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PetSmart, Inc. (PETM)

Q3 2007 Earnings Call

November 14, 2007 4:30 pm ET

Executives

Tawni Adams - IR

Phil Francis - CEO

Bob Moran - COO

Chip Molloy - CFO

Analysts

Matthew Fassler - Goldman Sachs

Michael Baker - Deutsche Bank

David Mann - Johnson Rice

Peter Benedict - Wachovia

Brian Nagel - UBS

Mitch Kaiser - Piper Jaffray

David Cumberland - Robert W. Baird

Chris Horvers - Bear Stearns

Jonathan Kramer - Cowen

Operator

Good day, ladies and gentlemen, and welcome to the PetSmart third quarter 2007 earnings conference call. (Operator Instructions) I would now like to introduce your host for today's conference, Ms. Tawni Adams, Director of Investor Relations. Ma'am, you may begin.

Tawni Adams

Good afternoon and welcome to PetSmart's conference call to announce our results for the third quarter of fiscal 2007. With me on the call today are Chairman and Chief Executive Officer, Phil Francis; our President and Chief Operating Officer, Bob Moran; as well as Chip Molloy, Senior Vice President and Chief Financial Officer.

Phil will kick off the call today with an overview of our third quarter results. Then, Chip will take you through the financial review of the quarter and our earnings guidance for the remainder of the year. Bob will provide a preview of the fourth quarter and an update on our ongoing work to drive meaningful shareholder returns. Finally, we'll take your questions.

Please keep in mind that everything we cover during today's call including the question-and-answer session is subject to the Safe Harbor statement for forward-looking information you'll find in today's news release. We'll post a reconciliation of the non-GAAP financial measures we discuss on the call to the most directly comparable GAAP measure in the investor relations section at www.PETM.com.

Thanks, and I'll now turn the call over to Phil.

Phil Francis

Thanks, Tawni. Hello, everyone and thanks for joining us. During the third quarter, we weathered the top line impacts of a tough consumer environment and our decision to exit our State Line Tack business and we did a nice job of managing inventory and expenses. That allowed us to deliver earnings of $0.23 per share. That's better than our recent guidance of $0.17 to $0.20 and we're on target to deliver solid earnings growth for the year.

Total sales grew 7.8%, driven by the addition of 106 net new stores since the third quarter of 2006, and comparable store sales or sales in stores open at least one year grew 1.4%.

The exit of the State Line Tack business cost us approximately 1.2% of comp for the quarter. We came into the quarter expecting some impact as we cleared out product from our State Line Tack business and remerchandised the space. We accelerated the remerchandising and I'm happy to report that at the end of the quarter we were fully reset with fast-moving and top-selling products in all of our stores. We think the worst of that impact is behind us. We are seeing sales in these 180 stores ramp back up and we believe we're in a good position heading into the holiday season.

The pet food recall had some lingering effects on the top line for the quarter; however, we're making progress. At the end of the quarter, we had 108 SKUs of the total 305 recalled back on our shelves. We expect vendor to add back an additional 163 SKUs by the early part of next year. The remaining SKUs, about 34, will not be returning to our shelves, because the vendor has chosen to rebrand, reformulate or discontinue the product.

We believe the unseasonably warm weather impacted certain categories of our business. As you can imagine, dog skiwear tends to sell better when the weather cools off, but beyond that beds, apparel, outdoor containment, heating accessories and consumables typically ramp up as the weather turns cooler. In the early part of the fourth quarter, we were seeing promising trends from cold weather categories and expect this momentum to continue through the holiday season.

The fires on the West Coast had a minimal impact on the business for the quarter. Only two of our stores were briefly closed while 34 stores were impacted indirectly as a result of evacuations, road closures and warnings about people and pets staying inside because of the smoke. Of course for us, the loss of sales is secondary to keeping pets safe. So we evacuated pets in affected stores to safe locations. This work was especially important for our birds who are sensitive to air quality issues. I'm pleased to report that we kept everyone safe.

