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Dollar General Corporation (NYSE:DG)

Q3 2011

December 5, 2011 10:00 am ET

Executives

Mary Winn Gordon – Vice President of Investor Relations & Public Relations

Richard W. Dreiling – Chairman of the Board & Chief Executive Officer

David M. Tehle – Chief Financial Officer & Executive Vice President

Analysts

John Heinbockel – Guggenhiem Partners

Meredith Adler – Barclays Capital

Analyst for Deborah Weinswig – Citigroup

Analyst for Aram Rubinson – Nomura Securities

Joseph Parkhill – Morgan Stanley

Analyst for Matt Nemer – Wells Fargo Securities

Anthony Chukumba – BB&T Capital Markets

Analyst for Scot Ciccarelli – RBC Capital Markets

Charles Grom – Deutsche Bank

Mark Montagna – Avondale Partners

Operator

This is the Dollar General Corporation third quarter 2011 conference call on Monday, December 5, 2011 at 9:00 am Central Time. Good morning and thank you for participating in today’s call which is being recorded by Conference America. No other recordings or rebroadcasting of this session are allowed without the company’s permission. It is now my pleasure to turn the conference over to Ms. Mary Winn Gordon, Dollar General’s Vice President of Investor Relations and Public Relations.

Mary Winn Gordon

On the call today are Rick Dreiling, our Chairman and CEO and David Tehle, our Chief Financial Officer. We will first go through our prepared remarks and then we’ll open up the call for questions. Before Rick begins, this morning we filed a preliminary prospective supplement related to a potential secondary offering by several of our existing shareholders of up to 25 million shares of our common stock plus up to an additional 3.75 million shares to cover over allotment. No shares would be sold by the company.

This offer is pending and there can be no assurances as to when it may be completed if at all. We will not comment further in our prepared remarks regarding the offer, nor will we address it in the Q&A sessions that follows, so in advance thank you for not asking about this topic.

Let me caution that today’s comments will include forward-looking statements about our expectations, plans, objectives, anticipated financial and operating results and other matters. For example, our fourth quarter and fiscal year 2011 financial and capital expenditures, forecasts, our comments regarding planned 2011 and 2012 merchandising, operations, expense control, and store growth initiatives, and comments regarding our expected consumer and economic trends are forward-looking statements.

You can identify forward-looking statements because they do not relate solely to historical matters or they contain words such as believe, anticipate, project, plan, expect, forecast, guidance, intend, the likely results, or will continue and similar statements. Because they are subject to significant risks and uncertainties we cannot assure you that forward-looking statements will prove to be correct or that any trends will continue.

Important factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our third quarter earnings release issued this morning, in our 2010 10K filed on March 22, 2011 and in the comments that will be made on this call. You should not unduly rely on these statements which speak only as of today’s date. Dollar General disclaims any obligation to update or revise any information discussed in this call.

We will also reference certain financial measures not derived in accordance with GAAP. Reconciliations to the most comparable GAAP measures are included in this morning’s earnings press release which can be found on our website www.DollarGeneral.com under investor information press releases. This information is not a substitute for the GAAP measures and may not be comparable to similarly titled measures of other companies.

It is now my pleasure to turn the call over to Rick.

Richard W. Dreiling

We are very pleased with our sales and earnings results in the third quarter. We’ve got a strong first three quarters with the third quarter building sequentially on our momentum from the first half of the year. We could not have achieved this level of success without the hard work of over 91,000 dedicated employees throughout our stores, distribution centers and store support center. We are in the midst of the busiest retail season of the year and I’d like to thank each and every one of our employees for their commitment to Dollar General’s mission of serving others every day.

Now, to recap the quarter, comparable store sales increased 6.3% driven by strong increases in both traffic and average ticket. Our total sales increased 11.5% to $3.6 billion. On an annual basis, sales reached $207 per square foot up from $200 a year ago. Operating profit was $311 million, an increase of $37 million or 13% over last year. Our operating margin rate was 8.6% an increase of 14 basis points over the 2010 third quarter.

Once again we had a very balanced approach to managing our financial performance. Gross margin decreased by 31 basis points but was offset by 45 basis points of SG&A leverage. Interest expense decreased from the prior year by $29 million. Adjusted net income from the third quarter increased 29% to $172 million or $0.50 per diluted share compared to last year’s adjusted EPS of $0.39.

Consumable sales continued to increase at a faster pace than the non-consumables with the strongest growth across our food and snack categories. Salty snacks, carbonated beverages, coffee and milk were the largest contributors. Pet supplies and healthcare also performed very well as we further increased our share of the consumables market. Our most recent Nielsen data showed that we have continued to increase our market share in units and dollars on a four week, 12 week, 24 week and 52 week basis.

Several areas within our non-consumable categories showed good success in the quarter as well. For example, automotive, hardware, stationary, sundries and domestics. We were pleased with our Halloween sales and back-to-school was strong. We are seeing signs of strength in several areas of our home category that had been weak for some time such as core bath towels, window treatments and bedding and we are optimistic that this trend will continue.

