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Fred's, Inc. (NASDAQ:FRED)

Q2 2014 Earnings Conference Call

August 28, 2014 05:00 PM ET

Executives

Pat Watson - IR

Jerry Shore - CFO

Michael Hayes - Chairman

Bruce Efird - CEO

Rick Chambers - EVP of Pharmacy Operations

Analyst

Andrew Wolf - BB&T Capital Markets

Jill Nelson - Johnson Rice

David Magee - SunTrust

Cris Blackman - Empirical Capital Management

Joan Storms - Wedbush Securities

Operator

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

Pat Watson

Good morning or good afternoon everyone. I should say this is Pat Watson with Corporate Communications. Thank you for joining Fred's to review the company's financial and operating results for the second fiscal quarter and the six months ended August 02, 2014.

Before we begin, I would like to remind everyone that management's comments in this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks. It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued this afternoon in the company's Annual Report on Form 10-K and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information.

Lastly, I would like to point out that management's remarks during this conference call are based on information and understandings believed accurate as of today's date, August 28, 2014. Because of the time-sensitive nature of this information, it is Fred's policy to limit the archived replay of this conference call webcast to a period of 30 days. This call is the property of Fred's. Any distribution, transmission, broadcast or rebroadcast of this call for commercial purposes, in any form, without the expressed written consent of the company is prohibited.

With those announcements, I will turn the call over to Jerry Shore, the company's Chief Financial Officer. Go ahead, Jerry.

Jerry Shore

Thank you Pat and thanks to all of you for joining us this afternoon for our discussion of second quarter results for fiscal 2014. With me and available for questions are Michael Hayes, Chairman; Bruce Efird, Chief Executive Officer; and Rick Chambers, EVP of Pharmacy Operations.

Before I begin my prepared comments, I will turn the call over to Mike Hayes, Chairman.

Michael Hayes

Good afternoon. As Navaho would say that many moves since I have addressed this illustrious group. Given the situation we believe the Board it would be important that an overview come from us. As you know we were and are heavily engaged with our advisors in the strategic alternative process as this strategic process is ongoing, we’ll advice you when decisions are made.

Rather than labor on every event, I will try to ballpoint the key financial factors along with the strategic factors Bruce, Jerry and the team will address them in a greater detail. In the fourth quarter of 2013, we were signaled that environment that was changing rapidly in both pharmacy and general merchandising. Pharmacy inflation in generics began increasing faster than ever in our history, while the payors were dragging their feet on increasing reimbursement rates to match the price increases. This combination has continued through 2014. The existing pharmacy distribution channels were being turned upside down as a largest retailing organization began partnering up with the wholesale distributors. As the big three pharmacy changes were now aligned with distributors, the stage became set for competitive and intense negotiation process as we went to the market for a new prime vendor agreement.

Fred’s was one of the largest retailers left to be sought after. While it became a time consuming and laborious process, the outcome has significantly improved our position going forward. The benefits of the contract range throughout the pharmacy division including acquisitions, specialty and retail. In the fourth quarter of this year, the contract will be in effect. Keeping with Murphy’s Law, the bricks-and-mortars’ general merchandising strength landscape was and is reeling from the loss of threats to the internet purchases.

The result of which created a new round of competitive pricing and marketing intensity or customer traffic, an environment that was going to make sure business was not going to be as usual. In anticipation that changes would be needed, we began the process in January, on engaging in a deep dive analysis into market and business model. By April with the help from a lot of sources, we were able to layout the steps we would undertake in both general merchandise and pharmacy to drive profitability.

As a result of our research, we believe that over the course of the next three to five years retailers that meet the needs and convenience driven trips will be more insulated from the internet migration and will allow Fred’s to increase market share. The past we’ve outlined is to become a more convenient pharmacy centric store that will supply a wide variety of need based trips and other small box competitors. What the research showed, while our selection was broader than other small box players. We did not have customer recognition of variety and mix we currently offer. Thus, we were not top of the mind aware or the customer for these additional trips. This premise was a critical factor of the new marketing program which Bruce, Jerry and the team will go into further detail.

The program we put in place to address the changing landscape has been as intense as we have ever experienced while the depth of inquiry studies and analysis was both refreshing and exhausting, if revealed the need for new processes and exposed important opportunities. More importantly, it revealed the actions that would enhance profitability at the most detailed levels in our organization. This has led to a consensus strategy that we are able to develop. We will be taking advantage of our store side converting our systems from past tools that will improve inventory management and productivity. Also we will expect to enhance our operating margin to improve sourcing, lower labor and storage expenses while improving customer satisfaction with the simplified store layout and delivery process, just the name and fewer the changes that are underway.

We anticipate the hardest part of this process will be completed by the end of the fourth quarter including the closure of 60 stores. In summary, the steps we’re taking in changes that are underway have one objective restore profitability and maintain growth.

As I mention for the past seven months the company has been dealing with multiple time-consuming projects, and our resources have been stretched to the limit. In March, I came back to support Bruce, Jerry and their team focusing on the implementation of general merchandises changes needed.

Thank you I appreciate the opportunity to talk with you and I’ll now turn the meeting back to Jerry.

Jerry Shore

Thank you Mike. As the Company reported in the press release earlier, Fred’s total sales for the second quarter for the fiscal 2014 increased 2% to $491.2 million from $482.2 million last year. On a comparable store basis second quarter sales decreased 0.1% compared to an increase of 2.2% for last year. The quarterly sales mix comparison was as follows.

