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Family Dollar Stores (NYSE:FDO)

F3Q07 Earnings Call

June 28, 2007 10:00 am ET

Executives

Kiley Rawlins - VP of IR & Communications

Howard Levine - Chairman & CEO

Jim Kelly - President & COO

Analysts

Matt Boss - J.P. Morgan

Mark Miller - William Blair & Co.

Bakley Smith - Banc of America

Mike Baker - Deutsche Bank

David Cumberland - Robert W Baird

Eric Mace - Credit Suisse

Dan Wewer - Raymond James

Kenneth Huang - Citigroup

Jody Yen - Buckingham Research Group

William Keller - FTN Midwest Research

Robert Du Boff - Merrill Lynch

Patrick McKeever - Avondale Partners

Tien San Lucas - AIM Investments

Meredith Adler - Lehman Brothers

Operator

Good morning. My name is Regina and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Family Dollar third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' prepared remarks, there will be a question-and-answer period (Operator Instructions).

As a reminder, ladies and gentlemen, this call is being recorded today, June 28th, 2007. I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you make begin your conference.

Kiley Rawlins

Thank you, Regina. Good morning, everyone, and thank you for joining us today. We appreciate your interest in Family Dollar. Speaking this morning will be Howard Levine, Chairman and CEO, and Jim Kelly, President and COO.

Before we begin, you should know that our comments today will include forward-looking statements, which are made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act. These statements address company plans and activities or events, which we expect will or may occur in the future. However, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ from our plans. We refer you to and specifically incorporate the cautionary statements contained in today's press release and in our other SEC filings.

You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this call. The company does not undertake to publicly update or revise its forward-looking statements, except as required by law. This morning, we will begin our discussion with some comments on our third quarter results from Jim and then Howard will share some of his thoughts with you. Jim?

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Jim Kelly

Thank you, Kiley. Good morning. Today, we reported earnings per share of $0.40 versus $0.37 per share for the third quarter last year. Those of you who have had the opportunity to read our press release probably noted that earnings were reduced by approximately $0.02 per share as a result of stock option related litigation. I suggest that you also note the lower than normal effective tax rate that enhanced earnings by about $0.01.

Several years ago, we discussed with you our belief that the best way to enhance our financial performance was through a focused effort to improve operating margin and asset efficiency. To that end, we have slowed new store growth and accelerated investments in both sales driving initiatives and programs designed to enhance performance.

Macro conditions, both from the perspective of the financial health of our customers and a competitive perspective, have been challenging. But notwithstanding these challenges, we are making progress. We have reported operating margin expansion during each of the four quarters beginning with the third quarter of fiscal 2006. The amount of expansion becomes even more significant when adjusted to reflect expensing of long-term incentive pay, which began in fiscal 2006 and certain litigation charges.

On a GAAP basis, we did not report operating margin expansion this quarter, but if results are adjusted for the impact of the stock option litigation, there was continued margin expansion. Inventory productivity has consistently improved for the past seven quarters. Inventory turns calculated on a 12-month moving average basis have improved 13% during this period, while gross margin return on our inventories improved 18%.

And expanding operating margin combined with greater asset productivity led to a 21% improvement in return on equity during the same period. Again, calculated on a 12-month moving average basis. Within this context, the third quarter represents a continuation of an overall favorable financial trend. But the quarter also reflected both some opportunities and challenges.

Let's take a more granular look. Comp store performance continues to lag our internal targets. While the 1.5% comp reported for this quarter was relatively competitive with those serving the low-income consumer, we believe that we can do better. Howard will focus his remarks on various programs intended to drive sales.

Gross profit as a percentage of sales expanded approximately 130 basis points, driven by increased sales of prepaid services, stronger sales of higher margin merchandise, and better purchase mark-ups. Shrink, markdowns and freight costs were relatively flat for the quarter, but we continued to believe that these areas offer opportunities for further margin expansion.

On the other hand, selling, general and administrative expenses as a percentage of sales increased around 160 basis points this quarter. Most of this deleverage can be attributed to the below target comp store performance and litigation costs. I would characterize much of the remainder as project-related.

We have discussed with you major projects such as Project Accelerate, which is designed to provide our merchants with a series of optimization tools, Store of the Future, which is the introduction of new store technology to improve customer and associate interface, centralization of procurement, which includes both the build-up of our indirect procurement department and the introduction of E-procurement technology, and facilities management, an end to end reengineering of our store facility management program, which also includes the introduction of new technology. Howard will update you in a moment on each of these initiatives. From a financial perspective, we remain convinced that they will each drive targeted benefits.