At the same time, we dispatched two emergency trailers to the fires and provided much needed supplies and care for evacuated pets. Our customers donated generously during the fires and saw PetSmart as the place best positioned to help pets during a crisis. As a result, we raised more than $300,000 for disaster relief.

The experience of the fire demonstrates again the unique connection people have with pets and with our brand. We think that connection and the emotional nature of our category, will continue to benefit us. In an environment where macroeconomic issues and the resultant slowdown in consumer spending have impacted many retailers, we believe there may be an impact on our business; however, to a much lesser degree. We're not seeing customers trade down in food or give up their pet. Instead, we're seeing continued growth in our ultra premium, natural and organic foods and we've seen services continue to grow.

In fact, service sales grew 23%, demonstrating that in good times and bad, our services customers are extremely loyal and see our services as a need, not a discretionary expense. Services growth has ramped nicely throughout the year. Our year-to-date growth through the third quarter was 20.3%, and we're on pace to achieve our 20% growth target for all of 2007.

So during a time of uncertainty in the environment, the best we can do is run our business well. We will continue to use all the data at our disposal to understand emerging situations and react quickly and appropriately and continue to drive top line growth. We're allocates our marketing mix to what we know drives traffic, emphasizing our competitive pricing and our unique value proposition. We are focusing on making our stores easier to run which makes us much more efficient and helps us to control costs. For the third quarter, we are pleased with where our expenses came in on a 1.4% comp and plan to keep that level of expense intensity going forward.

As we head into the holiday season we're well prepared to delight our pet parents. Our merchants have delivered our best holiday offering yet, with more than 1,300 exclusive SKUs at attractive price points as low as $2.99. Our stores are in a consistent format that is designed around our customer, with service offerings to prepare each pet with the high style grooming and party etiquette to attend even the most high-class holiday gatherings. If the pet is somehow not on the guest list, our hotels are ready to deliver five-star accommodations. Our stores are staffed with associates who are passionate about pets and ready to delight the pet parent.

We've done a nice job of managing inventory through the third quarter, and are headed into the holiday season with the right amount of inventory and the right products in stock and ready for the customer. We were pleased with our Halloween product sell-through and we believe we're on target to have similar success with our holiday products.

So we're committed to gaining share, delivering consistent financial results and generating long-term value for our shareholders. While we don't know how long any consumer weakness will last, we have a good business model and a solid plan to execute and emerge stronger.

With that, I'll turn it over to Chip Molloy, our CFO who will take you through the financial review of the quarter.

Chip Molloy

Thanks, Phil and hello, everyone. It's great to be here. I'm going to discuss our financial performance for the third quarter, provide guidance for the remainder of the year and discuss briefly my observations since joining PetSmart a month-and-a-half ago. Our consolidated net income was $29.5 million or $0.23 per share for the third quarter of 2007. That includes a negative impact of $4.7 million pretax related to the exit of the State Line Tack business. This net expense includes accelerated depreciation of assets, severance, and cost to remerchandise the former equine sections of our stores.

By controlling the costs to remerchandise this space and taking fewer markdowns to sell through the remaining inventory, we managed expenses to below the $7 million we previously estimated. Also included in our third quarter results was a $5.5 million pre-tax benefit for the recognition of gift card breakage. Our program is relatively new, and we now have sufficient historical redemption information necessary to recognize breakage. The benefit in the third quarter was for our portfolio of gift card balances from the beginning of the program until now. On a go forward basis, we will continue to recognize gift card breakage but the annual impact is unlikely to be material.

At $1.12 billion, our total sales increased 7.8% from the same period last year. As Phil mentioned, our comparable store sales or sales in stores open at least a year grew 1.4% for the quarter. That's on top of the 6.8% comp growth in the third quarter of last year, which was our highest comp quarter for 2006. Our total sales growth was also fueled by 106 net new stores open since the third quarter of last year, which was a 12% increase. Our total square footage increased from 20.3 million to 22.5 million or 11%.

