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Family Dollar Stores, Inc (FDO)

F2Q07 Earnings Call

March 29, 2007 10:00 am ET

Executives

Kiley F. Rawlins - Divisional Vice President, Investor Relations

James Kelly - President, Interim Chief Financial Officer, Chief Operating Officer

Howard R. Levine - Chairman of the Board, Chief Executive Officer

Analysts

Stacy Turnof - Merrill Lynch

Meredith Adler - Lehman Brothers

Scott Malat - Goldman Sachs

Matt Boss - J.P. Morgan

Patrick McKeever - Avondale Partners

Dan Wewer - Raymond James & Associates

David Cumberland - Robert W. Baird

David Mann - Johnson Rice & Company

Scott Mushkin - Banc of America Securities

Bernie Sosnick - Oppenheimer & Co.

Presentation

Operator

Good morning. My name is Thea and I will be the conference operator today. At this time, I would like to welcome everyone to the Family Dollar second quarter earnings conference call. (Operator Instructions)

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

Kiley F. Rawlins

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

Before we begin, you should know that our comments today will include forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act. These statements address company plans and activities or events which we expect will or may occur in the future. However, a number of factors, as set forth in our SEC filings and press releases, could cause actual results to differ from our plans. We refer you to and specifically incorporate the cautionary statements contained in today’s press release and in our other SEC filings. You are cautioned not to place undue reliance on these forward-looking statements which speak only as of the date of this call. The company does not undertake to publicly update or revise its forward-looking statements except as required by law.

In addition, this morning we will discuss non-GAAP financial measures which are intended to help investors understand Family Dollar's ongoing business performance. A reconciliation of these non-GAAP financial measures to the comparable GAAP financial measures is included in our earnings release issued this morning and available on our website in the news releases section of our investor page.

This morning, we will begin our discussion with some comments on our second quarter results from Jim, and then Howard will share some of his thoughts with you. Jim.

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James Kelly

Thank you, Kiley. Good morning. This morning, we reported results for the second quarter of $0.60 per share, an increase of about 71%. But as you know, this quarter had some elements that makes an apples-to-apples comparison with last year difficult. Let’s take a moment and walk through them.

First, last year’s second quarter results included a charge of $45 million, or about $0.18 a share, related to an adverse jury verdict. Excluding this charge, earnings were $0.53 per share.

Second, this year in the second quarter, we had the benefit of an extra week. We estimate that the earnings per share benefit was approximately $0.05, which was offset by about $12 million, or $0.05 a share, in unplanned expenses relating to our stock option review.

Adjusting for these items, that is the $0.18 a share litigation charge last year and both the impact of the option investigation and the extra week this year, earnings per share for the second quarter this year increased about 13% to $0.60 per share from $0.53 a year ago.

Overall, I would characterize performance as being solid. Despite lower-than-expected sales in the quarter, we maintained good cost control, and if not for the unplanned expenses associated with the stock option review, would have achieved operating margin expansion in the quarter. We are especially pleased with our continued improvement in inventory productivity, which we believe is positively impacting our shrink and manager retention trims.

Net sales in the quarter increased 12.2% and comp store sales increased 0.4%. During the quarter, we opened 83 stores and closed 16.

Despite a difficult holiday season, sales results in December were in line with our expectations, with results in many key seasonal categories performing better than expected.

Our merchandise presentations of holiday product, including toys, trim-a-tree, and gifts, all benefited from lower inventory levels and higher store manager retention. We had a better assortment and better store level execution this year and our customers responded favorably.

Apparel sales were disappointing and may have been negatively impacted by unusually warm weather leading up to the holiday.

January and February results were a bit softer than we had expected, largely due to our decision to accelerate the timing of schematic changes in a few of our key consumable categories.

Each year, we refresh our basic assortment, allowing our merchants to drop underperforming items and add new items. The transition to the new schematic can be disruptive as we make these changes. Our in-stock levels are affected as we sell through discontinued items prior to the reset and again after the reset as we learn more about the rate of sale of new product and as our customers become acclimated to the new positioning. The physical changes often create temporary disruption in our store as we remove product from the shelves, reset labels, and restock merchandise.

Three of our largest consumable categories -- household chemicals, paper and food -- were all reset during the second quarter, whereas last year much of the schematic work in these categories occurred in the third quarter. We accelerated the changes this year into months that generally have lower traffic patterns to minimize the impact of the transition and to better position our stores to focus on Easter and spring treasure hunt events.

Gross margin as a percent of sales increased approximately 60 basis points and was better than expected. Stronger sales of prepaid services, better purchase mark-ups, and lower inventory shrinkage offset approximately 50 basis points in negative leverage from increased mark-downs. Freight was relatively neutral in the quarter.

