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Dollar Tree, Inc. (NASDAQ:DLTR)

Q3 2011 Earnings Call

November 17, 2011 9:00 am ET

Executives

Bob Sasser – President, Chief Executive Officer

Kevin Wampler – Chief Financial Officer

Tim Reid – Vice President, Investor Relations

Analysts

Scot Ciccarelli – RBC Capital Markets

Charles Grom- Deutsche Bank

Joseph Parkhill – Morgan Stanley

Peter Keith – Piper Jaffray

Meredith Adler – Barclays Capital

Dan Binder – Jefferies & Co.

David Mann – Johnson Rice

Aram Rubinson – Nomura Securities

Joe Feldman – Telsey Advisory Group

Michael Exstein – Credit Suisse

Operator

Good day and welcome to the Dollar Tree Incorporated Third Quarter 2011 Earnings conference call. As a reminder, today’s call is being recorded. At this time, I would like to turn the call over to Mr. Tim Reid, Vice President of Investor Relations. Please go ahead.

Tim Reid

Thank you, Elizabeth. Good morning and welcome to the Dollar Tree conference call for the third quarter of fiscal 2011. Our call today will be led by Bob Sasser, our President and Chief Executive Officer who will provides insights on our performance in the quarter and recent developments in our business. Kevin Wampler, our Chief Financial Officer, will provide a more detailed review of the third quarter financial performance and provide our guidance for the remainder of 2011.

Before we begin, I would like to remind everyone that various remarks that we will make about future expectations, plans and prospects for the Company constitute forward-looking statements for the purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors included in our most recent press release, most recent current report on Form 8-K, quarterly report on Form 10-Q, and annual report on Form 10-K, all of which are on file with the SEC. We have no obligation to update our forward-looking statements and you should not expect us to do so.

In addition, as we have previously disclosed, in the first quarter last year – 2010 – we recorded a non-recurring, non-cash charge of $26.3 million or $0.13 per diluted share relating to a change in retail inventory accounting. Diluted earnings per share in the first three quarters last year were $1.82 including the charge. You are advised that all earnings or margin comparisons in today’s remarks from this point forward will exclude the charge unless otherwise noted.

At the end of our planned remarks, we will open the call to your questions which we ask that you limit to one question and one follow-up question, if necessary.

And now, I’d like to turn the call over to Bob Sasser, our CEO. Bob?

Bob Sasser

Thanks, Tim. Good morning everyone. This morning we announced our sales and earnings for the third quarter of 2011. I’m pleased to report that against a very strong quarter last year, our comparable store sales increased 4.8% - that’s a 4.8% increase over an 8.7% comp last year. The comp was driven by increases in both traffic and average ticket. Traffic increased 3.4% and average ticket increased 1.4%. Total sales increased 11.9% to $1.6 billion. That’s at the very top of our range of guidance.

Earnings for the third quarter were $0.87 per diluted share. This represents a 19.2% increase over last year’s $0.73 per share, an especially strong increase considering last year included the benefit of more than $0.03 per share from unusual items.

Operating margin for the third quarter 2011 was 10.3%, an increase of 40 basis points over the third quarter last year, and net income rose 12.1% to $104.5 million.

Year-to-date through three quarters of 2011, total sales were $4.68 billion, an increase of 12.7%, and comp store sales have increased 5.5%. Year-to-date earnings per share are $2.45, an increase of 25.6% compared with $1.95 per share in the first three quarters last year. This increase is excluding the charge we took in the first quarter last year. Year-to-date operating income has increased by $82.5 million. Operating margin was 10.3%, an increase of 70 basis points compared with the same period last year and net income rose 19.6% to $300.4 million.

Our U.S. inventory turns increased once again in the third quarter as they have consistently for the past six years. I am particularly proud of this performance. It’s been a team effort especially driven by planning, allocations, and replenishment departments working with their logistics partners. I have great confidence that we can continue to improve on this item with our ability to continue increasing our inventory productivity while improving customer satisfaction by having the right product in the right stores.

As I said earlier, I’m very pleased with third quarter results. This success speaks to the power of the model and the high level of execution across the entire organization. Today our stores are full, fun and friendly to shop. Our merchandise is relevant, a surprisingly value, and every item at our Dollar Tree stores is $1 or less. Customers love the stores and the product and the concept. They continue to shop in record numbers and are buying more each time they shop.

Sales growth in the third quarter came from a mix of both basic and discretionary products. The top performing categories including food, snacks, and beverage, health and beauty care, home products, and party supplies. Seasons have always been an important part of the Dollar Tree business and our seasonal assortments this year have been more complete and more compelling than ever. The sell-through on Halloween and fall seasonal merchandise was very good and our store teams have done an exceptional job of transitioning the front of our stores from Halloween to Thanksgiving and Christmas, and they did it virtually overnight. I think it’s been the best transition ever.

Looking to the future, we intend to continue growing and improving on our performance, and I have every reason to believe that we will. Over the next several years, it appears likely that customers’ demand for value will continue to grow and intensify. Dollar Tree is uniquely positioned to take advantage of this trend by providing more value to a broader range of customers.

In this effort, our stores and merchants are supported by a solid and scalable infrastructure which we continue to enhance. This year, we expanded our distribution center in Savannah, Georgia from its original size of 600,000 square feet to 1 million square feet in order to support continued growth of our business in the southeast. This project was completed on time and on budget with a total of $19.5 million of capital investment using existing cash. The expansion became operational in the third quarter.