In addition, we opened 30 new Pets Hotels since the third quarter of last year which is a 53% increase year over year. We expect to open an additional 16 net new stores and ten Pets Hotels in the fourth quarter.

Gross margins declined 11 basis points to 29.7% for the quarter. Merchandise margins improved in all three of our primary categories, dog, cat and specialty. Merchandise margins continue to benefit from our work to optimize prices and negotiate favorable terms with our suppliers. We are sourcing our products smarter and making assortment decisions that benefit both the customer and our margin. Those benefits are offset by increased occupancy costs associated with new stores and dilution from increasing penetration of our services businesses. For the year, we expect gross margins to increase 25 to 30 basis points. That includes the cost to exit the State Line Tack business and a benefit from the 53rd week.

Operating, general and administrative expenses were 24.4% or flat compared to the third quarter of last year. That includes the 39 basis points increase for the exit of the State Line Tack business and a benefit of 49 basis points from the gift card breakage. For the year, we expect operating, general and administrative expenses as percentage of sales to decrease 20 to 25 basis points. That also includes the cost to exit the SLT business and a benefit from the 53rd week.

Our net interest expense increased 47 basis points compared to the third quarter of 2006; the increase was primarily the result of the accelerated share repurchase and increase in capital leases. The funds required for the stock repurchase both reduced our investments in short-term securities that provide interest income and increased our debt interest. In addition, our new store growth increased not only our operating leases but also our capital leases resulting in an increase in interest expense.

Cash provided by operating activities was $29 million in the third quarter, and capital expenditures were $75 million. We're anticipating spending between $280 million and $290 million in capital for the year.

We ended the quarter with total cash, cash equivalents and short-term securities of $57 million. Average inventory per store decreased $40,000 or 7% to end the quarter at $534,000 per store.

We've done a good job of mitigating excess inventory despite the fact that our inventory balances per store generally rise in the third quarter as we prepare for the holiday season. We have established processes throughout our supply chain to efficiently manage inventory. In addition, we continue to get better at planning for promotions, such as Halloween, and have seen a higher sell-through on promotional product.

As was mentioned during second quarter call, our board approved a $300 million stock purchase authorization, which will be available through August 2009. We used $225 million of the $300 million authorization to initiate an accelerated share repurchase program. As a result, our outstanding share count was reduced approximately 6.2 million shares during the quarter. We expect our outstanding shares to be further reduced by approximately 775,000 shares before the program expires in January of 2008.

We initially funded the program with $125 million of cash and $100 million from our $350 million revolver. We paid down $20 million of the debt outstanding at the end of the quarter with cash flow generated through operations.

We have the tools in place for a strong finish to the year. Our business is well prepared, but we remain cautious due to macroeconomic uncertainty surrounding this year's holiday season. We project comp sales growth in the low single-digits and earnings per share of $0.70 to $0.74 for the fourth quarter. For all of 2007, we're projecting comps in the low to mid single-digits and earnings per share of $2.05 to $2.09.

Before I turn it over to Bob, I want to take this opportunity to give you my thoughts on why I joined the company and what I have observed in my first month-and-a-half on the job. When I did my due diligence, I liked that the business operates in a growing marketplace, has a solid and profitable model and generates a lot of cash. I also liked the idea that PetSmart has established itself as #1 in the pet specialty space and created a differentiated customer experience enabled by a strong services model.

I saw future potential for new store growth and profitable and scalable Pets Hotel business. At the end of the day, I love the fact that pet parents are not allowed to bring the pets into many competitors' stores.

Now that I'm here, I've seen firsthand the passion of the associates. I've also observed that this management team is pretty special. There's quite a bit of intellectual capital around the table and the common theme of humility throughout, which I believe is a somewhat unique combination. That combination can breed collaboration and enables innovation. I'm excited to be part of the team. After learning more about the business every day and its opportunities, I believe I can bring some value to this company.

