Fred's (FRED) CEO Jerry Shore on Q4 2015 Results - Earnings Call Transcript

| About: Fred's, Inc. (FRED)

Fred’s, Inc. (NASDAQ:FRED)

Q4 2015 Earnings Conference Call

March 23, 2016 10:00 ET


Pat Watson - Investor Relations

Ben Garner - Corporate Controller

Michael Hayes - Chairman

Tom Tashjian - Director

Jerry Shore - Chief Executive Officer

Mike Bloom - President and Chief Operating Officer

Rick Chambers - Executive Vice President, Pharmacy Operations

Bryan Pugh - Chief Merchandising and Marketing Officer

Craig Barnes - Executive Vice President, Supply Chain, Logistics and Loss Prevention

John Foley - Executive Vice President, Store Operations


Andrew Wolf - BB&T Capital Markets

Jill Nelson - Johnson Rice

David Magee - SunTrust

Tiffany Kanaga - Deutsche Bank


Good day, everyone and welcome to the Fred’s Fourth Quarter Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference to Pat Watson for opening remarks. Please go ahead, sir.

Pat Watson

Good morning, everyone. This is Pat Watson with Corporate Communications. Thank you for joining Fred’s to review the company’s financial and operating results for the fourth fiscal quarter and fiscal year ended January 30, 2016.

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

Lastly, I would like to point out that management’s remarks during this conference call are based on information and understandings believed accurate as of today’s date, March 23, 2016. Because of the time-sensitive nature of this information, it is Fred’s policy to limit the archived replay of this conference call webcast to a period of 30 days. This call is the property of Fred’s. Any distribution, transmission, broadcast or rebroadcast of this call for commercial purposes in any form, without the expressed written consent of the company, is prohibited.

With those announcements, I will turn the call over to Ben Garner, the company’s Controller. Good morning, Ben. Take it away.

Ben Garner

Good morning, Pat and good morning to everyone on the call. Thank you for joining us this morning for our discussion of the fourth quarter 2015. With us this morning and available for questions are Michael Hayes, Chairman; Tom Tashjian, Director; Jerry Shore, Chief Executive Officer; Mike Bloom, President and Chief Operating Officer; Rick Chambers, Executive Vice President of Pharmacy Operations; Bryan Pugh, Chief Merchandising and Marketing Officer; Craig Barnes, Executive Vice President of Supply Chain, Logistics and Loss Prevention; and John Foley, Executive Vice President of Store Operations.

Earlier this morning, we presented financials as well as adjusted financials. I will not be repeating all of these amounts in the following discussion. We also presented tables this morning to better illustrate trends over the last year. It is not our intention to provide these tables on a quarterly basis going forward.

Total sales for the fourth quarter increased 10% compared with last year. On a comparable store basis, sales increased 1.7% for the fourth quarter versus flat comparable store sales in the fourth quarter of last year. Comparable store sales consist of comparable store customer transactions or traffic, which decreased 3.2% from last year and the average customer transaction amount or ticket, which increased 4.9% to $23.86.

The quarterly sales mix comparison was as follows: household goods and soft lines increased to 28% from 25.9% last year; consumables decreased to 20.4% from 28.8% last year; pharmaceuticals increased to 50.4% from 44% last year; and franchise sales decreased to 1.2% from 1.3% last year. For the full fiscal year, total sales increased 9% to $2.151 billion from $1.970 billion in the year earlier period. Comparable store sales for the year increased 1.5% versus a decrease of 0.6% in the prior year period.

The year-to-date sales mix comparison was as follows: household goods and soft lines decreased to 22.6% from 25.3% last year; consumables decreased to 25.7% from 31.2%; pharmaceuticals increased to 50.2% from 41.9% last year; and franchise sales decreased to 1.5% from 1.6% last year. Total company sales per selling square foot for the past 12 months were $252 compared to $220 a year ago, a 14% improvement that was driven by specialty pharmacy sales growth and store closures in 2014 as part of our reconfiguration plan.

Now, as we discuss financial performance in the income statement. Results for the fourth quarter of 2015 include charges for an abnormally large increase in the LIFO reserve, impairment charges for the closure of five stores, adjustments for taxes and licenses, professional fees and other non-recurring items. Results for the full year fiscal 2015 include additional charges for estimated claims against the company related to a previously reported data breach. I would like to remind you, our LIFO had a negative impact on EPS on both the quarter and the year would still receive favorable tax treatments for this method of accounting. Results for the fourth quarter of 2014 and full fiscal year ‘14 were impacted by cost of closed stores and provisions for inventory reserves. The following discussions were noted includes non-GAAP adjusted totals for both years.

Adjusted earnings before interest, taxes, depreciation and amortization or adjusted EBITDA, which also excludes the impact of LIFO and stock-based compensation in the fourth quarter, increased by $13.5 million compared with the same quarter last year. Excluding non-recurring items in both years, adjusted EBITDA for the fourth quarter increased $2.9 million compared to last year. Adjusted EBITDA for the year increased $45.3 million compared with the same period last year. Excluding non-recurring items, adjusted EBITDA increased $16.8 million as compared to adjusted EBITDA last year.