Both the centralized procurement and facility management initiatives are inspected to result in a lower cost structure next year. Project Accelerate and Store of the Future will continue to pressure our expense structure, while driving benefits in the form of sales and gross margins.

Notwithstanding this, our objective is for cost savings from earlier projects to fund the cost of later projects so that expenses will be levered in the 3% to 3.5% comp sales range. Overall, through the first three quarters, excluding stock option litigation costs, we have been within this range and expect to be back in the range next year.

Our income tax rate for the third quarter was approximately 35% versus 37.7% for the third quarter last year. The decrease in the effective tax rate was primarily the result of job tax credits and an increase in tax exempt interest income. With the continued restraint of capital expenditures and improved, and improved inventory productivity, cash flow has been quite healthy.

Cash and short-term investments totaled approximately $357 million at the end of the third quarter this year versus approximately $168 million at the end of the third quarter last year. We resumed our stock repurchase program this quarter, buying 4.1 million shares at an average cost of $32.53.

Since the end of the quarter, we've acquired an additional approximate million shares. Our board of directors recently authorized management to acquire an additional 5 million shares of the company's stock, giving us a current authorization of approximately 6 million shares.

Inventories in total were down approximately 2% for the third quarter versus the third quarter last year and were down nearly 9% on a per store basis, excluding merchandise in transit to our distribution centers. Capital expenditures were approximately $86 million for the first three quarters this year versus approximately $144 million last year. This decrease results primarily from a lower capital spend for new stores in our distribution network. We now expect that capital expenditures for the current year to be in the $120 million to $130 million range.

Based on performance through the third quarter, we now expect earnings for fiscal 2007 to be between $1.62 and $1.65. This reflects an expectation of fourth quarter earnings of between $0.26 and $0.29 per share. I have noticed that some of you have been providing annual estimates that exclude the stock option review related charges, while others have included these charges in your estimates. To be clear, our guidance is on a GAAP basis and therefore includes the approximately $0.09 per share impact of these charges.

And now Howard will share his perspective. Howard?

Howard Levine

Thank you Jim, and good morning, everyone. As we have discussed on previous conference calls, the last several years have been challenging for the low income consumer. And this year, so far we have not seen much relief, as energy costs have continued to be volatile. This difficult economic environment has had an impact on those who serve the lower end. However, our commitment of making investment and operating decisions to support the long-term health of our business have resulted in an improving trend.

Our team has worked hard to improve our operational execution and to enhance the shopping experience for our customers. The result has been a nice improvement in many of our key metrics.

Excluding expenses and charges related to the stock option review, we have seen improvement in our operating margin and have delivered strong earnings increases in each of the last five quarters. Since fiscal 2005, we have improved return on average shareholder's equity, gross margin return on inventory, and inventory turn. And since January of '06, we have seen steady improvement in store manager retention. Today, overall store manager turnover is less than 40%; an improvement of about 20% and the turnover in urban markets has improved even more.

Many of our key metrics are moving in the right direction. But there is one area that continues to be softer than we would like. Comparable store sales. We have made investments in key traffic and profit-driving categories and these categories are performing well. For example, food has been a significant driver of comps, as we have executed our food strategy.

In early 2006, we began installing coolers in our stores. At the end of the third quarter of this year, about 4700 stores had coolers and we are on track to have coolers in more than 5000 stores by the end of our fiscal year.

This year we implemented the second phase of our food strategy, the enhancement of our food assortment to include a greater emphasis on quick prep and ready to eat products. This spring, we updated the food schematic in all stores to reflect this focus and the results have been very positive.

In addition, we expanded the square footage for food items in about 2000 stores. While it is too early to validate the sales lift from the additional space, these stores are delivering stronger comp sales results than the rest of the chain.

The next phase of our food strategy is the acceptance of food stamps. This spring we began a multi-year effort to refresh our register and point of sale technology through our Store of the Future project. This new POS system will enable us to process customers much faster through the checkout and will enable us to accept multiple tender types, including food stamps and credit cards. At the end of the quarter, approximately 300 stores were using the new registers and we expect to have about 750 stores utilizing the new system by the end of the fiscal year.

While food continues to be a driver of top line growth, we are struggling in some of our other key consumable categories. As low income consumers have continued to consolidate trips in response to energy costs, the promotional environment in some of our categories have also intensified. We have addressed the softness in these areas by sharpening our pricing on key items and by increasing our presentation space for promotions. Longer-term, we will use newly defined category management processes to determine the best assortment, promotional pricing and space strategies for these traffic-driving categories.