With that, I'll turn you over to Bob to walk through our strategy as we head into the fourth quarter.

Bob Moran

Thanks, Chip. When we spoke to you at analyst day, we told you we're committed to consistently deepening our relationship with the customer, to executing on the basics and to growing our successful differentiated Pet Services business. We believe those strategies can create shareholder value over the long term, and they put us in the position to weather the current economic softness and emerge stronger and even more capable of generating solid profitable growth.

Deepening our relationship with pet parents is all about delighting the customer each time they interact with us. We know pet parents have a choice where they shop and during a slowdown, we want to be the place they turn to because they can count on us to have what they need at the right value. So we're focusing our assortment around what the pet parent wants and needs right now, and we're capturing new and innovative trends so that we can give customers a reason to shop.

We will attract customers to our stores with increased offers that are aimed at driving traffic, raising awareness of our offering and our value proposition. We will use our Pet Perks card to reach out to occasional shoppers and give them new reasons to visit our stores.

We are continuing to build out our new stores, ending the quarter with 993 stores and 87 hotels. We believe these ongoing investments are critical to bring us closer to our customers and extend our offering and our brand. Operating excellence is the foundation of our business and of our ability to delight the customer. We remain extremely focused on consistent execution of the basics, which frees our associates to do what they do best, take care of the customer.

Having the right products in the store when they come in to shop us is our most basic commitment to our customer. We have done a great deal of process work in the last year, building a plan the entire business could execute on from our buyers to our DC's to our stores. The result of that work is that even with soft sales in the third quarter, we're heading into the holiday season with the right products and the right amount of inventory.

All of our former State Line Tack departments are remodeled and our Eagle II refreshes for this year are complete, giving us a good foundation to provide a consistent customer experience. We will close the year with about 70% of our stores in the Eagle II format and complete the remaining refreshes next year.

We're continuing to focus on simplifying processes so that we can manage expenses more closely during leaner times and become a more efficient business for the long haul. We believe this is the right time to continue to differentiate our brand by expanding our lead in the highly differentiated services business. Not only is this a part of our business not impacted by the consumer weakness, but it's difficult to replicate and it's highly profitable.

Once customers discover our pet services, they're extremely loyal; spending more in our stores and become a great source of word of mouth marketing which we believe continues to be the biggest driver of this important, highly profitable piece of the business. We now have the scale to market the Pets Hotel using TV advertising to a broad national audience. The ad helps us to drive traffic to both the hotel and the stores, but perhaps more important, it introduces the concept to many people who have not yet heard of the Pets Hotel.

In the short-term, we believe we have put ourselves in the best possible position to capture market share during the holiday season. The fourth quarter brings initial trial of our business from pet parents acquiring new pets or buying presents for their existing pets, which makes this time of year that delighting the customer is the most important thing we can do.

Our merchants have refined their buying for the holiday season, buying the right amount of inventory, focusing on products we know will sell, and offering an assortment that gives customers the right selection and the right value. With 1,300 exclusive products, we have positioned ourselves as the destination for pet parents during the holidays. We continue to be happy with our price position versus the competition, and think we have a strong value proposition in our offering. We have solid in-stocks across the chain and our holiday sets are in the stores and ready for shoppers.

Our merchandising and marketing departments work to give our stores a holiday set that was easy and efficient to put in place and it looks great. We are pleased with our online holiday shop. We have a full assortment of gifts, and for all of you looking for that last-minute gift for your pet, make sure you consider an e-gift certificate.

Our grooming, training, boarding, and day camp services give customers another reason to try PetSmart. We know the increased level of trial we experience during the holiday season gives us a chance to impress the customers and make pet services something they can't live without.

We're ready for this holiday season and we are tackling this challenging macroenvironment head-on. With solid performance in the fourth quarter, we hope to continue to attract those new customers to our stores and give ourselves a head start on 2008.