Our current logistics infrastructure can support sales nationally up to $8 billion. It provides efficient service to our stores today and continuing asset leverage as we open more stores. As always, we plan to add capacity strategically to support the growth ahead the need. In this regard, we’re currently developing plans to increase our logistics capacity in the northeast, and I expect these plans to be finalized over the next six months.

We’re growing our business in many ways – by opening more stores, by opening better stores, and by developing new formats, new markets, and new channels. During the third quarter this year, we opened 98 new stores and relocated and expanded another 24 stores. Through three quarters of 2011, we added 257 new stores and expanded or relocated 88 stores. Selling square footage increased 8.7% and we ended the quarter with 4,335 stores.

We are currently completing our store openings for this year. Consistent with our guidance, the final number of new stores opened this year will be 278 with 91 expansions, for a total of 369 projects and selling square footage growth of about 7% for the year.

In addition to opening new stores, we plan to open more productive stores. I’m pleased to say that we continue to make progress on store productivity. As I’m sure you know, sustained improvement requires a coordinated effort across the organization. At Dollar Tree, we’re concentrating our efforts on improved site selection, on rightsizing our stores, on opening new stores earlier in the year, through building a bench of qualified store management, and by emphasizing and expanding the most productive categories of merchandise.

Our expansion of frozen and refrigerated product continues. We installed freezers and coolers in 127 additional stores in the third quarter and now offer frozen and refrigerated product in 2,169 stores. We expect a total of 375 installations for this year. This is an important category because it serves the needs of our customers, drives traffic into our stores, and provides incremental sales across all categories, including our higher margin discretionary product.

Another key component of our growth strategy is the development of new retail formats, expansion of our geographic reach, and development of additional channels of distribution to serve more customers. DEAL$, our multi-price format, extends our ability to serve even more customers with more products and more categories. At DEAL$, everything is not a dollar but everything is a value. As we continue to grow and refine the concept, we’re offering more variety in our DEAL$ stores, more brands surprising value, and customers are responding favorably. Sales in third quarter were driven by increases in book traffic and average ticket. We’re extremely excited about the growth potential of the DEAL$ concept and the opportunity that it gives us to serve even more customers across the country. We ended the quarter with 181 DEAL$ stores.

When I speak of new geography in the current time period, I’m mostly referring to Canada, and our expansion into Canada is proceeding on schedule. In the fourth quarter 2010, we acquired Dollar Giant, which was a chain of 86 stores and we’ll end fiscal 2011 with 99 stores. In this first year especially, we’re investing in infrastructure, integrating processes, developing real estate plans, and building store teams for the future. We’re working very hard this year to develop compelling merchandise assortments while making strategic investments in infrastructure that will allow us to ramp up and support aggressive and profitable growth in 2012 and beyond. Our goal in Canada is to operate on an identical platform to the merchandising and productivity systems that support the U.S. stores, and much has been accomplished through third quarter.

Of particular note, the installation of store-level POS and enterprise-level merchandising systems has recently been completed. Systems and equipment have been installed and stores have been trained. This was a critical step in our plan. Sales data from these systems supports our planning, allocations and replenishment. We will soon have visibility to our own hands on order and sales with a trailing history by store and by SKU – key factors in the management of an efficient supply chain and improving customer satisfaction.

Earlier in the year, we solidified our logistics model in Canada and we’re now supplying product through our stores through distribution centers in British Columbia and Ontario. We have integrated the Canadian logistics with our Dollar Tree warehouse management system in the U.S., improving visibility and increasing efficiency. The merchandise teams have been integrated to leverage Dollar Tree’s buying power, and this has been a big transition but customers are beginning to find broader, more exciting assortments and better values in the stores. We expect this to gain momentum as we move through the holiday season.

As I hope you can tell, I’m extremely excited about the opportunities for Dollar Tree in Canada and proud of what has been accomplished in a short period of time. There is still much to do but the results will be worth the effort. Over the longer term, we believe the Canadian market can support up to 1,000 Dollar Tree stores. This is in addition to the 7,000 store potential for Dollar Tree in the United States plus additional growth in our DEAL$ format.

Last but not least, Dollar Tree Direct, our e-commerce business, is providing an opportunity to reach new customers through an additional channel of distribution. In the third quarter, significant progress was made with Dollar Tree Direct on a variety of fronts. First, Dollar Tree Direct is now offering the customers the opportunity to purchase smaller quantities on over 600 online items while continuing to offer more than 2,500 items for sale by the case. Second, Dollar Tree Direct launched a Spanish language version of the website to serve this important and growing customer base. Third, Dollar Tree Direct is now available to mobile users. Customers can view the merchandise, read product ratings and reviews, make purchases or utilize the store locator to find their nearest Dollar Tree store directly from their smart phones or other mobile devices.

Dollar Tree Direct continues to gain new customers. Traffic on the website increased 33% compared with the third quarter last year. New customers are finding us every day.

Now I’d like to turn the call over to Kevin who will give you more detail on our financial metrics and provide guidance.

Kevin Wampler

Thanks, Bob. As Bob mentioned, our diluted earnings per share increased 19.2% in the third quarter to $0.87. The increase resulted from our strong sales and expense control which resulted in a 40 basis point improvement in operating profit margin compared to the third quarter last year. Gross margin was 35.1% during the third quarter compared with 35.5% in the third quarter last year.

