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Executives

Howard R. Levine - Executive Chairman, Chief Executive Officer and Member of Equity Award Committee

Dorlisa K. Flur - Chief Administrative Officer and Vice Chair of Strategy

Kiley F. Rawlins - Vice President of Investor Relations & Communications

Michael R. Bloom - President and Chief Operating Officer

Kenneth T. Smith - Chief Financial Officer, Principal Accounting Officer and Senior Vice President

Analysts

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

John Heinbockel - Guggenheim Securities, LLC, Research Division

Joseph I. Feldman - Telsey Advisory Group LLC

Vincent J. Sinisi - BofA Merrill Lynch, Research Division

Mark K. Montagna - Avondale Partners, LLC, Research Division

Mark R. Miller - William Blair & Company L.L.C., Research Division

Joseph Parkhill - Morgan Stanley, Research Division

Deborah L. Weinswig - Citigroup Inc, Research Division

Bernard Sosnick - Gilford Securities Inc., Research Division

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

Family Dollar Stores (FDO) Q1 2012 Earnings Call January 6, 2012 8:30 AM ET

Operator

Good morning. My name is Teresa, and I will be the conference facilitator today. I would like to welcome everyone to the Family Dollar Earnings Conference Call. [Operator Instructions] I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin your conference.

Kiley F. Rawlins

Thank you, Teresa. Good morning, everyone, and thank you for joining us today. I hope everyone had a safe and happy holiday. For those of you who have dialed in, please note that we have posted accompanying slides on the Investor Relations page of our website. Before we begin, you should know that our comments today will include forward-looking statements regarding various operating initiatives, sales and profitability metrics and capital expenditures, as well as our expectations for future financial performance. While these statements address plans or events which we expect will or may occur in the future, a number of factors as set forth in our SEC filings and press releases could cause the actual results to differ from our expectations.

We refer you to and specifically incorporate the cautionary and risk statements contained in yesterday's press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which only speak as of today, January 6, 2012. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so.

We'll begin our discussion this morning with a review of the first quarter’s results, and then we'll take a few minutes to discuss our plans and outlook for the rest of 2012. Following some prepared comments from Ken Smith, Chief Financial Officer; and Howard Levine, Chairman and CEO, you will have an opportunity to ask questions. Mike Bloom, President and COO; Dorlisa Flur, Vice Chair, Strategy and CAO; and Jim Kelly, Vice Chair, will join Howard and Ken for the question-and-answer session.

Now I'd turn the call over to Ken Smith. Ken?

Kenneth T. Smith

Thanks, Kiley. Good morning, and happy new year, everyone. Yesterday, we reported another strong quarter at Family Dollar with earnings per diluted share increasing 17.2% to $0.68. This result was driven by solid sales performance and operating margin expansion.

Total net sales in the first quarter increased 7.6% year-over-year to $2.1 million. During the quarter, we opened 101 new stores and closed 4 stores compared to 85 openings and 18 closings in the first quarter of fiscal 2011. Comp store sales in the first quarter increased 4.1% on top of a 6.9% increase last year, driven both by increases in the average customer ticket and customer traffic.

Looking at sales by category in the first quarter, consumables again drove the sales growth, increasing 11.4%. To meet our customers' basic needs, we remain committed to increasing our consumables assortment, and the strong sales performance is validating this investment. While consumables sales were strong, many of our discretionary categories remained soft. Sales in the apparel and home categories both declined year-over-year, amid a very difficult economic backdrop and a warmer-than-average reporting period. As a result, consumables increased from 67.9% of sales last year to 70.3% of sales this year, a mix shift of approximately 240 basis points.

As planned, the negative impact of this mix shift as a percent of sales was largely offset by benefits from our global sourcing, private brands and price management capabilities. However, higher markdowns, freight and shrink led to a greater-than-expected 77-basis-point decline in gross margin. Responding to softness in our discretionary categories, we leveraged additional marks to spur in-season demand and proactively manage inventory risk. As a result, inventory levels in these categories remained well controlled at the end of the quarter. As expected, inventory shrink as a percentage of sales increased over last year as a result of the merchandise changes and transitions that we completed in stores in the second half of fiscal 2011.

As a reminder, we increased our food and HBA assortment by 20% and 25% respectively in over 5,700 stores. While we anticipate continued pressure over the next couple of quarters, I would note that shrink remains near all-time company lows. Good management of core expenses and our investments to drive process improvement led to another quarter of strong expense leverage. SG&A expense increased 4.1% over last year to $622.7 million. As a percentage of sales, SG&A expense decreased 96 basis points to approximately 29%.

I would note that most expenses were leveraged in the quarter. As a percentage of sales, lower insurance and store labor expense more than offset about 25 basis points related to investments to drive revenue growth, including store renovations, new store openings and enhanced marketing efforts.

Over the last several years, we have invested to improve core processes to better manage labor costs, our largest expense. The low core expense growth rate over the past few quarters reflects the returns of these investments. For example, we have implemented a new task management system to more efficiently manage store labor to complete required projects, and we recently revamped key operational procedures to more efficiently process our weekly store deliveries. These improvements led to tangible expense savings in the quarter.

