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Family Dollar Stores, Inc. (NYSE:FDO)

Q3 2014 Earnings Conference Call

July 10, 2014 10:00 AM ET

Executives

Kiley Rawlins - VP of IR and Communications

Howard Levine - Chairman and CEO

Mary Winston - CFO

Analysts

John Heinbockel - Guggenheim Securities

Matthew Boss - JPMorgan

Charles Grom - Sterne Agee

Paul Trussell - Deutsche Bank

Matt Nemer - Wells Fargo

Laura Champine - Canaccord

Scot Ciccarelli - RBC Capital Markets

Joe Feldman - Telsey Advisory Group

Meredith Adler - Barclays

Operator

Good morning. My name is Randy 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, Randy, and good morning, everyone. Thank you for joining us today. 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 expenditures 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, July 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, this morning we will reference non-GAAP financial measures which are intended to help investors understand our ongoing business performance. These measures include operating profit, net income and earnings per diluted share each excluding restructuring charges. A reconciliation of these non-GAAP financial measures to the comparable GAAP financial measures is included in our earnings release issued this morning and available on our website.

The amounts and timings 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.

Finally as many of you are aware, Carl Icahn and certain of his affiliates recently disclosed an ownership position in Family Dollar. As we have indicated before, we welcome constructive dialogue with all of our shareholders towards the shared objective of enhancing shareholder value.

The purpose of today’s call is to discuss our earnings results. We do not intend to make any further comments or statements during this call regarding any of our shareholders and we will not comment on any rumors or speculations that may exist in the marketplace. We thank you in advance for your cooperation in this regard

Our call today will begin with opening comments from Howard Levine, Chairman and CEO. Then Mary Winston, CFO, will review our financial results for the third quarter of fiscal 2014 and our outlook for the remainder of the year. Following our prepared comments, you will have an opportunity to ask questions about our results and expectations.

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

Howard Levine

Thanks, Kiley, and good morning, everyone. This morning, we reported our third quarter results and outlook for the fourth quarter. Before Mary discusses the quarter in more detail, I want to take a few moments to provide some high level thoughts on our recent performance.

While our long-term positioning in growth prospects remains strong, our results continue to be pressured by difficult competitive economic environment. Our core low income customers continue to deal with elevated unemployment levels, cuts to government benefits and volatility in energy prices and they are tightly managing their spending as a result. As expected, the environment remains very competitive as retailers look for ways to drive traffic as customers consolidate their shopping trips.

Although our financial performance remained below our expectations, we are making progress. Our team is focused and we are working hard and we are starting to see trends stabilize in critical areas. Notably, comparable store sales results in the third quarter in all four merchandise categories improved relative to our second quarter results. And the momentum carried into June finishing with the strong July fourth weekend.

Shrink trends improved for the second consecutive quarter. Store manager turnover levels have improved dramatically and inventory levels have stabilized which should result in improvements in profitability and inventory turns as we move into fiscal 2015.

As we discussed on our last call, our organization has a renewed commitment to providing our customers with great everyday values. We’re investing more than $50 million on an annualized basis to lower prices on nearly 1,000 SKUs to make us more competitive, while also scaling back on our circular events. Our EDLP initiative is beginning to take hold and is gaining good traction with our customers. And while we are still in the early stages of this longer term investment, we are encouraged by the unit increases that we have seen so far.

Although we are making progress to improve critical performance metrics, we are still very early on in our turnaround. We are executing these near-term initiatives to improve our performance and our teams are also investing in longer term programs to drive profitable growth.

As an example, our refrigerated and frozen cooler program remains a high priority initiative to drive trips and build the basket. And our McLane relationship continues to pay dividends. Refrigerated and frozen food sales have been robust, as McLane enables us to carry a national assortment across the chain. We plan to further leverage this relationship to help us accommodate the expansion of dairy and beverages and we’ll further expand coolers in all new and renovated stores moving forward.

Giving the competitive and economic environment over the last couple of years, we continue to introduce new traffic driving categories. Building on our food success and the decision to introduce tobacco, in fiscal 2015 we plan to begin a multi-year roll out of beer and wine.

From our research, we know that customers spend about $6 million on an annualized basis on adult beverages and our test has shown that our average beer and wine basket is two to three times larger than our average basket. We will have a limited number of stores selling beer and wine by the end of 2014 and plans to accelerate the roll out in fiscal 2015.

In addition, as part of our in-depth business review, we have been evaluating ways to leverage the diversity of our store base to improve productivity. As a result, we are launching a multi-year initiative to cluster assortments based on market dynamics, while creating a flexible supply chain and market-specific store maps to drive higher productivity and return on investments.

While we continue to focus on merchandising initiatives to drive traffic, we’ve also built a strong foundation over the last few years in our global sourcing and private brand programs to enhance our merchandise mark-ups and improve profitability. We have increased our direct imports as a percentage of total purchases and we have reduced cost by working more directly with our supplier base. Initial mark-ups on imported merchandise continue to improve year-over-year and we are delivering higher quality merchandise to our customers.

Our private brands business continues to gain momentum. In the third quarter, total private brand consumable sales increased about 9% and penetration improved to over 19%. We recently completed a number of package redesigns to stay fresh and appealing to our customers with more to come in the fourth quarter.

