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Target Corp. (NYSE:TGT)

Q3 2007 Earnings Call

November 20, 2007 10:30 am ET

Executives

Bob Ulrich - Chairman and CEO

Doug Scovanner - EVP and CFO

Gregg Steinhafel - President

Analysts

Jeff Klinefelter - Piper Jaffray

Robert Drbul - Lehman Brothers

Theresa Donahue - Neuberger Berman

Dan Binder - Jefferies

Charles Grom - JP Morgan Chase

Christine Augustine - Bear Stearns

Mark Husson - HSBC

Mark Miller - William Blair

Adrianne Shapira - Goldman Sachs

Uta Werner - Sanford Bernstein

Gregory Melich - Morgan Stanley

Wayne Hood - BMO Capital

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Target Corporation's Third Quarter 2007 Earnings Release Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, you will be invited to participate in the question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded, Tuesday, November 20th, 2007.

I would now like to turn the conference over to Mr. Bob Ulrich, Chairman and Chief Executive Officer. Please go ahead, sir.

Bob Ulrich

Thank you. Good morning. Welcome to our 2007 third quarter earnings conference call. On the line with me today are Gregg Steinhafel, President; and Doug Scovanner, Executive Vice President and Chief Financial Officer.

This morning, I will provide a brief update on our view of the current retail environment. Then, Doug will review our third quarter and year-to-date 2007 financial results and describe our outlook for the remainder of the year. Next, Gregg will provide an update on key strategic and merchandising initiatives for this year's holiday season as well as 2008. And finally, I will wrap-up our remarks and we'll open the phone lines for the question-and-answer session.

This morning we announced our financial results for the third quarter of 2007. Our performance for the period included soft sales in our higher margin apparel and home categories, combined with continued solid increases in our lower margin rate consumable and commodity businesses. This adverse sales mix produced lower than expected gross margin dollars in our core retail operations, leading to disappointing overall earnings. In contrast, our credit card operations produced yet another quarter of strong results.

During the third quarter, we continued to expand our store base, opening a total of 61 new stores in 23 states, including 43 general merchandise stores and 18 SuperTarget locations. Net of closing and relocations, these openings bring our total store count at quarter end to 1,591 stores in 47 states.

As evidenced by the volatility of our sales performance and that of other retailers during the past few months, the current consumer environment and economic climate is somewhat more challenging than earlier in the year. However, in contrast to the perception created by media reports, we have not observed any meaningful change in the frequency, timing or level of promotional intensity within the industry compared with prior years.

We remain confident in our Expect More, Pay Less strategy, our ability to stay relevant overtime by delighting our guests with unique merchandise designs and exceptional value, and our ability to maintain appropriate and sufficient discipline as we execute our strategy and plan for 2008. We believe that we are well-positioned to continue to gain profitable market share in the fourth quarter and throughout the coming year.

Now, Doug will review our results for the third quarter, which were released earlier this morning.

Doug Scovanner

Thanks, Bob. As a reminder, we're joined on this conference call by investors and others who are listening to our comments today live via webcast. Following our prepared remarks, we'll conduct a Q&A session, and Susan Kahn, John Hulbert and I will be available throughout the remainder of the day to answer any follow-up questions you may have. Also any forward-looking statements that we make this morning should be considered in conjunction with the cautionary statements contained in our SEC filings.

In my comments this morning, I'll discuss three topics, each of which has important implications for our financial performance in the fourth quarter and beyond. First, I'll review key aspects of our third quarter performance in our core retail operations. Second, I'll describe recent performance and metrics in our credit card operations. And third, I'll provide more detail on the newly authorized share repurchase program, which we announced this morning, and provide an update on our review of ownership alternatives for our accounts receivable. And of course, in conclusion, I'll share our outlook for the remainder of the year.

This morning, Target announced financial results for the third quarter of 2007. Overall, our results were disappointing as performance within our core retail operations fell short of our expectations, primarily due to the effect on our gross margin resulting from softer sale of our higher margin merchandise. Our credit card operations continued to deliver strong growth in contribution to our profits.

Let's review some of the key elements of our third quarter performance. Total revenues grew 9.3% to $14.8 billion, fueled by the contribution from new stores, a 3.7% increase in comparable store sales and the growth in revenue from our credit card operations. In our retail operations, we experienced weaker than expected sales performance in our higher margin categories, especially apparel. Even the sales of consumables and commodities remained strong.