On the other hand, our apparel sales have been disappointing. During the second quarter conference call we shared with you that we had started to gain traction in select apparel categories. In the third quarter, sales of core mens and boys, infants and toddlers, accessories and shoes were encouraging. We believe that repositioning of our merchandise with greater space allocation to infants and toddlers and mens and boys is the right move for the longer term. Where we have seen more pronounced softness is in our non-core and hanging apparel, especially in ladies. And while we believe we can improve our execution in this area, the economy has also been a factor.

High unemployment and underemployment, higher year-over-year gasoline prices, tightened credit requirements, continued weakness in the housing markets and uncertainty in the financial and political arenas continued to impact the consumer’s discretionary spending. We at Dollar General have been and will continue to respond to our customer’s needs by providing the right mix of items along with our unique combination of value and convenience they depend on us.

We continue to strengthen our merchandise offerings with great national brands and the continually growing selection of high quality national brand equivalent private brand products. We have added more than 175 SKUs this year bringing our total private brand consumable SKUs to almost 1,900. Sales of our private brands in the quarter were up 14% compared to an increase of 13% for national and other brands in the same category. In the third quarter, our private brands represented 23.9% of sales in their respective categories compared to 23.6% in the 2010 period.

We’re also making progress on improving our store in stock levels. In October our average out-of-stocks were 17% better than last year. In support of this initiative we’re investing in training and technology and we made important changes in our store recovery processes. This is an ongoing effort and we have a long way to go but importantly, our customers have taken note of our progress recently rewarding us with our highest customer satisfaction scores to date specifically noting our improved in stock.

We’re making significant improvements in technology to support our store teams and driving store performance. For example, over the last two years we’ve been upgrading our POS registers. We’ll complete the final 800 stores in 2012. I’m pleased that we recently completed the implementation of our store work force management system including a task management program to help the store managers effectively plan and schedule the team’s hours to accomplish all of the necessary daily tasks as well as any special projects. This system provides electronic updates to our district managers to identify store managers in need of assistances and keeps all of the field leaders aware of store execution levels.

Also during the third quarter we finished the installation of DSL and Wi-Fi capabilities to support faster and better communications with our stores. All of these changes will support our growth and help us continue to improve our operations as we expand our footprint in both new and existing markets.

During the third quarter we opened our first stores in New Hampshire, Connecticut and Nevada. We introduced our updated general market banner in Nevada and these stores are performing well above our initial expectations. These are our first new Dollar General markets since early 2007 and we’re excited about introducing the concept into new markets.

In total, through the third quarter we have opened up 482 stores and relocated or remodeled 544. Selling square footage increased 6.7% over the same time last year and we ended the quarter with 9,813 stores including 62 Dollar General Markets. We are on track to open a total of 625 new stores for the full year and to relocate or remodel 575 stores including 25 Dollar General Markets which are already complete.

In the fourth quarter we plan to replace six traditional stores with Dollar General Markets in areas where we believe we can serve our customers even better with our fresh meat, produce and expanded cooler assortment. We believe the DG Market concept is well positioned to serve food deserts in both rural and metro areas and reinforces DG’s heritage of serving the underserved.

Our new distribution center in Bessemer, Alabama is on track for completion in the first half of 2012 and we plan to begin serving our Arizona, New Mexico, Nevada and California stores from a lease facility in California also in the first half of 2012. I’ll discuss more of our plans for next year shortly, but now I’ll turn the call over to David who will give you more detail on our financial metrics.

David M. Tehle

We’re very pleased with our third quarter results. It was another great quarter for Dollar General. We have had strong sales momentum this year. We believe that our investment in price has been the right strategy for Dollar General and has helped us strengthen our reputation with our customers. As a result and as we expected, our third quarter gross profit rate continued to run below the prior year declining by 31 basis points to 31.0% of sales. This is still a strong margin rate in the current economic environment as well as from a historical perspective for Dollar General.

As we have seen all year, our mix of sales trended towards a higher percentage of consumables which generally have lower markup than non-consumables. While some commodity costs moderated a bit in the quarter, our overall purchase costs were up year-over-year, particularly on some of our food items such as sugar, coffee, salty snacks, nuts, vegetable oil and juice. Our LIFO charge was $11 million in the quarter or about 31 basis points based on the year-to-date prorated portion of our $35 million full year estimate of LIFO which is up $5 million from our prior estimate.

We’ve been successful in selectively passing through some of the impact of this inflation, although as I mentioned, we have been committed to investing in price to support our strong EDLP strategy. Transportation costs also increased in the quarter, primarily impacted by fuel rates which were up 28% on average for the quarter year-over-year. Shrink reduction and distribution leverage helped to offset these margin pressures.

Inventory shrinkage was at the lowest rate in well over a decade. As you know, shrink reduction has been a major initiative for us for several years and while we still have opportunities to improve, it’s great to see this dramatic progress. SG&A as a percentage of sales was 22.4% in the 2011 third quarter compared 22.8% in the 2010 third quarter, a decrease of 35 basis points largely due to the impact of increased sales and improved utilization of retail store labor which has resulted primarily from our new workforce management initiative.

Lower incentive compensation expense resulting from a more aggressive bonus target as well as other cost reduction and productivity initiatives such as our energy management programs and recycling efforts favorably impacted SG&A in the quarter. Items which partially offset these reductions included higher depreciation and amortization costs related to new store fixtures, new technology, coolers and purchase stores in addition to incremental costs relating to our improved data communication capabilities for store computers and charges resulting from increased customer usage of debt cards.