Several of our Treasure Hunt categories have been strong this year. As we have made strategic improvements in our seasonal and apparel assortments, we have experienced a positive impact on both sales and profitability. As part of our Treasure Hunt strategy, we continue to refine our promotional and advertising strategies. This spring we did a good job coordinating our circulars and in-store handouts with seasonally themed events in our stores.

For example, for Memorial Day, we introduced a new summer fun book; similar to the toy book we produced for the holiday season. The summer fun book highlighted lawn and garden, toys, and other key Treasure Hunt categories. In addition, as we have become more aggressive with markdowns to position fresh merchandise, we have improved the in-store presentation of seasonal items. The result of all these efforts have been stronger sales and increased inventory productivity.

We have also seen improvement in the performance of our apparel area. In fact, this quarter, the apparel and accessories categories was our fastest growing category. About a year ago, we added new management in our apparel area and under the leadership of this new team; we have narrowed our assortments, improved our in-store presentations, enhanced the quality of our products and increased the effectiveness of our markdowns. The result has been less inventory and stronger sales, clearly an effective combination.

One area of our Treasure Hunt strategy that has not performed, as we would like is the home area. As we apply some of the lessons learned from our apparel strategy to our home category, we believe that we can improve our performance. While we focused on improving our top line performance, we are also working to improve our profitability.

In 2006 we slowed new store growth so that we could focus on improving the profitability of both existing stores and new stores. Over the last two years, we have worked to improve our underwriting criteria, site development processes and grand opening processes to make sure that we make the best first impressions for our customers with each store that we open. While this year we have opened more stores in smaller markets, we have begun to see the benefit of these efforts as the performance of new stores is improving.

Today, 40% of our merchandise is manufactured overseas. And yet we work primarily with agents. In April, we began to lay the foundation for our global sourcing efforts with the creation of a senior role responsible for working with our merchants and to determine how we can best improve our sourcing capabilities. As we develop our global sourcing expertise, we believe that we can enhance our profitability by sourcing more products directly from the manufacturer.

Historically, our pricing strategy has been primarily dependent upon profitability goals and competitive behavior. As part of our Project Accelerate efforts, we have begun to apply a more scientific approach to pricing, one that considers not just competitive factors, but also customer sensitivity.

Last fall, we worked to determine appropriate price zones by market and to analyze item demand elasticity. This spring, we began an initial testing phase in a number of departments. We continue to refine our predictive models and forecast, and longer term; I continue to believe the price optimization will help us strengthen our price perception, while also enhancing our profitability.

In addition to focus on improving gross margin, we are also working to lower expenses. We are working to reduce our use of paper-based processes, increase our use of e-procurement and centralize our purchases of common services like floor care and pest control. We are also investing to improve the efficiency and effectiveness of our facilities management programs to include further automation of lease administration, more proactive centrally controlled maintenance programs, and a number of energy conservation programs.

As I mentioned earlier, we have steadily improved inventory turns and gross margin return on inventory. While we have made great progress in improving inventory productivity, I believe that we have an opportunity do even better. The ultimate goal is to ensure the right product is in the right store at the right time.

Over the last two years, as we have moved stores to a system-based replenishment model, we have reduced the safety stock of basic items, while improving in-stocks and increasing sales.

Today, our in-stocks are at the highest levels in two years, yet our inventories are lower. We have accomplished much in the first phase of centralized replenishment. Next, we will look to refine stock levels and space allocation, as we work to optimize sales.

We also have an opportunity to flow Treasure Hunt merchandise better. This spring, we began using the facility in Savannah, Georgia as an import center to help us moderate the flow of seasonally sensitive goods.

This approach has enabled us to utilize current trend data to improve our replenishment of seasonal merchandise to stores. Using in-season sales data, we can make better decisions about allocating products.

Our success in getting merchandise in season where it is selling well will help us increase our sales and reduce markdown risk.

I began my comments this morning with some thoughts on the macro conditions. Two years ago, as the economy became more challenging for the lower end, we saw it as an opportunity to increase investments in our business rather than curtail investments. Over the last several quarters, we have seen these investments deliver returns in a difficult environment.

Recently, there has been much speculation in the press regarding the health of the consumer. While we don't have any extra economic insight into the future, we do expect the environment will continue to be volatile. Energy prices will most likely continue to fluctuate, but there are some indications that life for many of our customers could get better.

Recently, unemployment rates for those with a high school education or less have stabilized and real wages have begun to improve. Our customer base is growing and with the recent focus on minimum wage of both the state and federal level, families at the lowest end of the economy may soon get some much-needed relief.

Regardless of the economic environment, we will stay focused on making Family Dollar a more compelling place to shop, work and invest. As we continue to invest to improve our operational execution and enhance the customer shopping experience, I continue to be very excited about the opportunity for Family Dollar.