Our efforts to drive greater operating efficiency center on our store simplification initiative with our palletization delivery program as a focal point. Our new pallet delivery program is an important investment to help us improve the long-term efficiency of our supply chain, simplify store processes and increase workforce retention. This process makes it easier for our teams to unload trucks and enables us to replenish goods to the sales floor more quickly. We have converted our North Carolina and Arkansas distribution centers and the Florida DC is in process. We intend to complete the transition in all DCs over the next few years.

Before turning the call over to Mary, I want to share a few final thoughts. As I have said before, our Board of Directors and management team are focused on enhancing value for all Family Dollar shareholders. Reflecting this commitment, the Board is engaged in the detailed review of the business since January of this year to identify ways to enhance performance. We are actively taking steps to improve our results and our trends are beginning to improve.

We have a great business and are in the early stages of a turnaround. We are committed to driving values for all Family Dollar shareholders and we’ll continue to take actions to achieve this important objective. Our in-depth business review continues. Even as we work to improve our near-term performance, we also continued to invest in longer term initiatives to strengthen our value proposition, improve our financial returns and increase operational efficiencies.

With that, I’ll now turn the call over to Mary to provide more color on our third quarter results and our outlook for the fourth quarter.

Mary Winston

Thank you, Howard and good morning everyone. This morning I will review our third quarter results and then discuss our outlook for the fourth quarter. While we are pleased with our improved sales trend, the quarter was pressured by a number of challenges, which resulted in third quarter earnings per share that was at the lower end of our expectations.

Looking to gross margins, the impact on merchandise markups from our pricing investments was larger than we anticipated. Expenses were also higher relative to our original expectations; we experienced elevated utility cost due to adverse winter weather in March and higher than projected property taxes primarily due to property tax revaluations related to our sale-lease back transactions. While expenses grew about 9% in the third quarter, higher than our recent trends, we expect growth to be a more modest 5% to 6% in the fourth quarter.

Moving to the details of the third quarter, total sales increased 3.3% to 2.7 billion and comparable store sales decreased 1.8%. The decrease in comp sales was primarily due to fewer customer transactions which was partially offset by an increase in the average transaction value. I would note that we continue to see trip consolidation across the overall market.

Sales in the market was strongest in the consumables category, building on our food expansion in 2012, this past March we refined our assortment by adding about 400 new items with a focus on national brands to drive traffic and customer loyalty. We also discontinued about 200 underperforming items. Early customer response has been favorable and we expect that momentum will continue to increase as awareness builds.

Our household chemical and paper categories are an ongoing opportunity. While the overall market is under pressure, we are committed to improving our performance and driving share gain. We recently made assortment changes within our household area and while we have yet to see stabilization in this key category, we’re focused on improving our results.

Trends in our discretionary categories strengthened sequentially from the second quarter with comps in home, apparel and seasonal all showing improvement. Apparel was led by ladies apparel and home and seasonal had key gains in home decor and toy. For the quarter, gross profit increased 2.1% to 910.9 million. Included in this quarter’s result was 1.5 million related to inventory markdown associated with our store closing initiative.

Excluding these markdown, gross profit grew 2.2% to 912.3 million, and as a percentage of sales decreased 37 basis points to 34.3%. In the third quarter, our sales mix continued to shift towards lower margin consumable and this resulted in about 73 basis points of sales mix shift during the quarter.

In addition, lower merchandise markup negatively impacted gross margin. This was largely due to our investment during the quarter to lower everyday pricing on nearly 1000 consumable SKUs. This investment was partially offset by benefit from our global sourcing and private brand program which continue to improve merchandise margins.

For the second consecutive quarter shrink improved as a percentage of sales. We continue to realize benefits from our technology investment and our efforts to stabilize inventory levels and improve store manager turnover.

SG&A expenses increased 8.9% compared to the third quarter last year and as a percentage of sales increased 149 basis points to 28.8%. The SG&A deleverage in the quarter was mainly the result of the decrease in comp sales.

Fixed cost including store occupancy and labor expenses delevered during the quarter. In addition, advertising expense increased. While we reduced the number of broad-based circulars during the quarter we selectively leveraged additional marketing vehicle to support underperforming markets and we increased our in-store signage in support of our EDLP campaign.

Operating profit excluding restructuring charges in the third quarter was 145.3 million or 5.5% of sales. In the quarter, we booked 24.5 million of impairment charges and other cost related to store closing and workforce optimization efforts, of which approximately 20.5 million were non-cash charges.

Our effort to close 370 underperforming stores is ongoing and on schedule. We have approximately 200 stores in the closing process and discussions and negotiations with the landlords are going very well. We are on track to close the remaining group of stores by the end of August and we remain confident that this will deliver 40 million to 45 million in annualized operating profit benefit through the combination of store closures and the corporate overhead reductions we have made.

The effective income tax rate in the third quarter of fiscal 2014 was 33.1% as compared to 36.2% in the third quarter of fiscal 2013. The tax rate this year was lower primarily due to foreign tax benefits associated with our global sourcing efforts and increased tax benefits associated with federal job tax credits.