Thanks and I'll turn the call back over to Phil.

Phil Francis

Thanks, Bob. Now let's open the call for your questions.

Question-and-Answer Session

Operator

Our first question comes from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

Could you talk about your sales trends in October? Only because it seems like the business probably ended up a bit better at the end of the quarter than it seemed like you were alluding to at your analyst meeting.

My second question, just to get it out there, relates to the impact of the 53rd week. You mentioned the impact to gross margin, if you could break out how you see it impacting gross margin and the SG&A, that would be very helpful.

Phil Francis

Matt, this is Phil, I'll try the first one. At the timing of the analyst call, the quarter was as tough as the quarter got; we had stabilized very soon after that when we started to get some cold weather. I think implied in your question were instincts that the end of the query was a bit better than we were feeling at analyst day and that is true. Things did stabilize a little bit and cold weather helped a little bit and your instincts on that one are correct.

Matthew Fassler - Goldman Sachs

In terms of the thinking about the 53rd week and you how it impacts; obviously it drives sales to some degree. Do you get leverage on cost of goods from that reported cost of goods from that?

Chip Molloy

The 53rd week, we will get some benefit in both margin and expenses. On the expense side, it's in the 5 to 10 range and on the margin side it is 15 to 20.

Matthew Fassler - Goldman Sachs

Finally, can you just give us a precise share count? I know that in the release you alluded to some carryover impact from the deal, but it would be helpful just to note that's a reduction from your fully diluted number, fully diluted average number reported in the quarter or whether it's reduction from the quarter ended share count that would help you.

Chip Molloy

The share count, we're at almost 131 million at the end of the quarter. We're expecting at the end of the fourth quarter to be around 129.2 million.

Operator

Your next question comes from Michael Baker - Deutsche Bank.

Michael Baker - Deutsche Bank

The fourth quarter outlook, $0.70 to $0.74, just trying to go through some of the math on some of the changes in State Line Tack and the MMI Holdings, et cetera. Can you just tell me, is the fourth quarter guidance different than you would have expected the fourth quarter to come in when you did your second quarter call? In other words, have you gotten a little bit more cautious? My math is maybe a $0.015 more cautious but I wanted to run that by you.

Chip Molloy

When we gave the guidance, it was $2.02 to $2.07 for the year, we didn't give a fourth quarter. But in the third quarter, we saved some expenses on the SLT piece, and we picked up the gift card breakage. The gift card breakage, we actually expected to receive that in the second half of the year but we were relying on our third-party vendor that manages our gift cards to give us the information so we can actually do the analysis. We were actually expecting that later in the year, so it came in early. Basically, for the fourth quarter, we're feeling better than we did at the analyst call.

Michael Baker - Deutsche Bank

So the key there, is in October, when you said $2.02 to $2.07 in early October, you were anticipating $0.25 from the gift card breakage?

Chip Molloy

We weren't exactly sure on the exact magnitude either. We knew it was going to be a benefit, we assumed it was going to be a couple pennies, we just weren't certain on the timing of it either and we were conservative as it relates to the timing.

Michael Baker - Deutsche Bank

But then again, as you just said, the bottom line is relative to what you were thinking in October, you actually feel better about the fourth quarter because as Phil said, things have gotten a little better.

On the pricing environment, I understand you're happy with the price differential, but we've done some pricing studies and I know others have as well. It does look like Petco's gone a little more sharper or promotional in the last couple of months. Do you agree with that? How do you react to that?

Phil Francis

Our focus is on the customer and taking care of our own business here. We watch pricing, we price against the whole market, not just anybody. We are aware, we have positioned ourselves where we have on purpose. We think we're still positioned where we have been versus the market. Our value proposition includes services, it includes variety in the customer experience and pricing.

We watch and respect all competitors, but we don't think there's been a material change in our overall position in the marketplace. Our model is price plus other things, and we think our model is intact as it has been for several years.