Household goods were 21.9% of sales decreased from 22.6% last year. Apparel and linen were 4.2% decreased from 5.7% last year. Health and beauty were 6.6% decrease from 7% last year. Paper and chemical were 8.4% decrease from 8.8% last year. Food and tobacco were 16.9% decrease from 17.8%. Pharmaceuticals were 40.4% increased from 36.4% last year. And franchise 1.6% decrease from 1.7% last year.

For the quarter comparable store traffic decreased 2.5% over last year while the average customer ticket increased 2.5% to $21.14. For the first six months total sales increased 1% to $989.5 million from $983.7 million in the year earlier period. Comparable store sales year-to-date decreased 1% compared to an increase of 0.5% in the year earlier period. The year-to-date sales mix was as follows.

Household goods were 21.6% decrease from 22.6% last year. Apparel and linens 4.9% decreased from 6.1% last year. Health and beauty 6.7% decreased from 7.2%. Paper and Chemical 8.2% decreased from 8.6%. Food and tobacco 16.9% decreased from 17.4%. Pharmaceuticals were 40.1% up from 36.1% last year and franchise 1.6% decreased from 1.7% last year.

And on a year-to-date basis comparable store customer traffic decrease 3.4% while the average customer ticket increased 2.4% to $21.60. Sales for selling square foot for the trailing 12 months was $209 comparable to the end at the same period of last year.

Before moving to earnings data, now let me summarize some key changes that have been included in the second quarter financial statement. The company is implementing several key operational changes that will impact the result for the remainder of fiscal 2014 with positive financial returns in 2015 and beyond. Included in the second quarter results are provisions to establish reserves for inventory clearance and store closings related to strategic changes. In total, these reserves amount to $14.8 million on a pretax basis or $0.26 per share. These are broken down into an $11.9 million write-down for promotional inventory. In addition, the Company plans to close 60 non-pharmacy stores that do not meet operational performance target and as a result of write-down of the fixed assets was recorded in the second quarter totaling $2.9 million.

Net loss for the second quarter of 2014 was $16.4 million compared with net income of $3.3 million last year. Excluding the reserves reported in the quarter, net loss was $7.1 million. For the quarter Fred’s net loss per share was $0.45 as compared to earnings of $0.09 in the same quarter of last year. Excluding the reserves, the net loss per share was $0.19. For the six months of 2014, there was a net loss of $10.3 million compared with net income of $14.7 million for the same period last year. Excluding the reserves, net loss for the year-to-date period was $1 million. For the first six months, net loss per share was $0.28 compared to earnings of $0.40 for the same period of 2013. And excluding reserves the year-to-date loss is $0.03 per share.

EBIT or earnings before interest and taxes, for the second quarter was a loss of $26.1 million compared to earnings of $5.2 million last year. Excluding reserves, EBIT for the second quarter was a loss of $11.3 million. For the first six months EBIT was a loss of $16.1 million or negative 1.6% of sales compared to earnings of $23 million or 2.3% of sales last year. Excluding the reserves, EBIT for the year-to-date period was a loss of $1.3 million or a negative 0.1% of sales.

EBITDA during the second quarter was a loss $15.9 million compared with earnings of $15.7 million last year and excluding the reserves the EBITDA was a loss of $1.1 million. EBITDA for the first six months totaled $3.9 million or 4:10s of 1% of sales compared with $43.8 million or 4.5% of sales last year. And excluding the reserves EBITDA was $18.8 million or 1.9% of sales.

Adjusted EBITDA which adds back the non-cash impact of LIFO and stock based compensation during the second quarter was a loss of $13.7 million compared with a positive $17.2 million in the same quarter last year. Excluding reserves, adjusted EBITDA was a loss of $1.8 million. And for the six month period, adjusted EBITDA was $7.4 million compared with $47.6 million in the same period last year. Excluding reserves, adjusted EBITDA for the first six months was $19.3 million.

Fred's gross profit for the second quarter decreased to $113.7 million or 23.1% of sales from $136 million or 28.2% of sales in the prior year. Excluding reserves, gross profit was $125.5 million or 25.6% of sales, a decrease of 260 basis points from the same quarter last year. And for the first half gross profit decreased to $256.1 million or 25.9% of sales compared to $287 million or 29.2% of sales for the first half last year. Excluding reserves, gross profit was $268 million or 27.1% of sales, a decrease of 210 basis points from the same quarter last year.

The deleveraging of gross profit in both quarter and year-to-date period are driven by the pressure on pharmacy, initial markup driven by the historically large generic inflation coupled with a lag in increasing payer reimbursement rates. Lower pharmacy department rebates despite a year-over-year sales increase was $7.1 million or 13%. Aggressive promotional activity throughout general merchandise also deleveraged. LIFO expense, which is a non-cash item, was $1.5 million in the quarter, $700,000 higher than last year. The difference negatively impacted EPS by $0.01. For the year-to-date period, LIFO expense totaled $2.1 million. SG&A expenses for the second quarter were 28.4% of sales, 130 basis points less than the same quarter of last year, excluding the provision for closed stores, SG&A was 27.9%, 80 basis points deleverage to the prior year.

The deleveraging is attributed increases in occupancy related costs, additional advertising expense associated with our new marketing program, higher payroll and stores to manage inventory levels and inventory levels and in Pharmacy department as a result of acquisitions and growth in number of occupancies. These were partially offset by favorable insurance reserves and medical expenses and lower amortization expense primarily as a result of extending the useful life of Pharmacy intangibles from five to seven years.