As we seek to drive better inventory productivity, we are using mark-downs more aggressively to position fresh merchandise better. This year, we initiated our end-of-season mark-downs a few weeks earlier than last year, even though our year-over-year fashion inventory levels were lower. This more aggressive approach to mark-downs has resulted in better gross margin return on investment, better inventory turns and a better customer-facing presentation.

SG&A expenses as a percent of sales increased approximately 90 basis points. The previously mentioned option review expenses drove most of this de-leverage, with flattish comp also a contributing factor.

Our income tax rate for the second quarter this year was 36.3% versus 37% for the second quarter last year. The decrease in the effective tax rate was primarily the result of the effect of changes in state income taxes and the retroactive reinstatement of certain federal jobs tax credits.

Cash and short-term investments aggregate approximately $416 million at quarter end, an increase of approximately $85 million or 26% over the end of the second quarter last year.

Asset management efforts continued to drive improvements. Inventories at quarter end were approximately 7% lower on a per-store basis than at the end of the second quarter last year. As previously mentioned, better inventory management has a direct favorable impact on both our customers and associates. As you know, inventory productivity is also a key to financial returns.

We have also raised the bar for targeted returns on capital expenditures but continue to invest aggressively to fund new store growth, improve store performance through initiatives such as the food strategy, and more effectively leverage technology.

Through the second quarter, capital expenditures were approximately $51 million versus $98 million for the first-half last year. As a reminder, CapEx last year included investments to support the opening of our ninth distribution center in Rome, New York. We now expect current year capital expenditures to be approximately $155 million to $165 million. This represents a reduction of approximately $35 million from our initial estimate and resulted from fewer new store openings and the deferral of a planned new distribution center.

Several years ago, we made a strategic course correction that shifted greater emphasis on driving financial returns. As a part of this shift, we slowed new store growth and last year opened 350 stores. Initially, we planned to gradually ramp up new store openings this year but now believe that we will open around 300 stores. This reduction in new store openings followed hundreds of decisions supporting our top priority -- improving financial performance.

On a positive note, the financial performance of new stores this year has improved. We continue to believe that Family Dollar has compelling growth opportunities and would expect our new store growth will accelerate as financial performance returns to historical levels.

Now let’s talk about the outlook for the rest of the year. With half of the year behind us, we are narrowing our full-year earnings guidance to a range of $1.63 to $1.69. This range includes the stock option review expenses incurred year-to-date -- that is approximately $0.02 per share in the first quarter and $0.05 per share in the second quarter -- but does not include an assumption for stock option review expenses in the second-half.

As we have discussed, we have made changes in our assortment to position our gradual acceleration of comp store performance in the second-half. Operating margin pressure is expected to continue as we expand our food strategy and in particular comp store sales remain in the low single digits.

On the other hand, we believe that better purchase mark-ups, including the impact of higher sales of prepaid services, lower inventory shrinkage, lower freight expense, and the benefits of a continued refinement of our operating and administrative processes can largely offset these pressures.

We now expect March comps to be in the 3% to 5% range. Remember, the benefit of Easter will move into March this year from April last year. For the full quarter, we expect comparable store sales to increase 1% to 3% and expect earnings per share to be between $0.39 and $0.43.

Before I turn over the call to Howard, I would like to mention that we filed our fiscal 2006 10-K and first quarter 10-Q yesterday afternoon. As such, we will be resuming our stock buy-back program. As a reminder, we currently have 6.1 million shares available under current authorizations. Howard.

Howard R. Levine

Thank you, Jim. Good morning, everyone. Throughout our nearly 50 year history, the competitive environment has continuously changed. We have seen competitors come and go. We have seen channel blurring, particularly in the food channel, as retailers have looked to meet more customer needs. We have seen consolidation and the demise of less efficient retailers.

Throughout all this change, Family Dollar has successfully adapted. When we stay focused on our customers and provide them with compelling values, our business has prospered.

Recently, one of our competitors announced some interesting news and there has been much speculation in the market about what the announcement could mean for other players in the channel. While it is unclear what the impact will be in the short-term, I am confident that the competitive landscape will continue to change. So rather than speculate about the short-term, we remain focused on the long-term opportunity and on improving our business and providing our customers with great values.

Our concept today is very different than it was when we opened our first store in Charlotte in 1959. As the retail environment has changed, we have evolved to serve our customers better. These changes have not occurred overnight but have been the result of methodical investment and paced change management. Over time, we have balanced short-term investments needed to drive sales growth with longer term investments required to improve our productivity and efficiency, but our strategic agenda has been consistent -- to make Family Dollar a more compelling place to shop, work and invest.