Operator

Your next question comes from David Mann - Johnson Rice.

David Mann - Johnson Rice

My question is about the growth you're seeing in services acceleration this quarter and in general. Can you elaborate a little more on the absolute growth you saw in grooming versus hotels, and perhaps let us know in some level of magnitude what the same-store growth in services might have been?

Phil Francis

I don't think we've typically done that. My recollection of the year, we really called that out as an echo of what we did in our first quarter call. We called out that unusually wet weather had hurt our grooming business in Q1. That led to concerns that, gee, is this growth story over? You didn't do 20, are you going to miss your promise and so on and so forth. With good execution and that problem behind us, we've clawed back in Q2 and Q3 all of that Q1 shortfall, mostly in grooming because of wet weather in the shave down and clip season. We believe that with new stores and new hotels coming, we're certainly expecting to achieve the 20% growth on the year. But we haven't called those out. I think at analyst day we had differentiated growth rates once a year, but we've never done it on a quarter and I think we're going to continue that policy.

David Mann - Johnson Rice

I have a question on the food side of the business with the recalled product. As you put some of these SKUs back on the shelves, can you just tell me a little bit on what the customer behavior has been? Do they come back to those SKUs entirely or has their behavior changed by the recall?

Phil Francis

This is Phil. My answer is in good faith, but imprecise. It's some of all of that. A lot of people are glad to see it back and just resume the behavior they had. We've talked a lot with our vendors and we share the same desire to repeat the behavior and repeat the sales we all enjoyed. They are spending through us to achieve that with the people we can talk to with cards. It's a bit early to tell just now. If you'll ask that again in 90 days from now, we'll have more data and we'll try to let you know how much was substitution and how much was return to the original product.

David Mann - Johnson Rice

I think as we go into the holiday season every year you talk about the exclusive product that you have. Can you just give us some sense? In previous years how important this exclusive product has been, and then relative to last couple of years how much more exclusively product do you have and how much more sales do you expect that to drive?

Bob Moran

I think if you talk to our store managers, they'll probably say this is the best holiday assortment we have had in our history. Obviously, we're learning off of prior years, both from a price point and also from a selection point of view, so a lot more fashionable, a lot more exclusive. Right inventories, right pricing, and the right presentation inside our stores.

David Mann - Johnson Rice

Thank you very much, good luck with the holiday.

Operator

Your next question comes from Peter Benedict - Wachovia.

Peter Benedict - Wachovia

Can you talk about how the customers, at least initially, have responded to the tests you guys are doing in pricing on the services side of the business?

I just wanted to talk about some of the expense control plans as we think out to '08, I know you're not giving guidance there yet but giving us a sense of maybe what level of same-store sales may be required to leverage SG&A as we look out into 2008? Thanks.

Phil Francis

Pricing on services, the tests are continuing. We have raised some prices. We are seeing no negative customer impact from that. The advantage we have is we can do it geographically; in the case of grooming, we can do it by breed. In the terms of any competitor of ours figuring that out, it would be a terrific migraine headache to try to sort out what it is.

As we have opened new hotels, we've tried different pricing, if it's a ways away from an existing hotel. All of those we'll be measuring through the holiday. Whatever we learn, we will incorporate into the rest of the business for next year. We'll be able to be more definitive and we'll bake that into the guidance we talk about on our fourth quarter call.

Bob Moran

Talking about expenses and expense leverage, as we look towards 2008 I think you're going to see a continuing extension of our focus on costs and cost take-outs. We've talked in the past about our labor management system that we'll be rolling out next year. We've been doing a ton of process reengineering, especially in the merchandise movement through our supply chain, which not only affects task and also labor hours in the store but it's much more efficient from a point of view of building towards the customer experience we want to have inside our stores.