For the first half of 2014, SG&A expenses were 27.5% of sales compared to 26.9% last year, a 60 basis point decline. Excluding the closed store fixed asset impairment, SG&A expenses were 27.2%, 30 basis points deleveraging from the prior year. For the second quarter, net interest expense was $163,000 compared to $129,000 by this year. On a year-to-date basis, net income -- net interest expense totaled 298,000 compared with 264,000 last year. The effective tax rate for the second quarter was 37.5% compared with 34.5% in the year earlier period. And for the first six months, effective tax rate was 37.1% compared with 35.2% in the prior year.

The higher rate in 2014 reflects the exploration of work opportunity tax credit which have not been renewed by Congress so far this year. With the losses incurred including reserve accruals and less favorable impact from the work opportunity tax credit, we now expect the full year effective tax rate to be in the range of 38% to 40%.

Moving to the balance sheet, cash and cash equivalents totaled $8.1 million compared with $7.9 million last year. Total inventories decreased 1.8% to $342 million at the end of the quarter from $348.3 million last year. Excluding reserves against inventory, the inventory balance at the end of the second quarter was $353.8 million, an increase of 1.6% over the same quarter of last year.

That 1.6% increase in inventory excluding the reserves is attributed to the inflation experience in Pharmacy department, primarily in generic inventory and the accelerated growth of our Pharmacy department in line with our strategic plans. General merchandise inventory was flat as compared to last year.

Excluding the inventory reserves, inventory turn was 3.8 turns at the end of second quarter, comparable to the same period last year. Capital expenditures for the second quarter totaled $6.1 million compared with $2.6 million in the second quarter of 2013. The second quarter breakdown of capital expenditures includes $0.7 million for new stores and pharmacies, $3.7 million for existing and remodeled stores and $1.7 million for technology, corporate and other miscellaneous upgrades. And on a year-to-date basis, capital expenditures totaled $11.3 million compared with $9.4 million for the first half of 2013. The breakdown of the year-to-date capital expenditures includes $1.5 million for new stores in Pharmacies, $7.2 million for existing and remodeled stores and $2.6 million for technology, corporate and other miscellaneous upgrades. Additionally, there was $8.1 million related to acquisitions of Pharmacies as compared to $5.4 million in the second quarter of last year and on a year-to-date basis expenditures for acquisitions of Pharmacies were $16.5 million compared to $7.8 million last year.

At the end of the second quarter, accounts payable was $121.4 million or 35.5% of total inventory compared with 103.6 million or 30% at the end of same period last year. Total debt at the end of the quarter was $17.2 million, compared to $5.4 million last year. There were $13 million in borrowing on our revolving line of credit at the end of the quarter.

Moving to cash flow, for the first two quarters of 2014 net cash provided by operating activities was approximately $17.2 million, free cash flow which we identify as net cash provided by operating activities, minus capital expenditures and pharmacy acquisitions was a negative $10.6 million. The company operates 704 discount general merchandised stores including 21 franchised Fred’s stores.

At the end of the end of the second quarter there were 627 company-owned full sized stores, 56 company-owned express stores and 21 franchised stores for a total of 704 discount general merchandised stores which includes 357 pharmacy departments.

During the second quarter Fred’s net locations remained unchanged. The company’s total selling square footage remained at 9.3 million at the end of the quarter. We now expect to open a range of 8 to 12 stores during 2014, we will also open between 38 and 46 new pharmacies in 2014, closings in 2014 are anticipated to be 70 stores and 10 pharmacies.

With these projected openings and closings, we project selling square footage to decrease approximately 10% in 2014. Our financial guidance for the third quarter and the remainder of the year and looking into 2015 is as follows. We now anticipate August total sales to be in the range of 2% to 4%, while comparable store sales in the range of flat to positive 2%. We have been pleased with sales and customer traffic months to date with both sales and customer traffic performing positively in each of the first three weeks. We expect good sales in the current week. However, the calendar shift at the end of the months does not work in our favor.

In the quarter the company expects total sales to be up 3% to 5%. Over last year, the comparable store sales are expected to be in the range of 1% to 3%. Gross margins, we anticipate pressure to continue in the third quarter with the same three factors driving the impact. Pharmacy margins pressure, general merchandized pressure from traffic driving marketing programs as well as lower volume of higher margin goods being shipped into our stores. And then additionally below productive inventory close out programs that have been implemented.

As a side note, we will receive an upfront payment of $6.3 million at the initiation of the new pharmacy distribution contracts which will positively impact cash flow but not gross profit, in line with GAAP this amount will be amortized on a straight line basis over the life of the contract. With all of the factors above we expect gross margin in the third quarter to be approximately 280 basis points below the same period last year.

With the margin pressure pointed out, we now expect the loss in earnings per share in the range of $0.08 to $0.12 for the quarter. We anticipate approximately $0.03 per share attributed to one-time expenses during the quarter and so excluding those one-time charges earnings per share in the range of $0.05 to $0.11 loss. EBITDA excluding the one-time expenses will be in the range of $6 million to $9 million and adjusted EBITDA which adds back the non-cash items will be in the range of $7.5 million to $10.5 million.

In the fourth quarter earnings per share will again be impacted by one-time cost primarily resulting from the closing of the 60 stores which will take place during the quarter. GAAP requires the closing cost for inventory markdowns operating expenses and lease liability to be recorded at the time of closure. We anticipate one-time cost for the fourth quarter to be a loss of approximately $13 million on a pre-tax basis or approximately $0.22 per share.