Our third quarter gross margin rate was 31.9% of sales, 54 basis points lower than last year. All of this net decrease resulted from a soft sales of our higher margin merchandise. And while our expense rate increased by 14 basis points, remember that our rate analysis continues to be affected by a couple of small financial reporting refinements that have benefited gross margin rate and have had a parallel inverse effect on our expense rate over the past four quarters.

In other words, analytically, the magnitude of our gross margin rate decrease was slightly greater than reported and our expense rate was essentially unchanged from last year. Thankfully, this is the final quarter in which these refinements will have any year-over-year impact on the analysis of these rates.

Our credit operations continued to deliver strong third quarter profit performance. Average receivables grew 19.6% over last year, faster than our pace of sales, primarily due to changing the product features for yet another group of our higher credit quality Target Card accounts to become higher limit Target Visa accounts. This most recent wave of activity resulted in higher receivables balances due to increased charge activity both within and outside of our stores.

As a result of both, our increase in receivables and a modest increase in the core risk metrics in our portfolio, we increased our reserve in the quarter by $23 million. At this level, we continue to believe that we are adequately reserved for expected losses in the portfolio consistent with our past practice. On an annualized basis, our credit card contribution to earnings before taxes as a percent of average receivable was 8.6% this year compared to 8.8% a year ago.

Turning to other factors on the P&L, net interest expense in the third quarter increased $28 million from $149 million a year ago to $177 million this year, primarily due higher average funded balances, including the debt to fund our substantial receivables growth. And our effective income tax rate for the quarter was 38.1% compared with 37.4% in last year's third quarter. This increase was driven by an unusually low rate in this quarter last year. For the full year, we continue to expect our effective tax rate will increase modestly from our 2006 rate of 38.0%.

Bringing all these elements together, our third quarter earnings fell short of last year's performance. Specifically, net earnings decreased 4.4% to $483 million compared with $506 million last year and diluted earnings per share fell 3.5% to $0.56 from $0.59 a year ago.

Beyond the P&L, our balance sheet inventory position grew 12.2% from a year ago, faster than the 9.0% sales increase in the quarter. However, the relationship between these two growth rates was significantly influenced by the shift in our fiscal calendar, which moved our third quarter end one week closer to the holiday season compared to last year, capturing a greater portion of our typical seasonal inventory build.

Turning to share repurchase, during the quarter we invested $172 million to buy approximately 3 million shares of our common stock at a weighted average price of $57.29 per share. Through the first nine months of 2007, we've repurchased $1.2 billion of our common stock, acquiring 19.7 million shares at an average price of $60.72 per share.

Since the program's inception in June 2004, we have repurchased 90.7 million shares of common stock, representing over 10% of our current shares outstanding at an average price of $51.20 per share for a total investment of approximately $4.6 billion. Weighted average diluted shares outstanding in the most recent quarter were more than 13 million shares lower than the corresponding figure last year, a reduction of more than 1.5%.

As you know, on September 12th, we announced that we would conduct a review of the use of debt in our capital structure in the pace of our share repurchase activity. This morning we announced the results of that review. Our Board has approved a new $10 billion share repurchase program that replaces the remaining authorization under our previous program.

Based on this morning's share price, execution of our new program would represent a gross reduction of more than 20% of our current outstanding shares. We expect to complete this new share repurchase program within approximately three years, and under the right combination of business results, liquidity and share price, I would expect to complete half or more of the program by the end of 2008.

Part of the funding for this program is expected to come from an increase in the use of debt in our capital structure. Yet, we believe our execution of this program, which is independent of any specific outcome from the review of ownership of our credit card receivables, will allow us to maintain a credit profile consistent with the ratings objectives we outlined in September. Specifically, we said then that we expect to maintain the necessary credit profile to preserve our long-term debt ratings within the A category. We are confident this plan achieves that.

Our September announcement also indicated that we intended to explore alternative ownership structures for our credit card receivables. At this point, we're still engaged in a vigorous review, and it is premature to speculate on any possible decision coming out of the review. We continue to expect that we will be able to announce a decision before the end of December and explain our rationale, either to sell or to maintain ownership of some or all of the receivables in the portfolio.

On the subject to what would happen to share repurchase in the event of a potential receivable sale, I would expect this possible transaction to have only a small impact, if any, on the pace of our share repurchase execution, depending on how much risk is transferred to a new owner.