In addition, improved risk management programs and workforce retention efforts resulted in positive trends in workers' compensation and general liability claims. As we have discussed on past calls, we have worked to stabilize our workforce and improve our store management processes. We have increased store training and enhanced our safety and risk management programs. As a result, we are achieving positive trends in workers' compensation and general liability claims.

Operating profit in the first quarter increased 11% to $134.9 million. Operating profit as a percentage of sales expanded to 6.3% as compared to 6.1% in the first quarter of fiscal 2011. Interest expense increased to $6.7 million from $3.5 million in the first quarter of 2011. As a reminder, we issued $300 million in 10-year notes in January of 2011. The effective tax rate during the quarter was essentially flat. As a result, net income in the first quarter increased 8.1% to $80.4 million.

Turning to the balance sheet. Merchandise inventories at the end of the first quarter were 14.3% higher year-over-year, reflecting our ongoing investments in consumables to meet increasing customer demand. Average inventory per store increased about 10%.

Moving to the cash flow statement. Capital expenditures in the first quarter of 2012 increased to $130.9 million as compared to $38.9 million in the first quarter of 2011. This increase is in line with our previously announced guidance of $550 million to $600 million for the full year as we invest aggressively back into the business to support future growth. The increase was primarily driven by increased store renovations, relocations and expansions; increased new store openings; and expenses related to the construction of our 10th distribution center. In the first quarter, we renovated, relocated or expanded 262 stores and opened 101 new stores. Finally, the company purchased $27.4 million of its common stock during the first quarter. As of the end of the first quarter, the company had the authorization to purchase up to an additional $309.9 million of common stock.

Now let's turn to our expectations for the remainder of fiscal 2012. I'll begin my discussion with a recap of December sales. As we announced in our press release, December comp store sales increased about 4%. Our consumable sales growth was strong. But similar to trends we saw in the first quarter, discretionary category sales were pressured by economic weakness and unseasonably warm weather patterns. Based on these results, we expect comparable store sales in the second quarter to be around 5%. We also expect that gross margin trends in the second quarter will be similar to our experience in the first quarter.

Taking these considerations into account, we expect earnings per diluted share in the second quarter of 2012 will be between $1.10 and $1.18 as compared to $0.98 in the second quarter of 2011. This assumes the weighted average shares outstanding in the quarter will be around 118 million shares. Based on our results year-to-date and our second quarter expectations, our full year fiscal 2012 earnings guidance remains between $3.50 and $3.75 per diluted share as compared to $3.12 in fiscal 2011.

In fiscal 2012, we expect total net sales will increase between 8% and 10%, driven by more new store openings, our renovation program and the continued expansion of our consumables assortment. We expect comparable store sales to increase between 4% and 6%.

For the year, overall, we expect that gross margin will be pressured, but we expect this pressure will wane as we move through the year as we cycle many of the pressures we faced in the second half of fiscal 2011. We will continue to focus on driving greater efficiencies and keeping our core costs low. At the same time, we are accelerating our investment agenda, and this will drive total expense growth for the year of around 6% to 7%. However, we plan to leverage these investments through strong top line growth and are working to deliver another year of operating margin expansion.

Now I'll turn the call over to Howard for some additional remarks. Howard?

Howard R. Levine

Thanks, Ken, and good morning, everyone. I hope you all had a safe and happy holiday and happy new year to all of you. Ken has taken you through our first quarter financial results in detail and confirmed our expectations for the rest of the year. Before I provide an operational update, I'd like to provide some additional color on our December results. The holiday season started off well with strong customer response to our Thanksgiving and Black Friday events. Although momentum slowed in the first few weeks of December, sales picked up during the final countdown to Christmas, and similar to past years, the week after Christmas was also strong.

As Ken noted, consumables continue to deliver double-digit sales growth even during this highly discretionary period, and we would expect this momentum would continue through January and February when customers have been historically more focused on basic needs. Clearly, customers are buying closer to the holidays and are prioritizing their purchases based on need and financial constraints. In response to these trends, we have expanded our selection of consumables while reducing our discretionary assortments. As a result, we have expanded our market share and increased customer traffic.

While the near-term operating environment is expected to remain challenging, our long-term strategic plan is delivering results. We are driving greater revenue growth both through the acceleration of new store openings and comp store sales performance. We are working quickly to capitalize on opportunities to fulfill more of our customers' basic needs while further curtailing space and inventory to discretionary categories, and we are increasing profitability. Reflecting our first quarter results, we delivered our 15th consecutive quarter of double-digit earnings per share growth.

As we turn to the rest of fiscal '12, we expect that the environment will continue to be challenging for our customers, and our experienced team remains focused on executing our long-term strategy. We continue to invest aggressively to drive revenue growth. This year, we plan to open 450 to 500 new stores, a 50% increase over last year's pace. In the first quarter, we opened 101 stores, nearly 20% more than in the first quarter of last year, and we entered an important new market, California. Our new customers in California are responding very well to our values, and I'm excited about the opportunity to build our brand.