Several factors contributed to this performance. IMU on many categories increased in the third quarter, reflecting continued improvements in sourcing and the flexibility of our merchandise model. Also, we leverage occupancy and distribution costs in our U.S. stores. These factors were offset by, first, basic consumable products increased by about 170 basis points as a percentage of sales in the third quarter, reflecting the continuing shift in our merchandise mix to meet consumer demand for needs-based products and the expansion of our frozen and refrigerated capability. Second, the higher cost relative to sales in our Canadian stores as we strengthen the supply chain, developed new merchandise assortments, and invest in growth. Third, freight costs continued to increase in the third quarter driven by diesel fuel prices that averaged $0.84 per gallon above the same period last year. This was partially offset by ocean freight expense, which was down slightly from the third quarter of last year as expected. In addition, shrink and markdown expense increased slightly as a percentage of sales relative to the third quarter last year.

SG&A expenses were 24.8% of sales for the quarter, which is an 80 basis point improvement from the third quarter last year. This was driven primarily by, first, an 80 basis point decline in payroll-related expenses due to increased productivity, leverage on comp store sales, and lower incentive compensation compared with last year; second, a 15 basis point reduction in depreciation. These improvements were partially offset by an increase in operating and corporate expenses relative to last year when we recorded a realized gain of $2.7 million relating to the favorable resolution to a legal matter. That gain contributed $0.01 per share in the third quarter last year.

Debit and credit card fees increased slightly, reflecting growth in usage of these types of tender. In the third quarter compared to the third quarter of last year, debit card penetration increased 120 basis points, credit card penetration increased 50 basis points, and SNAP penetration, although small, continues to grow.

Operating income increased $24 million compared with the third quarter last year. Our operating margin for the quarter was 10.3%, a 40 basis point improvement compared to the third quarter last year. Year-to-date through the third quarter, operating margin is 10.3%, an increase of 70 basis points from the same period last year. Dollar Tree’s operating margin remains among the highest in the value retail sector.

You may note that other income declined in the third quarter relative to last year. As a reminder, in the third quarter last year dividend income of $5 million was recorded in other income based on a dividend declared by Ollie’s Holding Inc., of which the Company owns 10.5%. This contributed about $0.02 per diluted share last year.

The tax rate for the quarter was 36.4%, slightly higher than the third quarter last year and lower than our expected tax rate for the quarter. For the first three quarters, the tax rate was 37.2% compared with a tax rate of 36.8% during the same period last year.

Looking at the balance sheet and statement of cash flow, cash and investments at quarter-end totaled $280.2 million versus $392 million at the end of the third quarter 2010. During the third quarter, we invested $249.1 million for share repurchase, including a $200 million ASR that repurchased 3.3 million shares. This ASR concluded in November, which resulted in the Company receiving an additional 100,000 shares. During the first three quarters, we invested $345.9 million for share repurchase and repurchased 5.2 million shares. The diluted weighted average shares outstanding for the third quarter was 120.7 million.

In October, the Board of Directors authorized an additional $1.5 billion for share repurchase. The decision reflects the Company’s commitment to build value for long-term shareholders and our confidence in the future.

Our consolidated inventory at quarter-end was 7.5% greater than at the same time last year, and selling square footage grew by 8.7%. Consolidated inventory per selling square foot decreased by 1.2%. Inventory turns have been increasing for the past six years and we expect this trend to continue for the full year of 2011.

Capital expenditures were $75.5 million in the third quarter of 2011 versus 56.6 million in the third quarter of last year. For the full year, we are planning capital expenditures of about $240 million. Capital expenditures are focused on new stores and remodels, the addition of frozen and refrigerated capability to 375 stores, IT system enhancements, and approximately 19.5 million for the expansion of our distribution center in Savannah, Georgia.

Depreciation and amortization was $41.1 million for the third quarter versus 38.9 million in the third quarter last year. For the full year, we expect depreciation of approximately $165 million and that depreciation expense as a percent of sales will continue to decline for the full year.

Turning now to our guidance for the fourth quarter of 2011, we are forecasting sales in the range of $1.89 billion to $1.94 billion and diluted earnings per share in the range of $1.50 to $1.57, which would represent a 16% to 22% increase compared to the fourth quarter of 2010 earnings per diluted share of $1.29. The sales range implies a low to mid-single digit comparable store sales increase.

For the full fiscal year of 2011, we are now forecasting sales in the range of $6.57 billion to $6.62 billion based on a low to mid-single digit increase in comparable store sales and 7% square footage growth. Diluted earnings per share is expected to be in the range of $3.94 to $4.01, representing an increase of between 22 and 24% over our record earnings per share of $3.23 in fiscal 2010 excluding the non-cash charge in the first quarter of last year. Our guidance also assumes a tax rate of 37.7% for the fourth quarter and 37.4% for the full year. Weighted average diluted share counts are assumed to be 119.9 million shares for the fourth quarter and 121.8 million shares for the full year. Our guidance assumes no additional share repurchase this year.

With that, I’ll turn the call back over to Bob.

Bob Sasser

Thanks, Kevin. Once again, I’m very pleased with our Company’s third quarter performance. It was a terrific quarter. In the face of tough comparisons, our traffic continues to grow and our average ticket is increasing. As a result of this, comp store sales increased 4.8% and total sales grew almost 12%. Despite high fuel prices which averaged $3.83 per gallon, operating margin increased by 40 basis points to 10.3%. That’s the highest third quarter operating margin since 1998 when diesel fuel was less than $1 a gallon; and our earnings per share increased by 19.2% on top of a 43% increase last year.

In addition, during the third quarter the Company completed the expansion of our Savannah DC, a key element in supporting our continued growth in the southeast. U.S. teams installed and trained the major portion of our IT infrastructure in Canada, including POS systems in all stores. Dollar Tree Direct has launched significant enhancements to DollarTree.com, including break pack, Spanish language, and mobile capability.

The Company repurchased $246 million of stock and announced a renewed authorization from the Board for an additional $1.5 billion of share repurchase.