In 2005, we introduced four key initiatives to drive sales and laid the foundation for better execution and higher financial returns. These initiatives were a new food strategy, the urban initiative, an enhanced treasure hunt strategy, and new stores. We have made significant improvements in each of these areas and this year we expanded our focus to include concept renewal and project accelerate. Let me give you an update on our progress.

First, our food strategy; our research indicates that our customers spend a significant percentage of their discretionary income on food purchases. Because of cash flow and home storage capacity constraints, lower income consumers are more likely to make more fill-in trips than higher income consumers.

In 2005, we launched our food strategy to better meet the frequent fill-in food needs of our customers. The first phase of this initiative was the rollout of our refrigerated coolers. Today, approximately 4,400 stores have coolers and we are on track to have coolers in about 5,000 stores by the end of this fiscal year.

This year, we have launched the second phase of our food strategy. Linking with the cooler assortment, we have created an expanded food assortment that includes more quick prep and ready-to-eat products. In February, we began the rollout of this expanded food assortment. Our goal was to complete the expansion in 2,000 stores within six weeks. I am pleased to share with you that we have achieved our objective. While this new food assortment has been in stores only a short time, we are encouraged by the early results.

While food drives increase customer traffic, generally food has lower mark-ups. That is why we continue to develop and enhance our treasure hunt strategy. Treasure hunt merchandise is merchandise that generally has higher mark-ups, creates customer excitement and differentiates us from our competition. Frequently, these items require better merchandising, marketing, and mark-down management. Most often, treasure hunt items fall into categories like apparel, home and seasonal.

This year, we experienced a challenging holiday season. However, lower inventory levels and better store management retention heading into the season contributed to better seasonal presentations. I was particularly pleased with our performance in key categories like toys and trim-a-tree.

Typically, January and February are transitional periods for us as we exit the holiday season and prepare for spring. As part of our focus to drive inventory returns, we began a more aggressive fall and winter clearance event after Christmas. This contributed to strong apparel comps in January and lower inventory levels in the stores, which has helped our store managers transition more easily to our spring assortment.

As many of you know, Easter is a week earlier this year and spring has already come to many of our markets. In anticipation of the increased traffic around the holiday, we wanted to position our stores with a compelling seasonal presentation and an improved assortment of basic consumables. This is one of the reasons why we accelerated the timing of some of our annual schematic changes in key consumable departments. While this transition has created some disruption in our stores, we believe that these changes will position us for better sales in the second-half.

I believe that our customers will particularly appreciate some of the exciting changes we have made in our apparel area. As we announced last week, this spring we have introduced Hanes in all of our stores. The introduction of this nationally recognized brand, combined with the work we have done in our apparel program to reduce inventory, narrow our assortment and improve our quality, should deliver improved sales and profitability.

While our merchandising team continuously evaluates and adjusts our assortments to serve customers better, our concept renewal team is focused on improving the shopping environment and driving more fundamental change. We are taking a broader view to include store layouts, in-store communication and merchandise adjacencies. Our goal is to create a store that provides customers with a more appealing shopping experience that is competitive with other small store formats.

Today, we have five concept renewal lab stores and we continue to learn and enhance our presentation to the customer and to make the stores easier to operate. We continue to test different fixtures, signage and other updates, both inside our store and outside our store. We have developed versions of the store to accommodate various footprints and we continue to work to reduce the development cost.

We have begun to incorporate many of our learnings from our concept renewal efforts into our new stores and our customer and associate reactions have been positive.

Our urban markets continue to represent key strategic opportunities for us to build competitive advantage and drive higher financial returns. To address the operational challenges in urban markets resulting from significantly higher sales, we have created an organizational model which relies on a more fluid and flexible workforce. In addition, in these markets we have provided additional HR and loss prevention support. We have increased our focus on associate selection, training and retention, and we have implemented an Internet-based sourcing tool to pool applicants in a given market. The results have been higher store manager retention, lower inventory shrinkage, and better returns.

This year, we are making investments in new POS technology through our Store of the Future project. This new technology will facilitate faster customer throughput, support the acceptance of additional tender types, including food stamps, and provide managers with better workflow management tools. By the end of the fiscal year, we expect to have Store of the Future technology in approximately 1,000 stores.

Through our project accelerate efforts, we are working on further supply chain improvements for urban markets to include the adoption of a more flexible pricing policy that reflects relative market conditions, the development of more tailored assortment, and better management of space within these stores.

However, project accelerate will not drive improvements only in urban markets. Rather, project accelerate is a multi-year effort designed to optimize all of our merchandising and supply chain operations through a review of processes, personnel needs, and technology tools. Our focus includes merchandise and financial planning, category management, price optimization, space management and assortment planning.