Now, operator, we would be pleased to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Charles Grom.

Matt Boss - J.P. Morgan

It's actually Matt Boss in place of Chuck Grom today. Couple questions. First, with regard to your fourth quarter margin outlook, could you just elaborate a little bit on the higher expected markdowns, specifically which categories will be most impacted? And also the disconnect between faster inventory turns in the quarter and lower inventory growth year-over-year that we saw in 3Q?

Jim Kelly

Yes, I think that the fourth quarter is what we would consider a clearance quarter. If you look at the cadence of our business, the second quarter's a clearing time for the winter and fall goods, and the fourth quarter becomes a clearing time for the summer and spring goods.

Coming into this season, we had significantly less inventories, primarily in the older inventory categories. On the other hand, we have a healthy assortment of the spring and summer goods, so as a result of that, as we enter into the clearance quarter, we are expecting a little more markdown activity.

In addition to that, the markdowns, the second markdown of the spring and summer goods were in the first week of September, which was the first quarter of this year last year, and they will be in the fourth quarter this year. So you do have some timing differences in the markdown area that are also a factor there.

Matt Boss - J.P. Morgan

Okay. Second question, during, during Kroger's recent EPS conference call, they spoke to gross profit margin pressure, particularly from an inability to pass along some of their input costs to the customer from inflationary pressure in food. Is this something that you're seeing in terms of, in terms of your margins and what are you seeing in terms of food inflation currently?

Jim Kelly

There's no question there has been quite a bit inflation in the food area. We have managed to do that fairly well, I believe. We were very careful in the way we look at our pricing and the competitiveness of our pricing with others in our channel, as well as other retailers, and have seen that we have been able to pass price increases on to the customer fairly, fairly well. Our margin plans are intact and feel like we've been able to manage through that fairly well so far this year.

Matt Boss - J.P. Morgan

Okay. Thank you.

Operator

Your next question comes from Mark Miller.

Mark Miller - William Blair & Co.

Hi, good morning.

Jim Kelly

Good morning.

Mark Miller - William Blair & Co.

I was hoping you could elaborate on the updated guidance and it's lower on a reported basis, but is your intent to signal a change on an operating basis, or is it a similar guidance for fiscal '07?

Jim Kelly

I think it's fairly consistent, Mark. What we did have was a third quarter that had higher than expected gross margin increase, and also higher than expected expense deleverage.

We're looking at the fourth quarter to be a more normal quarter for us. So it's -- I think it will be fairly consistent with the broader year.

Mark Miller - William Blair & Co.

Can you talk about trends moving through the quarter? March and April had lower comps, May was better, how much of that was due to completing some of the schematic resets, the launch of Hanes and then I guess for June, you were saying within the range, but there would be a different interpretation of the low end versus the high end. So would you be willing to provide more context where you are within June?

Jim Kelly

We'll be reporting June in the next couple of weeks, Mark, so we're not going to comment any further on June. We still have two big weeks ahead of us here. We've got the clearance activity beginning this week. We've got the Fourth of July holiday, so we're not going to make any further comment on June at this point, but to your first question, regarding the, the acceleration of comps, we do believe that, as we discussed, that most of our initiatives were implemented in that February, March, April time period. We have gotten through most of those.

The food resets are going -- went very well and we're seeing improvements in our sales in those stores. We're very pleased with some of the results in the apparel area and some other Treasure Hunt categories, would like to see some better traction in some of the other consumable categories that I mentioned, but are addressing those and look to see those reaccelerate very soon.

Mark Miller - William Blair & Co.

With your expense rate or investments requiring a 3% to 3.5% comp for fiscal '08, does that imply, then, that you're expecting better comp growth fiscal '08 versus fiscal '07, or are you still expecting further gross margin to offset those expenses, which would then be deleveraged if you're less than that, or are you looking at a point where the margin recovery is topped out?

Jim Kelly

Well, I think that we have targeted, Mark, is expansion of the operating margin, which is a combination of those two. Some of these projects, as I mentioned, particularly Project Accelerate, has been very useful in our efforts to expand the gross margin as well as to support some of the sales initiatives.

On the other hand, it has pressured expenses. But in terms of the plans for next year, I think the main thing that we are committed to is the thing that, of operating margin expansion. As we finalize the details of our plan, we'll be providing a bit more guidance in terms of the individual P&L components.

Mark Miller - William Blair & Co.

Looking forward to that, thanks.

Operator

Your next question comes from Scott Mushkin.