We also continue to improve the productivity of comp stores. In the first quarter, we delivered a 4% comp on top of a 7% comp last year, despite continued economic pressures and unusually warm weather conditions. Importantly, our brand awareness, value perception and customer satisfaction scores all increased again this quarter.

Critical to our efforts to improve customer satisfaction and increase store productivity is our renovation effort. In these stores, we have created a more inviting shopping environment that includes a refresh of the building facade, including new signage. We have expanded key consumable categories and created more intuitive merchandise adjacencies, and we have improved navigational signage and leveraged new fixtures that increase capacity and simplify restocking and recovery processes. And we have raised our customer service standards.

As I have said in prior calls, this renovation effort is one of the most significant investments we have ever made. I believe that the improvements we are making will strengthen the Family Dollar brand, enhance our competitiveness and drive sustainable productivity improvements in the future. Customers have responded well to these improvements. Our customer satisfaction scores in renovated stores are higher than the company average, and renovated stores continue to deliver double-digit comps post renovation.

It's been about a year since we finished the initial wave of renovations, and we are very pleased with the response from our customers and team members. As our customers increasingly rely on us for more of their basic needs, we continue to enhance our assortment. As we launch the next wave of renovations, we will continue to adapt the space and improve the layout to further support the expansion of consumables, and we are capitalizing on opportunities to reduce renovation costs.

We are on track to renovate, relocate or expand about 1,000 stores this year. So by the end of fiscal 2012, nearly half of the chain will reflect a newer, more competitive shopping experience. To help us increase overall store productivity, we will continue to adapt our assortment to changing customer demand. Strategically, we are focused on expanding our assortment in key consumable categories, both through our renovation effort and broader-based assortment changes.

Food continues to be a significant trip driver. Through our renovation initiative, we have significantly expanded our assortment of food. Last spring, we incorporated a number of these new items in existing stores that had not been renovated, and our customers have responded well. This quarter, we will add 300 new food items in all stores, including about 100 new private brand items. These additions will position us to capture more trips and reinforce our value proposition.

HBA is another category with strong potential to drive both trips and higher ticket. We are very pleased with the customer response to our broader HBA assortment and intend to add around 150 new items to the assortment this year. In addition, we will launch our Family Wellness brand to provide our customers with quality over-the-counter merchandise at great values.

As we invest aggressively in growth businesses like food and HBA, we will continue to drive inventory increases as we expand our assortment. While these investments will impact short-term inventory productivity, we believe that these expansions will position us to drive longer-term market share growth and increase store productivity. Even as we accelerate our investments in consumables in response to growing customer demand, we are managing our discretionary businesses more cautiously. Discretionary categories in general are more sensitive to weather changes and economic conditions. To help us manage overall inventory risk in many of these categories, we are leveraging additional promotional tactics in season to drive greater sell-throughs and increase overall returns.

While many discretionary categories like home and apparel can experience some year-over-year volatility, they do play an important role in our long-term strategy. Not only do they increase profit margins, they also help provide us with an opportunity to differentiate the Family Dollar shopping trip.

Going forward, we intend to simplify our discretionary assortments further while increasing our relevancy and value proposition. Strong growth of consumable categories and contraction of discretionary categories does have an impact on the mix of sales. However, when we look at the trend over time, we can see that we have successfully mitigated the impact of the shift. Five years ago, consumables were approximately 61% of sales compared to 70% in the first quarter of fiscal '12. For that same period, gross margin was 34.2% of sales compared with 35.3% of sales in the quarter just ended.

While quarterly margin performance will be impacted by short-term fluctuations in diesel costs, seasonal markdowns and inventory shrinkage, we believe that our opportunity to expand our penetration of private brands and direct sourcing will help us to continue to offset the longer-term impact of a greater consumable mix.

Before we take your questions, I want to reiterate how pleased I am with the progress we are making. Although the environment continues to be challenging, we remain focused on executing our long-term strategy. We are adjusting our plans and accelerating investments in key growth areas that are delivering results. In the face of such of a volatile operating environment, I feel very good about the enhancements we have made to our leadership team, particularly in the merchandising areas. We continue to strengthen our team to better support our growth, adding a number of experienced retailers to our team of knowledgeable veterans.

Mike Bloom, our new President and COO, has been part of the team for nearly 13 weeks, but he has already made important contributions to our merchandising, supply chain and store operations areas. In her new role as Vice Chair, Strategy and Chief Administrative Officer, Dorlisa Flur is leading our efforts to become a more customer-centric company and improve our business model. And working with our food teams, Trey Johnson, our new Senior VP of Food, has been an integral part of the development of our longer-term food strategy.