Our objectives are to offer better merchandise assortments that address meaningful local market differences, improve fact-based planning and analytics, better aligned space requirements with merchandising programs, execute optimized pricing that enhances our price image, and establish stronger career paths that develop, measure, and value expertise.

We have launched the project last fall and while much of the work will not impact our stores for several quarters, I am pleased with the progress we have made. We have developed new price zones based on the analysis of relative market prices, operating costs, customer density, and other factors. To better understand sales and profitability impact, we have begun a test of price optimization in a few markets.

Utilizing customer research, we have developed a category management strategy that reflects the way our customers shop our stores, and we are realigning our merchandising and supply chain organization and processes to reflect this customer-centric approach.

We have selected a merchandise financial planning tool that will help us better link financial planning and merchandising decisions and help us more efficiently and effectively manage space in our stores. We expect to have this system in place by the end of this fiscal year so that we can utilize the tool in fiscal 2008.

Even as we are investing to increase the relative profitability of our existing stores, we are also investing in new stores. As we have slowed our new store growth, we have strengthened our processes and capabilities. We have created market development strategies to guide our site selection focus and we have enhanced our selection review and approval processes. We are also strengthening our cross functional support of store opening processes to ensure that our customers’ first impression is positive. As a result, our new stores are performing better.

New stores are important to our future but we are determined to improve our total company returns and to grow in a profitable return-sensitive way. While we will open a significant number of stores this year, we will continue to constrain this growth in favor of focusing on a broader based improvement that will drive better performance in our 6,000-plus store franchise.

To that end, this year we are investing in several initiatives designed to improve the efficiency and productivity of our stores. We are implementing an e-procurement tool and have already realized some success in a number of online auctions for key supplies. We are developing a more proactive, centrally controlled maintenance program and we are testing new energy conservation technology that has potential to lower our utility costs.

In summary, I am very excited about the opportunity that exists for Family Dollar. Our cohesive management team is focused on improving our financial returns and on building shareholder value. While the competitive environment will continue to change, we remain committed to improving the shop-ability of our stores and increasing our relevance to the customer. Staying focused on these key things will make Family Dollar a more compelling place to shop, work and invest.

Now, Operator, we will be pleased to take some questions.

Question-and-Answer Session

Operator

(Operator Instructions)

The first question is from Stacy Turnof with Merrill Lynch.

Stacy Turnof - Merrill Lynch

Good morning, everyone. I have a couple of questions about your expanded food assortment. Would you be able to put some numbers around how comps are being impacted by that? Number two, how much you have actually expanded in terms of percentage points, as a percentage of total sales?

Howard R. Levine

Good morning, Stacy. Just as a reminder, the growth in our food strategy is primarily premised on taking advantage of the frequent customer visits that our customers make. We tested last year the expanded food assortment and we are very pleased with those results and what we were able to accomplish. The linkage between what we are doing in the coolers and our in-line assortment is working and we are accomplishing our objective there.

Stacy Turnof - Merrill Lynch

My second question related to the store expansion strategy is; I understand that you are taking it down, but do you expect it to get back up again to that 5% or 6% range in the following year?

James Kelly

I think the issue is one of relative priorities. Our focus first and foremost is driving our financial performance back to historical levels. As we achieve that objective, I think you will see a gradual acceleration of new store growth.

Operator

Your next question is from Meredith Adler with Lehman Brothers.

Meredith Adler - Lehman Brothers

You talked about the efforts you made to change, to re-planogram in key categories in the second quarter. When you look at sales across the entire store, did you see stronger results in the categories that were not being re-planogrammed?

Howard R. Levine

When we were transitioning through the schematic changes, we believe that we had some disruption in our sales and have not really seen deterioration in other categories during that process. We are through with the major transition in the consumable area to include the food at this point and are very pleased with where we are today.

James Kelly

Meredith, one indicator of that might be the expansion of our gross margin. As we indicated improvement in initial mark-up, for example, our initial guidance had indicated pressure on the margin to be a result of the sales of lower margin consumables. So the disruption was primarily in those departments that we were having transitions.

Having said that, when your major traffic-driving departments are disrupted, it does have some impact on other categories.

Meredith Adler - Lehman Brothers

Great, and then, could you just maybe talk to us a little bit about how you managed to achieve the better purchase mark-ups? Does this have to do with negotiating with vendors or just generally better procurement?

Howard R. Levine

The answer to both of those questions is yes. Our merchandising team has been enhanced over the last year with the addition of Robert George, Mike [Kovitko], along with Mr. [Scanlan], I think the team is working very hard to drive improvements in purchase mark-up and continuing to maintain our strong pricing image.