Earnings per diluted share including the restructuring charge of $0.14, excluded the restructuring charge of $0.14 were $0.85 compared to $1.05 last year. Merchandise inventory at the end of the quarter increased 7.9% to 1.59 billion compared with 1.47 billion last year. Average inventory per store increased 2% versus last year driven by consumables as a result of our food and laundry schematic changes.

Inventory in our discretionary categories continues to be well controlled. Capital expenditures in the quarter were 87.5 million as compared to 190 million in the third quarter of fiscal 2013. The decrease in capital expenditures was primarily a result of lower new store investments as we continue to diversify our financing vehicles. In addition, supply chain investments were lower as we cycled investments related to the construction of our 11th distribution center, which opened in fourth quarter of fiscal 2013. During the quarter, we opened 111 new stores compared to 129 openings in the third quarter last year. In addition we expanded, relocated or renovated 266 stores in the quarter compared to 228 stores last year. Reflecting our commitment to returning excess capital to shareholders, in the third quarter of fiscal 2014 we paid 35.3 million in dividends.

Now let’s turn to our expectations for the fourth quarter and the full year. For the fourth quarter, we expect that comp sales will be approximately flat. We expect that our pricing investment will continue to pressure gross margin and we expect that SG&A will increase 5% to 6%. As a result, we expect that earnings per diluted share for the fourth quarter will be between $0.75 and $0.85, excluding approximately $0.37 related to restructuring charges.

For the full year, excluding the impact of the extra week, we expect the total net sales will increase in the low single digits range and the comp store sales will decline in the low single digit range. We expect the gross margin will be pressured, and we expect SG&A will delever 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 $3.07 and $3.17. This range excludes approximately $0.51 in restructuring charges.

And now, I would like to turn the call back over to Howard for some closing remarks.

Howard Levine

Thank you, Mary. While the last few quarters have been challenging, our Board and management team have assessed our business and proactively taken the right steps to capture the opportunities for our improvement. Our team continues to work hard to improve our performance and we’re beginning to see the results of our efforts. We recognize that we still have work to do and the operating environment will likely remain difficult; however, we feel good about the early trends and believe that we’re on the right track to improve our performance and to reiterate the Family Dollar team remains focused on executing our strategy and creating value for all shareholders.

That concludes our prepared remarks and now operator, we would be happy to take questions.

Question-and-Answer Session

Operator

Thank you. We’re now ready to begin the question-and-answer session. (Operator Instructions) I will now take the first question, John Heinbockel from Guggenheim Securities.

John Heinbockel - Guggenheim Securities

How much of that improvement was discretionary? And then you think the fourth quarter will be flat as well, is that conservatism or do you see something in July and August, I don’t know if there is anything around the store closures and clearance, but how do you think that would make you a little more cautious about improvement in the remaining months of summer?

Kiley Rawlins

John, it is Kiley. I don’t think your phone was turned on when you started asking the question, could you start over.

John Heinbockel - Guggenheim Securities

Yes, so basically -- you’ve referenced that June comps were flat in the release, right. How much of that improvement from the third quarter was discretionary, is that a lot of it? And then for the full quarter you’re looking for flat to up a little bit, given that progress is that just conservatism on your part or do you see something in July and August that makes you a little more cautious, I don’t know if the clearance sales of the 370 you’re going to close, if that has any impact, but what’s your thought on the remaining months of the summer?

Howard Levine

We saw sales improve sequentially in all the major categories from the second quarter into the third quarter. We hope that those trends continue as we move throughout the remainder of the summer in the fourth quarter. Optimism won’t be the word that I would use, I think it’s just us getting back to what we talked about a couple of quarters ago and that’s getting focus back on our core customer, making sure that we built assortments to drive value even in this difficult environment and we feel like we’ve made some good progress there, for the first time in a long time I’ve got some positive constants, some key discretionary categories which over the long haul are important to us from a differentiation standpoint importantly from a margin standpoint. We believe that you know the month of June got off to a pretty good start, we were delighted with the July 4th weekend, particularly some of the seasonal sales and some of the apparel sales that we saw there and our hope is you’re right we are clearing out merchandise from these closed stores which does have some impact to the quarter but the majority of that is just the core stores that we’re keeping open and our ability to just get our company repositioned to deliver that value to our customer that we need to do.

John Heinbockel - Guggenheim Securities

And then secondly on the beer, wine initiative, so early thoughts on how many stores, how many SKUs on average, how much space does that take up and where do you get the space from right, I assume you’re not going to take it from consumables, so do you take it from apparel and home?