Bakley Smith - Banc of America

It's actually Bakley Smith here for Scott Mushkin. I just want to ask about, I guess you guys have touched a little bit on the gross margin sustainability. As you look out further, do you think this is that you'll continue into 2008 or is it, are we towards the end of the cycle there?

Jim Kelly

No, I think if you looked at the primary drivers of the gross margin increase into the future, what we've talked about is global procurement, which we’re still in the fairly early stages of refining those processes. We've talked about price optimization, for which we are still in the early stages of that initiative.

We've also talked about how the project accelerate optimization tools should drive more efficiencies, not only in the, the sales area, but also the management of the gross margin. So I suspect that we're going to continue to look at gross margin expansion as a component of our overall financial metrics going forward.

Bakley Smith - Banc of America

But I mean when it comes to your customer, it seems to me that, the prices tend or savings tend to end up in their hands more than, than on the bottom line. I mean is that something you've contemplated using the savings that you get to try and drive better, better same-store sales?

Jim Kelly

Absolutely, and we've had significant improvements in the quality of our merchandise, which is to say that we have delivered better values to our customer this past year and that's something we'll continue to strive to do. On the other hand, I think that as we improve processes and lower our cost structure, an element of that belongs to another constituency group, and that is our investors. So there will be some to the bottom line, and some to our customers.

Bakley Smith - Banc of America

Okay. And then just last question on the urban initiative again you talked about it a little bit. I mean, is there any plan to, it sounds like it's going better, but then, I may have missed something, but it didn't sound also that you were necessarily going to kind of accelerate the opening of new urban, new stores in the urban initiative. I mean is there any plans for that over the next 12 months or so?

Howard Levine

It is, we're very pleased with the progress that we're making in the urban initiative. And just to go back for a minute, we continue to believe that we're creating some strategic advantage for ourselves and learning how to operate stores better in the types of markets. There is no other operator in our channel that has operated in these markets and we feel that there is some great opportunities to take advantage of that.

Two-thirds of consumer consumption takes place in these top 50 markets. We have about 14,00 to 15,00 stores in these markets, and not everyone of these markets is exactly alike and what we're spending our time doing now is going back and tweaking and making adjustments that are necessary to continue to drive profit margin improvement, which we're currently experiencing in about 80%-plus of those markets today.

We also were investing significantly in these markets, and these are the stores that will be the first stores to receive the new POS technology. So we continue to be very positive about the urban initiative and are making substantial investments in these stores.

Bakley Smith - Banc of America

Thanks very much.

Kiley Rawlins

Regina, before you take the next question, we have quite a few people in the queue this morning. If you could keep your questions to two or less, it should enable us to get through more of the queue this morning. Thank you. Regina, next question?

Operator

Your next question comes from the line of Mike Baker.

Mike Baker - Deutsche Bank

Thanks, guys. So I'll take my two questions. The first one is in the stores where you put in the expanded food we know the comps are better. What about the margin impact in those stores? Are you successfully in your words moving customers across the aisle to some of the discretionary products there?

And then my other question, simply, so in my count, you had about $22 million in legal and back dating costs. I assume we don't expect those to continue in the fourth quarter or next year, so in some respects, you already start with a 30 basis point advantage in our operating margins next year. Is that a fair statement? Thanks.

Howard Levine

Let me answer the last question first and say not certainly hope so. We're glad to make progress in this area and get it behind us, but I also want to point out there was an extra week in this year also that we're going to have to deal with, Michael.

On your first question, it's really a little early to be giving any kind of results on the expanded food. We have accomplished our primary goal of being more relevant to these frequent, to our customers with these frequent fill-in trips, starting with the coolers and then linking what we're doing with the coolers, better with our in-line assortment. So we are seeing traction there and are pleased with the rollout and where we are currently, but it's just a little early to be giving out any additional results on it yet.

Mike Baker - Deutsche Bank

Well, if I could just add, I know when you tested the result, you were able to move customers across the aisle and the margins were no worse in those stores than others, I mean. So I'm wondering if you just update in that sense.

Kiley Rawlins

Michael, I think you are correct. When we did our first test last summer, we were obviously pleased with the results, or we would not have rolled it out to 2,000 additional stores. I think, we finished the expansion in the stores in mid March and then as you know, had some seasonal shift with respect to Easter and some weather issues. So we've got a lot of noise in the data right now. We are trying to scrub it to get a better sense of what the lift to the basket is, as well as the impact on the overall store. So hopefully we'll have more visibility to that to be able to provide to you in a couple of months.

Mike Baker - Deutsche Bank

Okay. Thank you.

Operator

Your next question comes from the line of David Cumberland.

David Cumberland - Robert W. Baird

Good morning. Jim, you talked about taking the second markdown of season items earlier this year. Is the timing of the first markdown also shifting to be earlier?