Then there's every single line expense, especially on the controllable side, putting a lot of focus on, be it supplies, be it travel, be it insurance, be whatever. We're looking at every single element and then bringing state of the art type of work in. For example, we're looking at reverse auctions and bidding out a lot more in a number of areas so that we can take a tremendous amount of savings.

A great example of that is the cost for our bandanas that we have in the salons, we've been able to take a significant amount of cost out by doing a little bit more global sourcing. Nothing is sacred and everything is being looked at to continue our focus on expense leverage going forward.

Operator

Your next question comes from Brian Nagel - UBS.

Brian Nagel - UBS

First, a point of clarification. As you look at the impact of the State Line Tack that you said in the press release was $4.7 million, which I figure is about $0.02. October 10 you said $0.04. Did something change there?

Chip Molloy

We thought it was going to be about $7 million, which rounds up to about $0.04 in our pre-tax basis earlier in the year. A couple things. When we remerchandised space, we went at it, we tried to do it more efficiently with those costs and manage that. As we sold through the product, we were able to sell through the product without taking as many markdowns as we had previously estimated. So at the end of the day, we felt like we managed through that exercise much better than we originally estimated. We saved a couple million dollars in the process from what we expected.

Brian Nagel - UBS

On the breakage charge in the quarter, I assume that $5.5 million is some type of catch-up?

Chip Molloy

That's a catch-up. Since the inception of the gift card program, those balances build over time, it's a catch-up for our current liability of gift cards. That's a one-timer. As I said in the comments, we won't see that kind of impact going forward.

Brian Nagel - UBS

Did you make any changes to the way you reserve for that going forward?

Chip Molloy

No changes going forward at all. We're required to recognize gift card breakage. You can't do it when you first start selling gift cards at all, you have to create a history of redemption. Once you have a couple years' worth of history, then you can go back with your auditors and they evaluate it, you look at all the data, analyze it, estimate it, approximately how much will not be redeemed.

Once you do that, it's a catch-up. A lot of retailers have been doing it in the last couple years. Our program is newer than many of the other retailers, once we had the data we were able to do it. Going forward it's going to be a small amount each year.

Brian Nagel - UBS

Going back again to the announcement you made on October 10, at that time you tempered your guidance upon weather and general consumer concerns. The weather now has turned more favorable and you're seeing your business improve, could you better dissect the impacts on your business between warmer than expected weather and the general consumer weakness?

Phil Francis

The simple answer is no we can't. With the passage of more time, we might be able to look back, but right now you've got recall and weather and State Line Tack going at the same time and the only variable is store sales, it is those three. But our sense continues to be that there's probably some macro out there but we think it's less for us than it is for other people. If we can sort anything out, try this again in 90 days, and after the holidays should we be able to develop any more clarity, we would certainly share it with you.

Operator

Your next question comes from Mitch Kaiser - Piper Jaffray.

Mitch Kaiser - Piper Jaffray

Thanks guys, good afternoon. I was hoping you'd comment, you saw an acceleration in services sequentially despite the weak comp. Was there anything that you did promotion-wise there? I'm surprised it accelerated given the weak comp.

Bob Moran

Actually when you look at services, the customers participate in that don't really probably worry much about the macroeconomic issues. They really spend through their loyalty to the brand. So if you think about what Phil mentioned about Q1 and Q2 where we were impacted mostly in Q1, a little bit in Q2 by cold weather, we've been able to obviously accelerate that.

You do not ever use promotions in services. It's about quality. It's not about promotion at that point in time. So we just basically went back to the basics, talked to our customers. This is one of our businesses where we do have relationships, we do have conversations with the customer, we build off of that and obviously we remind them about appointments. It worked very well to the tune of 23% for the quarter. So I feel good that we're over 20% for year-to-date.

Mitch Kaiser - Piper Jaffray

Just to clarify, was the gift card breakage or the buyback in the guidance that you gave at analyst day?

Chip Molloy

It was not. The amount was not included in our guidance for the third quarter.