We are singularly positioned to do even better in the future. The business model is powerful and flexible. Tested by time and validated by results, we have proven that Dollar Tree can adapt to a changing environment. Through good and bad economic times over the Company’s 25 year history, the Company’s record of superior sales and earnings continues, and we’ve never been bettered positioned for continued growth and improvement.

The balanced mix of high value consumer basics and unique assortment of fun, seasonally correct discretionary products positions Dollar Tree stores to be relevant to customers in all economic circumstances. In challenging times, customers can find the values they need on everyday basics because we have the things they need; and when times get better and consumers have a few extra dollars in their pocket, the Dollar Tree assortment of fun, compelling discretionary product can’t be beat. At Dollar Tree, yes, you can afford to splurge – those discretionary items are still just a dollar.

We continue working to keep our values high. The buyers have just concluded their fall buying trip. The trip was again very successful with higher initial markup, great values, and a terrific merchandise selection; and there’s more to come. Looking ahead, there are plenty of opportunities to grow our business. We have a vision of where we want to go and the infrastructure and capital to make it happen while generating substantial free cash, and we will continue to use our capital for the benefit of our long-term shareholders.

It’s an exciting time at Dollar Tree. We’re having a great year. We transitioned quickly from Halloween and our stores are now set with our best merchandise ever for Thanksgiving and the Christmas holiday season.

We’re now ready for your questions. So that we can accommodate as many callers as time permits, we ask that you limit your questions to two.

Question and Answer Session

Operator

Thank you. If you would like to ask a question, please signal by pressing the star key followed by the digit one on your touchtone telephone. If you are using a speakerphone, please make sure your mute button is turned off to allow your signal to reach our equipment. Once again, we ask that you please limit yourself to one question and one follow-up question. Again, please press star, one to ask a question. We’ll pause for just a moment.

Our first question comes from Scot Ciccarelli with RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

Hey guys. How are you?

Bob Sasser

Good, Scot.

Scot Ciccarelli – RBC Capital Markets

Good. Question about the gross margin – if you were to isolate the impact of the mix shift, what was the gross margin impact just from that?

Kevin Wampler

Well you know, we don’t necessarily break those things out specifically, Scot, but I would love to give you a little direction overall as it relates to gross margin. So obviously we’re down a little less than 40 basis points for the quarter, but again, IMU again was higher. The values that the team has put together continue to be extremely good. In this quarter, our consumables did shift by about 170 basis points – that’s the largest shift we’ve had this year. I believe the first half of the year was closer to maybe 120 points of shift, so that is the biggest shift. And for the most part, it did offset the IMU gains that we saw.

The other things that went into this is the fact that Canadian effect, in a sense. We’ve talked a little bit about the idea that the occupancy costs in Canada are higher. The other thing you need to remember is where really we have Canada costs included in the current year, there were no costs for Canada in the prior year. So from a comparison standpoint, that has an effect as well. But again, it’s a big investment in Canada and we believe it’s the right thing, and there is a payday somewhere down the road; but this is what we really need to do at this point in time. A significant change really in logistics as well when you think about the fact that historically the model for them had been a direct store delivery model, where now we’re going to third party distribution centers, one of each side of—one in Toronto and one in Vancouver.

Lastly from the standpoint of fuel, diesel fuel up $0.84 as we’ve spoken before. The increase of $1 for diesel fuel for a year is probably $0.07 to $0.08 of hit for us, and we’re able to offset that a little bit by ocean freight, but again, it was a headwind for the quarter. And then just a tiny bit of shrink and markdown effect for the quarter.

One thing I would mention as it relates to the fourth quarter guidance is the fact that it basically assumes that gross profit will be flattish to slightly up, and we feel pretty good about that. Obviously within that, you assume the IMUs to be up, fuel will still be a little bit of a headwind, Canada will be fully comparable in the sense that—I think it was this day a year ago we announced the closing of the Canadian acquisition. So I think that’s—I don’t want people to think that the 40 BPs is ongoing. We feel pretty good about where we’re headed from a gross profit standpoint.

Scot Ciccarelli – RBC Capital Markets

That’s very helpful. And then can you just give us a feel for the relative growth rates at Dollar Tree versus DEAL$? I know you don’t break out DEAL$ specifically, but is it comping at about the same rate as the Dollar Tree chain, a little bit better, a little bit worse? That would be helpful. Thanks.

Bob Sasser

Scot, we don’t break it out but I’m very pleased with the comps in our DEAL$ stores, and the opportunity as we go forward is for higher volume stores in that DEAL$ format, and we’re seeing evidence that we can do that now.

Scot Ciccarelli – RBC Capital Markets

All right. Thanks a lot, guys.

Operator

We’ll take the next question from Charles Grom with Deutsche Bank.

Charles Grom – Deutsche Bank

Thanks, good morning. Just on the 4.5% comp, can you remind us how it trended over the past few months, and how much do you think the Halloween shift impacted sales? And I’m just curious – did it also hurt gross profit margins at all during the quarter?

Bob Sasser

The sales were pretty consistent across the quarter. The Halloween shift did effect—we lost that day of Halloween selling and that went into the fourth quarter, and that’s a big day, by the way, so there was an effect from that. But sales were pretty consistent across the quarter, and when you look at it by region, it was very consistent by region of the country. The southeast led but only slightly, followed by the Midwest. So sales were consistent. The Halloween shift impacted us somewhat, and the other thing was we did have some bad weather. We had a hurricane and the snowstorms in the northeast right there that final week of the quarter, so that was the other unusual thing, I guess, that happened in the quarter.