Net loss for the fourth quarter of 2015 improved by $4.3 million. Excluding non-recurring items, adjusted net income improved by $1.7 million compared to adjusted income in the prior year. Net loss per diluted share in the fourth quarter 2015 improved by $0.11 per share. Excluding non-recurring items, adjusted quarterly net income per share improved $0.05 compared to adjusted per share income in 2014. Net loss for the year decreased $21.5 million compared to the same period last year. Excluding non-recurring items, adjusted income for 2015 improved by $10.7 million as compared to the adjusted loss in 2014. For the year, net loss per share improved $0.60 compared to 2014. Excluding non-recurring items, adjusted net income per share in 2015 improved $0.29 compared with the adjusted loss per share in 2014.

Moving to explanations of variances, adjusted gross profit increased $2.3 million on adjusted gross margin rate de-leveraged 200 basis points in the fourth quarter. Adjusted gross profit for the year increased $18.4 million, while adjusted gross margin rate de-leveraged 150 basis points compared to the prior year. The de-leveraging rate was primarily driven by the sales mix shift towards low margin specialty drugs and continued reimbursement pressures. The gross margin rate in our general merchandise departments outperformed last year in the fourth quarter and on a year-to-date basis. We saw favorable leveraging in adjusted selling, general and administrative expenses of 280 basis points in the fourth quarter of 2015. Significant leverage was driven by higher sales related to our pharmacy growth initiatives, lower occupancy cost associated with our closures in 2014, controlling labor while achieving a 9% sales growth and supply chain efficiencies.

Moving to the balance sheet, cash at the end of 2015 was $5.9 million compared to $6.4 million in the prior year. Total inventories increased 7.9% to $340.7 million compared with $315.7 million at the end of the fourth quarter of 2014. General merchandise inventory increased 6.9% primarily as a result of spring inventory purchases and inventory in transit. Pharmacy department inventory increased 14.7% as a result of inflation and pharmacy department growth. Inventory turns at the end of the fourth quarter 2015 improved to 4.7x a year compared to 4.1x a year in the fourth quarter of 2014.

Capital expenditures for the fourth quarter totaled $7.4 million compared to $5.4 million last year. On a year-to-date basis, capital expenditures totaled $23.2 million compared to $23.3 million last year. Additionally, during the fourth quarter, there was $3.6 million invested in acquisitions of pharmacies as compared to $9.3 million in the fourth quarter of 2014. Year-to-date, expenditures for acquisitions of pharmacy were $78.2 million compared to $37.6 million for the same period last year. The higher pharmacy investment is driven by the Reeves-Sain Drugstore Incorporation and EntrustRx acquisition, which totaled $61.6 million.

At the end of the fourth quarter, accounts payable was $184.7 million or 54.2% of inventory compared to $143.3 million or 45.4% of inventory in the same quarter last year. The higher percent of inventory this year primarily reflects better payment terms with our vendors and additional payable balances from our EntrustRx purchases. Total debt at the end of the year increased $46.5 million to $53.1 million as compared to $6.6 million last year. This comprised of $50.8 million related to the Reeves-Sain Drugstore and EntrustRx acquisition and $2.3 million for mortgage debt. There were no borrowings for working capital at the end of 2015.

We define free cash flows as cash flows generated from operations, less capital investments and before the distribution of dividends. Excluding the investments by EntrustRx, our free cash flows were positive for the year. At the end of the fourth quarter, there were 659 general merchandise stores, which included 373 retail pharmacy departments. In addition, the company had three specialty pharmacy only locations opened at the end of the fourth quarter. The company’s total selling space was approximately 8.6 million square feet of the end of the year.

Our financial guidance for the first quarter of 2016 and the upcoming full fiscal year, which does not include an estimate of further data breach related expenses, is as follows. For the first quarter, total sales are projected to increase 8% to 12% as compared to last year. Comparable stores are projected to increase 1% to 3%. We are pleased with what we are seeing during the month of March and expect comparable sales towards the upper end of this range. For the full fiscal year of 2016, the company expects total sales to increase 5% to 9%. Comparable store sales for the full fiscal year are also expected to increase 2% to 5%. The estimated contribution of specialty sales growth to total company comparable sales is approximately 100 basis points to 200 basis points. Based on our earnings projections, adjusted EBITDA in the first quarter which excludes the impact of LIFO and stock-based compensation is expected to be in the range of $13 million to $16 million compared to $11.6 million in the prior year quarter, an increase of 10% to 35%. Adjusted EBITDA for the year is forecasted to be in the range of $73 million to $78 million, an increase of 35% to 45%. Earnings per diluted share in the first quarter are projected to be in the range of flat to $0.03. Earnings per diluted share for the full fiscal year of 2016 are expected to be in the range of $0.27 to $0.32. The earnings projections do not include further costs of the 2015 data incident occurrence.

This concludes our financial summary. I will now turn the call over to our CEO, Jerry Shore, for comments.

Jerry Shore

Thank you, Ben and good morning to everyone. I appreciate you joining our fourth quarter and fiscal 2015 earnings call. I am proud to share with you the company’s accomplishments in 2015 and our plans to drive even stronger performance in 2016, capitalizing on the strategic investments and initiatives we recently announced. I will also comment on the performance in our pharmacy department and expansion of healthcare solutions. Mike Hayes will follow me with comments on the press release that was issued earlier this morning.