Operating profit increased by 13% to $311 million or 8.6% of sales in the 2011 third quarter compared to $274 million or 8.5% of sales in the 2010 third quarter. Our $29 million decrease in interest expense for the quarter resulted primarily from lower average borrowings due to the repurchase of our senior notes and reduced amounts on our interest rate swaps. The effective income tax rate for the quarter was 37.1% compared to 35.6% for the 2010 period. If you will remember, the 2010 period included a reduction in income tax reserves resulting from the resolution of several previously uncertain tax positions.

For the 39 week year-to-date period, net sales were $10.6 billion, an increase of 11.2% over last year. Same store sales increased 5.9%. Comps improved sequentially throughout the year from 5.4% in the first quarter to 5.9% in the second quarter and 6.3% in the third quarter. Sales growth has been driven primarily by our strong consumables performance and has reflected increases in both traffic and average ticket throughout the year.

Our 2011 year-to-date gross profit rate was 31.6% compared to 31.9% in 2010, a decrease of 35 basis points. That’s attributable to the higher mix of consumables, increased product and fuel costs, and higher mark downs to sell through certain home and apparel products. We recorded and increase to the LIFO reserve of $25.4 million in the 2011 period compared to $.7 million in the 2010 period. These factors were partially offset by selective price increases, lower inventory shrinkage and leverage of our distribution center costs.

On an adjusted basis, SG&A decreased by 51 basis points to 22.2% of sales in the 2011 period compared to 22.7% of sales in the 2010 period and our operating profit increased 13% to $997 million or 9.4% of sales compared to 9.2% of sales last year. Adjustments include expenses related to the secondary offering of stock in both 2010 and 2011 and $13.1 million related to payments and accruals in the 2011 first quarter related to two legal matters. These are discussed in detail in our 10Q.

Year-to-date interest expense decreased by $44 million from last year to $165 million in the 2011 period and pre-tax loss on debt repurchases from earlier this year totaled $60 million compared to a pre-tax of $15 million in the 2010 period. The effective income tax rate was 37.4% for the 2011 period compared to 36.9% for the 2010 period. We reported 2011 year-to-date income of $474 million or $1.37 per diluted share. On an adjusted basis net income increased by 23% to $520 million or $1.50 per share compared to adjusted net income of $424 million or $1.23 per share in the 2010 39 week period.

Our strong operating performance resulted in year-to-date cash flow from operating activities of $604 million. That’s a 50% increase over last year. Year-to-date we invested $363 million in capital expenditures and reduced our long term obligations by $566 million. As of October 28th total inventories at cost were $2.09 billion, up 5% on a per store basis from the prior year. This increase resulted from increased commodity costs net of LIFO charges and the addition of new items to the company’s merchandise offerings primarily consumables.

Inventory turns based on the most recent four quarters were 5.1 times. Long term obligations at the end of the quarter were $2.7 billion. Net of cash our ratio of long term obligations to adjusted EBITDA was 1.5 times at the end of the third quarter compared to 2.1 times a year ago. We are pleased to announce that our board of directors has authorized the company to purchase up to $500 million of our common stock. Given our strong cash flow and significant deleveraging of our balance sheet, we believe a share buyback is the best way to give back to our shareholders and further strengthen our capital structure.

The timing and amount of transactions under this program will depend upon price, market conditions, regulatory and contractual requirements and other factors, but it is our intention to repurchase these shares over the next year. This morning we also filed a preliminary prospectus supplement with regard to an additional secondary offering of our stock by Buck Holdings, our controlling shareholder. In connection with this proposed offering and as part of the overall share repurchase program, we’ve entered into an agreement with Buck to repurchase approximately $185 million of our common stock concurrently with and conditional upon the completion of the secondary offering at a price per share equal to the net price Buck receives in the secondary. The amount of this repurchase is roughly equivalent of our current buy back capacity under our credit facilities.

Now for an update on our 2011 earnings guidance. Based on our year-to-date performance and our current expectations, we are raising the 2011 full year or 53 weeks earnings estimate to a range of $2.29 to $2.32. That’s based on 345 million weighted average diluted shares assuming we repurchase the shares from Buck Holdings in the quarter. We expect a full year tax rate of about 38%. Total sales for the year are expected to increase approximately 13% and keep in mind this is a 53 week year.

Same store sales are now expected to increase approximately 5.6% to 5.8% based on a comparable 52 week period. Same store sales for the fourth quarter are forecast to increase approximately 5%. Adjusted operating profit for the 53 week 2011 period is expected to increase approximately 15% over fiscal 2010 driven by increased sales and prudent expense management. Purchase cost increases, higher fuel costs and weakness in discretionary spending are expected to continue to pressure our gross profit rate in the fourth quarter in line with what we have seen year-to-date.

Guidance now includes an estimated full year LIFO charge of approximately $35 million. Full year interest expense is expected to be in the range of $205 to $210 million. Capital expenditures are expected to be in the range of $550 to $600 million. We’ll provide 2012 guidance in connection with our fourth quarter earnings, but as you build your models for 2012 please keep in mind the following investments we’ll be making for the long term growth of our business.