Charles Grom – Deutsche Bank

Any sense for—could you quantify the shift plus the weather for us, since it was significant?

Bob Sasser

You know, I don’t believe we’ve actually quantified it. The impact of Halloween, of course we’ll get that in our fourth quarter numbers, but we’re—we didn’t lose it, it just moved over one day. The weather, I will tell you that snowstorm that last week impacted our stores probably more than the hurricane did. It was sort of a surprise to everyone, and we lost more stores and more stores with electricity in the northeast than we ever did with the hurricane that was early in the quarter. But I can’t quantify that for you. We still think it was a great quarter, 4.5 comps, it was very consistent; and it was up against a terrific quarter last year. You know, we went in thinking that it was going to be an opportunity to really show our stuff against a strong quarter, and I was real pleased with where we came out. The 25-year anniversary was very strong. I guess you’d remember we had our 25th year anniversary this year, and we celebrated with a lot of 25% more, same low price merchandise during the quarter. We drove a lot of sales with that, and it was right in turn with what the customers are looking for now in their search for value, and they’re looking for ways to balance their budgets. So again, very relevant to the times and drove some sales, drove some traffic in a quarter up against a really terrific quarter from a year ago.

Charles Grom – Deutsche Bank

Okay, great. And then second question – curious on what your buyers are seeing on the cost front for the back half of next year. You commented they’d just returned from overseas and they’re seeing higher IMUs. Just wondering if you could flush out what they’re seeing and potentially quantify how much you think costs are going to be dropping in the back half of next year for you. Thanks.

Bob Sasser

Chuck, the buyers—as you know, they just returned from buying their fall, and again, the initial markup is higher than last year, higher than plan on that buying trip. They do that because our flexible model allows them to first of all change the product, not the price. You know, we change product from season to season for many reasons. One is to stay relevant; one is to continue to create more excitement, and the other is to manage our margins. So we’re always going to be able to manage our margins, especially on these import buying trips. Frankly though, with demand being down in China, business is not that good around the world and the Chinese makers that we’re working with are incented to do business. So while we are a big buyer in China and while we can change our product, we’re actually seeing the opportunity to create even more value as we go to market on these trips. So I think—I can’t quantify for you but I can tell you that our initial markup on that buying trip was higher, and I believe the values are better then ever.

Operator

Once again ladies and gentlemen, please limit yourself to one question and one follow-up question. We’ll go next to Joseph Parkhill with Morgan Stanley.

Joseph Parkhill – Morgan Stanley

Hi, good morning. I was just wondering if you could talk a little bit more about the shift toward consumables. You mentioned this a little bit in your opening comments, but do you think you’re pushing more of the consumables or do you think that it’s the consumer that’s pulling forward the demand?

Bob Sasser

Joe, I think that’s a good question, and we are always focused on the customer. I will tell you that from our standpoint, we’re excited about selling more of the consumables because we’re also selling more of the variety too. The customer is searching for value. They are trying to balance their budget. Unemployment is, as you know, at all-time highs and we have found new customers. They’re looking to us to help them as they search for the things they need every day – our HBC products, high value merchandise. They need that right now. Our household supplies, cleaning supplies, paper, chemicals – all of those things, all the things that you need in everyday living, our customers are looking for. We have that and as our customers more and more are coming to us for that, we’re giving them what they want. So in that regard, it is very much a reaction to what the demand is from the customers pulling more and more of that product.

Now while they’re in there, they’re still buying our variety. We had a good Halloween. We had a terrific sell-through. We’re now set for Christmas. I expect Christmas to be the same results. They like our surprising value in our party supplies and all the things around the fall parties, the Christmas and holiday parties. They like our stationary, they like our party, they like all the toys and all the things for the kids, and those are all high margin things that we sell. So that’s increasing along with the consumable products.

Also in the quarter, the third quarter, you have Halloween in there but basically it was an opportunity to highlight our 25th anniversary and give customers even more of what they wanted. We had some terrific values in cleaning supplies in HBC, and really across the store – 25% more, same low price, same price for 25 years. And the customers really liked that and they responded favorably to it, and you can see that in our traffic.

So that’s a long answer to your question, but I believe if you think about what customers are looking for, that’s what we’re giving them; and they really are looking for value on basic consumable products.

Joseph Parkhill – Morgan Stanley

Great, thanks. And then my follow-up would just be on the fourth quarter for sales guidance – how do you think about the compare from last year since you were impacted—you know, with the snowstorm, how do you take that into account when guiding for this year when the weather is kind of uncertain in the fourth quarter as well?

Kevin Wampler

Well, as we look at that, Joe, we basically—you know, every year you could have weather, you might not. You don’t really know. You can plan your sales and your merchandise assortments, and you build that out, and weather is either going to happen or not. Now, we’re in all 48 lower states, so there’s likely to be weather somewhere. That’s just a fact of nature and just part of doing business. So I don’t think we look at it any differently. Can it potentially—if the weather is really great from a shopping perspective, could it be a benefit? It could be, but that’s not a given in any way.

Bob Sasser

We’re not counting on any better weather than we had last year, frankly, in our guidance. And if we get better weather, it will be just better.

Operator

We’ll take our next question from Peter Keith with Piper Jaffray.

Peter Keith – Piper Jaffray

Hey, good morning. Thanks for taking the question. Had a question on the gross margin, the impact you highlighted from the higher costs of the Canadian stores. It sounds like that may have been attributed to revising the distribution model. Is that a cost now that we should expect to kind of flow through your gross margin for the next couple of quarters?