We have been very pleased with the progress we have made in improving the mark-up and hope to see that we continue to drive margin expansion.

Meredith Adler - Lehman Brothers

My final question is as you expand the food assortment to more stores and then, certainly in the urban areas as you start to take more tender types, do you need to do something to communicate to your customers that you have new and different things in the store, and how do you plan to do that?

Howard R. Levine

I think the marketing of some of these changes is extremely important. We are going to address that so as we can continue to communicate not only inside the store but also some additional marketing outside of our store.

Meredith Adler - Lehman Brothers

So that would mean more advertising?

Howard R. Levine

Not necessarily. More focus on in-store marketing. There could be some additional resources put to inform our customers what is happening with some additional advertising -- not additional advertising, advertising that is already planned to incorporate some of the announcements within some of the existing plans that we have already.

Meredith Adler - Lehman Brothers

That’s part of your guidance?

James Kelly

Meredith, in terms of the overall enhanced food strategy, we have talked about the enhanced assortment but we also changed the assortment in 6,000 stores as a part of our schematic change to place a greater emphasis on some of the customer trips that we are now targeting. As a result of that, we have an ability through our normal circulars, planned circulars, to highlight a lot of the more significant changes to our food strategy throughout the chain, to further enhance the broadening of the assortment through more in-store and strategically placed advertising support in limited markets.

Meredith Adler - Lehman Brothers

I just have one final question; you may have talked about this at your analyst meeting, but do you have any special new technology that is helping you take your mark-downs on apparel or other seasonal merchandise more effectively? Or is it just about the focus of everybody within the organization?

James Kelly

I think it is about a change of direction relative to how we want to manage our fashion business, so that sets the stage from a policy and practice perspective. In addition to that, we have augmented our support groups for the buyers to provide more data through a data warehouse that enables them to have a greater appreciation of the status of our inventories as well as the potential for mark-downs.

As a part of project accelerate, there is an element in there focused on promotional activities and promotional price optimization, which will simply be a further enhancement to our current practices.

Howard R. Levine

Meredith, if I could add, we really have a renewed focus on inventory productivity and I think there is sometimes some confusion that additional mark-downs means less profits. We are not taking that approach. The question you asked me earlier about better mark-ups, better mark-ups allow us to be more aggressive in mark-downs. Being more aggressive in mark-downs and clearing out older goods allows us to present newer goods more timely, so the whole effort of refreshing our store and keeping inventory fresher is a key objective.

As we have also talked about, we think having less inventory and turning more frequently makes our stores easier to manage, easier for our stores to navigate, and has been crucial in driving and improving manager retention and shrink improvement. So there is a nice linkage between all of the efforts that we are making through the company and we are very pleased with the efforts that we have made but still have a lot of opportunity to continue to improve results.

Operator

Your next question is from Scott Malat with Goldman Sachs.

Scott Malat - Goldman Sachs

Good morning. Could you give us an update on the store manager turnover? I know you had said in the first quarter it was down 20% year over year. Do we have an update on that?

James Kelly

I think the trend continues to improve at a rate not dissimilar from one that we had seen over the last three or four quarters. This is an area that we basically are focusing an awful lot of resources and that it has proven to be absolutely critical to the creation of a compelling place to shop. I am not going to provide the specifics of the trendline, but directionally the rate of improvement continues to be fairly consistent.

Scott Malat - Goldman Sachs

Where are you versus historical levels? Is this at lower levels versus historical?

James Kelly

Yes, significantly lower than historical and substantially lower than several years ago. I would add that it is lower levels even with a greater proportion of our stores in the urban markets where the challenge is greatest. So we are making improvement in the face of today’s mix and are at historically low levels.

Scott Malat - Goldman Sachs

Following up on the quick prep and ready-to-eat, the expanded food selection, is it safe to say that the margins on those goods are at a higher average than the rest of your consumables?

Howard R. Levine

No. Generally, food and consumables are lower mark-up items -- higher turn, higher velocity through our stores, so from a gross margin dollar expectation, we expect them to generate significant gross margin dollars, but there is margin pressure as a result of that. That is really why we focus so hard on the treasure hunt strategy, to drive the higher margin categories so that we stay in balance.

James Kelly

That is very true in the context of our overall merchandise assortment. If the question was in the context of other consumable products, I think single serve, ready-to-serve can be slightly better than the core of that mix.

Scott Malat - Goldman Sachs

Thank you.

Operator

Your next question is from Charles Grom with J.P. Morgan.