First, startup costs in the Alabama and California DCs will impact our SG&A expense before they open sometime in the first half of the year. Second, once operating these DCs will impact gross margin given the ramp up time to full capacity. Third, we will be making some investments in SG&A as we begin to expand into California and as we open more DG Markets in 2012. These investments will help us capture growth opportunities over time and ensure the strength of our business for the future.

With that, I’ll turn it back over to Rick and he’ll share more about things from an operational stand point.

Richard W. Dreiling

First, I’d like to update you on our Black Friday results and plans for the holidays, and then I’ll share a few of our initiatives for 2012 before opening it up for questions. We are very pleased with our sales through the month of November. Our sales are better prepared for the holidays than ever before in part due to our improved merchandise allocation processes, combined with better work flow management. We have a great mix of toys, gifts, apparel and home décor as well as gift wrap, bows, trim-a-tree, candy and holiday baking needs.

Our ads have been well timed and we’ve accelerated some of our promotional activities to add excitement and further drive traffic into the stores. As you all know, a number of the big box retailers started their Black Friday promotions early adding to an already highly competitive holiday retail environment. Like last year, our stores opened both early on Thanksgiving Day and Black Friday, and customer response to our Thanksgiving week advertising was positive.

This year we continued to offer a great assortment at enticing price points for Thanksgiving Day and Black Friday. Some of our special featured items included a seven inch e-reader for $50, a Garmin GPS priced at $65 and a 60 game Atari Flashback for just $25. We also had some great values in our store during the week leading up to Thanksgiving and many of these items were available online for the first time.

Looking forward to 2012, we’re putting plans in place that build on our commitment to our four key operating priorities which are: driving productive sales growth; increasing gross margin; leveraging process improvements and information technology to reduce costs; and strengthening and expanding Dollar General’s culture of serving others. We are still in the process of wrapping up our plans for 2012 but wanted to share a few of our more significant initiatives with you today.

Let’s start with our priority of driving productive sales growth. The returns on our new stores remains some of the best in retail thanks to the capabilities we have developed in our real estate model. In 2012 we expect to open approximately 625 new stores. We also plan to continue our remodel and relocation program with an additional 550 stores in 2012. In total, we expect square footage growth of approximately 7% yet again in 2012. I should point out that a higher percentage of our new stores next year will be in our newer states including an estimated 50 stores in California.

As I mentioned earlier, we are also testing the further roll out of the DG Market concept. We currently expect that about 40 of our new stores in 2012 will be Dollar General Markets. We’re excited about the opportunity to introduce the concept in both new and existing markets. The results of the DG Market remodels we have completed to date and the early success of our five DG Market stores in Las Vegas are very encouraging.

To support our western stores we expect to enter into a short term lease for a distribution center near Bakersfield California which we expect to open in the first half of 2012. As David mentioned, the DC will serve our new California and Nevada stores as well as our existing stores in Arizona and New Mexico. We will continue to enhance our category management efforts and we are focused on optimizing our planogram productivity.

We have embarked on region specific plans to ensure that we have the right balance of offerings based on demographics and store statistics. We expect to continue to expand our merchandise offerings at the $1 price point and plan to add more items in food and snacks as well as seasonal in 2012. Our $1 Christmas ornament program is terrific and we think there are other opportunities of that nature.

Additionally, we plan to further expand our cooler presence. Currently, our new stores are opening with 14 to 16 coolers and we are installing four additional cooler doors in approximately 1,200 existing locations to better serve our time conscious customer. We increased the number of coolers in 500 stores this year still leaving approximately two thirds of our stores today with eight cooler doors or fewer.

Fresh and refrigerated foods helped us drive customer traffic and increase basket size by serving a greater share of our customers’ needs. We will continue to take an aggressive stance towards improving our in stock position. This is a never ending effort which requires focus on store level perpetual inventory accuracy as well as improved execution across ordering, fulfillment, stocking and delivery.

With regard to expanding our gross margin, we have been limited in 2011 by the shift towards consumables which has been driven by economic pressures on the consumer. However, some areas of our non-consumables appear to be gaining traction and we plan to remain focused on growing this higher margin part of our business model. Going forward, we believe we have the ability to capture additional savings from both our sourcing program and private brand development.

It the area of sourcing, we are expanding product sourcing to new categories and importing from new countries. To further expand our private brands we’ll be adding 150 new SKUs as we move into new categories. We also intend to take additional steps in our price optimization efforts and expect to utilize multiple price zones while remaining true to our EDLP strategy in 2012. Zone pricing is as much about markdown control as it is about price.

We will share more specifics about our merchandising projects and our initiatives to leverage cost when we report yearend and give guidance for 2012. I am very excited about the many significant opportunities that remain ahead of us. We’re proud of our leadership position in the channel and we’re looking forward to continuing to be first to market with fresh new ideas as we further growth the Dollar General brand.

I’ll now open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Heinbockel – Guggenhiem Partners.

John Heinbockel – Guggenhiem Partners

A couple of things, when you look strategically here over time as you add more private label and add more cooler space and other categories, where do you think assortment comes out? Given you’re not going to enlarge the size of the store, where do you pull stuff out either by items or categories, what’s your thought on that?