Operationally and excluding these one-time costs, we expect to return to profitability in the fourth quarter in the range of $0.05 to $0.09 per share. In that quarter, we expect to begin to see the benefits of the new pharmacy contracts along with improvements in general merchandize business during this heavy sales quarter. Based on the results and our projection for the third and fourth quarter, we now project total year earnings per share for fiscal 2014 to be a loss of $0.48 to $0.58 per share. Operationally and excluding onetime items we anticipate approximately flat earnings for the year. Full year EBITDA excluding the onetime expenses during the year will be in the range of $40 million to $46 million. Full year adjusted EBITDA, which adds back to non-cash items will be in the range of $48 million to $54 million.

Moving to the balance sheet and cash flow for the back half of the year, with our new initiatives in place in producing positive results, we are anticipating improvement in the balance sheet and cash flow. With the initiatives to sell low productive inventory and close 60 stores, general merchandise inventory levels and terms will improve significantly. Although free cash flow was negative throughout the first half of the year, the company is committed to turning this positive for the full year in the range of $5 million to $15 million. This will be accomplished through the initiatives just mentioned and aligning use of capital towards most productive investments. Decisions on growth, business, investments and dividends will be driven by the best returns for our shareholders. We will continue our growth in pharmacy and emphasis towards penetrating those stores currently without pharmacies.

As a preview to fiscal 2015, I will give you some high level financial guidance and the points driving the improvement. In fiscal 2015, we expect financial performance to return to and exceed the performance of the years prior to 2014. Our forecast has earnings per share in the range of $0.72 to $0.82 and EBITDA in the range of $86 million to $96 million. Some of the key factors that will drive the results our continued growth in pharmacy and raising the store penetration to over 65% by the end of fiscal 2015 with record pharmacy operating profit levels with the new distribution agreement turn rapid specialty pharmacy growth and other profit driving initiatives. General merchandising gross margin improvement through the return of shipments with high margin goods after rightsizing sourcing improvements and improving operating expense leverage that comes with the positive comp sales.

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

Bruce Efird

Thank you, Jerry and good afternoon everyone. I’ll begin this afternoon with a high level summary of our second quarter performance followed by review of our strategic priorities for the remainder of the year and how we’re positioning Fred’s for the future. As a result of the changing retail environment, we challenged our sales to view our business more critically and take a certain strategic action to improve future performance. Today, we will outline several significant strategic actions and operational restructuring directed toward delivering stronger bottom line results in the remainder of 2014 and in 2015. The headline for our strategic change in centered around accelerating our pharmacy growth and transitioning Fred’s to a convenient pharmacy centric model.

In the second quarter, we made a number of key changes focused on rebuilding customer traffic; first, we re-priced key trip driving segments of our business allowing us to market the traffic generating items during the quarter to improve our transaction trends and rebuild market share; second, we launched the new ad program and marketing strategy to highlight our convenience model and regain general merchandise sales momentum. These changes included; implementing in beginning of the month four page broad sheet ad with 75% of the circular devoted to consumables at market leading promotional prices and 25% of the ad highlighting key convenient center items. Additionally, we revamped our mid-month ad design to heighten awareness of our convenience departments to drive customer trips while improving our overall mix and margins. To complement these ads, we executed new weekly in store circulars highlighting key items in our convenient centers designed to expose the depth and diversity of our product mix.

Our customer are already seeing a big difference and the reaction is positive. We’re pleased with the results of these strategic programs and marketing actions reflecting stronger sales trends in general merchandise and improved customer traffic trends during the quarter. General merchandise departments have reported better performance in the quarter include health aides, housewares, stationary, toys and sporting goods, hardware, automotive and several key consumable departments. With our new ad program and marketing strategy now in place, we expect these positive sales trends to continue in the back half of the year; third, during the second quarter we took positive action to align our inventory with the new convenience model. In July, we rolled out a clearance in inventory initiative in all stores to recapture inventory dollars by exiting or reducing product categories that are not aligned with the convenience model, which is key to improving our gross margin return on investment.

As a result of this action our average general merchandised inventory in the stores is approximately 2% below last year at the end of the quarter. As Jerry noted in his comments, we took a book write down of cleared inventory in the second quarter enabling us to accelerate this process. In parallel with this inventory initiative, we reduced merchandised shipments to our stores by $9 million, which impacted gross profit by approximately $750,000 in Q2 as a result of our retail accounting method, which calculates the margin of goods going into the stores.

In the second quarter, we made several key additions to our leadership team. Jerry Colley joined Fred as our Executive Vice President of store operations; Ken Donahue was hired as our Senior Vice President and Chief Information Officer. We also added Craig Barnes and Kelly Ma to lead our new sourcing team. Craig assumed the role of Senior Vice President of Global Sourcing and Hardlines Merchandising responsibility.

Kelly Ma joined Fred as a Vice President of International and Domestic sourcing all of these new leaders bring demonstrated experience in each of their positions at other larger retail organizations. To further augment our sourcing team, we’ve engaged TestRite International as our strategic sourcing contractor which expands our global sourcing capabilities.

Moving to pharmacy, pharmacy department performance, we continue to see significant margin pressure. This margin pressure was created by rapid and pronounced cost increases on both branded generic products and by policy changes made by our current distributor. These cost increases impacted pharmacy gross margins by approximately 225 basis points in the second quarter. We saw accelerated gains in pharmacy script and sales growth throughout the quarter in July we had our highest script comp performance of the year along with the total script increase of over 6% compared to last year.