In summary, let me combine all of these elements and share some additional perspective on our expectations for the full year. Year-to-date through nine months our comparable store sales have increased 4.3% and total sales have increased over 9%. Our fourth quarter outlook envisions a similar comparable store sales increase in the range of 3% to 5%, and our total sales increase sharply lower than our year-to-date growth as we annualize the extra week in 2006.

In addition, so far this year, our gross margin and expense rate are each largely unchanged from prior year levels. Looking forward, while we expect some continued adverse sales mix effect on our gross margin rate in the fourth quarter and in 2008, it should be a less important factor than in the quarter we just completed.

Separately, we're working very intently on an array of initiatives designed to control the growth rate of our expenses to be equal to or lower than our overall growth in sales. We expect these efforts to bear fruit in the fourth quarter and into 2008.

In our credit card operations, we expect to continue to enjoy strong growth in receivables, driving revenue growth, and strong contribution to earnings, reflecting disciplined management of our portfolio with delinquency rates and net write-off rates most likely to remain within the range implicit in our current balance sheet reserve. As a result, we expect to continue to enjoy substantial strategic and financial benefits of our credit card operations regardless of who actually owns our receivables.

As you know, a variety of factors have contributed to our belief since the beginning of this year, that our EPS growth opportunities would be greater in the first half than the second half. And while we believe that our year-over-year prospects are better in the fourth quarter than the third quarter, our EPS growth will likely be quite modest compared to last year's results.

We remain confident in our underlying strategy and in our continued ability to generate outstanding financial performance over the long-term. We are confident that our proven record of growth, innovation and disciplined execution will continue to benefit our shareholders on average with double-digit percentage increases in EPS for many years to come.

Now, Gregg will provide a brief summary of current business trends and describe several of our current merchandising initiatives.

Gregg Steinhafel

Thanks, Doug. As Bob and Doug have just described, our third quarter financial performance did not meet our expectations. While we are disappointed with these results, we remain confident in Target's underlying strategy and our ability to generate profitable market share growth in the current economic and competitive environment.

Our focus remains firmly centered on delivering our Expect More, Pay Less brand promise to our guests by providing a continuous flow of trend rate in affordable merchandise in convenient, easy-to-shop stores, and we believe we are well-positioned to execute this strategy in the fourth quarter and beyond.

As we head into the holiday season, we are particularly excited about our well-balanced assortment of must-have and differentiated items, all at an exceptional value. For example, we continue to feature exclusive collections and gift items by emerging designers in our apparel and accessories category. Just last month, Target introduced an assortment of limited edition shoes and handbags by Holly Dunlap under the celebrated Hollywood label, which will only be in stores for 60 days.

In late December, we will further reinforce our reputation for affordable style and accessories with our introduction of Loeffler Randall for Target, a limited time assortment of shoes and handbags by designer Jessie Randall. And, earlier this week, we debuted our newest GO International collection by Erin Featherstone, which will be available through December. The line includes women's fashion, jewelry and accessories, and it's characterized by feminine detail such as ruffles, velvet and heart-shaped motif.

Target is keenly focused on being the definition for all our guest holiday entertaining needs, including food, dinnerware, home decor and holiday trim. In September, Target was honored by Bon Appétit Magazine with the Tastemaker Award at its 10th Annual Award Ceremony in New York. The award recognized Target's commitment to offering unique and differentiated home and entertaining solutions for our guests. Again, this year we have a broad assortment of everything our guests need to create special holiday meals and memorable occasions.

In stationery, the Isabelle de Borchgrave holiday collection features elegant paper products, including tablecloth and serving bowls that make holiday entertaining both stylish and easy. In food, Target has introduced delicious new Archer Farms frozen [yogurt] which all bake at the same oven temperature, making preparation simple and stress free. And for the perfect mealtime ambience, Target's assortment includes elegant tableware in holiday colors and winter designs and a variety of festive linens to compliment the table decor.

Target is also the destination for this year's most wanted gifts, including electronics, video games, toys and small appliances. Digital cameras, LCD TVs, video game, hardware and software, and MP3 players and accessories continue to dominate the list of hottest items in electronics While in toys, the safety of our guests remain our highest priority, we continue to work closely with vendors to ensure the best product in terms of both safety and quality is on our shelves, and we are keenly focused on being in-stock on trusted games and toys.