2015 was a very exciting year at Fred’s, highlighted by several key accomplishments. Total sales increased 9% for the year and comparable store sales increased 1.5%. Especially pleasing were the total sales increase of 30% in our pharmacy department and the turnaround of general merchandise departments to positive comparable store sales in the back half of the year. On an operational basis, we returned to profitability through strong sales and by leveraging SG&A expenses. For 2015, SG&A expenses were flat in dollars to last year and leveraged by 240 basis points. The team understands the importance of leveraging expenses while continuing to improve supply chain, operations and investing in technology. Investing back into our business strategically sets the stage for us to execute on our vision to first be a pharmacy and deliver healthcare services that improve the outcomes of the people in the communities that we serve.

In 2015, we took significant steps forward to invest in the infrastructure to best position Fred’s for future success and provide long-term shareholder value. Examples of these investments include hiring key experienced industry leaders to shore up talent; investing in the largest acquisition in company history to position Fred’s to grow in the ever-changing healthcare landscape; investing in technology with a heavy focus on pharmacy to control costs; and reduce cost-to-fill, while allowing advancements in healthcare services; implementing a new initiative management office focused on process improvement; improving the general merchandise sales mix, with balance gains throughout most product departments. And one of the most exciting advancements was the development of our new store prototype, which we have begun rolling out in the New Year. Mike Bloom will talk much more about this initiative.

Now, I would like to elaborate on what is happening in pharmacy. As we look back on 2015, several key accomplishments created a strong foundation for 2016 and beyond. The challenges with script contraction and margin compression in 2015 are well documented, but based on the investments we made in 2015 and continue to make in 2016, we are well-positioned to overcome these challenges as shown by the positive script growth we delivered in February. The work in 2015 around labor management and lowering cost-to-fill delivered benefits in the back half of 2015 and established the foundation for which our 2016 pharmacy plan is built.

Our labor management plan is on track to deliver a 10% reduction in cost-to-fill for the year, with additional upside when our new pharmacy enterprise system rollout is completed. While we have great confidence that labor management will garner strong returns along into the future, we must continue growing the top line and driving additional scripts. The launch of our new enterprise pharmacy system will not only enable us to achieve additional reductions in cost-to-fill, but also opens up additional advancements that allow us to communicate electronically with our patients to improve adherence and drive script comp growth.

Also in 2015, we implemented new inventory management technology, order insight. This module improves our inventory forecasting based on algorithms of dispensing history and future needs. This allows us to more effectively manage inventory levels and most importantly improves the patient experience by reducing out of stocks and partial fills thus also increasing scripts.

The next key accomplishment is our completion of the acquisition and integration of EntrustRx and Reeves-Sain Pharmacy into the organization. This strategic acquisition strengthens our position in specialty pharmacy, further integrates Fred’s with manufacturers, payers in the medical community and positions us to capture share in one of the fastest growing segments in the healthcare. Our decision to move forward with the acquisition was based on the key components of leveraging our retail pharmacy network of over 370 brick-and-mortar locations. Of approximately 400 specialty pharmacies that are operational today, only a small handful can offer the access and value of retail storefronts that provide the opportunity for customer pickup and pharmacist patient engagement on a daily basis. As we completed our first year with the EntrustRx acquisition, we are on plan in achieving the ROI we anticipated from this investment.

Another key benefit of the new workflow system is bring up pharmacy staff to provide more healthcare focused programs to drive the business, such as our expanded immunization program that we referenced on earlier conference call, had a 21% increase over last year’s increase of 32%. Even with the very weak flu season this year, programs focused on increasing compliance and adherence, which not only generate additional prescriptions but also improved healthcare outcomes for the patient and a company initiative to improve our performance within the Medicare Part D star rating measurements that are critical to Medicare Part D plans. We will have a trained specialist at each pharmacy that is focused on patient interaction and proactive intervention with providers to improve adherence and patient outcomes. Our goal is to be amongst the top 20% of performers in 2016, with a focus on continuous improvement. There is market shift towards performance based payer models that rewards those providers that can impact outcomes. We are well positioned to participate in this new payer environment over the coming years.

Last year, we also partnered with the telehealth provider to pilot the first telemedicine facility within a Fred’s store. Based off early promising results, we are currently finalizing plans for additional openings in 2016 that will help strengthen our positioning within our communities as a provider of healthcare services. We also joined with a healthcare provider to open a medical clinic within one of our Arkansas communities that had no primary care provider, again with good results for our pharmacy. We will continue to explore strategic opportunities in the markets we serve to expand our offerings. Our migration towards becoming a healthcare company is critical for the communities we serve. Strategically, we will accelerate the integration of general merchandise assortment, pharmacy, clinical services, specialty pharmacy and access to other healthcare providers, with the ultimate goal to be a primary source for healthcare needs of our customers.

In summary, I am excited about the positive momentum we have throughout the company going into 2016. As Ben said, our adjusted EBITDA in 2016 will grow from $54 million to a range of $73 million to $78 million, an increase of 35% to 44%. Our projections include strategic investments in infrastructure through store growth, remodels, talent – further talent upgrades, technology and process improvements, all of which are necessary to remain competitive in the retail and healthcare industry. A more specific breakdown of these strategic investments and the financial impacts in 2016 are; new store growth and remodels, investing $2.2 million or $0.04 per share; talent upgrades made during 2015 and additions in 2016, total approximately $2.5 million or $0.04 per share, investments in technology with key system upgrades in specialty pharmacy systems, JDA supply chain and merchandising enterprise systems, and completion of the new pharmacy inventory management and enterprise systems. The total EBITDA impact is approximately $2.5 million or $0.04 per share and marketing expansion to drive our healthcare message of $1.6 million or $0.03 per share. These investments are projected to have a negative earnings impact of $8.8 million EBITDA or $0.15 per share in 2016, but will drive significantly more than the investment in 2017, with accelerated performance in future years.