During the quarter, we completed 9 acquisitions, 5 new pharmacy locations and 4 incremental acquisitions with a full acquisition pipeline for the balance of the year. Our specialty pharmacy growth continues to outperform expectations with specialty sales up 49% over the second quarter of last year. With a new pharmacy contract benefits ahead of us the team plans to ramp up our specialty pharmacy focus, which includes both retail specialty pharmacy and EIRIS health services. We’ve seen exceptionally positive traction in this rapid growing segment of the pharmacy industry and anticipates continued growth in our specialty business as the team and our consultants work to secure URAC accreditation this year.

Shifting to our outlook, as we look forward to the balance of the year and position for 2015, we anticipate strong improvements in the pharmacy department particularly in our gross margins as our new pharmacy distribution agreement provides benefits starting in the fourth quarter.

During third quarter, we will transition to our new pharmacy wholesaler, Cardinal Hill. We’re extremely confident our new prime vendor agreement not only puts us back on solid footing as it relates to the challenges we’ve experienced around vendor cost increases but also offers many other components that will support our long term growth initiatives both and profitability and new union expansion.

We anticipate the improved script comp performance we’re seeing each month during the first half of year to continue and even accelerate in the second half as many of our growth initiatives matures. For example, we’re ahead of schedule on our Time My Meds program, which is an appointment-based model to drive improved patient compliance and adherence. We’ve already exceeded our patient enrollment goal by over 40% and we’re beginning to see benefits improved script comp.

The team has successfully executed the training and marketing programs needed to deliver our strongest year ever in the area of immunizations. We are capturing immunization opportunities both in store as well as off side immunization clinics that we expect will deliver a year-over-year increase in total immunizations greater than 50%. As discussed earlier, had a solid first half in regards to completing our growth plan for pharmacy acquisitions and the balance of the year is no different.

We’re seeing interest activity in the acquisition markets and do not anticipate this trend to change. Through first half of year we’ve completed 18 acquisitions consisting of 10 new pharmacy locations and 8 incremental acquisitions. We currently have approximately 25 to 30 acquisitions that are in various stages of the process that we anticipate to be completed in the back half of 2014. We expect the position acquisition momentum to carry through 2015 enabling our pharmacy team to achieve the 65% to 70% penetration of our store base. This pharmacy department penetration goal is a priority given our model stores with Pharmacy continues to achieve strong operating profit and margins.

Summarizing our position on healthcare services, I would point out that yes we have experienced recent headwinds and our current pharmacy performance, but the execution of our new prime vendor agreement the expansion of our acquisition program, specialty pharmacy growth and clinical services initiatives we are very bullish on the future of pharmacy. These initiatives along with our new distribution agreement with result in the headwinds shift in creating tailwinds by the end of the year. Looking forward, our primary focus on over the next 12 months will be transitioning Fred’s to a convenience and pharmacy centric model, driven by data-based inventory management and measured on GMROI.

We are committed to taking aggressive action to leverage both healthcare services and convenience trends to capture additional trips. Our store and distribution team will execute programs to reduce labor and enhance customer experience by improving product flow from the distribution center through the store to floor within the same day.

In the second half of 2014, we will close approximately 60 stores which don’t meet our ROIC thresholds. All of these stores are without pharmacies and these closures will allow reallocation of capital to accelerate pharmacy acquisitions and introduce new categories to our general merchandise mix. We will also relay approximately 75 stores with our new frontend configuration for faster checkout and a realignment of category adjacency to highlight and brand our convenience centers.

Based on the general merchandise comp sales improvement, customer traffic trends and market shares gains we will continue our new advertising program and marketing strategies. Additionally, our sourcing team and new sourcing structure will strengthen our overall inventory and buying all design to drive GMROI. Our new sourcing capabilities allow us to manage inventory levels more effectively and source goods more profitably going forward. So let me highlight the major factor for our confidence in the future.

As Jerry noted, we anticipate the strategic actions and plans will position Fred’s to deliver EBITDA in the range of $86 million to $96 million in 2015 with a primary contributors being the new pharmacy distribution agreement; number two, closing unproductive stores, allowing reallocation of capital to pharmacy growth; number three, inventory realignment completion with shipments returning to normal and number four, the continuation of improved comp sales trend.

The foundation of the company is strong and we anticipate the actions and initiatives we had outlined including new marketing and advertising inventory realignment, new sourcing structure, lower prices on stronger traffic drivers and key additions to our leadership team will bring stronger financial performance in 2015 while allowing us to continue our growth.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we will take our first question from Andrew Wolf with BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

I wondered if you would give us any pro formas on the 60 store closures. Assuming they are probably, given they lack pharmacy, maybe half or a little more than half the normal volume of a store. And also, as a tie-in to the guidance, it appears that there would be negative EBITDA. Is that -- in total? And if you could maybe frame or give us a sense on how much that is.

Bruce Efird

Andy they are in round numbers, those 60 stores have sales in excess of $80 million. They are losing about 10% on an operating basis and they are flat to down slightly on the EBITDA basis. But as you can see that they are having a trouble on the contribution margin which drives a lot, which is a big factor in next year’s performance.

Andrew Wolf - BB&T Capital Markets

Okay. And just sort of segueing to the earnings power suggested in the 2015 EBITDA target, you know, guidance states that between closing the stores and new agreements, that gets you -- gets the Company to the low end of 2015 guidance. But what is the base, and how do we get that base?