Howard Levine

Yes, I’ll start off with that, the space is coming from many different number of areas, some tightening up of some consumable categories that may not been as productive as we like as well as some of the discretionary categories and that’s one of the key issues that we’re dealing with as we begin this rollout, but just to step back for a moment, you know we’ve been testing beer and wine now for about two years and have really learned a lot about the business and the excitement to us is first they put this in the business for a trip that we weren’t even eligible for in the past and that’s exciting to us and what that means in terms of driving additional traffic to our stores, and while it is a lower margin category what we’re also excited about is the size of that basket being two to three times what our normal basket our average basket is, the devil is in the details though, to your point in trying to determine what the appropriate assortment is and there’s some regionality to that decision and we feel very good about our team that’s in place that helps driving that. A lot of enthusiasm of what it means to us over the long haul, it will not be a program that is in all stores, as I’m sure you know there’s some states where retailers are not permitted to sell beer and wine and there’ll be some stores that we’d de-select just given security issues or other challenges from a state standpoint that may not accommodate it, but the results have continued to grow, I’ll even tell you, although it’s only in about 200 stores we had our high beer sales over this July 4th weekend that we’ve had since we started the tests so we continue to grow and continue to build on that momentum and are really excited about what it means to us.

Operator

We will now take our next question from Matthew Boss from JPMorgan.

Matthew Boss - JPMorgan

As we think about the gross margin dynamics beyond this year, we believe we’re seeing a trough and you expect to build from here on the gross margin?

Mary Winston

When we think about gross margin, first of all let me just say as we look out to FY ’15 we are still in the process of developing our budget and haven’t finalized our numbers yet. We do continue to expect to see our business to shift towards consumables, although not to the magnitude that we’ve seen in the past. We expect as we go into FY ’15 to see continued momentum from the changes we’ve just made and the pricing investments that we just made in lots of consumable category, and our expectation is that that’s going to drive continued mix shift and continue to put pressure on gross margin, we’re not yet in a position to quantify that, we’re still looking at our plans for next year, but that’s the trend that we expect to see.

Now we do expect to continue to see ongoing benefits from the programs that we’ve talked about as well and global sourcing and private brands and those things are going to continue to offset some of the pressure in the margins and we’re happy with the stabilization that Howard just talked about on the discretionary side and that’ll help as well, so those are some of the trends that we’re seeing going forward.

Matthew Boss - JPMorgan

Okay, great and then on the expense front, as we look ahead incorporating the reduced square footage profile, what comp do you think you can achieve leverage and any further expense opportunities just that you guys have uncovered.

Mary Winston

Yes, and you know expenses we continue to view the same way so your question is a great one and you’re thinking about it the right way because we do look at our square footage growth as the key component driving our expenses, because a lot of our expenses are fixed, somewhat in occupancy and store labor, and so some of the growth will be taken away by lowering the number of new stores next year, we are looking across every area of the company and have continued to do that throughout this year, to find opportunities, to lower cost so that we can add value to our customers and we’re going to continue to do that. So as you know we’ve taken a hard look at our corporate infrastructure and we’ve made some changes there and some reductions that are going to result in benefits next year we’re realizing some of those benefits, a little bit in the third quarter and some in the fourth quarter but certainly a full year impact of that as we go into FY ’15, and so we expect expenses to be moderate. From a comp standpoint I would say we still are looking you know, 2% or something to, in order to break even, because we do again have the square footage growth and the expenses associated with that that are somewhat fixed.

Matthew Boss - JPMorgan

Okay, great and then real quick last one for Howard, higher level do you think we’re seeing [some kind of] [ph] lower end stabilization out there? Or do you think that the improvement that you have seen here towards the end of the quarter and into early next quarter, do you think that that is mostly company specific?

Howard Levine

The answer to that will come out in the next few months Matt, but I will tell you that our observations are it’s still pretty tough out there. The low end consumer has not benefited in this recovery at all, in fact I think have slipped further back. Unemployment trends remain high. The government cutbacks continue, there is quite a bit of healthcare uncertainty coming from this unbelievably cold winter, heating prices, heating oil and gas prices are moving upwards. So there is, it’s a tough playing field out there.

All that being said we are really focused on improving our business and getting back on track on delivering great value and while it sounds like I am complaining about all those trends what it does mean to us is there are going to even be more people out there looking for great values and opportunities to help them get through these challenging times out there. And we believe with the actions that we’re taking in the directions that we’re going in that we’re very well positioned to get our fair share there. So it’s going to be tough, we know that but we think we’re up forward and we think we’re doing the right things to drive the business even through a difficult environment.

Operator

We’ll now take our next question from Charles Grom from Sterne Agee.

Charles Grom - Sterne Agee

You have made the thousand price investments that you guys have made. I was just wondering if you guys could elaborate a little bit more on the product areas where you’ve made those investments. And I guess you alluded to some elasticity benefits. Just wondering if you could maybe quantify that to some degree for us?

Howard Levine

Sure, my update on pricing is going to be pretty high level Chuck given that we’re still really early in into, we just completed the most recent price roll out at the end of March, so still very early into that but it’s gaining traction. Overall the skews that we reduced price are showing nice unit lifts, our customers are responding more quickly than we actually thought. We tried to enhance that with some of our investments on the marketing side with some great end store assignments to let them know what we’re doing. And they’re delighted with it. So again very positive most of the price adjustments were in the consumable areas not as much in the discretionary side which is most visible to them given the turn on those categories but again some good traction there. We’re creating some energy and some excitement in our stores. We think that as we said earlier this is a long-term investment that will continue to grow over the next year or so.

Charles Grom - Sterne Agee

I guess we’ll look for an update next quarter. I guess my next question is it’s pretty impressive that your comps are improving even as you reduce the number of circulars. And I am just wondering if you maybe would elaborate or maybe Mary could just quantify the number circulars that you dropped this year versus last year and what your expectations are for the fourth quarter on both fronts?