Finally, a few weeks ago, we announced the promotion of Paul White to EVP, Chief Merchandising Officer. Through Paul's leadership and strategic vision, we have improved the productivity of many of our discretionary categories. And in his new role, Paul will help us continue to broaden our appeal and deliver greater value to customers. I continue to believe that we have tremendous opportunity to expand our market share and improve our productivity, and I am confident that the investments we are making will continue to position us to deliver strong financial returns for our shareholders.

Before I open up the call for questions, I’d just like to take a second to recognize Jim Kelly. As I reflect back over our last 15 years, I think we've done about 60 of these calls together, but I have lost count a long time ago. Jim has been a great part of our team, and we will certainly miss him and wish him well. So in his last call, feel free to inundate him with as many questions as you would like.

Now operator, we would be happy to open up the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Deborah Weinswig of Citigroup.

Deborah L. Weinswig - Citigroup Inc, Research Division

If we look at your commentary around second quarter gross margins and being similar to the first quarter, can you help us understand what the markdown trends might look like in light of the holiday season?

Howard R. Levine

Sure, Deb. Let me step back and, kind of just to provide a bigger picture, look at what's happening with gross margin. First, in the first quarter, we had almost a 250 basis points mix shift that we went through with the addition of our consumables and the slower sales of some of the discretionary categories. Most of that was offset by continued benefits from our global sourcing initiative, our private brand strategy and our pricing capabilities. So we feel as though most of that mix shift has been offset by some of our initiatives and would expect to continue to do so through the rest of the year. Further, when we look at shrink, shrink is something that has popped just a little bit on us. Primarily, we attribute that too to some of the disruption that we've gone through with the number of different projects over the past years, but we would expect to get that under control over the next few quarters. Now next, I look at freight, and freight is something that I think our supply teams have navigated through carefully. With the opening of our 10th DC later on in this year and with the opening of our 11th DC in the coming years, we feel that we'll have further opportunities to mitigate some of our transportation costs. So that leaves markdowns, and markdowns were definitely impacted by the softness of discretionary sales. And like any retailer, when you're faced with softness in discretionary sales, you have to react. We began doing that in the first quarter. It continued into the month of December, and now, we're in a clearance mode. What we did this year was try to attack some of the slowness in-season. In years past, we haven't been that aggressive, and we decided through some of our capabilities that we have the opportunity to impact some of the sell-throughs in-season while customers in our stores, shopping. We feel longer run, that's the best way to liquidate and get through some of the seasonal inventories and feel very good about how we were positioned at the end of the first quarter. As we worked through the month of December into the remaining clearance months, we are again well-positioned and feel as though we've incorporated in our guidance the additional markdowns that will be required to liquidate those inventories. So that gets us through the first half of the year, and I apologize for the long answer, but I know there's some questions about this issue, and I really wanted to make sure I had the opportunity to address them properly. As we look to the back half of our year to address the seasonal markdown issues, we have curtailed quite a few of our discretionary receipts to better navigate through this choppy environment. So we feel as though some of the markdowns related to some of the discretionary will ease a bit as we work through the year. Shrink will still be an issue, but we're working through that, and freight will be something that we'll deal with. But the big picture mix shift, we do feel as though our initiatives, particularly global sourcing and private brands, will help offset that quite a bit. I'll also add, Mike and the team are going overseas tomorrow. Some are overseas now, but Mike will be going over there because one of the things we would like to do was speed up some of the benefits from our global sourcing initiative and our private brand efforts to further help mitigate some of those mix shifts. But as we look out over the year, there will be some pressure there. I know that's different from what we said, but I think the company is working through those challenges, and at the end of the day, our goal is to improve our operating margin. So sorry for the long answer, but hopefully, that helps.

Deborah L. Weinswig - Citigroup Inc, Research Division

I appreciate the color. And then with regards to SG&A, one of the comments in the press release was that some of the benefits were offset by enhanced marketing efforts. Can you expand on that?

Howard R. Levine

Sure. As I'm sure you all have seen, the last several months have been extremely promotional, not only in our channel, but the big box retailers have gotten very aggressive, and we had to react. We built a Black Friday, Thanksgiving event this year that was very successful. We'll look to continue to drive our marketing efforts. It's something that Mike has given a lot of attention to see how we can further drive traffic in our stores. So we believe that we're competitive there. We'll continue to enhance and improve our efforts there. But longer run, we do expect the environment to continue to be extremely promotional.

Operator

Joe Feldman of Telsey Advisory Group.

Joseph I. Feldman - Telsey Advisory Group LLC

Just wanted to get a little more color on some of the drivers in the quarter in terms of the traffic versus ticket. I mean, it seemed like both were up and decent. Was one a bigger drive this quarter? And also on -- I guess on the ticket side, were you seeing much of a difference in the basket to -- was it units? Or was it ticket again in the basket -- or that AUR, I guess, in the basket?