Jerry Shore

I am sorry Andy. If you take the base that I mentioned which is EBITDA in the range of $40 million to $46 million. Then you add on the impact of the pharmacy and the closed doors, those two items alone get you to the low end of our EBITDA range and then with the driver from merchandising expense leveraging et cetera, it’s the high end of our range.

Andrew Wolf - BB&T Capital Markets

Hello?

Jerry Shore

And the one other point going back to your first question about the closing of the stores, we evaluated these stores on a return on invested capital and evaluated these returns as compared to what we would getting the cash flow out of those stores turning them into more positive investment such as pharmacy growth to make this decision and that’s how and we’ve talked all along about getting to the 65% to 70% penetration and this is a key factor in getting there.

Andrew Wolf - BB&T Capital Markets

Thanks. And just one other question on pharmacy profitability, which I think Bruce mentioned, would start to turn up in Q4. It sounds like it's a great deal with Cardinal, and driving a lot -- most of them, it sounds like. But can you just speak to these generic drugs that are seeing this sort of unprecedented inflation and how that's causing everybody, Fred's, up to the big three to have big margin compression and profitability issues, where do you see that trending for Fred's or the industry? But obviously speak more for Fred's. Is that gross profit per script which was deteriorated whatever the number is? Obviously materially. Is that ever going to recover, or is it more like something you think can stabilize over time? And it mainly a generic book of profits.

Rick Chambers

This is Rick. Along those lines with the generic cost inflation we do not anticipate that to go to 12 to 24, 18 month range prices we saw before we do anticipate this inflation to continue most recently from one of the industry leading as there was a report at on that is pretty much substantiated that very thought going forward. We do anticipate overtime the gross margin or gross profit dollars per script to come back in line with what we had seen historically, even though the rates will be pressured because I’ll remind you not to get into too much detail, if you looking at generic prescription we might be getting $8 of retail on it there is very little room for that gross margin dollar expansion but as you move into drug now that selling for $80 depended on how your contract is set up. You do have more room for that gross profit dollar to expand even though the right will be pressure the dollars to have that opportunity to be much higher.

Andrew Wolf - BB&T Capital Markets

Okay. And Rick, you’re seeing that through negotiations currently with payors and the PBMs?

Rick Chambers

Well, it’s the combination of both of how we structure this new agreement with Cardinal as you remember back within our last agreement with the AmerisourceBergen, we were beginning at the beginning of that branded generic conversion wide and we structure that purposely around the generic conversion, brand conversions to capture much margin from that particular industry dynamic as we could. And we approach this contract negotiation now differently now adjusting with the generic cost inflation in place we’ve done it from a different angle that coupled with the work we’re doing with the payors.

Operator

And we will now take our next question from Jill Nelson with Johnson Rice.

Jill Nelson - Johnson Rice

A question on pharmacy acquisitions as you aim to kind of ramp up that. You talked about availability in the market being pretty good. Could you talk about maybe the pricing given you've got some big goals ahead of you?

Rick Chambers

Yes. Jill this is Rick. As Jerry and Bruce both alluded doing that 25 to 35 number that we see for the back half that will put this right on target for our 2014 plan again setting the stage for our 2015 where we have 55 in our five year outlook. We are seeing a lot more activity out there as reasons that we cited before with these independent owners, legislation, technology changes, just the pressures from both state and federal level in terms of reimbursement and they’re all getting at a point where they’re willing to take the equity out of their life-long investment.

Now as far as the pricing it is becoming a little more competitive out there as other chain players are looking of those incremental opportunities and their markets but also what you have left today are more what I would call survival of the fittest that have survived the Medicare Part D program in 2006 a lot of AMP and [Indiscernible] changes that have taken place at the federal level they have been able to survive all these hardships that are come from through all these industry changes. So they are going to be higher volume stores which will call for want a higher price prescript that we’ve been able to complete positively in that versus our competition.

Jill Nelson - Johnson Rice

Okay. And then just talking about trying to -- as you convert the store model to more of a convenience-type format, could you talk about maybe square footage? Do you see that kind of changing for the box versus what you have now? As well as kind of the merchandise mix; it seems as though a lot of the categories that you are exiting are more discretionary in nature which typically hold higher merchandise margins. Could you talk about the mix as well? Thank you.

Rick Chambers

No, lot of the categories will be exiting on a peripheral sections of the category where we extended the mix out too far. And as a result the GMROI on those are way too low. The data base decision making process that we’ve entered into now allows us to take those skews out of the process, puts that skew back into a pool that the DMMs now have to inject back in not only new categories but new product lines as they start to come out quicker and put them in the forefront of the marketing strategies.

So that’s the most important significant change when you move to data base decision making and you also end up with not only removing of lower productivity skews that get the opportunity to look at the whole category GMROI upon the category. There are about six to eight categories that are being evaluated at this time that can be brought into the next and the additional space that we’ve been able to open up, these categories will be injected in over the next course of the next six to nine months. You try and keep it to a balance because you don’t want to change too much of the store because when you go above the 2% to 3% transition in a six months period, the customer starts to wonder their old Fred’s is still the core Fred’s.

Bruce Efird

Just to add to that as we transition some of these departments and categories the focus will be on the convenience or immediate need departments and products that are more insulated from the Internet migration over time. So we see that as a transition and it’s based on the success that we’ve had on the expansion of automotive and hardware which is more of a needed now convenience type trip.