Howard Levine

Let me take that and again I am going to come from the high level on this. And how we’re looking at our promotional strategy. And you have to link that with your first question and that’s the investments that we’ve made in our pricing over the last couple of months. At a high level our goal right now is to drive our EDLP. We know over time that that’s what our customers really want, they want to know when they come into our store, the they’re going to get great value every day. We’ve taken a big step; $50 million annualized investments to reestablish that within their minds. At the same time what we’re doing is also trying to adjust the cadence of our circular events. And also understanding how we can use better tools to more effectively reach our customer. So what I mean by that is using some digital and social media at a more effective way to reach them.

Again at a high level the plan would be to have an average of one or two events per month, which is down from what we have been running. There is that point of diminishing returns that we found in driving traffic into our store and our ability to manage the frequency of those events. So we’re making adjustments there and I think when I look back I’ll be it was a long time ago in the mid 90s we went through the same thing where we had 25 to 30 events and we began reducing over time, we saw some really nice comps even as we were reducing the number of circular events. Now the different year than back then it is today but I think there will be similar results as we continue to build back that momentum that we need to drive our EDLP.

And the last thing I’ll say on that is we talked about changing our distribution methodology up until the last couple of years, we had always used direct mail. We’re back into using direct mail we’re not using the Sunday inserts (ph) nearly as much as we were before and that is all getting back to this broader theme of focusing back on our core customer, figuring out how we can reach for more effectively and we feel this mail, again very early only a couple of months into it. As what we have always done up until the last two or three years to drive traffic into our stores and so we continue to monitor that and think that that will continue to leverage a way to better reach our customers as well. So, sorry for the long answer but there is a lot of thoughts that’s going into this and it’s going to take time for us to figure that proper balance and cadence. But we are excited about the start and where it’s going.

Charles Grom - Sterne Agee

Just a real last question here for Mary, on the fourth quarter if my math is correct, it looks like you are expecting margins to be down say 50 bps year-over-year if we assume like a flat up and few hundred store closings which if you look at the margins on a two year basis, it does imply a pretty big pick up sequentially now. I know you are going to get about 40 basis points because of the store closings or at least that’s what I think it will be. I am just wondering if you can may be just touch on just from a modeling perspective, what you are expecting for gross margin performance and then also what are you expecting for SG&A dollars in the fourth quarter? Thanks.

Mary Winston

Okay. So, as it relates to gross margin and I am not going to be as specific as you were in terms of specific basis point but I would say you are in the ballpark and the things that are going to put pressure on our gross margin would be what you have already referred to the shift in mix. We do expect to see a continued shift in mix to consumable. We expect to continue to see a little bit of pressure on our markups as a result of the pricing investments that we made. On the positive side, we expect to continue to see benefits from global sourcing and private brands, both of those programs continue to help offset some of the pressure we see on margins and they are right on track in terms of what we were expecting in terms of their contribution.

So, net-net we are going to see pressure on gross margins but those are the things that’s ups and downs I guess within that. We would expect to see continued improvement in shrink and our markdowns are well controlled and so I think that’s the major categories that we are looking at in gross margin. On expenses as I mentioned in my prepared remark, we expect expenses to be up around 5% to 6% that’s obviously a more reasonable level than we saw in this quarter and when we look at that year-over-year what’s driving that 5% to 6% increase is that we do on the positive side. We have lower incentive comp and I guess offsetting some of that is cost associated with store closures and everything. We also have the benefits from the corporate overhead reductions that we have taken both at the staff level but across many other cost categories as well and so that continues to help us maintain control over our SG&A.

And we are just going to continue to keep at it with that until we see sales move to the level that we need them to. We are always tight on expenses anyway that’s just part of our D&A as a low cost operator and we will stay focused on that.

Operator

We will now take our next question from Paul Trussell from Deutsche Bank.

Paul Trussell - Deutsche Bank

You have highlighted that it’s early in the turnaround process and that you continue to evaluate additional opportunities to improve but you have given us a list of initiatives that are ongoing and that are upcoming. If we just look at this combination of items that are part of the strategic plan today, what is the financial impact expected long-term to the business model and what’s the expected contribution to sales? How should we think about margins over the next three years as you roll-out the items that you have already provided?

Mary Winston

Okay. So, let me just talk in general I mean as you know we have announced two or three things that we are doing. We have announced the closure of 370 stores. We are right in the process as I said in my prepared remarks of getting that done. We have got about 200 stores in the process and another 170 that we are working on. Our expectation and plan is to have all those stores closed by the end of this fiscal year, so clearly with that timing we didn’t see any benefit from that or saw very little benefit from that in the third quarter. We will see a little benefit from it in the fourth quarter but the primary benefit will be as we go into FY15.

Secondly, as you know we reduced about 10% of our corporate overhead or our corporate staff and we have made other cuts across corporate overhead. We took that action in the third quarter, at the beginning of the third quarter, so we do see some benefit from that in our SG&A in the third quarter. We will see more benefit in the fourth quarter and we will see the full year impact of that as we go into FY15. The combination of those two things as I mentioned in my remarks, has an operating profit benefit of 40 million to 45 million. So, next year we would expect to be realizing the full impact of the majority of that.