Kevin Wampler

I mean obviously, really the—we’ve had a lot of infrastructure and investment up there and there’s a cost to do that, and it’s a change in model and it takes a little while to get everything as efficient as you’d like it to be; and that will continue to get more efficient as we open more stores as we go down the road. So as I’ve said, we don’t really break these parts down individually, just trying to give you some color on them. Because of their size, their cost structure is not going to be as efficient as Dollar Tree’s at the end of the day, so that’s really the way we look at it. It will not be that efficient, so on an overall basis it might pull it down a little bit, but now it’s comparable and I think that will kind of take care of itself.

Bob Sasser

You know, Peter, we bought the company for a couple of reasons – one, because the opportunity to expand growth, it’s a huge opportunity there; but also for the opportunity to improve the economics of that company. They were less profitable than Dollar Tree when we bought them. We bought them in fourth quarter last year, not in third quarter. When you’re looking at third quarter this year, you’re seeing the effect of Canada in this year’s third quarter against no Canada last year in third quarter, so that’s two things to consider. But look – we think we can improve it. That was the reason we bought it – opportunity for more growth, 1,000 stores in Canada. We think we can do that and we think we can bring more value and improve the operating economics of those Canadian stores.

Peter Keith – Piper Jaffray

Okay. Certainly you could see the opportunity going forward. I guess I’m curious now that the Canadian stores have been in your results for the last year, you had highlighted at last year’s analyst day you thought it would be accretive. Has it turned out to be accretive after all the investments, or has it been a slight drag on the earnings for the last 12 months?

Kevin Wampler

It’s been a slight drag, Peter.

Peter Keith – Piper Jaffray

Okay. All right, thanks a lot, guys. Good luck for the holiday season.

Kevin Wampler

Thank you.

Operator

We’ll go next to Meredith Adler with Barclays Capital.

Meredith Adler- Barclays Capital

Thank you very much. I’d like to maybe just talk a little bit about real estate. You guys seem to be not having any problems getting stores. If you could just maybe talk about the environment – is the weak consumer economy and the weak economy in general really changing the availability or the cost of the stores you’re leasing or are staying the same? And I guess I’d ask about regionality, too, because I think some parts of the country have become more expensive. But maybe you could talk about that.

Kevin Wampler

Sure, Meredith. Yeah, obviously I think from an availability standpoint, if you look over the last three years in a tough economic environment, we have been one of the companies out there that has consistently been opening a significant number of stores, and that does create some opportunity in the sense that developers know, one, that we have a great balance sheet, we’re going to be there for the 10, 15, 20 years, whatever our lease and option terms are to be able to make those payments. And so there are centers that we might not have gotten called on before or we might not have been the first people that they would have called, but we get those calls earlier now. And so we potentially get to see some centers that are maybe a little better than we might have saw in the past, and so I think there is from an availability standpoint some opportunities that we’ve been able to take advantage of.

At the end of the day, it’s still about profitable growth for us. It’s really making sure we’re selecting the right stores, the right places where we’re ready to grow so that we can make sure and continue to return the kind of financial returns we’ve been able to over the last several years. So could we grow faster? Well, we’ve grown a little faster this year and maybe we’ll look to grow a little faster next year as well, but we have these opportunities but it’s really important for us to really look at each site and go through that process.

Meredith Adler – Barclays Capital

And then just a follow-up – does the fact that you’re adding coolers and freezers make it harder to get a site that’s anchored by a supermarket? Are you getting more pushback, or is it just not a big enough part of your mix for anybody to be concerned?

Kevin Wampler

Well, I think it’s always something you have to look at at the center. It’s dependent center-by-center as to whether there is a lease restriction related to freezers and coolers, or in some points just food in general. So those don’t necessarily directly effect our decisions; it’s really just dependent on the center. We like to go, obviously, where we have the opportunity to put in our full mix of freezers and coolers. We think it’s a great shopping experience for our customers when we’re able to do that, and we do look to do that wherever we can. But we’re in plenty of centers where maybe we can have some freezers, but it all works out at the end.

Bob Sasser

Meredith, we’re not a grocery store and we’re not going to be a grocery store, and restrictions are something we’ve always had to deal with, whether it be grocery stores with freezers and coolers or party stores with our party, or with other stores with our picture frames. So it’s something that’s not new. The freezers and coolers are new for us, but dealing with restrictions is something we’ve always had to do.

Meredith Adler- Barclays Capital

Great. Thank you very much.

Operator

We’ll take our next question from Dan Binder with Jefferies & Company.

Dan Binder – Jefferies & Co.

Hi, good morning. It’s Dan Binder. I had two questions for you. The first one is on incentive comp. You mentioned it was a little bit lower. I was just wondering if that is a function of it shifting from one quarter to the next, or is there a better reason for the incentive comp to be down given that you’ve been outperforming this year? And then second question is related to inventory – really phenomenal job on controlling that. But as we head into the holiday season, just want to understand how much inventory you have coming down the pike here. You know, it’s up 7% and change on the kind of sales increase you had. Can you just give a little idea on how you’re getting that productivity to improve so much?

Kevin Wampler

Well as far as incentive comp piece, I’ll address that one first. Obviously, we have—if we look compared against a year ago, a year ago we had a knock-out year as well and basically 100% of the targets were met, and we knew that fairly early on. And so this year we’re not at 100% of the targets. We’re building upon good years upon good years, so the targets go higher and we’re not achieving at quite the same level this year, so that’s really the reason for that change in incentive comp.