In summary, I am so appreciative of the hard work and dedication of the entire company. We have a dedicated team that recognizes that the model for the future is a cohesive retail and specialty healthcare services provider, focused on improving outcomes for our customers while delivering strong shareholder returns. We look forward to reporting the continued progress throughout the year and I will now turn the call over to Michael Hayes, Chairman.

Michael Hayes

Good morning. Thank you, Jerry. 2015 was a year like none we have ever seen before. Walmart, the largest retailer in the world, went through from the small box market. Walgreens announced the acquisition of Rite Aid, leaving only two major retail RX chains out there, of course, Fred’s, too. While the Internet made double-digit gains in the retail sector having significant impact on the larger boxes, all of which offer Fred’s opportunity and risk. We recognize change, meaning the board, was needed as the driving profit forces for both pharmacy and general merchandising were adjusting rapidly.

To make sure Fred’s lives in the fifth position, to participate and grow in the changing market conditions, Fred’s and the Board needed to make some hard decisions and look for opportunities to expand our reach in the rapidly growing healthcare arena. The first step in any orderly transition is to bring on a change agent that has a vision that understands the needed changes and the importance of protecting your core business while doing so. I believe we accomplished this by naming Jerry Shore as CEO. Jerry worked diligently with the Board of Directors to revamp and revitalize the stores, distribution and general merchandising management.

Jerry quickly got the pharmacy team focused, driving us deeper into the healthcare business with a key goal of increasing our penetration into the specialty business. Rick and his team accepted the challenge. And we are able to the acquisition of Entrust to position us in the specialty market and Entrust continues to break new grounds for Fred’s every quarter. At the same time, working with the Board, Jerry has transitioned all the key roles in our management team. Today, we have in place a stronger and I really mean stronger, more energetic and experienced team than ever before. It’s led by our new President, Mike Bloom and Chief Operating Officer; Rick Chambers, our EVP of Pharmacy Operations; Craig Barnes, our Executive Vice President of Supply Chain, Logistics, Planning and everything else; Bryan Pugh, Executive Vice President, Chief Merchandising and Marketing Officer; John Foley, Executive Vice President of Store Operations; and Rick Sain, who heads up our Specialty Pharmacy Program.

24 years ago, in March, we took Fred’s public. I have enjoyed all of those years, although some more than others. But by far, the accomplishments of the past 18 and 24 months have been the most satisfying and also the most difficult as we repositioned Fred’s. Making the hard decisions to shed unproductive assets, bringing a new management team, we work our capital lines as we push forward with a significant acquisition of RX specialty business were both challenging, time-consuming, but not without their accomplishments.

In early January, working with Board of Directors, Jerry and Tom, we set out a program from 2016 that allowed management to drive both the budgeting and strategic processes. What was unique about this process was Tom Tashjian, worked closely with Jerry and his team and the Board of Directors to build the 2016 plan and I was available as needed. Monday, I informed Jerry, Tom and the board that I would not be standing for reelection as Chairman and recommending that Tom be appointed the new Chairman, which the Board did. This allows us an orderly transition as we needed to approach the shareholder meeting. I will remain a Director and hopefully share the opportunities of the future.

Tom will make an outstanding Chairman. Just to mention a few of the highlights. Tom holds over 300,000 shares of stock, which he purchased in the open market. He has worked diligently to bring on board with Jerry, our new President and Chief Operating Officer. He has the strong financial background, which was highlighted as he was one of the top analysts on Wall Street in the retail sector. He has been a successful entrepreneur for over the past 10 years and is known for his ability to build consensus.

Thank you for allowing me to serve you for these past 24 years. I am comfortable that the new team, Board of Directors, led by Tom, will bring continued success to Fred’s.

Now, I would like to ask Tom to say a few words.

Tom Tashjian

Well first, I would like to thank Mike Hayes for decades of service to the Fred’s company on behalf of shareholders, employees and the Board who have worked closely with him. Next, I think it’s important to recognize that over the last year Jerry, Mike and Rick have assembled senior executives from a wide array of companies that focus our strategy even more so. Bringing executives in from AutoZone, Walgreens, CVS, Dollar General, Family Dollar and Walmart has allowed them to know together best practices from all of those retail leaders. I look forward to being very supportive of the strategies that they have divine as we move ahead and focus on a small market healthcare format.

Let me turn it over now to Mike Bloom.

Mike Bloom

Thank you, Tom and good morning everyone. As Jerry mentioned, we are extremely proud of our many accomplishments in 2015 and the continued positive momentum in our business. The foundation that we have laid for 2016 and beyond has positioned us for stronger growth. Last January, we brought clarity to our entire organization with our renewed focus on the retail and specialty pharmacy patient as well as our customer-centric shopping experience across the entire store. Before I begin the year end review, I would like to briefly start with a high level summary of the fourth quarter. First, with the numbers, general merchandise departments comparable sales had a 740 basis point improvement over fourth quarter 2014. December alone had a 791 basis point improvement in comparable sales over last year. Our gross margin improved 535 basis points in the fourth quarter of 2015 over the fourth quarter of 2014. Based on these results, it’s clear that our holiday strategy worked.