Kiley F. Rawlins

Joe, this is Kiley. I think as we said in our comments, the comp this quarter was driven by ticket and traffic. Ticket was a little bit stronger than the traffic. I think if I look at the basket, it's not a whole lot different. I'd say that our number of items is up slightly. Again, I think that comes back to the number of food items that we've added and a lot of the consumable expansion. Interestingly, as we look at December, as you would expect, the comp in December was driven by traffic as we've seen in years past. So I think if we look at that, those metrics over time, certainly going through the early parts of the recession, our comp was driven more by traffic. In the last, gosh, I think 4 quarters, it's leveled out and balanced out nicely a bit. Well, certainly, with the changes we're making, we would expect that to be balanced going forward as well.

Joseph I. Feldman - Telsey Advisory Group LLC

That's helpful. If I could follow up with one quick one. Just any thoughts on where you think consumables ultimately top out in the mix? I mean, does it stay around the 70%? And what does that really mean for the margins going forward?

Howard R. Levine

Sure, Joe. Let me take try to take a stab at that. When we step back and just look over the last 10 to 12 years, we've seen a dramatic shift from discretionary purchases to consumables to close to 70% of sales at the end of the first quarter. What you heard us say is we're planning to add to our consumable mix and mitigate risk with discretionary purchases, and I would expect that to continue. It's hard to give you an absolute answer because of the uncertainty with the economy. I know there's some out there that think if the economy improves, that, that's a negative for Family Dollar, when actually, that's a positive for us in that we see a pickup in discretionary sales during that time period. But we're not walking away from discretionary. As I tried to indicated earlier, it's an important part of our mix. It's an important part of the shopping experience when a customer comes to shop with us. So we're looking to get better as I've talked about for a number of years there. I mean, we're still excited about what the opportunity that those businesses bring to us. So to summarize, I do think consumables will continue to grow as a percent of the sales at least over the next year or so. But longer run, we're hoping that we can do as much consumable business as we possibly can and drive as much discretionary. So at the end of the day, it's going to be really driven by the customer.

Operator

John Heinbockel of Guggenheim Securities.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So a couple of things, Howard. If you look at what you're doing with non-consumables, do you think you have -- you sort of alluded to it. Do you think you have the right mix there, the right price points for this environment? And as you tweak that, how much of a difference can that make in non-consumable sales, assuming the economic environment doesn't change?

Howard R. Levine

Sure, John. I think what I would say is the objective is -- and I have said this before, is not just driving comps at the area, but to try to improve overall productivity and sell-throughs. Really, that's the direction that we've given our merchandising teams is we're not looking to get a big comp, if any comp, out of that area, but we do think there's an opportunity to enhance sell-throughs, to be more relevant, figure out the role that some of these nondiscretionary categories play -- or these discretionary categories play in the dollar store, and I think we're getting some traction there. This economic environment has been somewhat of a setback, but longer run, we're still committed to those. I think we have an opportunity to do a better job there, and I believe that we will.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Okay. Secondly, when you think about -- you didn't talk to it much on the call. You think about price optimization, how big a role is that going to play in mitigating some of the mix shift? Do you think it's a bigger opportunity in consumables or non? And is it bigger in everyday pricing or markdowns, do you think?

Howard R. Levine

Good question. And I think we have opportunities in all areas, frankly, John. I think as we have gotten more traction there, our objectives are being reached. Let me mention primarily that our customer surveys, the proprietary research that we do, the hundreds and hundreds of customer pricing surveys that we do are showing that our price perception is still very strong to our customers, and we're doing everything that we can to continue to protect that. That said, there are still opportunities for us to continue to improve that price perception both in consumables and on the discretionary side. One of the things that we were able to leverage through this most recent holiday period was to utilize some markdown optimization tactics to ensure that we were addressing the stores that needed to have their inventory reduced that had the most inventory in the discretionary categories. In other words, we were able to allocate markdown dollars to those stores that needed it the most. We'll get better with that. We'll also get better on the promotional side about how to better utilize our tools to enhance our promotional pricing capabilities. So all areas are up for improvement. It's something that Mike is attacking as we speak. So I would look for continued opportunities to drive margin as well as improving our price perception with our customers.

John Heinbockel - Guggenheim Securities, LLC, Research Division

All right. Then just one final thing. It would look to me like consumables might have accelerated from the first quarter into December and that you might -- in your thinking for the rest of the quarter that, that would continue. Is that fair or no?

Howard R. Levine

Yes, that's fair.

Operator

Dan Wewer of Raymond James.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

I have a follow-up on your comments about inventory. I'm concerned that we're seeing a decline in inventory productivity. For instance, you noted that inventory dollars in food and HBA were up 20% and 25% respectively. Yet if you look at the revenue growth in consumables, it's up about 11%, about less than half of the rate of the inventory growth, and it suggests that those incremental inventory dollars are not generating the same kind of revenue productivity that they used to.