As far as inventory, we feel really good about our inventory position. Obviously, we continue to work with our planning and allocation team, continue to work with looking at stores. You know, we have more stores and more items on replenishment now than we ever have. We’ve gotten more efficient in those regards. We’ve gotten better with looking at stores as far as clustering them and determining how to open them up, what inventory categories are going to be important store-by-store. So a lot of it is technology that we’ve been able to implement and continue to gain efficiencies with that have continued to help us, and it’s obviously been a big point that we’ve tried to work on because we think it’s a very important thing. And honestly, the thing is we’ve had less inventory for the past two or three years now, and really it has not hurt our sales at all. So it really does show that you can gain these efficiencies and not hurt your sales.

Dan Binder- Jefferies & Co.

Great, thank you.

Operator

We’ll now move to David Mann with Johnson Rice.

David Mann – Johnson Rice

Yes, thank you. Good morning. Great quarter, guys. First question – Bob, you talked earlier about IMU going up on this recent trip. Can you just compare how that increase in IMU would look against the recent trips earlier in the year? Are you seeing it getting a little better or a little deceleration?

Bob Sasser

It’s a little better, David. I think this whole year, our initial markup trip-to-trip has increased. Now, that’s always something that we balance—you know, there’s a balance between cost and value, and so as we get better cost we tend to sometimes invest that into more value for the item, and at the end of the day we’re not pushing really hard to increase the initial markup remarkably year-over-year, trip-over-trip, because we want to make sure that we maintain relevance to the customer, the highest value product that we can possibly deliver at the margins that we like for our P&L. So the buyers have just done a terrific job. I’ve got to tell you, the merchandise is better than ever, and I’ve been here a while now so this is going to be the best fall and Halloween season that you’ve seen at Dollar Tree. And in this tough world economy, we’re at Dollar Tree using the power of our buying. We’re open to buy. Our buyers are really good at putting together assortments for that dollar price point. That’s what their focus is. Nobody does a dollar price point like Dollar Tree does, and that’s what you’re seeing when you go into our stores. I think when you see our fourth quarter assortment, our holiday assortment that’s coming up here, you’re going to say, wow, it’s even better than last year. And I’m seeing that going into next year as well.

David Mann – Johnson Rice

And then Kevin, in terms of operating expenses, great leverage this quarter. How should we think about the leverage or growth of SG&A in the fourth quarter? And can you call out what the extra legal fees were last year that were in operating expenses?

Kevin Wampler

Yeah, last year the—are you referring to Q3, David?

David Mann – Johnson Rice

I thought there were some in Q4. Would that not be correct?

Kevin Wampler

That I don’t remember. We had a benefit in Q3 a year ago from the settlement of a legal matter.

David Mann – Johnson Rice

I’m sorry – I was referring to any legal fees that were tied in with Dollar Giant or any other professional fees.

Kevin Wampler

Yeah, there would have been some but they were fairly small, and they would not have materially moved the needle, is the way I would look at that, I guess. From an overall—you know, as we look at our SG&A and we saw great leverage in our payroll expenses this past quarter, and really give a lot of credit to the store teams. They did a real nice job with increasing their productivity, and as I’ve said before, it’s our largest SG&A line that we have, so when we can do that, that’s really important. And it really kind of ties back to a great extent to some of the things we’ve talked about in the past, which was flow of product across the chain, making sure we’re being efficient in how we move that product into the stores, which helps them on their end run better stores, move product from the back room onto the sales floor and then drive sales. So we look at that as very positive and we hope we can continue to see some benefits there.

On an overall basis, obviously we think depreciation we’ll continue to leverage. I think our payroll we can continue to leverage, but we’ve still got to execute to it at the end of the day and driving sales always helps that in any given quarter.

David Mann – Johnson Rice

Thank you.

Operator

We’ll take the next question from Aram Rubinson with Nomura Securities.

Aram Rubinson – Nomura Securities

Hey guys, good morning. Two questions – one around seasonality and then a follow-up. When you look from Q3 to Q4, I’m just wondering how much does the mix change of consumables kind of recede into Q4 from, say, prior quarters?

Kevin Wampler

Sorry for the silence – I was actually looking it up here for a second. But it is fairly significant in the sense of the overall mix. You would basically see consumables that have been running above 50%, it’s all down closer to the mid-40s, basically, in the fourth quarter. So it is a fairly significant shift in our mix in the fourth quarter comparably.

Bob Sasser

And Aram, it’s not so much that the consumables fall off and go negative; it’s that the other, the variety goods increase faster. So with Christmas, people are buying more of the party supplies and the trim-a-tree merchandise and the wrap and the bows and the toys and all those things, the variety things for stocking stuffers and all those things that you want for Christmas.

Aram Rubinson – Nomura Securities

Thanks for that. The follow-up is if I look historically, I guess I see that your sales per square foot in the fourth quarter used to be higher than they are now, but your sales per store are actually higher now than they’ve ever been in the fourth quarter. And so the question is to kind of drive that relevance seasonally, are there either shifts in reallocation of space to Q4 to drive even more of that seasonal discretionary business, and also wondering if there are things on a throughput basis to do to be able to even push greater seasonal relevance in Q4?

Bob Sasser

Well, there’s a lot more Christmas trim-a-tree and Christmas merchandise in fourth quarter, and if you go into our store in fourth quarter, we like clean and neat and orderly and aisles clear and all those things, but when you walk into a Dollar Tree in fourth quarter, we stack it higher and deeper because the demand from the customer is there. It makes it more exciting, it makes it more seasonal, there’s more color. We do end caps, the front wall, the front windows, the side stacks – you know, all the things, they turn into red and gold and silver and all the things for the holiday season.