Jim Kelly

No, the timing of the first markdown is fairly consistent and to be clear, the timing of the second markdown isn't that different. What is different is the first week in September is in the fourth quarter this year, whereas last year, the first week in September was in the first quarter of this year. So you've got a shift of a markdown week between the fourth quarter and the first quarter of next year. That's just the retail calendar shift that resulted from the extra week this year.

Kiley Rawlins

Regina, could we have the next question?

Operator

Your next question comes from the line of Eric Mace.

Eric Mace - Credit Suisse

Hi, thanks for taking my question. On the gross margin, I don't think I heard this. Could you break out the benefit from prepaid services in the quarter?

Jim Kelly

We haven't. We did in the first quarter and it's been fairly consistent in that 40 to 60 basis point range.

Eric Mace - Credit Suisse

Okay. Thank you.

Operator

Your next question comes from the line of Dan Wewer.

Dan Wewer - Raymond James

Howard, in the 300 stores with the new POS equipment, are they all taking food stamps at this point?

Howard Levine

Yes, they are.

Dan Wewer - Raymond James

And what have you learned thus far about how best to advertise the fact that you're taking food stamps and the customer acceptance?

Howard Levine

We're continuing to work through that. We do have quite a bit of in-store signing, in-store signage supporting, or telling our customers that we do accept food stamps. We don't have any results that we're willing to talk about now because it's still early, but the employee and customer reaction has been very positive and we continue to believe that that is the final, or one of the final legs of the food strategy initiative.

Dan Wewer - Raymond James

And since the initial rollout, as I understand is limited to the urban initiative stores, does that prohibit you from advertising the acceptance in your circulars?

Howard Levine

That is a constraint, but there's things that we can do to work around that, as we've done in other cases with specific stores. But keep in mind that a lot of these urban stores are in heavily populated areas with a lot of street traffic and right now our efforts is just trying to address it at the point of sale point right now.

Dan Wewer - Raymond James

In visiting stores, I see some clever items, such as your answer to the Crocs, I think that these had a $4 or $5 price point sandals, kind of curious how those more discretionary items are working with your customer.

Howard Levine

They are doing very well. One of the things that I've talked about in the apparel and shoe area is how and what role apparel and shoes plays in the dollar store space today. An item like the Crocs and/or flip-flops are perfect and have received very well by our customer and frankly wish we had more.

Dan Wewer - Raymond James

And then just real quick, on pricing optimization, do you have an example of something that, you discovered where, either you could raise pricing without any pushback from our customers or perhaps on the other side, where you found it made more sense to reduce a price point?

Howard Levine

Yes, I'm not going to get into specifics on that, Dan, but that's exactly some of the things that we're trying to work through and understand and the more time that we allow the system to analyze and process the data, the better the result will be for us. But those are some of the things that we're trying to understand better as we work through, through this price optimization.

Dan Wewer - Raymond James

Okay, great. Thanks.

Jim Kelly

Sure.

Operator

Your next question comes from the line of Deborah Weinswig.

Kenneth Huang - Citigroup

Hi, Actually this is Kenneth Huang (ph) for Deborah Weinswig. Can you guys talk about your push out of quick prep and ready to eat some more? What was the thinking behind that, and also would that be rolled out to all the urban stores first? And finally, will that have any impact on your shrink?

Howard Levine

The, the beginning point on determining the expanded food store was how we can be more relevant to our customers with the frequent fill-in trips that they make. We work with any of the number of -- whether it's ACNielsen, IRI, any of the other databases to help support the decision, along with our customer research to try to link what we're doing in our coolers with what we were doing in line. There was no decision to put this only in urban stores. We went through on a store-by-store basis, so it's pretty broad types of, in terms of types of stores that we rolled it out, and it's been received very well by, in all of those stores, so we're very pleased with the way we're becoming more relevant in those frequent fill-in trips that our customers often make. I think your other point on shrink, we don't see any material change in shrink in those categories and are managing through that fairly well.

Kenneth Huang - Citigroup

Great, thank you.

Operator

Your next question comes from the line of John Zolidis.

Jody Yen - Buckingham Research Group

Good morning. This is Jody Yen (ph) calling on behalf of John Zolidis. Can you please tell me if you have seen a measurable positive impact in sales at your stores in markets where Dollar General has closed a store?

Jim Kelly

Sure.

Jody Yen - Buckingham Research Group

And in addition, are there any markets that are experiencing a measurable negative impact from competition such as Wal-Mart, Dollar Tree or other opening stores?