Matt Boss - J.P. Morgan

Thank you. It is actually Matt Boss filling in for Chuck this morning. My first question is; what factors were behind the higher March outlook of 3% to 5% versus 2% to 4% previously? Specifically, what areas of the store are doing better than planned? Also, what types of trends are you currently seeing at the low-end, given the choppy macro environment that we are seeing?

Howard R. Levine

Matt, as we have talked about earlier in the calendar year, we were very focused on getting our consumable department set. We had seen good trends there. The warm weather has certainly helped and we are very pleased with the direction that we are going.

In terms of the state of the low-income consumer, I probably sound like a broken record on this one but the low-income consumer is always stressed and always strained. We have understood that for years. When things like minimum wage increase happen, that is a great benefit to them. When gas prices come down, that is a great benefit to them. Conversely, when they go the other way, that has a negative impact. When you are living paycheck to paycheck, we have a consumer that is strained.

That is the void and the niche that we are really filling today, is providing great value and great pricing to those consumers and working very hard in driving traffic and being more relevant to more customers.

Matt Boss - J.P. Morgan

Okay, that’s helpful. Another question that I had is could you walk us through the factors that impacted gross profit margin in the quarter in a little greater detail? Specifically, the impact of prepaid services, as well as which categories saw higher mark-downs? Finally, can you quantify where you are at today regarding shrink and the opportunity that lies ahead?

James Kelly

I think that we have hit the major areas that are impacting our gross margin and we are really not prepared to provide more granularity to that.

Within the shrink area, we have talked about it now for some time. We were in the mid-three range, 3.6 or so, and over the last four or five quarters we have seen that moderately but consistently go closer to our intermediate goal of 3%. We still have a way to go with shrink but we are very pleased directionally with where we are going and pleased to report another quarter in which shrink savings enhance our operating margin.

Matt Boss - J.P. Morgan

Perfect. Thanks and good luck.

Operator

Your next question is from Patrick McKeever with Avondale Partners.

Patrick McKeever - Avondale Partners

Good morning, everyone. My question is on your urban market stores and the kinds of sales volumes you are seeing in those stores. You have talked about it in the past but I do not know that you have given us an update too recently; how did the volumes in your urban market stores compare to the volumes in your non-urban stores? Sales volumes.

Howard R. Levine

Just as a way of updating everybody, why did we choose to go into urban markets and why did we decide to approach with an improved operating model in most stores is premised primarily on the higher volumes. In some cases, it could be two times or more than an average store in a more rural market. We never really had the problem of generating the sales there. The problem was improving the profitability, and with our urban initiative, we had begun to see some very nice improvements in our returns there.

As we have talked about, managed retention is improving. Store shrinkage is improving. The shop-ability of these stores is improving and we continue to invest into these stores. A lot of the Store of the Future, the new POS technology, will be rolled out to these stores this year, so we continue to make investments and continue to expect our returns to improve.

Patrick McKeever - Avondale Partners

Howard, are the urban market stores generating stronger returns than your non-urban market stores then? Has that happened yet?

James Kelly

Patrick, I think for the most part the answer is yes. There are some urban markets where that is not true, particularly the highest cost, most intense markets. For example, New York.

On the other hand, some of the improvements that we are making to include the price optimization work and to include some of our logistical efforts that flow goods more effectively to the stores, are having a very positive impact on those stores. If one excludes a couple of pockets, then I think it is fair to say that the urban markets are performing very, very well.

Patrick McKeever - Avondale Partners

That’s good to hear. Thank you very much, Jim. Thank you, Howard.

Operator

Your next question is from Dan Wewer with Raymond James.

Dan Wewer - Raymond James & Associates

Jim, I wanted to follow-up on the store expansion plan. Earlier in the year, the thought was that we needed to see an improvement in returns in these doors before accelerating expansion back to a 6% or 7% rate, and it sounds like you are already seeing that. Has there been a shift in the requirement that now you are requiring the total company returns also to return to close to historic levels before accelerating new store unit growth?

James Kelly

I think there is an integration of those two issues. Certainly the performance of a new store in isolation is dependent on a lot of factors around that new store. But it is the old rising tide lifts all ships and a lowering tide lowers all ships, so when we move from an 8% operating margin range closer to a 6%, it lowered the tide that also had an impact on new stores. So we are trying to raise the tide for all boats and that will have a significant impact on new stores, which then will support more aggressive investments in that area.

Dan Wewer - Raymond James & Associates

Is there a benchmark perhaps of a 7% operating margin that you want to see before taking the unit growth back up?

James Kelly

We really have not locked in on a specific benchmark but certainly as we move up the assessment leads a little bit more towards the new stores. But it is really one of the decisions that we are trying to make in the context of how do we deploy our human capital as well as our financial capital in a way that is most effective for the overall company’s results and our shareholders. So it is a balancing act and it will to some extent depend on where we are with our major other investments to include project accelerate, Store of the Future, and concept renewal.