Howard R. Levine

Yes. I think it's -- let me address the overall inventory productivity issue, and then if others have some details they can fill in, please go ahead. But again, this is a little bit different than we talked about in the past that we would have expected inventory productivity to continue. One of the things that I want point out though, and this is very similar to the issue when we were expanding our store operating hours that we had to spend the money to get the hours, and it's not an immediate payback there, and it's basically the same issue when we look at the growth in our assortment. We are expanding our assortment. The minute that we expand that assortment, we lose productivity. We expect that to continue through the year, but I want to make it clear that we haven't forgotten about what the term inventory productivity means. That is still an important metric to us. I think, over time, we have demonstrated strong inventory productivity, but as we're going through this phase of growing our assortment, there is going to be some growth in our inventory, and that is something that we're factoring in and dealing with. But importantly, discretionary is going to be well-maintained and well-controlled as that's where we really have the risk, but our teams are aggressively adding to those consumable assortments, and we would expect to have a little more growth in inventory. But over time, we want to get back to inventory productivity improvements...

Kiley F. Rawlins

So Dan, just -- wait, Dan, just to clarify, the 20% and 25% is the increase in SKU count, not inventory. Certainly, the inventory growth this quarter as we've seen for the last couple of quarters has been driven by consumables, but it's not up 20% or 25%.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

But still just thinking if your same-store sales are up 4%, your inventory per store is up 10%. You're getting less than half of the pop in sales of your own inventories. Is there an issue with maybe the inventories are at a bottleneck in the distribution centers and not in the stores, and that's why the sales productivity isn't better?

Howard R. Levine

No, no. It's just as I addressed. We're building those inventories, and it would be our expectation that over time, that we would continue to see inventory productivity. There's plenty of goods at our distribution centers, but nothing's stuck. In fact, those are at the levels that we want. Our in-stock at our DCs is very strong, and the flow of our goods remains very strong as well.

Kenneth T. Smith

Dan, I would add though that while nothing is stuck in the pipeline, we're making SKU changes at an unprecedented rate, and what that does require you to do is to build up within your distribution network the new SKUs as you liquidate the old SKUs. So there is some transitional inventory in the pipeline.

Daniel R. Wewer - Raymond James & Associates, Inc., Research Division

I have just one quick follow-up, if I could on the -- I think there's some confusion as to why the company is guiding second quarter same-store sales at 5% if the largest month in the quarter was up 4%. Does that just reflect the change in mix, and that will be more leveraged on consumables in January and February which is the sweet spot of your business? And it sounds like now your same store sales and consumables are probably north of 6% right now. Is that the reason for the more upbeat guidance for the quarter?

Howard R. Levine

Yes, Dan. I think -- the month of December is the most discretionary month of the year by far. It would be our expectation as we go into more basic months like January and February, where consumables are more focused on more basic needs and consumables, that comps would accelerate to get us to that about 5% comp area.

Kiley F. Rawlins

I would note, Dan, that, that's a trend that was similar to last year as well. Last year, we had about a 4% comp in December and saw an acceleration in the rest of the quarter.

Operator

Bernard Sosnick of Gilford Securities.

Bernard Sosnick - Gilford Securities Inc., Research Division

I'm curious about toys which you've been very successful with in previous holiday seasons. How did you do with toys this year?

Howard R. Levine

Bernie, the strength of our toy program has been and continues to be that $5 to $10 price point. We had a great selection this year. We had a great selection of branded licensed toys for $5 that did great. We had the expanded video game assortment that was strong. So toys was a -- is a very profitable business for us and one that we did have a few bright spots.

Bernard Sosnick - Gilford Securities Inc., Research Division

Okay. Overall, a satisfactory performance from toys, I assume?

Howard R. Levine

Overall. I mean, I wouldn't want anybody to think we couldn't do better, and that's always our goal. But given the economic environment out there, I think we hung in there.

Bernard Sosnick - Gilford Securities Inc., Research Division

Okay. The other point I'd like to get to is could you give us some color on the performance of rural stores versus urban, especially over the last few months? Sorry to interrupt.

Howard R. Levine

No, no, sure. Could we get back to you on the details of that one, Bernie?

Bernard Sosnick - Gilford Securities Inc., Research Division

Okay. Well, before I jump off, I want to wish Jim Kelly a long and happy retirement.

Operator

Joseph Parkhill of Morgan Stanley.

Joseph Parkhill - Morgan Stanley, Research Division

I was just wondering if you could elaborate a little bit more on the weakness in discretionary. If you think about unemployment getting a little bit better, I know it's still elevated, but gas prices also seem to be leveling off. So I was just wondering, do you think any of the weakness has to do with merchandising or competitive activity?

Howard R. Levine

Sure, Joe, and thank you for the question. And yes, as I said earlier, I think there's always improvements that we can make in our assortment and despite whatever the economic environment is out there, but I would urge you to take a look at our core customer out there. Our core customer is still very stressed, elevated unemployment areas. We're hoping to see some of that improve over the next year where some of our folks can get jobs back, but there's been dramatic cutback in government subsidies, all kinds of things going on that have impacted the core customer. And when you're faced with what am I going to have for dinner versus buying a new shirt, our customers pretty quickly figure out what's most important. That's something that we're dealing with and working through and would expect to continue over the near term.