Rick Chambers

And to your other question, the size of the store going forward will be smaller not much, we’re estimating with the distribution changes that we’re making right now that we can probably take out about 1,400 square feet out of our store size. Most of them will be coming from the back room as we inject in this new process that will be very, very important for upgrading of the labor reductions and to be able to get a higher customer satisfaction because the stores sometimes we found in some of our study we’re not getting new good to the store floor fast enough.

Operator

And we will now go to David Magee with SunTrust.

David Magee - SunTrust

Just sort of building on that last question. If you sort of look out several years from now, what the Fred's store might be evolving into, is it -- will we still see home decor and apparel, or will we see sort of a more just more of a drug store at that point in time?

Bruce Efird

You will still have forms of apparel in the store that would still be a part of the store. There is a much more significant and better sector of the market that we have left; we kind of have not entered into. As you know today in the apparel industry active wear is one of the driving forces of the industry. We’re moving strong to be able to become a player in that market. And also the studies have now brought back and showed us sectors of the market where we have a customer base that we haven’t really properly addressed. So apparel will be, but its square footage will remain slightly small than its current configuration. If that is helpful.

Jerry Shore

I think Mike had in his note that we really see our box within our convenience model has really being a benefit to the future as we have room and categories that others don’t to drive more of the need based customer trip. One of the mistakes that came out at the research that was really shouldn’t have been so socking to us. Was the fact that we learned that the customer did not appreciate the breadth and depth of our mix. In fact we were not in any of the top of the mind awareness as the categories that we were thinking we are very proud of, that our marketing process that we had been going through over the years just had not gauged the customers.

The new program that date is underway, the team has underway is getting traction very fast and has improved a little right across these categories and we’re becoming closer and closer to being top of the mind. But the overall forecast **…it will take us another four to five months to be able to get the customer really aware of the depths and breadth of our assortment and that’s where we’re focusing our market expansion.

David Magee - SunTrust

Thank you, Mike. A question on the new wholesale agreement -- or I guess with regard to the generic reimbursements. Does this sort of make you whole as far as generic inflation in the future, or does it give you $0.50 on the dollar towards that end? I was trying to keep it simple. I was trying to see how well you are covered going forward with this sort of new separate dynamic.

Rick Chambers

This is Rick. It’s a little tricky trying to get into the details of that but that getting into the details and has to be quite honest because of the confidence you have the agreement is I am sure you’re aware of. All I would say is in others they want to come in but it does put us in a position to better protect us with some of the surprise if you will that we did see in the fourth quarter has rolled into the balance of ’14 it gives us much better visibility into that go forward so in terms of our forecasting and how we can handle that on a go forward basis.

Bruce Efird

And Dave just a real high level these guys did a great job of partnering with Cardinal and we’re exceptionally excited about the opportunity. And again not only just only contracted itself but for the overall partnership but the benefits the financial benefits are included in our guidance. And we do see this as a significant opportunity to really accelerate our specialty pharmacy growth and that’s not only in 2015 but in to ’16 as well.

David Magee - SunTrust

Thank you. And then just lastly I think I heard Jerry you say that the lease liability on the closed stores would be roughly $0.22. Did I hear that correctly?

Jerry Shore

No, that is the impact of all of the cost of closing the stores including the lease liability which is a relatively small number but it also includes the markdowns that will be taken at the time of closing shrink and the fees associated with the closings. We probably will use a third party still to be determined but all of the cost. The lease liability is a small portion of that because most of these stores are actually at end of lease term and even on month to month.

Operator

And we will now go to Cris Blackman with Empirical Capital.

Cris Blackman - Empirical Capital Management

Thank you. Jerry, I think you fortunately answered one of my questions. I was curious, I think you have had maybe 75 stores or so roughly they were month to month on your leases. How many of those of the 60 were in that category?

Jerry Shore

Well, Cris there are a good portion of them, it’s not all of the 60 just because the stores are on month to month does not mean that they’re not producing return. We stay 18 months out in our review of leases. And so it gives us the opportunity to negotiate with the landlord so it does give us opportunity.

Cris Blackman - Empirical Capital Management

And if I look at your budget for what you're going to spend on scrip acquisitions for the full year, you spent, what, $16.5 million so far. Are you still looking in the $32 million -- $30 million, $32 million total scrip cost -- acquisition costs?

Rick Chambers

Cris this is Rick. To achieve that number we had planned in the back half it will be in that range you’ve mentioned yes.

Cris Blackman - Empirical Capital Management

Okay. And then if we look further out, once we get some of this inflation moderating on the generics, what kind of operating margin should we expect out of your stores and pharmacies? I know in the past it's been maybe 4.5% to 5%; somewhere in that range is where you are hoping to land that. Is that still a figure that you would expect or that you would budget for or hope for?

Rick Chambers

Well, it is the amount that we have included in our modeling going forward it does give us the opportunity then to take stores without pharmacies that are operating at flat to negative and bring that up to that level which is very large return on your investment. Cris I want to just to go back to the question you asked earlier, we do have that amount in our cash flow projections one of the things that we are finding is that Rick and his team are spending a little more on the size of the acquisition but we will stay I believe we will stay within the ranges of the capital expenditure.

Cris Blackman - Empirical Capital Management

And then…

Michael Hayes

Cris just I would add to that is the we’ll stay in that range but we talked about before the fact that we were open to acquisitions in the specialty arena as well. So there may be opportunities beyond the current plan the one-off pharmacy acquisitions.