The other thing that we are thinking about is the performance of our stores and we talked about that when we talked about the lowering of the number of stores we are opening next year. And as we said on our last earnings call, we didn’t take that action because we felt the market was saturated or any of that it was an effort to selectively pick kind of the best of the best from our pipeline and portfolio and really look at what the store performance and store returns was going to be. So we are expecting improved returns from our new stores as we go into next year and start to roll that out. So that’s all going to play into the mix as well, and then next year we’ll have the continued benefit from the initiatives that we were talking about even before we did this strategic effectiveness. So global sourcing will continue to ramp up our private brand penetration, we’ll continue to move in the direction that we’d like it to, and so, all of those things are going to blend together to help benefit results next year.

Paul Trussell - Deutsche Bank

Okay, that’s helpful. But no specific financial targets, it sounds like in terms of EBIT margins back to 7% or specific sales per square foot goals that you like to outline, is that correct?

Mary Winston

No, not that I’d like to outline today, as we get to our next call we’ll obviously be talking more about how we see FY15, we’ll talk about long term at that point. But obviously our goal is always to improve our operating margins and so that’s continues to be our objective.

Paul Trussell - Deutsche Bank

And just lastly from me, if you can just give a little bit more color on one of the initiatives announced today regarding the multi-year clustering initiative. Just how should we think about that going forward?

Howard Levine

Sure Paul. Basically that way we’re thinking about that is we’re a chain of 8,000 stores spread across 46 states and while we may call it a cookie cutter operation just about everyone of these stores and different in some way shape or form. And what this effort is, is really to try to leverage the diversity of our chain with local customer demand and specific market demographics. It’s something that really impacts the assortment in the states with our store. So just as an example, over the last several years we’ve added a lot of space to our food area which has been good overall but there are also a pretty large group of stores that and during our effort to create more space for food because of states away from apparel and it could have been a very strong apparel store.

So one of the things that we’ll do as we analyze these differences is we may not have taken that space from apparel to food. We may have created at what we’ll call as food store. Conversely, there is other stores that may have hacked their business and food and we don’t have the right space of the assortment to maximize our business and some of those category. So we’re going to be able to better specify assortments within the given demands. And we’ve created a team to do that. We’ve got the technology and the analytics ongoing now. We’re going to go cautiously on this to make sure we understand what it means to us but think it’s an excellent way for us to improve productivity in our stores and to maximize inventory turn and gain ROI. And over the long haul really helps us just cater given stores to the demands, the demand characteristics of those particular markets.

It’s not going to be one store has an assortment there will be large clusters of stores obviously we want to be able to manage this going forward. So we’re putting all those metrics in place and are excited about what it means over the long haul to our business.

Operator

And we will now take our next question is from Matt Nemer from Wells Fargo Securities.

Matt Nemer - Wells Fargo

Good morning. Thanks for taking my questions. First, Howard, I was hoping that you could provide a little bit of qualitative commentary around the performance in your rural stores versus your urban stores relative to recent trend?

Howard Levine

Sure. Sure, Matt. What I can tell you is our rural stores are doing better than our urban stores. We think a lot of that has to do with some of the challenges that are in these intercity markets and some of these major urban centers. The folks in those markets are having a hard time finding jobs and are struggling and I think it’s impacted our business a little more than it would be in rural area where I think things are little more stable.

We think, we still think we have tremendous opportunities in these urban markets because there is so many customers that we’re not even capturing. But I do think there are some clear demographic differences and those customers are struggling a little bit more as compared to some of the rural markets.

Matt Nemer - Wells Fargo

Thank you. And just as a follow up to that, am I correct that the urban stores are about 40% of the base and are there any specific actions that are targeted at that set versus relative to some of the initiatives you mentioned today?

Howard Levine

Yes, it’s probably closer to 45% Matt and yes and just to step back for a minute as you know our renovation program when we started several years ago was mainly geared toward some of these rural and suburban markets as opposed to some of the urban markets. Now that we’ve gotten through most of the rural and suburban markets, our focus will be on renovating and updating those stores in the urban markets. And we think that that’s going to be a big benefit to some of those intercity markets.

The competition is as not as intense in some of those markets, so we do think we have opportunity to continue to drive our business there and think, that there is so many customers that haven’t even heard of Family Dollar yet in some of those dense markets that give us excitement there to drive the business over the long haul.

Mary Winston

Yes. Let me just add to what Howard said, if I could. I mean, urban -- operating in urban market has always been a strength for us, so we do that well. And our urban stores tend to be some of our largest stores with our largest volumes and some of our most profitable stores. So we’re happy with that. And so to Howards point, we’re focusing our renovation programs there with the expectation of further improving the success in those stores in those markets.

Matt Nemer - Wells Fargo

Okay. That’s helpful. And then just lastly, you’ve had a kind of nice change in trend in some of your discretionary categories. Just wondering, if we’re seeing any impact from the price to actions in consumable that’s maybe driving a little bit of improvement in those categories or there are some other factors that you can point to that sort of turned the trend in discretionary? Thanks.