Joseph Parkhill - Morgan Stanley, Research Division

Okay. And then also just as a follow-up, your remodels that are entering the second year, how are those performing? And then I also was wondering how discretionary is performing in remodeled stores. Is it similar to the rest of the chain? Or is there an improvement there?

Howard R. Levine

Sure. I'm going to let Dorlisa take that one.

Dorlisa K. Flur

Well, I think overall, we've been pleased with the results of our renovation program. As Howard indicated in his remarks, customers have responded very well to the changes in our assortment, our shopping experience. Our satisfaction scores are up in our stores. They're sustaining at higher levels when stores move into their second year, and we've been able to attract a broader base of shoppers to those stores. So that more discerning shopper is also staying with us. So we're continuing to see very strong performance of our renovation stores. It is early days as they move into their second years, but we're very encouraged by the positive performance trajectory on those stores.

Joseph Parkhill - Morgan Stanley, Research Division

Great. And then as far as discretionary in those stores, sorry?

Dorlisa K. Flur

I think you must understand that in these renovation stores, a part of the program was to inject more consumables, and so that means, of course, we have seen more of the change come from those areas like food and HBA. But the shopping experience is one that provides a more intuitive framework for the customer, and so we are also seeing very strong performance of our discretionary areas.

Operator

Vincent Sinisi of Bank of America.

Vincent J. Sinisi - BofA Merrill Lynch, Research Division

I wanted to ask about your entry into California. I know when you guys had made the announcement back in November, you had called out 4 locations. Just wondering if you can give us an update there and also if the preparation for California contributed any meaningful amount of your increased freight during the quarter.

Howard R. Levine

Sure. Let me let Mike take that question as he has been the team member that was out there most recently. Mike, go ahead.

Michael R. Bloom

Yes, thanks. So, I guess, a couple of things. First, we are really excited about our entry in the California market. In fact, on my second week on the job here, I made a trip out to California. And as many of you know, I've got -- I have a lot of experience in California from my previous life. So we entered this market with a very different mix than maybe we're used to in our prototype store. We've got more coolers for refrigerated and frozen foods than we have in our core stores as well as a lot more shelf-stable foods for the Hispanic consumer. We've also expanded categories like household chemicals to address, again, very specific customer needs, Hispanic needs. But the most exciting part and what I'm most excited about in California is how well we've been received by our customer base out there. We're very pleased with the very -- with our early results, and of course, as Howard always says, we're constantly looking for ways to evolve and improve the performance. I can tell you one thing that we're very excited about the growth opportunity in California for the Family Dollar brand. And I guess as far as freight goes, it's 4 stores. So it's -- there's no impact.

Vincent J. Sinisi - BofA Merrill Lynch, Research Division

Okay. So it still is, at this point, just at the 4 locations?

Michael R. Bloom

That's right.

Vincent J. Sinisi - BofA Merrill Lynch, Research Division

Okay. And then one just quick follow-up, if I may. As you continue to focus on increasing private label and sourcing efforts, could you give us any commentary in the context of your consumables and HBA expansion if those efforts are going to be a meaningful part of that?

Howard R. Levine

Yes, absolutely, Vinny. We've got 2 new names, which I know you've heard the Family Gourmet, which has been refreshed at least once since the initial rollout, and we're working on additional refreshes and improvements there. Private brands and food will be an important part of our assortment, and I would add in the HBA areas, the new name, Family Wellness, you'll begin to see in our stores in the very near future, again, a very important part of our assortment, speaks well to the economic situation for our consumers. It's going to give them a great choice and great value against the number of name brands that we are also adding to our assortment.

Vincent J. Sinisi - BofA Merrill Lynch, Research Division

And of the -- you had called out about 300 new food items expected for the second quarter, about 150 HBA for the year. Is it safe to say that close to a majority percentage of those would be from your own brands or not that much?

Howard R. Levine

No. I think of the 300, maybe about 100 of those would be Family Gourmet, and then the HBA area would be fewer than that.

Operator

Mark Miller of William Blair.

Mark R. Miller - William Blair & Company L.L.C., Research Division

Given the company maintained the same EPS guidance range for fiscal '12, but yet, it sounds like the gross margin outlook is a little bit tighter, I was hoping you could help us understand where you might have made some adjustments in expenses or found productivity gains.

Kenneth T. Smith

I think, as we've framed out the full year that the -- when you back up and look at the entire year, the great news is we -- our strategy that we've put in place for the year is working well, executing well against our investments and our initiatives and driving the top line. We do -- similar to the first quarter where we had a bit of pressure from markdowns with a little more than expected cost that created some margin pressure, and we offset that with some expense savings, we have tweaked the full year a bit that way. But structurally, it hasn't significantly changed. We still expect the pacing of the business to continue in that 4% to 6% comp rate for the year. Margin, as we move through the year, we expect the pressures, particularly in the 3 areas that we've seen pressure recently of markdowns, shrink and freight, we see that pressure waning in each of those areas as we move to the back half of the year. Certainly, when you see markdowns as Howard elaborated on, we have an opportunity for fewer markdowns in the back half. Freight, clearly, the anniversary-ing of tough diesel costs eases dramatically in the back half, and then shrink is an opportunity as well. So we're not dramatically different in our full year view. A bit of extra pressure from margin and some expense savings that give us the continued guidance at $350 million to $375 million.