Cris Blackman - Empirical Capital Management

Okay, good. And then finally, is there any ongoing cost related to the strategic buyers -- advisors we have engaged? And any expectation of cost for the balance of the year in that area?

Jerry Shore

None that we don’t have accrued for.

Bruce Efird

Yes, Cris we do -- we are paying expenses and those expenses are included in our forecast.

Bruce Efird

Operator, we probably are getting toward the end of our time.

Operator

And would you like to take one last question?

Bruce Efird

Yes.

Operator

We will take our question from Joan Storms with Wedbush Securities.

Joan Storms - Wedbush Securities

Jerry, you had quantified the buckets to return to profitability next year. Then number one was the new pharmacy contract with Cardinal that would provide an automatic lift; and then, two, the stores; and then three would be a combination of the positive impacts of the new store format. Can you quantify what those three buckets and the general area might be? Like, you know, a third, a third, a third? Or --?

Jerry Shore

No. And Joan, let me jump in with -- it’s not just the pharmacy contract but the growth in pharmacy in specialty. I said that we anticipate the pharmacy to have their highest operating profit ever. So Again most of it is coming from the pharmacy but then there is also the 60 store closings and then on the general merchandise and store side we will make reductions in the losses that we’ve seen by improving the traffic and improving the margin. I don’t have ranges within each one of those. At this time, we are looking six months back already. As time progresses, we will.

The other thing that I would point out and why we are looking at EBITDA as heavily as we are because of the cash flow side of it. In comparison to discount retail and other retailers, we get the question why are not we performing there. And there especially with the pharmacy growth, there is a large amount of depreciation and amortization. So getting that EBITDA up to that $90 million to $100 million range is important to us because it really opens up the opportunities for us. We’ve generated good cash flow, we did have debt at the end of the quarter but it was relatively minimal at about $13 million. Now we are into the time that is going away and so we still have maintained strength of the balance sheet. And I am surprised, Cris, the last question didn’t get [indiscernible] reserves balance sheet really are off, really potential understate the value of the company and I am not going to get into the valuation of the company but those are two sides of all items.

Joan Storms - Wedbush Securities

Okay. And then -- so you have the $14.8 million in the rest of the guidance for the year. And what was the cost for the inventory clearance in the second quarter? Did you quantify that?

Jerry Shore

The comps for the inventory clearance in the second quarter?

Joan Storms - Wedbush Securities

Yes, the costs. Yes.

Jerry Shore

Oh, the cost. On the operating side of that, the cost in the stores was over $2 million. The inventory that we sold in that was relatively low in the second quarter. It just started at the very end of the quarter, but we did incur considerable operating expenses.

Joan Storms - Wedbush Securities

Okay, $2 million. So you've tested the new marketing, and you are doing -- you feel like you're doing pretty good there. Where are you in the process of actually testing one of a real store format? What's the merchandise that you want to have in there?

Jerry Shore

Well all of the new categories won’t get in -- we will plug those in over the next six to eight months. The first two full roll out stores we expect to open within the next 20 days, we will have both of them open. We are one, one way and one another way. But the -- I think as Jerry mentioned the $2 million that we win, a lot of that was to get the other stores back into line in the format. So…

Joan Storms - Wedbush Securities

Well, I'm just curious how you can gauge how the stores are going to perform if you don't even have like a couple of test stores in place yet.

Bruce Efird

We’re not putting any of that benefit in anything we gave you in guidance.

Joan Storms - Wedbush Securities

That’s not in any --

Bruce Efird

No, absolutely not, none of that. What we did to develop guidance that we took our absolute trends. We took our trends and we took specific initiatives that we are in – we are in the balance of this year, we layered only those on and then we took out all the negatives of different events that were in last year to give you the trend for the balance of this year when we go into 2014, we’re using simply the comp trends that we have in place and we’re adjusting margin on only three factors. The big factor in adjusting the margin for 2015 is the fact that in order to get the inventory down to the levels that we want to see at that in the stores and open up the space, we’ve had the cut of shipment in virtually all the high margin areas for the last 4.5 months and as you’ve seen our margins been hit by 200 to 225 basis points, very hard hit that we have to absorb. When we roll out into 2015, those adjustments will have been made and the new systems program that we put installed in, the buyers will be back being able to bring shipments back to normal levels for 2015. So that’s one of the major margin adjustments that will be able to go. The second one was we used our comp trends only based on our trend. Our trend is general merchandising, as you know in the first quarter was substantially negative, second quarter some of the action was taken that we’re able to reverse that trend and we’re now running in a slightly positive trend with a marketing program in place and the secondary part of the program which we’re very strong on is working even better as we move the customer around the store. So, we’ve only used trend analysis to give you guidance, there is nothing in there for any of the benefits of becoming floor to the stores which could be one of the biggest changes that we make in the company, the second one is stability from sourcing, we’ve not put sourcing claims sitting right across on this now and we put together in a very powerful sourcing team. So none of those are incorporated in the process, they are all benefits that will come we just struck with trend analysis.

Operator

This does conclude our question-and-answer session. Mr. Efird, at this time I will turn the conference back to you for any additional closing remarks.

Bruce Efird

Thank you very much and thank you for your interest in Fred’s and hope everyone has a great Labor Day weekend. Thank you.

Operator

Ladies and gentlemen, this does conclude today’s conference. We thank you for your participation.

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Source: Fred's (FRED) CEO Bruce Efird on Q2 2014 Results - Earnings Call Transcript
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