Let’s talk about what drove these strong results. It started with a great plan developed by our merchants, marketers, supply chain teams and of course, store operators. The cross functional plan was laser focused on delivering a new and improved customer experience during the holiday selling season. We enhanced several key elements of our seasonal strategy. Assortment changed to address our customer needs. In-store merchandising plans changed to make it easier for our stores to execute and for customers to shop for seasonal merchandise. Our distribution processes and timing changed to support our stores. We placed big bets on many categories that paid dividends during the holiday period and we marketed these big bets frequently in our circulars and in our stores.

As we look at a review of 2015, it’s important to start with a refresher of the five key strategies that we introduced to you in March of last year. They were; to elevate and invest in talent, improve the total store customer experience, migrate our distribution network to an end-to-end supply chain, improve operating margins, and develop a more profitable, sustainable and growth-oriented business model. From a talent perspective, the current leadership team that Jerry and I have assembled is the best team I have worked with in my 34-year career. The combination of new talent, with an incredible depth and breadth of experience along with promotions of high performing internal candidates with vast institutional knowledge is the formula for a truly great team. The team is aligned, accountable, collaborative, thought provoking, innovative and delivering results.

Additionally, the bar has been raised for the entire organization and team members have really stepped up their game. There is a noticeable culture change that centers on a positive winning attitude in the store support center, distribution centers and in our stores. Improving the customer experience is paramount to sustainable and profitable growth. For those of you that have been in our stores, you know that the majority of our stores are old and tired. Since 2000, we have only remodeled 158 stores or 24% of our fleet. Most stores have had category refreshes, but still that old and tired field. In November of last year, we launched a new prototype store, about only been a few months. I am happy to share the following results for the general merchandise departments in this one store.

Comp sales are outpacing the company by 900 basis points. The gross margin rate is 52 basis points lower than the chain due to the mix shift. However, gross margin dollars are 740 basis points better than the chain. Based on these encouraging results, we are planning to remodel 5 stores per month for the next 10 months. Work began in earnest in February. As of today, a total of 14 stores have been remodeled with the new prototype. By the end of fiscal 2016, we plan to have completed approximately 60 stores or about 10% of the chain. The pace at which we continue our remodels after that will depend on the success as we move through the chain. Evolving to a fully integrated end-to-end supply chain is a key enabler to transforming our retail business model. Our goal is to become an efficient supply chain that makes it easy for our stores to operate and enhances the customer experience.

Last quarter, I reported to you that we lowered our supply chain expense. I am happy to report that in the fourth quarter, our supply chain expense has dropped 62 basis points to 4.4% of general merchandise sales. For the year, our supply chain expense is 5.15% or 19 basis points lower than last year. We are well on our way to achieving our goal of 4.5%. The reductions in supply chain expenses were due to outstanding strategic thought leadership and the flawless execution of the plan by the entire supply chain team. Some of the highlights include strategic consolidation points throughout the country to reduce less than truckload shipments, rerouting store deliveries, which reduced approximately 12,000 stem miles per month, eliminating one third-party carrier, eliminating a satellite warehouse and implementing an efficient order quantity model to reduce lead times and shipments into the DCs. At the end of the day, it’s all about improving our operating margins and building a sustainable and profitable business model for growth.

Let me walk you through some of the very encouraging metrics that illustrate we are clearly moving in the right direction. From a general merchandise department comp sales perspective, we are making good progress. When we compare 2015 comp sales by quarter versus 2014, first quarter comp sales improved 245 basis points. Second quarter comps increased 137 basis points. Third quarter comp sales increased 251 basis points. And fourth quarter comp sales increased 740 basis points. In total, 2015 comp sales improved 343 basis points over 2014.

From a general merchandise department gross margin rate perspective, we are also making good progress. When we compare 2015 gross margin rate by quarter versus 2014, first quarter gross margin rate actually declined by 79 basis points. Second quarter gross margin rate increased 626 basis points. Third quarter gross margin rate increased 680 basis points. And fourth quarter gross margin rate increased by 535 basis points. In total, gross margin rate improved 433 basis points over 2014.

Our mix of sales has changed fairly dramatically throughout 2015 versus 2014, which aligns with the sales in gross margin metrics I just reviewed. One example is our household goods segment, which is comprised of high margin, kitchen and housewares, hardware, automotive, bedding, bath, home furnishings, notions and as seen on TV. This department started out minus 90 basis points in the first quarter of 2015 and ended up at plus 90 basis points in the fourth quarter as a percent of sales for general merchandise departments. This is a true testament as to how our customers use us as their local general store. And quite frankly, it’s one of our biggest competitive advantages, because we carry an expanded assortment in these high margin categories that our customers are looking for.