Richard W. Dreiling

That’s actually a great question. We’re right around 10,000 SKUs now if you count the in and out seasonal items. We actually think that’s the right SKU count. Our category management process is very robust and when we raise the profile to 78 inches that allowed us the ability to expand and contract different categories. My team does what’s called [HEAP] mapping where we go in and not only look at how SKUs and categories perform in terms of sales but we also look at it in terms of margin. It’s very much an evolutionary process. We’ve expanded some categories on both the consumable side and the non-consumable side and we’ve contracted categories in the consumable and non-consumable side. It’s very much an evolutionary thing. But the SKU count we have right now, we think is the right amount.

John Heinbockel – Guggenhiem Partners

As sort of a follow on to that, you’ve got some non-consumable businesses that are doing a fair bit better than others. What’s the commonality between the ones that are doing well and are there learnings from those categories that you can take to the ones that are not doing well?

Richard W. Dreiling

Another good question. I think what we’re discovering in this economic time is that non-consumable items that are less discretionary that I have to have are doing much better than a purchase I can put off. I have to have socks, and I have to have underwear but I don’t have to have a brand new pair of jeans. I don’t have to have that fancy hanging item. What we’re doing here is really when I called this out it was interesting in that the core non-consumable items are starting to do pretty good again.

John Heinbockel – Guggenhiem Partners

Finally, if you think about then sort of the trade off, you obviously would like to capture a higher income customer, at least moderately higher income down the road. How do you balance kind of getting more basic or too basic in your offering which would make it less easy to attract that customer?

Richard W. Dreiling

I actually think John that staying with the basic things is going to attract every customer. Everybody has got to have socks, everybody has got to have t-shirts. By staying focused on that I actually think we might be broadening our appeal.

Operator

Your next question comes from Meredith Adler – Barclays Capital.

Meredith Adler – Barclays Capital

A couple of questions, you have accomplished a lot in terms of labor management and also energy management. I was just wondering whether you believe there is still more opportunity in both those areas? Is there more technology coming in terms of labor management or is it just using this technology more effectively?

Richard W. Dreiling

I’ll take it and David will probably piggyback with me. I think the technology being installed was of course the first piece of all of this, the most important piece. But what the labor management system is allowing us to do is step back, analyze what we are doing and believe it or not eliminate unproductive work as well as allocating the work properly through the store. So we still think we have lots of legs yet on that. The energy management system, we continue to have many stores in the chain we haven’t gotten that installed in yet so there’s still an upside there also.

David M. Tehle

The only thing I’d add to that is this task tracking and compliance, this electronic to-do list that’s available in workforce management is very impressive, it’s called the START program, store task assignment response tool and it really allows the DMs and the stores to keep track of what should be getting done, reporting back on it and seeing what is and isn’t getting done. Again, we’re just starting to use these tools and the third quarter is when we finally got this installed in the whole chain so now the learnings begin and the productivity comes out of these tools. I still think we have a ways to go before they’re fully productive.

Meredith Adler – Barclays Capital

I have an unrelated questions, just about real estate, you guys do a lot of build to suit and I think you did mention cap ex spending on actually buying stores. Could you just talk a little bit about kind of what’s happening with developers and do they have the funding to build stores or are you doing more of that? Then, what would you do with the assets if you owned them would you [inaudible] or something like that?

David M. Tehle

We’re still seeing our developers do a great job for us overall. Again, we set aggressive goals at the beginning of the year and we meet those goals and we reaffirmed our guidance on the store openings for this year so we’re feeling good about that. Having said that, one of the byproducts of the store buy back of course is it does give a little more capital out there to the developers and I think long term the back half of your question there on the store buy back, at some point we might bundle some of these stores and do some type of financing transaction with them. But, we’re in no hurry to do that. Again, the stores that we have bought back have been outstanding stores that we want to keep for a very long time.

Meredith Adler – Barclays Capital

So you’re not actually – just to get a new store open you’re not using your own capital?

David M. Tehle

No.

Meredith Adler – Barclays Capital

I do have just one final question, I was very pleased to see the stock buyback. You did say that you’re at your limit now in terms of what the bank facility permits but I’m just wondering why now? What made you decide to do it now?

Richard W. Dreiling

I think as we look at our capital structure and first and foremost, and I’ve said this many times, our number one priority continues to be investing in the business. Our opening new stores, doing relocations, remodels, and having the infrastructure to support the stores both inside and out whether that be distribution centers or creative innovative things we’re doing within the four walls of the store.

We’ve reached the point now on our debt levels, and after having some meetings with the credit rating agencies in September where we feel like the overhang issue with Buck Holdings will probably prevent us from being investment grade until we do something about that. We also believe because of where we are on our ratios we can go out in the marketplace and get if not investment grade interest rates, very, very close to investment grade interest rates and that’s the main reason we want to be investment grade anyway, is to get the lower price financing.

We think this is an opportunity to return cash to our shareholders in a very productive way. Again, as we mentioned, it will include a direct purchase from Buck Holdings which addresses the issues with the credit rating agencies. And ultimately down the road should leverage us to a formal investment grade.

Operator

Your next question comes from Analyst for Deborah Weinswig – Citigroup.

Analyst for Deborah Weinswig – Citigroup

I just wanted to kind of dive into your eCommerce business and kind of what learnings you guys have had over the last few months and then how Cyber Monday and things like that panned out for you guys?

