Miller - William Blair

So given that my math is right, that roughly about $7 million better outcome in the quarter than what you reported, or $0.03. Is that the right range? If that is, what would be the reasons why you did $0.03 better on earnings? Is that shrink, is it markdowns, what are the factors?

Jim Kelly

I think that we had better performance at the gross margin level, which means specifically that we came out a bit better with our markdowns and a bit better with the shrink. So those were the two drivers at the gross margin level.

In addition, most of the expenses, other than those associated with the options, were very well-controlled. In fact, in most expense categories we actually came in below plan. So it's a combination of better performance and shrink in markdowns and improved cost performance.

Mark Miller - William Blair

Okay. On the inventory outlook, it sounds like we should see continued further improvement this next quarter, given the clearance approach will be continuing. I wanted to confirm that.

Thinking a little bit more towards the intermediate term, as you lap the beginning of the aggressive clearance activity in the summer, how should we think about that impacting inventory change? Maybe you can discuss, Jim, briefly some of the other factors which impact growth of inventory relative to store growth or sales growth, however you think about it, a little bit longer term. Thanks.

Jim Kelly

I think from an inventory perspective, and I will defer to Howard in just a second to discuss some of the sales area. From an inventory control perspective, the improvements that we are realizing at this point are not necessarily tied to the markdown clearance program. We have had a fairly consistent approach to clearing inventories at the end of every season. What we are doing now is we're working on the execution of those programs. As those programs become better executed, then we will come closer to maximizing the sales from each season's goods. So I think net-net that will be favorable and is simply an improvement in the markdown process.

The bigger side of the inventory reduction efforts have really been around the more robust implementation of our automated replenishment program. That is something that we installed five years ago, but when we installed it, we put a lot of safety stock into the stores. As we continuously finetune the tool, you can take out more and more of that safety stock while still maintaining high in-stock levels. So that as a singular item is probably one of the largest items driving better inventory productivity.

The second area of major significance is really the decisions around our planning merchandising decisions in terms of what quantities to buy and when to flow them into the stores. We are much more precise in terms of buying the right quantities and sending them to the right stores than we were several years ago. As a result, we are running sales of fashion merchandising at levels equal to or better than what they have historically been on less inventory. In other words, the sell-through rates for our typical fashion categories are much improved.

We see opportunities with better tools in the hands of our merchandising supply chain professionals to further drive that improvement. And yes, we are targeting further improvement, whether you are looking over a horizon of the next several quarters or the next several years.

Howard Levine

Mark, what I would add is our long-term goal is to continue to focus on inventory productivity. There are so many benefits to us as a company, the obvious ones being better returns on that inventory. The second benefit, and we've heard this loud and clear as I visit stores, when I talk to a store manager, what do you think has helped you handle the flow of product this year? Time and time again I heard about having the flow of the product more appropriate and having less overall inventory to manage.

One of the biggest challenges for our store managers, particularly during this time of the year, is having to handle the same product multiple times. We really tried to address that this year and continue to believe we have opportunities to do that further. The thought of driving more sales with less inventory is something that is very doable and something that our merchants and our planning group have done.

The other benefit to it and we were talking about this at the end of last week was we are now in a better position to take advantage of opportunities that may come up on an opportunistic basis. While that is not in major part of our merchandising strategy, the fact that we have room and space in our stores to take advantage of what those opportunities are is something that is a big benefit to us as well.

Overall, it is a major goal of the company to continue to do drive inventory turn and inventory productivity. We are very pleased with the progress we've made this year and we look to continue to make similar progress in the future.

Mark Miller - William Blair

Great. It does seem like it also helps customer perceptions of shoppability and housekeeping overall.

Howard Levine

Absolutely.

Jim Kelly

Mark, it is interesting that customer surveys consistently indicate when they go into a store with lower, better controls in inventories versus another store with higher inventories and perhaps more residuals, that the customer's view is that the assortment has been broadened. So how goods are presented in a store has a dramatic impact from a customer perspective in how they receive your assortment and how they view the convenience of the shopping experience.

Mark Miller - William Blair

Very good, thanks.

Kiley Rawlins

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

Operator

Your final question comes from David Cumberland - Robert Baird.

David Cumberland - Robert W. Baird

Good morning. My question is on the 2,000 stores that will get the larger food selection by the end of the year. Is that an increase in the number of stores that will get the larger assortment compared to your prior comments?

Howard Levine

Yes, David, it is. As we began looking at finalizing the rollout and the implementation, as well as the positive results that we achieved, we decided to go ahead and add additional stores to this year's plan.

David Cumberland - Robert W. Baird

Thank you very much.

Operator

At this time, there are no further questions. I will turn the call back over to Ms. Rawlins for any concluding remarks.

Kiley Rawlins

Thank you, Bridget. Unfortunately, today we did not get through all of your questions. As always, I will be available after the call for any follow-up questions you may have. Again, we appreciate your continued interest in Family Dollar and we wish you a happy and safe holiday.

Operator

Thank you for participating in today's conference. You may now disconnect.

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Source: Family Dollar Stores F1Q07 (Qtr End 11/25/06) Earnings Call Transcript
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