Howard Levine

We, for years, have been dealing with competitors opening stores in our markets and we have opened stores on their market as well and have worked through those very well over the history of the company. When somebody does open, obviously there is some initial impact, but we seem to come back very nicely on almost every circumstance.

In terms of the Dollar General closings, when they are liquidating their merchandise on the stores that were within those markets, there is some short-term impact, but it's fairly quick and our operators have told us as soon as they are closed, we're getting more than our fair share of the business as a result of those closings. So, again, we're working through all those issues. I think fairly well.

Jody Yen - Buckingham Research Group

Thank you.

Operator

Your next question comes from the line of William Keller.

William Keller - FTN Midwest Research

Good morning, everyone. Thanks for taking my questions. Two things, I'm wondering if your fourth quarter guidance includes any impact from the minimum wage increase, which should be increasing here shortly. And then second thing, looking at working capital here at the end of the third quarter, seems to be down quite a bit. And I'm wondering if there's any sort of timing issues in current liabilities. I saw income taxes payable increased quite a bit here at the end of the quarter. Thank you.

Jim Kelly

Yeah, I think one, the forecast doesn't really take into account the impact of the minimum wage increase. That's going to be from a federal perspective, take place at the end of July. So we would expect that it would take several weeks to kind of run through the system and we will see what kind of impact it has, but it's not included in our projections right now.

The working capital question, I'll have to look into. Perhaps you can check with Kiley, but overall, our liquidity position is very, very strong, with the constraint of CapEx as well as the issues associated with better inventory productivity, the liquidity, again, is very strong. The liability area does include some accruals that we break out later on. Those are broken out for you, I think you'll see that most of the growth there is a byproduct of letters of credit associated with in-transit goods, as well as accruals associated with various insurance reserves. So, again, we are very pleased with the overall working capital management right now.

Operator

Your next question comes from the line of Stacy Turnof.

Robert Du Boff - Merrill Lynch

Hi, this is actually Robert Du Boff on behalf of Stacy. First, in terms of the automatic replenishment on your basic items, where are you in terms of that?

Howard Levine

It's rolled out to the entire chain, close to the entire chain at this point.

Robert Du Boff - Merrill Lynch

And on how many SKUs?

Howard Levine

All of our basic SKUs.

Robert Du Boff - Merrill Lynch

All of them, okay.

Jim Kelly

Let us clarify something there, because I think a lot of retailers talk about automated replenishment and there tends to be something that goes along the line, automated replenishment is automated replenishment is automated replenishment. The reality is we had all of our stores on automated replenishment five years ago, but we simply set the various controls so that the safety stock was very, very large and we allowed the store managers to order in addition to what the automated replenishment technology suggested. What has occurred in the last 12 months is that we have slowly tightened the parameters of our automated replenishment, which then enables you to reduce safety stock and at the same time, we have transitioned the responsibility of the store manager from ordering to a responsibility for maintaining data integrity of the inventories in the store. So it is those latter things that have been driving productivity of late as opposed to any new system rollout.

Robert Du Boff - Merrill Lynch

Great. And one follow-up. Hanes appears to have been pretty successful. Should we expect more major brands to be announced in the apparel area any time soon?

Howard Levine

The Hanes rollout has gone very well for us and we do look to develop a branding strategy in the apparel area, so stay tuned.

Robert Du Boff - Merrill Lynch

All right, great. Thanks.

Operator

Your next question comes from the line of Patrick McKeever.

Patrick McKeever - Avondale Partners

Hi, good morning, everyone. Just a follow-up on the question about Dollar General and what's going on with that company. What is the percent of your stores that overlap with, say, Dollar General store?

Jim Kelly

Roughly two-thirds.

Patrick McKeever - Avondale Partners

Two-thirds, and, Jim, would that be two-thirds within a few miles? What are the parameters…?

Jim Kelly

We define the trade market based on an analysis on a store-by-store basis and it would differ, for example, if indeed you were in a rural town it, might be a 5-mile area. If you were in an urban market, it might be significantly less than that. So they are defined from a trade perspective as opposed to a given number of miles apart perspectives.

Patrick McKeever - Avondale Partners

Okay. Got it. And on the new point-of-sale systems that are planned to be in 750 stores by the end of the year, are you planning on -- you mentioned taking EBT and also potentially credit. Are you planning on doing some sort of a credit card acceptance any time soon, or is that something that we should think about for fiscal year 2008?

Howard Levine

Patrick, the new POS system will allow us to process credit, and we are going to be testing credit cards to understand both the positive and the negative impacts from that but no plans for a rollout at this point, as we're just beginning the initial testing.

Patrick McKeever - Avondale Partners

Okay, great. Thank you, Howard.