Howard Levine

Sure, Matt. And a good question. The way we would like for to work in the way, I think it is working is the investment in some of the consumable categories, are generally some of those traffic driving categories. So the effort around investment in the price and consumable is to make sure that we got great pricing after and every day to drive traffic into our store and as you know traffic is top right now, so the fact that traffic is off, is not only impacted consumable sale some but it also is impacted some of the discretionary categories. So as we get more attraction with these pricing investments on the consumable side, I think that it does help to drive more people in the store and will help to lift even discretionary sales even further.

But I think currently the biggest reason I would give this for improvement discretionary trend is the way our team is acclimated to the value proposition that we’re striving for. And really figuring out what skews were best in the Dollar store business that we can make some money on that also with something that our customers interested in buying from us. And I think the teams, particularly in the apparel area have come a long way and trying to determine what that assortment is and getting the sale through that are necessary to drive the margin. And I think, they get it and the team is excited about that.

And our effort here is that it continues to drive that, get excitement around the Dollar price point as an example, get excitement around this key price points like $5 is really what the customers is looking for us. And really, just staying focused on that core customer. One of the things that I talked about in the past that our businesses we work, now it sounds like a cliché but we were trying to be all things all peaceful and the long term strength of this business if always and will continue to be our core customer and making sure that we build our assortments to satisfy in that area. And I think the discretionary group is well on the way to that. And hopefully those trend continue, particularly as we get through back to school and into the key holiday season.

Operator

And we will take our next question from Laura Champine from Canaccord.

Laura Champine - Canaccord

Those came in below your initial estimates. And I am just wondering what your initial estimate was on inventory growth in the quarter? And…

Mary Winston

We seem to be having some technical difficulties, so we’re missing the first part of the question. Can you repeat the question?

Laura Champine - Canaccord

Sure. So I am just wondering what inventory growth you had expected? And given the weaker than expected sales trend? And also what you’re anticipating as far as an inventory write down charge around the store closures in Q4?

Mary Winston

In terms of inventory growth, our inventory growth is not dramatically off, what we were expecting. We were expecting to be building inventory as we went into our schematic resets in the late February and into March and so into the third quarter. So we were building inventory even in the second quarter to support those reset and that was exactly what we were expecting to do. So now, as we move forward we’re looking to get momentum in the sales from that end to see that stabilize but it’s not our line with what we were expecting.

Operator

And we will take our next question from Scot Ciccarelli from RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets

Hey, guys, Scot Ciccarelli. The question is, can you talk a little bit about the geographic difference that you’ve seen over the last quarter? And how that might reconcile, was the pressure being experience by lowing some consumers?

Howard Levine

Sure, Scot, good morning. They’ve really -- as you look back our results over the third quarter, not a lot of geographical variances in sales that we saw.

Scot Ciccarelli - RBC Capital Markets

Right. So you’re sure your team is pretty consistent across the board, okay. Can you also talk about I guess this is prior for Mary. The table, the inventory ratios now it decrease three quarters in a row, can you talk about what’s driving that? And thoughts on that ratio going forward is there something going on in terms of vendor payment terms or is it just kind of, just help us understand what’s going on with that ratio?

Mary Winston

And you touched upon it, I mean vendor payments aren’t just something that we’ve been taking a look at. We are looking at all components of our working capital. So we are trying to manage our inventory levels appropriately, we are looking at our payables including our terms with our vendors and looking at what’s appropriate time the two together, the payables level along with the terms and the inventory turns of the products that we are getting from each vendor and trying to maximize that appropriately in order to manage our working capital.

Scot Ciccarelli - RBC Capital Markets

Yes, but that doesn’t really explain why the ratio has been decreasing over the last couple of quarters. Is it stemming from a particular reason?

Mary Winston

I wouldn’t say it’s stemming from one particular reason. We started a couple of quarters ago of looking at this closely, we are trying to take actions to manage it and -- but there is not one specific thing that’s driving it. I think there are lot of factors that are flowing into that.

Scot Ciccarelli - RBC Capital Markets

Can you highlight a couple of those key factors then?

Mary Winston

Well, I just mentioned some of them. I mean we are -- we have of course the inventory build which is affecting the inventory associated with the recess and the other things that we are doing. At the same time, we have ongoing activity with our suppliers around the cost of that inventory as well as our payment terms. We have -- any number of things happening with our allowances and those dynamics with our vendors as we switch to more of an EDLP strategy. So there are number of components that are pluses and minuses there.

Operator

We will take our next question from Joe Feldman from Telsey Advisory Group.

Joe Feldman - Telsey Advisory Group

Hi guys, thanks for taking the question. Wanted to ask about with the beer and wine roll out, what have you seen with the test stores in terms of the gross margin impact like if consumables obviously have lower margin and I assume beer and wine do as well, how we should think about that as the rollout begins?