Mark R. Miller - William Blair & Company L.L.C., Research Division

Ken, thanks. I think I understand the markdown and the freight potential changes through the year, but could you elaborate a little bit on shrink? And first, I’d just like to understand, what were the specific challenges that you encountered in some of these merchandise transitions? And then as you hope to relieve that pressure over the next few quarters, what are the specific actions that you're taking right now?

Kenneth T. Smith

Specifically, the reality of it is, in the back half, we touched, as I mentioned, over 5,700 stores with some merchandise moves. What that means is there's a lot of activity in the stores, and typically, when you have a lot of moving parts, you're moving merchandise, we're increasing some inventory levels. So that kind of strained the shrink environment a bit. The reality also is you don't see shrink as it lags a bit, the actual hit to the P&L, if you will, from when you may have that kind of disruption. So we're facing that in the last quarter and this recent quarter. Our -- I would tell you though, this organization -- and we remain keenly focused on shrink. You can't talk to an operator that isn't very focused on shrink, shrink improvement, and everyone in our operations organization has a focus on various loss prevention tactics, more visibility, using the tools we have to identify potential shrink quicker, and we expect those -- those have given us a great result over the last few years, and we expect that traction to come in and ease the pressure in the back half on shrink.

Operator

Mark Montagna of Avondale Partners.

Mark K. Montagna - Avondale Partners, LLC, Research Division

I'm trying to get my arms around direct sourcing cost savings opportunities. I'm hoping you could tell us what percentage of total sales is from private brands and then what percentage of consumables comes from private brands.

Kiley F. Rawlins

So I think, Mark, that at the end of last year, our total private brand penetration was about 25%. On consumables, it was about 16%. In the first quarter, we continued to see great growth in private brands. I think something like 16% or 17% growth in consumable private brands in the first quarter. So that trajectory is continuing. As I think we've said on past calls, our goal is -- our near-term goal is to get penetration of consumable private brands up to 20%, and we are certainly well on our way. From a direct sourcing standpoint, if we think about the merchandise that's manufactured overseas at a -- on a cost basis, I think it's low-30s percent of merchandise.

Mark K. Montagna - Avondale Partners, LLC, Research Division

Okay. So I assume you can never get to 100% direct source. Is there a certain ceiling that you can help us with in terms of high how direct sourcing can go for your private branded product?

Howard R. Levine

Yes, the area that we see as having the most opportunity is dealing directly with the factory. Today, that represents around 10% or so, and that's a very low number. We would expect that to continue to grow because that's where the biggest saving is, is we can begin to cut out those middlemen that are taking several hundred basis points away from us. The first step was getting our overseas office set up. We've done that. We've got our teams in the U.S. working very closely with them. So we would expect that to grow dramatically over the next several years. It's a very important part of our longer-term strategy of mitigating some of the margin pressures that we're seeing from the consumable additions.

Operator

Scot Ciccarelli of RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Scot Ciccarelli. Regarding the November quarter, it's not the first time where we've seen sales in the November quarter maybe a little bit lighter than what people are expecting. I'm not sure if you've ever looked at this, but do you think your customer base changes a little bit in the November, December timeframe? In other words, do you think you maybe lose some of those middle-income consumers during the holiday timeframe that are coming in during the bulk of the year?

Howard R. Levine

No, Scot. The way I’ve thought about it, and we've been asked that question many times, the September, October, November time period are transitional months for us. We're never quite sure if it's going to get cold when we want it to get cold, and I would say the same things as we transition to the early spring. It often feels like we're always hoping it's going to be cold when it's hot and we want it to be hot when it's cold, but I think that's the primary issue that we're dealing with. As we get to the month of December, the issue was discretionary. December, as I said earlier, is just the heaviest month of discretionary sales that we have, and when the economy is challenged and our customer is out there shopping for toys or trim-a-tree items or whatever she's looking for, when things are tough, if they bought their kids 3 toys, it may be 2 toys. If they bought 3 ornaments, it may be 2 ornaments. There's challenges and offsets that she's constantly having to work through. In my opinion, that's the biggest issue, and what we see, and this has been true for many, many years, once we skip through December, we get back to more basic months of January and February which hits more the sweet spot of our business and where consumables are a greater portion. So in my opinion, that's more the issue.

Kiley F. Rawlins

And Howard, I might add that, actually, December is the month we have the strongest visit rate from our mid-income shoppers. There are many of them that only come in during that time of year to get their wrapping paper and $5 and $10 toys. Okay, well, it’s a little after 9:30 and unfortunately, we didn't get through our entire queue this afternoon -- or this morning. As always, I'm available after the call for any follow-up questions that you may have. Thank you for your interest in Family Dollar, and I hope you have a great day and a great weekend.

Operator

This concludes today's conference call. Thank you for your participation.

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