From a sales per square foot perspective in general merchandise departments we see a similar trend throughout 2015. While we started out flat in the first and second quarter, we saw strong positive trends in the third and fourth quarters. Sales per square foot increased $1.21 in 2015. Inventory turns have also improved slightly by 4 basis points in the general merchandise departments. Looking at traffic and ticket in the general merchandise departments, traffic is down 25 basis points over 2014, which is attributed to inefficient promotional activity last year that drove unprofitable traffic into our stores. In addition, we are facing some challenges in our food business, which we are in the process of fixing. Conversely, we are seeing a strong trend with comp ticket performance. Ticket for the full year is up 369 basis points over 2014. Ticket performance is being driven by our mix of sales as well as the addition of higher priced national brands. I think it’s fair to say that there is a clear trend developing here with marked improvements on key metrics in each quarter throughout 2015. This now leads me to 2016 and beyond. As Jerry mentioned, we have made the strategic decision to invest in areas of the business that will enable us to deliver on our promise of growth and shareholder value.

Let’s discuss a few of these strategic investments. I mentioned on the last call that we have partnered with JDA for a new replenishment, allocation and space planning system. Our current replenishment system is based on a very antiquated Mini Mac system and does not take into account lost sales, seasonal forecasting and store specific item data. JDA is a significant enhancement that will drive sales, improve in stock and overall inventory productivity. We must improve the customer experience. As I mentioned earlier, we will implement approximately 60 prototype stores this year that includes remodels relocated in new stores. We will invest to improve our store standards, such as clean floors, lighting, cooling and heating. Our stores must meet our customers’ expectations of a comfortable and clean shopping environment. The stores are the face of Fred’s to the customer and improving the overall experience should result in a positive halo effect that will keep them coming back. We will execute a complete reset for all food, beverage and candy categories to ensure we have the right adjacencies and the right mix of product to meet our customers’ needs and increase sales in these traffic driving categories.

In an effort to raise the bar around our marketing efforts, we are in the process of selecting an advertising agency to assist us with messaging to our customers to drive traffic to our stores and pharmacies. We will continue to heavy up on our pharmacy advertising in an effort to drive script growth and create awareness around our healthcare services offerings. We will continue to build campaigns focused on driving general merchandise, department sales and pharmacy to front store conversion. We will continue to execute the initiatives that we started in 2015, such as e-auctions, category business reviews, promotional effectiveness, increasing direct importing and improving private brand quality, packaging and penetration. Lastly, we will continue to invest in talent to ensure that we have the right thought leadership to achieve our goals.

The investments I just outlined will provide the foundation for the team to continue delivering strong results in the general merchandise departments in 2016. Capitalizing on our solid 2015 performance and leveraging recent trends, we expect the general merchandise departments to deliver the following in 2016; A comp sales improvement between 200 basis points and 250 basis points, Traffic improvement of 75 basis points to 100 basis points, And further expansion of gross margin and general merchandise of 25 basis points to 30 basis points. In closing, I am as confident as ever in the leadership team, this unique business model and the growth prospects for Fred’s as a regional provider of healthcare services and value merchandise in the markets that we serve. Our strategies are working, our stores are executing and most importantly, our customers are voting and the results showing.

Before I turn it over for Q&A, I would like to introduce you to our new vision statement. A growing regional pharmacy provider of healthcare services, improving the outcomes of the people in the communities that we serve by delivering solutions that are safe, affordable, innovative and easy to access, complimented by a broad assortment of valued price and quality national and private brands, all while delivering consistent, strong shareholder value. This new vision will serve as a beacon for the entire organization to rally around and to use as a daily filter to ensure that we deliver on our promise to our customers, our team members and our shareholders. Thank you and we are looking forward to 2016 and beyond as we continue to develop a sustainable and profitable business model.

And now, I would like to turn it over to Augusta for Q&A.

Question-and-Answer Session


Thank you. [Operator Instructions] Our first question will come from Andrew Wolf of BB&T Capital Markets.

Andrew Wolf

Thanks. Good morning. I guess, Mike, on the front end and the general merchandise department, just the guidance you gave and the expectations just throwing some quick math. It looks like a little less than half of that would be of the increase in same-store sales would be from the 60 or so remodels. Am I kind of getting that right? And could you talk about generally on the not remodeled store or the rest of the store base, where you see most of the momentum coming? Is it going to be from getting the consumables right or is it going to be something else?

Mike Bloom

Yes. Thanks, Andy. So, the remodel stores should – again, quick math, should probably be responsible for about 20% of that growth. The balance of...

Andrew Wolf

Andy, sorry to interrupt, but keep in mind the rollout of the remodels for the year.

Mike Bloom

Yes. I was going to say its 5 stores a month, so you have to allow for momentum. Obviously, there is clearly a little bit of dip when you go into remodel store it takes about 3 weeks to do a store. So, I think it’s more around the neighborhood of 20% than the 50% that you suggested. And a lot of the comp sales growth is coming from, quite frankly, Andy, most of the initiatives that I mentioned, right? We have got – clearly, fixing the food will be a big piece of that, but we have been – we have talked a lot about the category business reviews and the continued growth that we are having in health and beauty aids, our home goods that I mentioned, our mix change in home goods, that’s being driven by – or driving higher sales, our apparel business is driving higher sales. So, it’s actually pretty balanced across the business, with the exception of food, which we are in the process of turning around.

Andrew Wolf

Okay. So, even though I did my math on a pro forma basis, I guess that is will help us look as you look into ‘17, then it starts to ramp up the remodel effect even if you kept it at the same pace and I guess...