Howard Levine

Sure, Joe. Obviously, we feel pretty good about the financial results of the test given the rollout and to your point, it is a lower margin category but that is offset somewhat by the basket size that we’re seeing from that. So overall, we hope it kind of washes out with that basket size and the margin that goes into basket. So we absolutely are looking forward to be accretive to the margin and would expect all of our efforts to drive that at the end of the day. So bottom line is we feel very good about it, what it means to our business and as we get more critical mass there, we think we’d be able to leverage the costing side even a little bit better than we are today along with some of the promotional allowances and cadences that we can build from that. But overall again it’s a trip that we weren’t getting before that we are now getting and we really like the basket characteristics to go along with it.

Joe Feldman - Telsey Advisory Group

Got it, got it, that makes sense, you’d get greater profit dollars to help leverage. Okay. And then I think there is on another question regarding it. To go back to the core initiative and I think somebody was trying to ask you before, but how much will that cost to do the cooler expansion? And again I think similar to a prior question about the beer and wine, where is the space going to come from? Will it just come from the rest of the consumables department or is there another part of the isles that goes away?

Howard Levine

So, don’t have specifics on the overall cost of the program in front of me right now and clearly there is an investment in the coolers, that’s something that we’ve been doing and really since going back to 2005. But it is a heavy investment, but we think really critical to the overall success of our food program. And when you couple that, the cooler presentation and the claim relationship and what we are building in terms of our own inline food program that really creates the still in food trip that is just critical to us today and over the long -- over the long run, will continue to be an important trip driver for our customers.

The investments as I said upfront is there, but we believe and have looked through it and think that we’ll leverage that. And in terms of your question on space, a very good question and the way we are dealing with that is on a store-by-store basis, there is actually a layout in the plan that we are coming up with. And in some cases, we do have the space and if we can continue to further grow our coolers and in some cases we are not going to be able to do that. But being extremely mindful of that and ensuring that we do have the room in the space to add the coolers with when appropriate. But overall, when we do renovate a store, we can’t create the space and particularly with the new store and the initial plans, we are able to draw in there and have the nice home for it and it’s without too much trouble.

Joe Feldman - Telsey Advisory Group

Good to hear. Thank you very much for the explanation and good luck with this quarter guys.

Howard Levine

Thank you, Joe.

Mary Winston

Randy, I think we’re about out of time. So I think we will take one more question please.

Operator

We will take our last question with Meredith Adler from Barclays.

Meredith Adler - Barclays

Thanks sir for taking my question. I was wondering, I was very intrigued Howard, when you talked about trip consolidation. And I was wondering what you could, what is it you’re seeing, how do you know that there is trip consolidation going on?

Howard Levine

Simply that's the metrics of fewer trips in a larger basket size along with what we’re seeing, is what we’re seeing and that seems to be driving it.

Meredith Adler - Barclays

Okay.

Mary Winston

We’ll get a lot of that information from Nielsen. And so while we see it’s certainly in our own register data, we also get the market perspective from Nielsen and IRI.

Meredith Adler - Barclays

Okay. And then you made some comments, Howard, about advertising being up and that you were actually spending a little more money in some underperforming markets. Could you talk a little bit about what are those markets and what are you doing specifically and is it helping?

Howard Levine

Well, I’m not going to go into the specific markets, Meredith, but it is helping and it’s utilizing digital, it’s utilizing some mail efforts to try to with those customers know that even we’ve renovated the store and in addition to that we have lowered our prices. There is a number of efforts that have been out there to be a little more targeted with our spin there and it’s been productive and it’s been very helpful in those troubled markets.

Meredith Adler - Barclays

Okay. And I just have one final question for Mary. The incentive comp was down this quarter and you said it will be down next quarter. Was it also lower in the first half or I guess my real question is; is there anything that happened this quarter that reflected a reversal of existing incentive comp accruals?

Mary Winston

Hi Meredith; thanks for the question. No, there was nothing unusual that happened this quarter. So last year we did have some amount of incentive comp in our numbers and this year pretty early on based on our internal targets and our internal metrics we’re paying bonus incentives. We reduced that number and have not been accruing it this year. So that's why we’re seeing year-over-year positive on incentive comp.

Meredith Adler - Barclays

Okay. I’ll squeeze in one more because you’ve all been very concise. Is there any way to connect SG&A dollar growth with square footage growth, which was flowing in meaningfully next year, is there some clear way that we can say this is what it means for SG&A dollar growth?

Mary Winston

Yes. Well, you know what I would is some of the things that we’ve said before and then I’ll kind of let you guys do the math around it. But two-thirds of our SG&A expense is essentially fixed and it relates to store occupancy and store labor. And so those are the expenses that are basically fixed and they are tied very much to square footage growth. There are probably other expenses as well, but those are the big ones. But you know utilities and things like that would also be tied to square footage growth.

So I think just looking at a lion share of our SG&A, looking at what you would anticipate square footage growth to be, you can kind of get to what that number might be.

Meredith Adler - Barclays

Okay. Thank you very much. Good luck.

Mary Winston

Thanks Meredith. So unfortunately we’re a little bit past 11 and we did not get to all of the questions today. As usual, Kevin and I will be available after the call for any follow-up questions you may have. Have a great day.

Operator

This does conclude today’s conference. Thank you for your participation.

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Source: Family Dollar Stores' (FDO) CEO Howard Levine on Q3 2014 Results - Earnings Call Transcript
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