Dan Wewer - Raymond James & Associates

Jim, a different question; at the beginning of the second quarter, I believe the guidance for the year was $1.57 to $1.69. Do you recall how much legal expense was included in that forecast?

James Kelly

I do, but we do not provide that granularity. I will say that the legal expenses that we have incurred this year to date exceed the initial plan, notwithstanding the option investigation, but the amounts are reasonably consistent with the original base.

Dan Wewer - Raymond James & Associates

I guess it’s the fact that you are still embracing the high-end of that range, $1.69, despite those legal costs, suggests that you are more bullish on the second-half of the year than you were say three months ago. What has changed on that? Do you see this drop in the tax rate continuing, or are there some other factors that make you more confident?

James Kelly

I think the tax rate will remain volatile and model out somewhere around 37%. There was some catch-up with federal credits this quarter.

I think the reason for my optimism is premised on first-half performance. We have absorbed a $0.07 a share hit, $0.02 in the first quarter, $0.05 in the second quarter, as relates to an unbudgeted expense area, the option review, and we were able to as a team tweak other elements of our plan and exceed in some areas, such as the gross margin area, and basically achieve close to our initial results for the first-half. So it is more of a reflection of the accomplishments to date than necessarily a tweaking of what our original forecast was for the back-half.

Operator

Your next question is from David Cumberland with Robert W. Baird.

David Cumberland - Robert W. Baird

Thanks. You talked about some seasonal categories performing better than expected in Q2. The press release shows seasonal and electronics as the division with the lowest sales growth by far, so I am wondering what caused the overall slowness in this area.

Howard R. Levine

I think a lot of the prepaid change had an impact on that, David, but the way we have approached this past holiday season was we look at both sales and profitability and have tried to improve the quality of the sales within those categories, so when I say I am pleased, in some categories the comp store increase may not have been as high as in years past but the sell-throughs and the gross margin improvements were. In some categories, we were able to accomplish both. We were able to drive comps and improve gross margin, so sales is certainly one component and an important component. However, we are focused on both sides of the equation, sales and gross margin.

David Cumberland - Robert W. Baird

That helps. My other question, you are now planning the Store of the Future program in 1,000 stores by fiscal year end. Did you increase that number from the prior indication, and will all 1,000 be urban stores?

James Kelly

We did slightly increase that number. I think initially we were more in the 750 range, but that project is moving very, very well and we are very comfortable with the returns that it is capable of generating. So yes, there is an enhancement. Many of the 1,000 stores will be in the urban markets. Perhaps most will be, but there will be some other markets in which we will be rolling out Store of the Future.

Operator

Your next question is from David Mann with Johnson Rice.

David Mann - Johnson Rice & Company

Thank you. Good morning. In terms of the fewer openings for this year, can you break that down in terms of whether they would have been urban versus other? Then, along those lines, are you seeing any lease restrictions in terms of the enhanced food strategy and the ability to find leases that will allow this?

James Kelly

Could you repeat the first part of your question please, in terms of what?

David Mann - Johnson Rice & Company

I’m sorry. The 100 fewer stores that you plan to open, is that a reduction across the board or is that more urban versus other?

James Kelly

I think it is across the board, although you will see that the mix of new openings is more consistent with the historic balance of our portfolio, which means slightly less focus in the urban areas and just a better rounded mix, or a mix more consistent with our historical portfolio mix.

David Mann - Johnson Rice & Company

The second part of the question is whether the enhanced food strategy is facing lease restrictions in terms of the ability to find sites?

Howard R. Levine

David, we have been dealing with some of those challenges for several years now. With the enhanced food, we have not seen it accelerate any further from what it was prior to that.

David Mann - Johnson Rice & Company

Another question, in terms of the freight being neutral in the quarter, can you break that down a little bit further? I would assume you are seeing some benefit with the New York DC. Then, if you could just elaborate a little more on why you think that freight will be less of an impact in the back-half.

James Kelly

I think as we move through the year, you get, on an average basis, a little bit greater benefit from the opening of the additional DC’s. Over the last two years, if you will recall, we opened one in Florida and one in New York, so that will have a somewhat gradual influence.

There are also some spikes in freight costs that is associated with the volume of shipments as the fixed cost element gets absorbed slightly different year over year. I think in the aggregate though, as one positions toward shorter stem miles, it provides a favorable downward trend, all other things being equal, and we would expect over the long run that to be helpful.

David Mann - Johnson Rice & Company

And in terms of the outlook for freight for the back-half, how are you making assumption on fuel costs?