Richard W. Dreiling

The eCommerce site is up and operational, I’m pleased to say that. We’re adding SKUs to it almost on a weekly basis now as we grow the size of the site. I will give you an interesting observation, all of the electronic items we had in the stores were also on that website. All of the electronic items sold out within three hours which we thought was really amazing. The business is building.

As I’ve said before, it’s not like it’s going to be a large part of our sales long term, it’s more of a convenience to our customers and really gives us a lot of awareness when we go into new markets. But yes, it’s moving along at a steady pace.

Analyst for Deborah Weinswig – Citigroup

Then just kind of to talk about the sourcing, moving into new countries, can you expand on that a little bit and what you’re doing there and what your people on the ground are saying?

David M. Tehle

We continue to build our sourcing efforts and we’ve mentioned before, we’re looking in different areas of China going more north and more western in terms of where our presence is going to be. But just to give you a flavor of some of the things that have happened very recently in the breadth of what we’re doing, we’re sourcing pickles out of India right now. We’re doing aluminum foil out of China, denim shirts out of Kenya, and bandanas out of Pakistan. So we continue to really expand our foreign sourcing efforts and we see that even getting broader and broader as we move forward in this effort. So stay tuned there, we still think there’s a lot of legs on foreign sourcing. And of course, as you know that helps take costs out of the business any time we take an item and take it over seas.

Operator

Your next question comes from Analyst for Aram Rubinson – Nomura Securities.

Analyst for Aram Rubinson – Nomura Securities

First of all, just a little bit on the competitive environment, you signaled the past couple of quarter there might be some gross margin compression and that’s come to pass but it hasn’t really hurt your results at all. You’ve had some terrific unit and dollar market share gains. Would you say the response has been stronger to your pricing strategy than what you might have expected?

Richard W. Dreiling

Another really good question. I’ll tell you, the competitive environment, particularly if you look at what happened around the whole Black Friday. Black Friday is turning into Black Friday week. People are pulling stuff forward. I think the competitive environment is very, very competitive but it’s not irrational. It’s not like people are out there doing crazy things.

I will say though that everybody is working the value message incredibly hard whether it be EDLP, or whether it be promotional mark downs. I think the consumer is traveling across multiple stores and multiple channels more than we’ve seen in the past.

Analyst for Aram Rubinson – Nomura Securities

One other question, as the DG Market starts to become a bigger component of your store growth, I mean one of the benefits we see is you get more square footage growth for each new unit. Can you speak to some other effects on the P&L for instance EBIT margin impact?

David M. Tehle

I think the key on the DG Market is the sales volume that it generates. Keep in mind a DG Market has an average sale of $4 to $5 million versus the $1.4 that we see out of our regular box. We have several stores that last year in fiscal year 2010 produced over $9 million in sales so this is the volume piece of the equation in terms of what it provides to us. The raw margin dollars and profit margin dollars that we get out of a DG Market is very impressive. Now, the mix is more consumable so the margin percent is somewhat lower but again the dollars, the raw dollars we get because of the volume is very impressive.

We also think there’s an opportunity in smaller markets that are what we call food deserts to add tremendous volume where we can go into a town that really needs a DG Market and get a lot of volume and get a lot of market share. That’s really the way we’re playing the DG Market.

Operator

Your next question comes from Joseph Parkhill – Morgan Stanley.

Joseph Parkhill – Morgan Stanley

Just along those lines of the consumables, from a long term perspective do you think there is a proportion of sales where you consumables will actually max out at? And, along those lines is there an amount of mix shift in consumables that you feel comfortable with in offsetting from a gross margin perspective?

Richard W. Dreiling

What we don’t want to be long term Joe is a 7,100 square foot grocery store. We’ve said that all along, the importance of getting the non-consumable side to be as productive as the consumable side. Having said that though, our whole merchandising strategy is building around letting the customer vote with what they’ve got in their pocketbook when they’ve got it. So I’ve never really stood up and said, “Geeze, I’d feel really good if it was 60/40, 75/25,” or whatever. We’re going to let the customer decide that.

But what we’re going to continue to do is work on ways of taking costs out so we can pass it on to consumer in terms of everyday low price. As we get better on the non-consumable side I think we’re going to see that start to accelerate again. Remember, also the work we’ve done on the consumables side has been the [inaudible] items we’ve introduced, all of the private brands we’ve introduced, the whole $1 items we’ve introduced in consumables and GA. We’ve actually caught some of this ourselves.

Joseph Parkhill – Morgan Stanley

Then from a margin perspective, I mean this quarter you had about 150 basis points of mix shift ex LIFO gross margins would have been flattish. Is that a rate that is sustainable or were there some puts and takes?

David M. Tehle

As we look at the third quarter obviously the three big impacts were the LIFO charge that we had, the sales mix that you mentioned and then the transportation costs because of the price of fuel. Again, as we look at fourth quarter we see, in terms of the impact, fairly similar to what we’ve seen the first part of the year overall in terms of the basis points that we’re anticipating to be leveraging in the fourth quarter. So we do see that continuing as we move forward into the fourth quarter.

Richard W. Dreiling

I think too when you look at the consumable and non-consumable mix in the third quarter, the rate of movement into the consumables side actually slowed down a little bit compared to the two previous quarters of the year.