Operator

(Operator Instructions). Your next question comes from the line of Tien San Lucas.

Tien San Lucas - AIM Investments

Hi, good morning. You've made a lot of progress in your apparel category. Can you give me a sense of the margin improvement in this category? And then secondly, are there any structural or other reasons why you wouldn't be able to apply your learnings to other product categories?

Howard Levine

We are very pleased with the margin improvements that we've made in our apparel area. The numbers surrounding apparel, that the markups have always been better than other categories. One of the challenges is what you have to do at the end of the season to liquidate, so what is your final margin on those? And we've improved on both areas there.

We continue to focus on cleaning up at the end of the season, to keep merchandise fresh, to make the stores more shoppable for our customers. And there are absolutely some principles that can be applied to all areas of our business. When you hear me talking about making our stores more shoppable, keeping inventory more fresh, allowing our stores to present the goods more effectively are all things that we can do better and learn from the apparel area. So I think there are a lot of learnings that we can take to other areas of our business.

Jim Kelly

I would add on a little bit there. We think broadly of the fashion part of our business as working under the Treasure Hunt umbrella and that umbrella has included not only apparel, but other areas such as toys and lawn and garden and it is improvement across the entire fashion part of our business that has been very helpful in driving gross margin expansion.

It is also that area of our business that things like price optimization, which also becomes promotional optimization or markdown optimization, import, or global procurement area tend to have the greatest impact on the fashion part of our business.

So one of the things we've worked hard on over the last decade is to make sure that the mix of our sales have been balanced between core consumables and the fashion part of our business and that's given us now an opportunity to leverage the margin potential of that entire spectrum of our business.

Tien San Lucas - AIM Investments

Great. Thanks so much.

Operator

Your next question comes from the line of Meredith Adler.

Meredith Adler - Lehman Brothers

Good morning. Couple of questions. You talked a little bit about weakness in sales of basic items outside of food and I was wondering how that flows into the gross margin. If you would have the sales you had expected in those categories, would the gross margin have been different?

Jim Kelly

I think yes. Any time you change the mix to have a higher proportion of lower margin items, it would negatively impact the gross margin. On the other hand, it would help leverage expenses, so at the operating margin line, I will take it.

Meredith Adler - Lehman Brothers

Okay. And then if you could talk about centralization, I was maybe just a little bit confused. Were you talking primarily about the centralization of the procurement of services, or was there some change in the procurement of goods and I would have thought you were doing all that centrally anyway?

Jim Kelly

Well, I think we were really talking about all of our indirect spends, whether they be supplies, whether they be floor cleaning in the stores, whether they be batteries in our distribution network, but it also includes services, such as various consulting services. So what we are doing is centralizing a much greater portion of our spend so that we can leverage our buying power.

Howard Levine

And, Meredith, we also will be experiencing some reverse options in the merchandising area as well, but most of our efforts is trying to centralize procurement of all these various supplies that 6000, and services that 6000-plus stores and 9 distribution centers undertake individually in some cases. So there's a huge opportunity to utilize our buying strength and power through technology to improve controls and costs in this area.

Jim Kelly

It's about a $400 million spend that we are attacking.

Meredith Adler - Lehman Brothers

Okay, that's great. And then just one quick question, global procurement and timing of price optimization, both of those you said are in their early stages. Do you have some sense of when you would actually see bottom line benefits from both, either?

Jim Kelly

I think we are already seeing some. I mean looked at the gross margin expansion and some of the inventory productivity. I've got to credit the merchandising and logistical groups for actually not waiting for all the technology, but changing some of the processes that are in place in order to improve margin performance and sales performance.

So I think we have already gained some traction there. I think there's some traction that is measurable that has resulted from the price optimization area. That, too, would show up in the gross margin. We talked about an improvement in the purchase markup, which is really the area of impact that one could expect there.

On the other hand, what we have said in both of those areas, we expect a multiyear rollout. So as we discuss our plan with you for next year, we will give you a little better guidance in terms of how much benefit we're looking for over the next 12 months. But right now, I would say that it's fair to say that we have recognized relatively modest benefits, but enough benefit to give us a great deal of confidence in terms of what the potential may be.

Meredith Adler - Lehman Brothers

Great. Thank you very much.

Operator

At this time there, are no further questions. And we'll now turn the call back over to Ms. Rawlins for any concluding remarks.

Kiley Rawlins

Thank you, Regina, and thank you, everyone, for joining us this morning. As always, if you have additional questions, I will be available after the call. Thanks, and have a good day.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.

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Source: Family Dollar Stores F3Q07 (Qtr End 6/2/07) Earnings Call Transcript

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