James Kelly

I think our fuel costs assumptions are fairly consistent with the prior year. In other words, we are not expecting any significant change from today’s levels.

Operator

Your next question is from Scott Mushkin with Banc of America Securities.

Scott Mushkin - Banc of America Securities

Hi, this is actually [inaudible] stepping in for Scott here. I think I pretty much have all of my questions answered, but I wanted to ask about, you mentioned new store productivity has improved and I wanted to get at what the drivers are there.

James Kelly

There is a whole series of steps that have been taken to work on basically our market optimization down through the site selection a little more efficiently, but also in the processes that are involved in the opening of the store. We have better linkage now between our operators as they develop staffing resources for new stores, the real estate department as they plan for the openings, the merchandise department and the logistical department. As a result of that, I think our presentation to customers in the initial 30 to 60 days in which you form impressions and develop customer relationships, is much better.

What that is doing is giving us an enhanced return, which is we run return on investment models that model out the expectations for each stores and our new stores now are performing much, much better relative to those return expectations, which are basically premised on the desire to achieve targeted investment returns. That is what I meant by it.

Scott Mushkin - Banc of America Securities

Thanks. I guess I am just a little unclear on the legal expense. Have you provided guidance, or is there more to come? In 3Q and 4Q, should we model in a little more in a similar amount? What is the outlook there?

James Kelly

I think that the financial guidance that I provided excluded any guidance relative to potential legal costs associated with the option investigation. I would remind you that this investigation is being managed by an independent committee of our board and that committee is performing their task in a way that they see fit. We have not received any guidance from the committee relative to any future actions.

We do believe that their work is near completion, so we are somewhat optimistic from that perspective, and we are very, very pleased that we were able to file our 10-K and our 10-Q yesterday afternoon.

Kiley F. Rawlins

Thea, I think we have time for one more call.

Operator

Yes, Madam. Your next question is from Bernie Sosnick with Oppenheimer.

Bernie Sosnick - Oppenheimer & Co.

Thank you. Just to be clear on the sequence of things, you said that you had worked on the food, household chemicals and paper groups in resetting them. Were they completed at the beginning of March? Is that it?

Howard R. Levine

Yes. We started at the beginning of the calendar year and worked all the way up to the end of February.

Bernie Sosnick - Oppenheimer & Co.

Would it be correct to assume that those departments account for perhaps as much as 50% of your sales normally?

Howard R. Levine

It is a little less than that.

Bernie Sosnick - Oppenheimer & Co.

All right, so it is a significant disruption. The apparel department, you added Hanes. Is that completely reset by now?

Howard R. Levine

That should be complete in all stores by now, yes.

Bernie Sosnick - Oppenheimer & Co.

Okay. I missed the sales decrease, the sales per store. Could you just repeat that please?

James Kelly

The sales or comp sales per store was 0.4%. The comp inventory per store was minus 7%.

Bernie Sosnick - Oppenheimer & Co.

Thank you. And the apparel inventory?

James Kelly

The apparel inventory was slightly lower on a per-store basis than the overall inventory.

Bernie Sosnick - Oppenheimer & Co.

Could I assume that with the reset, you might have actually moderated your inventory per store?

James Kelly

Generally speaking, Bernie, the resets result in a slight addition to store inventory, all other things being the same because you have to stock up for the new items while you are liquidating the old.

Bernie Sosnick - Oppenheimer & Co.

Okay, but you are adding SKUs and you are saying there was a slight increase in inventories for those departments, which suggests a much more significant decrease elsewhere. Where would that decrease have occurred on a per store basis?

James Kelly

I think, without providing too much granularity here, it is fair to say that we have leveraged the automated replenishment of our stores to bring down basic inventory quantities almost throughout the store. In addition to that, the focus on freshness within our fashion side of our business and the flowing of our fashion business more aggressively has similarly resulted in some significant reduction virtually across the board in all fashion areas.

Bernie Sosnick - Oppenheimer & Co.

Thank you. I just want to say that you had said at the meeting for investors that you were looking for much more discipline in the stores, and seeing the resets, I compliment you on accomplishing that.

James Kelly

Thank you.

Howard R. Levine

Thank you.

Operator

Ladies and gentlemen, we have reached the end of the allotted time for questions and answers. At this time, I would like to turn the conference back over to Ms. Rawlins for any closing remarks.

Kiley F. Rawlins

Thank you, Thea. It is 11:00, and unfortunately, we did not get through all of the questions today. As always, I am available after the call for any follow-up questions you may have. Thank you.

Operator

Thank you for participating in today’s conference, ladies and gentlemen. You may now disconnect.

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