So the throughput, I’ve got to tell you, I was just talking to our head of stores for the west coast last night, and he says the back rooms in the stores—right now, we’re going into the peak inventory time at Dollar Tree historically, going towards the Thanksgiving week, and he says the back rooms are in terrific shape. The stores, the sales floors are in great shape, so we’re getting it into the store and through and onto the shelf and into the selling area a lot cleaner, quicker and more efficiently now, which speaks to a high degree of the more efficient smoothing of the inventory flow into our stores, some of the things Kevin was talking about earlier – knowing what we own and what stores sell what, and giving it to them closer to the need.

So I’m not sure—if the question was can we do even more in the fourth quarter, the answer is yes. Our sales per square foot, although I’m happy with the productivity increases that we’re having, we can do more. There’s a whole lot of opportunity at increasing our sales per square foot. The reason for going from—going way back in history from the small, 4, 5, 6,000 square foot stores into the 10 to 12,000 square foot stores, initially it lowered our sales per square foot but it gave us open to sell, basically. So since that time, the mid-2000s, we’ve been rebounding and our sales per square foot do continue to improve year-over-year.

Operator

And ladies and gentlemen, we have time for one to two more questions. We’ll go next to Joe Feldman with Telsey Advisory Group.

Joe Feldman – Telsey Advisory Group

Hi guys, how are you? Congratulations on the quarter. Wanted to ask about California a little bit. Your two other deep value competitors plan to enter there next year, and was just wondering if you guys are planning anything or focusing more of your growth next year there to defend market share, or how you’re going to approach that competitive incursion?

Bob Sasser

Well, thank you for the question. Look, they’re terrific stores, terrific competitors. I admire both of those folks very much and I think they do a nice job. California is not new for us. We’ve been there since 1998. We currently have over 350 stores right now in California, and if you counted the west coast including Oregon and Washington, it goes up over 500 stores. We’ve been there for a long time. We’ve got two DCs in California alone. We have three distribution centers on the west coast. We have management oversight, we’ve got store teams, we’ve got real estate relationships, property management skills, and we love California and we’re going to continue to grow in California. We’ve expanded our logistics capacity out there over the last couple of years and we intend to continue growing in the state of California, as well as the whole west coast.

So look, there’s a lot of business to be done, I guess enough for everyone. But we’re going to stay focused on what we do, and we certainly have made a commitment to California and the west coast.

Joe Feldman – Telsey Advisory Group

Got it, that’s helpful. Thank you. And then if I could follow up with another sort of separate question – I was just thinking, if you look at the trends within your debit and credit card usage, the penetration keeps going up, which makes sense. I mean, that’s obviously how people tend to shop these days, or increasingly so. Curious if you’re seeing any difference in the mix of what you’re selling as a result of that, or if it’s actually helping to drive the average ticket because people feel like, well, I’m just swiping a card instead of handing over $7 or something.

Kevin Wampler

Yeah. Well you know, we’ve had debit and credit in almost three years now, I think, completely, and it continues to grow. And I think you’re right – it is just the way people shop today. I mean, even younger people that would have been a cash consumer now carry debit and credit cards pretty regularly. As we look at it, it is obviously a higher ticket item for us at the end of the day, so our average ticket run $7.80, but if you basically take a credit or debit transaction, it’s almost double that. So people buy a larger basket when they use that method of payment, and that’s why it was an important part of our business when were able to roll that out across the chain. So I think it’s something that we’ll continue to operate in that manner that we’ll continue to see it grow as an overall part of our business.

Operator

And we have time for one last question that will come from Mike Exstein with Credit Suisse.

Michael Exstein – Credit Suisse

Thanks very much. Following up on the real estate issue and California, the only group in retail that looks like it’s really accelerating its square footage right now are the value chains, as you call them. Is there any concern that you all collectively will over-build the segment in the short term?

Bob Sasser

Well, I guess you could do that. We feel that we’re different than the other guys. You know, we sell everything for a dollar. We’re extreme value. Our customers like to shop with us because they can find the things they need, the things they want, and a little bit of a shopping experience so that’s really how we’re focused. We look at where our opportunity is to grow our stores, which corners and which markets, and we’re trying to maximize our real estate in that way.

As far as over-building, we’ve got a long way to go. We think we can operate up to 7,000 stores in the U.S. and then the DEAL$ model adds to that, so we’re excited about continuing our growth. I don’t see any over-building from us in the near future.

Michael Exstein – Credit Suisse

Okay, that’s great. And one more question – in terms of Canada profitability going forward, does it have the same sort of seasonal characteristics as the U.S.?

Bob Sasser

Yeah, pretty much. They have pretty much the same seasons and the same type of seasonal characteristics, and profitability going forward, there’s huge opportunity from where they were when we bought them to what we can bring with the power of our buying and with the infrastructure that we know how to do that we’re currently installing. We’re going through a period of investment in Canada, and I’ll say again – if you look at third quarter, we have the Canadian numbers in our third quarters numbers this year. They weren’t in there last year. We didn’t buy them until fourth quarter of last year, so you’re looking at sort of a comparison that is not apples-to-apples. But the opportunity is high there. We think the customers will respond positively to all the great things that we sell at Dollar Tree – our imports, our seasonal imports are very desirable for the Canadian customers, and we’re beginning to see some of the new product showing up in those Canadian stores now.

Operator

And that’s all the time we have today for questions. I’ll turn the call back over to Tim Reid for any closing comments.

Tim Reid

Just want to thank you all for participating it the call, for your interest in Dollar Tree, and particularly for your investment in our Company. Our next sales and earnings release and conference call are scheduled for Wednesday, February 22, 2012. That’s when we’ll release results for the fourth quarter and full-year 2011. In the meantime, have a great Thanksgiving and a great holiday season. Thank you.

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