Joseph Parkhill – Morgan Stanley

If I could just ask your intentions on repaying debt next year? Has that changed at all with the share repurchase or do you still intend to?

David M. Tehle

I think again, as we look at next year there are two pieces of the debt to talk about. The first one is the revolver, our asset based lending revolver, and that becomes due in July of 2013. So as we enter next year we’ll be looking at refinancing that and obviously that’s just a refinancing and a lot of that will depend on the market and how we see interest rates going when we think would be an opportune time to do that.

On the sub debt, the $450 million of subordinated debt, you’re probably aware we can purchase that on a [105] price in July of next year. The current thought process on that more than likely is that we’ll do a refinancing on it and roll it into some type of much lower cost debt than the interest rate than it’s at. Again, the feeling is based on what we’re hearing from the credit rating agencies that the goal of getting the overhang out of Buck is probably what’s more important than taking debt down in terms of getting us to investment grade so we’re focusing a little bit more on that overall. Of course, we’re very comfortable with our debt and where it is today and the leverage ratios that the company is living under.

Operator

Your next question comes from Analyst for Matt Nemer – Wells Fargo Securities.

Analyst for Matt Nemer – Wells Fargo Securities

Just a question on the apparel sales decline, do you think any of that weakness was related to weather during the quarter? Then giving the strength in some of the basics should we expect you to accelerate any of those changes or sort of further refine the percent allocation to basics?

Richard W. Dreiling

It was a little bit warmer to be honest. I would not attribute it to the weather. I would say it’s an example of a discretionary purchase that our customer can hold back on. I think a lot of the more fashionable things in apparel are not going to get any better until we see a major change in the macroeconomic environment out there. I do think that staying focused on fashion, the basic items, the colored t-shirts we talked about with pockets and things like that, I think our customer is continuing to respond to that and we’re going to stay focused on that for now.

Analyst for Matt Nemer – Wells Fargo Securities

Then just given the decline in apparel how are you thinking about the potential mark down risk in 4Q and I guess in general how are you thinking about mark downs and promotions versus last year? You mentioned the competitive environment is rational but is there sort of room in guidance to be a little bit more promotional in December and January if need be?

Richard W. Dreiling

Yes, we’re very comfortable where our mark down budget is across every side of the business right now. We pretty well know where we’re going to be.

Analyst for Matt Nemer – Wells Fargo Securities

Then just lastly, within home you mentioned a few categories that performed well, towels and bedding. Other than just SKU rationalization in the category, can you talk about what you’ve done to drive this increase? Those categories don’t appear to be entirely needs based so any color on what you’ve done there to drive that?

Richard W. Dreiling

I have to say our towel program this year in terms of the quality of the product and we’re more fashion relevant in regards to color. And I think also, part of our strategy that we’re learning about is that we need to turn our non-consumables more frequently and that our customer comes in once a week or once every other week and what we need to be able to do is have something different for them to see. That is part of what we’re embarking on and some of the strategies and some of the areas we’re starting to see is we’re turning the product a little faster.

Analyst for Matt Nemer – Wells Fargo Securities

Then just lastly, can you provide an update on the beer and wine roll out?

Richard W. Dreiling

I continue to be pleased with the beer and wine. We’re in about 3,500 stores now or about 40% of our chain. I will tell you when beer is in the basket those stores have a 1% additional comp so we’re real pleased with what we’re seeing.

Operator

Your next question comes from Anthony Chukumba – BB&T Capital Markets.

Anthony Chukumba – BB&T Capital Markets

I just had a couple of questions related to real estate, new store openings in particular. I just wanted to clarify what are your projected store closings for this year and then for next year?

Richard W. Dreiling

You know it’s usually a handful of stores, maybe about 50.

David M. Tehle

Right now we’re at about 40ish and we’re thinking probably about 50ish somewhere in there.

Anthony Chukumba – BB&T Capital Markets

So 50 for this year and also for next year?

Richard W. Dreiling

We haven’t arrived at next year but that number is pretty consistent if you look back over the last four years of the company.

Anthony Chukumba – BB&T Capital Markets

Then just a little bit of a bigger picture question on new store openings. You mentioned 7% square footage growth next year, Family Dollar is obviously getting more aggressive with new store openings as well as their store remodel program, Dollar Tree continues to open stores and obviously they’re a little bit of a different animal. How do you think about long term, are you concerned at all with everyone pretty aggressively opening stores that you might get to a point where there’s just too many dollar stores in the US? How do you think about that?

Richard W. Dreiling

That’s really a good question. I’ll tell you [Static] got this morning that blew me away is that the number of dollar stores is now larger than the number of drug stores in the United States today which is the first time that’s happened. I think obviously there is a saturation point but our work now tells us that there’s 8,000 existing opportunities in the states we’re in. There’s another 3,000 to 3,500 opportunities in the states we’re not in. So there’s 11,000 opportunities to grab out there.

The other advantage to our model is they don’t have to be 25 or 30 miles apart. They can be much closer together because our trade areas is smaller. Remember, one of the driving pieces of this model is not only the value equation the customer gets but the convenience angle as well.

Operator

Your next question comes from Analyst for Scot Ciccarelli – RBC Capital Markets.