Mike Bloom

That’s right.

Andrew Wolf

I mean is the thinking internally if these 60 stores work the way they are expected, then that would ramp up pretty significantly?

Mike Bloom

Yes, Andy. It is our intention to do that. We are doing at this year, on this controlled basis, so that we can analyze it, measure it, adjust and move forward.

Andrew Wolf

And just on the quarter, I might have missed this, but were you able to quantify or just talk about how much the light flu season impacted the sales and profits? And similar, what the effect is on the delay in the tax return season and maybe just – is there a net lower disposable income for your main customers due to some of the changes in the Affordable Care Act?

Mike Bloom

Yes, Andy. The flu season did have a significant impact on it. We report it each month. And for the quarter on the total company basis, it was somewhere around 100 basis points. Rick, you may want to talk about that and...

Rick Chambers

Yes. On the overall total sales comp impact, as Jerry said, it was around that 100 basis points in sales comp. And then when you look at just in the pharmacy area itself, it was around 200 basis points of impacting our sales comp. So, we are starting to see a slight increase in flu activity going into ‘16. We were cautioning internally that it’s not going to be similar to, I think you would have seen in January, February timeframe or even early March when you historically see those streams, but it is anticipated to extend even in the April, with some flu activity.

Mike Bloom

And Andy just to address your – the other part of your question about the profitability of that. The profitability on that 100 basis point miss on comp, plus the impact on new sales and in cough and cold expanding it to cough and cold is approximately $2 million on a pre-tax basis which is about $0.03 of earnings.

Andrew Wolf

Thank you. That’s helpful. Now, I just wanted to do a quick housekeeping, so we can understand the investment impacts are going through the income statement, JDA and marketing and so on, store conditions, $0.15 worth, is that a gross number or a net number, were there - I mean is that pure increase, is that the swing?

Mike Bloom

That is the net number. That is taking the investments less the benefits that we will see in 2016 and those are net numbers.

Andrew Wolf

Okay. So that’s – but is that also – when you compare it to what you invested in ‘15, were the investments in JDA, for example this year, significant enough that would add up or is it really basically a $0.15 headwind?

Michael Hayes

It is not a total headwind as compared to 2015. And I don’t have the breakdown of that, Andy. I can report that to you later as to what the incremental is over 2015. But it is significant to 2016 earnings as compared to total earnings per share and where consensus was. We looked at – we missed – I think our earnings range was about $0.05 below consensus and these investments are significant, are 3x that amount.

Andrew Wolf

Okay, thank you.


Our next question will come from Jill Nelson with Johnson Rice.

Jill Nelson

Good morning. Can you just talk about given the slowdown you saw in pharmacy scripts at the second half of ‘15, kind of your expectations of pharmacy script comps for 2016 and some initiatives you have in place to improve that number?

Michael Hayes

Jill, I am going to let Rick answer that, but I am going to be real careful about breaking down of our comp between general merchandise and pharmacy and specialty, etcetera.

Rick Chambers

Yes. Jill, as we mentioned earlier, we did see that slowdown in script comp in the back half, but with some of the initiatives that we have in place for 2016, Mike touched on it around the marketing, that’s probably one of the key drivers for us as we move into ‘16 because there has historically been some pharmacy marketing, but not – not to the magnitude that we have. And we invested in this year go forward and then also in working with John Foley and his team in terms of store standards and really getting stores cleaned up as Mike again alluded to the old and tired stores of just improving that customer experience. That also is helping early in the year in 2016 that we saw in February that Jerry mentioned. And then also, around the healthcare services, immunizations, that’s one of the drivers also at least continue to see increases in. We feel that creates a very loyal and sticky customer, if you will, as once we get them into to the pharmacy and the store, to really – to hang on to them going forward. And then lastly, around our star initiative with compliance and adherence programs that again going after those high value patients that have a large script volume in order to drive that increased script count around that.

Michael Hayes

And you do have a positive script count in 2016.

Rick Chambers

Yes. But you have a plan for ‘16 is a positive script comp. And as I have said earlier, in February, we started off with a positive script comp as well, so...

Jill Nelson

Okay. And then last question, just you talked about some issues on the food category side, can you talk about that. And then, I think you mentioned a reset for that category could you talk maybe timing of that to occur in the stores? Thank you.

Jerry Shore

Sure. The food resets – so let me address maybe some of the challenges first. We have got some assortment challenges. We have got some service challenges with some of our outside wholesalers. We have got some adjacency problems in our stores, not laid out necessarily how the customer thinks about when she shops for food. And we do have a location problem where food is not in the ideal location as it is in our group prototype stores, where we have moved it upfront. So, we have done several things. We have done a complete – we have already done a complete sort of remerchandising and cleansing, if you will, of the food departments. We had our stores and they executed. They did a great job over a very short period of time, got the planogram integrity back in shape, clean the shelves, rotated product and got us back into a sort of a steady state. Our new planograms and assortment will be introduced in at the end of Q2 and beginning of Q3, it’s a lot of category. So, we are touching every food and beverage and candy category segment in the store, including refrigerated and frozen. So, we will be touching those at the end of Q2 and into Q3.

Jill Nelson

Appreciate it. Thank you.

Jerry Shore



Our next question comes from David Magee of SunTrust.