Operator

Your next question comes from David Cumberland - Robert W. Baird.

David Cumberland - Robert W. Baird

First a question on the State Line Tack space. For the stores that were converted earliest, how has that part of the store been performing so far?

Phil Francis

This is Phil. Our expectation when we did this that we'd ramp the sales up over a year. The very earliest ones are about halfway into the year and the limited data so far, but the data we have would say that we're on the path as expected. Please remember, we did the worst stores first and we did the best stores last. So it hasn't made much impact yet because the very best stores have been reset for two-and-a-half weeks. But in the early days, on the worst selling State Line Tack stores, recovery has been on the path we projected.

David Cumberland - Robert W. Baird

It looks like the CapEx plan went up by $10 million; is that right? What's the reason for that?

Chip Molloy

It went up slightly, we have some projects that were originally planned in Q1 and we're just seeing some of our projects are ahead of schedule and we're starting to work those through and it's increased our CapEx for the fourth quarter.

David Cumberland - Robert W. Baird

Chip, you mentioned the impact of the State Line Tack costs on your operating expenses. Were any of those costs in your cost of sales and if so, what was the size of that impact?

Chip Molloy

It's immaterial. It's a couple basis points but it's immaterial.

David Cumberland - Robert W. Baird

Last question in case I missed it, the contribution from traffic and ticket to your sales growth?

Chip Molloy

For Q3, the transactions were 64%; those are total transactions. Dollars per transaction, 36%.

Operator

Our next question comes from Chris Horvers - Bear Stearns.

Chris Horvers - Bear Stearns

As the comps recovered, did you see the mix recover? Hard goods sales also picked up?

Phil Francis

I would not in the quarter validate what's implied in your question here. Our consumables business is strong and the hard goods are more impacted by lack of cold weather than the consumables are. We would expect some normalization in Q4 time period, as we look backwards here, the food business consumables is strong. When you have seasonal weakness related to cold weather, that's around the business but is more important in hard goods, I would not say in Q3 they recovered proportionately. I would anticipate they would move away from that trend in Q4. That's a good question to ask us 90 days from now.

Chris Horvers - Bear Stearns

It sounds like it's continued to pick up the first couple weeks here in November. Is that fair?

Phil Francis

Well, early days. We're not in the habit of given monthly or daily or weekly kind of comps here. That's a policy we'd like to continue. We have seen some cold weather. We're ready for the holidays. The State Line Tack is behind us and the recall effects are mitigating away and we're trying to run the business and take care of the customers very well.

Chris Horvers - Bear Stearns

The $2.02 to $2.07 that you put out at the investor conference, did that include the roughly $0.02 or did it not include the roughly $0.02 for the gift card breakage?

Chip Molloy

It did include for the year, it just was the timing was off.

Chris Horvers - Bear Stearns

So it was in 4Q, so essentially 4Q is up by $0.02?

Phil Francis

Yes.

Operator

Your next question comes from Jonathan Kramer - Cowen.

Jonathan Kramer - Cowen

You guys made nice progress on your inventory reduction. Just wanted to get the key drivers behind that and also your thoughts on a sustainable rate?

Phil Francis

Jonathan, I'd love to talk about inventories because I think that's been a focus not only this year but last year. It started last year by customers telling us that probably the best promise we could make to them is about being in stock and we started experimenting with different levels of stock to really focus, what is the optimal level? As we got back learning, we've been building that into the system.

Simultaneously, we started really working on our discontinued inactive inventories and obviously working on the State Line Tack inventory has really brought a lot more and better inventory productivity into the system. We feel that focus and learnings will be applicable, not only for Q4 but into the future. We feel that we're moving in the right direction.

Operator

At this time, we are out of time for further questions. I'd like to turn it back to management for closing remarks.

Phil Francis

Thanks very much. From all of us to all of you, we hope you and all of retail have a great holiday season. We'll talk to you in about 13 weeks or so. Thank you.

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