Analyst for Scot Ciccarelli – RBC Capital Markets

My question is on store traffic. You noted that your comp in 3Q came from both traffic and ticket and I’m curious on the traffic increase is that additional visits from your existing customers or are you actually attracting new customers into your store?

Richard W. Dreiling

It’s actually both.

Analyst for Scot Ciccarelli – RBC Capital Markets

Then I guess maybe a broader question then on your customer profile and maybe how that’s changed over the past year. I know you’ve talked about over the past couple of years attracting some consumers that were maybe trading into the category and had never shopped a dollar general before so I’m curious if you’re still seeing that and whether the trade in customer, whether they’re sticking?

Richard W. Dreiling

As a matter of fact it’s interesting you brought it up, we talked the last quarter about our core customer, the trade in customer, and the trade down customer. The trade down customer and the trade in customer are still our fastest growing segments right now. When I say that, I don’t want to lose sight of the fact that our core customers is still 59% of our shoppers and still 83% of our sales. But this idea that people are trading down and trading in and sticking, that is playing out.

Operator

Your next question comes from Charles Grom – Deutsche Bank.

Charles Grom – Deutsche Bank

Of the 625 stores you’re opening, how many are in new markets? Then when you look at the 625 that you’re going to open up next year, how many are going to be in quote unquote new markets again?

David M. Tehle

It looks like 96% of them are in existing markets and 4% in new markets in terms of what we’re doing right now. Next year, and again this can change as we go forward, but you’re probably looking at somewhere about 10% in new markets 90% in existing markets.

Charles Grom – Deutsche Bank

Then on the new markets, how would you expect the new store comp waterfall to shake out?

Richard W. Dreiling

You mean when they enter the cycle?

Charles Grom – Deutsche Bank

Yes, and historical you guys have had a pretty consistent comp out of the gate 11% year one, 7% year two, year three around a 5%. Would you expect it to be similar?

Richard W. Dreiling

I wouldn’t expect it to be any different to be honest with you. We are entering two entirely big markets here so I think I need to give you a little more view on that when we get a little closer but I’d model it the same way for now.

Charles Grom – Deutsche Bank

Then just to switch gears, on the commitment to lower prices could you just dissect broadly which product categories you’ve chosen to keep prices lower? Do they tend to be more of the KBI’s as opposed to the second tier?

Richard W. Dreiling

Yes, it’s more of the good stuff to be honest about it paper, chemical, a lot of food items. What we’re really watching, as I’ve said before, is particularly price points. The dollar price point is very, very critical for our customer and everything we’re doing is exactly like we’ve said all along. We make our price adjustments and if we see a significant erosion in units we back it back off.

Charles Grom – Deutsche Bank

Then just one quick housekeeping, on the full year EPS guidance of $2.29 to $2.32 could you just quantify the EPS lift that you’re going to get from the extra week?

Mary Winn Gordon

Earlier in the year we had stated what that was back at the time that we first issued our guidance.

Charles Grom – Deutsche Bank

Was it about $0.05 to $0.06?

Mary Winn Gordon

Yes, that is correct.

Operator

Your last question comes from Mark Montagna – Avondale Partners.

Mark Montagna – Avondale Partners

A couple of quick question just regarding gross margins and SG&A, when you look at the SG&A for next year you were talking about the Alabama impact with the distribution center and also California, I’m wondering with assuming you achieve a mid-single digit comp, should the payroll management software more than offset the additional expenses related to the DCs in California?

David M. Tehle

We have several things we’re working on in terms of offsets and of course we haven’t finished our budgeting process yet so it’s a little preliminary to lock and load on any number of certainly the labor standards from workforce management will continue to help us as we move forward and as I mentioned earlier as we mature in terms of using that and understanding that tool and using it even better we think there is still more to come out of that.

The energy management systems that were mentioned again, right now we’re thinking we’ll be in a little over 8,000 stores at the end of fourth quarter and as we roll into next year you’ll get the impact of having those in the stores for a full year and then we’ll obviously finish up putting them in the stores. We think there’s still room in damages in terms of how we receive the product from vendors and then just the full court press on things like supplies, shopping bag usage, maintenance in the stores, rent, continuing to look at ways to take costs out of rent as we renegotiate contracts. So a lot of things going on that should help provide offsets to the items I mentioned earlier.

Mark Montagna – Avondale Partners

Then just regarding the gross margins, I’m curious about the merchandise margin gains that you should be able to get from apparel and home. Is there a certain point we should expect to see the merchandise margin improvements in these two categories?

Richard W. Dreiling

I need to reflect on that one for a minute. I mean logically, yes. I have to say as I think about it while we’ve made some improvements there’s enough areas out there where we still have to work on it so I think it’s going to be a period of time using sourcing, allocating the space, getting a little more work done on allocation of space and then I think we’ll get there. I don’t want to be a 7,100 square foot grocery store and it’s one of those things we have to work our way through to yet.

Mary Winn Gordon

I think that will wrap it up for us from a time standpoint but thank you to everyone for joining us on the call today and thank you for your interest in Dollar General. Please feel free to give me a call if there’s anything that I can help you with.

Operator

Ladies and gentlemen that concludes today’s presentation. You may disconnect at this time.

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Source: Dollar General's Management Discusses Q3 2011 - Earnings Call Transcript
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