David Magee

Yes, hi, good morning and congratulations for all the positive changes last year.

Jerry Shore

Good morning, David.

David Magee

Couple of things. One is the – you talked about the specialty pharma growth and I am curious how satisfied you are with that business from a profit margin standpoint? Is that pretty visible going forward that division’s ability to maintain margins?

Jerry Shore

David, this is Jerry. We are satisfied with what we have achieved on the EBITDA line. The specialty operating margins are lower as you would imagine than the retail pharmacy, but they are significantly above what we reported for the year and are accretive to our operating margin and our earnings and that will continue to be the case. What we like greatly about this is that it gives us the opportunity to leverage our expenses in a lot of different areas. We are, as we said in our prepared comments, integrating the specialty into our brick-and-mortar and that will be a key driver of earnings and EBITDA and will drive a good operating margin. It is lower than it does lower the goals that we had talked years past of 4%, but it is good operating. And there is so much upside as we move into new therapies and as that business changes. We have a lot of – Mike James and Rick Sain are moving into limited distribution with manufacturers and payer engagements. Rick can probably talk more about that than I can, but it is a very promising area of our company.

David Magee

Thank you, Jerry. And on a similar note, the – how much visibility do you have with regard to wage pressure, labor in the stores this year? Is that something that you got a pretty good handle on?

Jerry Shore

That is a risk, David. As you know, there is political legislative actions potentially. We are working very heavily. John Foley is working with HR to build our model and restructure our model as legislative changes take place. John, I don’t know if there is anything you want to add to that?

John Foley

Yes. We have got a team that is actively looking at every process and procedure that we have within the store, the front of the store and the pharmacy. And we are also looking at this legislation that’s coming down the road in terms of what does our future operating model look like if we have to mitigate payroll expense in the future.

Jerry Shore

First, to sum that up David, as a company, we are working to lessen that risk and mitigate where we can.

David Magee

Are you saying pretty good supply of applicants right now or is it becoming more of an effort to attract those, just given that other retailers are raising their wages right now?

John Foley

As of today, we have plenty of applicants and store staffing at this present moment is not an issue.

David Magee

And John, you have implemented programs through local community colleges to raise the talent levels.

John Foley

Yes. We have expanded our reach in terms of where we are looking for qualified management candidates for the future. We have expanded into a lot of community colleges as well as some other 4-year universities.

Michael Hayes

I would just add, that is the one of the benefits that John has brought to the company, is the ability to recruit and develop talent.

David Magee

Great. Thank you and good luck.

John Foley

Thank you, David.


And we do have one more question in the queue that will come from Paul Trussell of Deutsche Bank.

Tiffany Kanaga

This is Tiffany on for Paul.

Jerry Shore

Hi, Tiffany.

Tiffany Kanaga

Hi. First, I wanted to ask if you could breakdown your projected EBITDA improvement with a little more color in terms of what percent of the increase is driven by pharmacy and specialty and how much is supply chain improvements and cost savings and general merchandise improvements?

Jerry Shore

Okay. If you will allow me a second to look, so in terms of – and I am going to go from pretax – lift from pretax basis, Tiffany. If we look at the improvement in the range of $13 million to $15 million in pretax improvement, it really is about 50-50 coming from the general merchandise side of it and the retail specialty or total healthcare services. What is pleasing to me and we thought about that the general merchandise side has not been profitable in previous years and we have now – we will turn that around in 2016. And the general merchandise side of the – front store side of the business will go past the breakeven point and bring profitability to the company. So I hope that helps without getting too detailed into that.

Tiffany Kanaga

Yes, that was helpful. And I also wanted to touch on reimbursement rate pressures specifically, which was a drag on the quarter, but you didn’t discuss entirely to 2016, are you seeing any change in the trend there and are you building any improvements or conversely, deterioration into your projections?

Rick Chambers

Tiffany, this is Rick. Where we are as we look in 2016, we don’t see material changes from the pressure we would anticipate, similar pressure going into 2016. We have seen some change in particularly one of our Medicare Part D preferred networks and actually two of them, they are fairly concentrated in our areas that have had a different perspective on how to handle the DIR fee or the direct and indirect remuneration fee for Med D networks. And we are seeing some benefit from that. There is some equal challenge on the – with the initial markup that we deal with on that with reimbursement rate. Also, we have added an additional team member that will begin in a few weeks. He is going to be handling our payer relation engagement at a more senior level and be able to find those opportunities where we can work with the payers to improve any types of reimbursement. But then also lastly we are seeing a shift and move towards more of a performance-based payer network, but again, it revolves back around with the star initiatives that Jerry touched on earlier. So, we think we believe and very confident that we are in a good position to be able to impact that favorably based on the ability that we have with our pharmacies to engage with those patients daily, so...

Tiffany Kanaga

Alright, thank you very much.

Jerry Shore

Thanks, Tiffany.


We have no other questions at this time. I would like to turn it back to Mr. Shore for closing remarks.

Jerry Shore

Thank you everyone for joining us today. We look forward to talking to you in the future. There are so many exciting things going on at Fred’s. And I also would like to echo the comments that Tom said about Mike Hayes. I greatly appreciate the time I have had with Mike and do continue to – do look forward to continuing to work with Mike as a board member. Thank you very much to everyone.


That does conclude today’s conference. Thank you all for your participation.

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