We are also delighting our guests with a totally innovative holiday campaign called Wow or Never. With this campaign, we are offering an assortment of 20 exclusive items available for seven days only while supplies last, beginning on the Sunday after Thanksgiving. When guests purchase one of these qualifying gifts with their Target REDcard, they are automatically entered to win incredible prizes ranging from a new Maserati to an African Safari.

Just in time for the holidays, Target is also introducing a unique assortment of new gift cards, including 12 designs of eco-friendly card made from a biodegradable substance called PHA. In addition, we continue to introduce innovative technology to our gift card assortment, including Mr. Magorium's Wonder Emporium design with a piano that plays music, a card featuring functional holiday lights, and a card showcasing the first ever full motion lenticular video. As in past years, gift card sales and redemptions are expected to drive significant traffic and transaction volume throughout December and January.

Our continued emphasis on delivering excitement in our own brand presentations and introducing new highly respected national brand assortment will also drive post-holiday traffic and sales at Target. Our announcement yesterday, which described our new exclusive partnership with Converse, is an example of our unwavering commitment to delight over guests and deliver on our Expect More, Pay Less brand promise.

The Converse One Star assortment, which launches in February, includes vintage inspired sports lifestyle apparel for men and women, and footwear for men, women and children. We are thrilled to be partnering with Nike and bringing this iconic brand to Target, and are confident that it will excite our guests and drive incremental sales and profit.

In addition to driving traffic and sales through our dedication to innovative merchandising and distinctive marketing, we are also intently focused on managing our inventories and being in-stock. At the end of the third quarter, despite softer sales in apparel and home inventories, we're in very good condition, and we are carefully managing our flow of goods in the holiday season and as we plan our business for early 2008.

To ensure that we are prepared to react quickly and efficiently in a variety of sales environments, we remain focused on finding additional opportunities to leverage our sourcing, technology and supply chain sophistication. For example, we continued to improve our product design and development process to enhance quality and fit and increase speed to market. We continue to develop our distribution network by adding regional and import capacity to support our growth, and we are pursuing opportunities to reduce inventory while improving in-stock levels, improving transit times and eliminating costs throughout our supply chains, both domestically and internationally.

We have always been disciplined and intentional in managing our business, even as we remain focused on creating and exploiting opportunities to grow our sales and gain market share profitably. As we look to the remainder of 2007 and enter 2008, we continue to embrace our culture of continuous innovation and disciplined execution. By consistently delivering on our Expect More, Pay Less brand promise, we are confident that Target will deliver solid results this holiday season and will remain relevant to our guests' overtime.

Now, Bob has a few concluding remarks.

Bob Ulrich

As you've just heard in detail, we continue to find new ways to delight our guests with distinctive marketing, exciting merchandise and exceptional value, and we remain optimistic about our fourth quarter performance. We believe that Target is well-positioned to grow profitably in this economic and competitive environment. And we feel confident that Target will continue to deliver substantial value for our shareholders overtime.

That concludes our prepared remarks. Now, Doug, Gregg and I will be a happy to respond to your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Jeff Klinefelter with Piper Jaffray.

Jeff Klinefelter - Piper Jaffray

Yes. I have a couple of questions for Gregg. Could you provide any more details on the comp or margin trends of apparel and home as it relates to the average comp trends of your store right now and what impact it had on the margins in Q3 and expected to have in Q4 recognizing the mix is pressuring comps? Are the margin trends themselves down in those categories as well, because of promotional activity?

Gregg Steinhafel

No. The gross margin rates in all of our business segments performed well in the third quarter. And our gross margin shortfall is exclusively related to the mix impact of both apparel and to a lesser extent home growing at a slower rate than our higher growth, lower margin categories in hard lines and food.

Jeff Klinefelter - Piper Jaffray

Okay. In terms of the comp trends, Gregg, is it something where it's tracking well below the chain average? Are you still seeing any stabilization in the home? And what are your expectations for Q4 and into the spring season in those two categories?

Gregg Steinhafel

Well, we still expect some sales mix deteriorations in the fourth quarter, but not to the extent that we experienced in the third quarter. In apparel, specifically, weather patterns are now more normalized than they were in September, October. As you know, we had record high temperatures throughout the nation at that time, and they are reasonably normal. So we expect some slight deterioration, but not to the same magnitude in apparel.

Our home business actually has been performing pretty well, softened up a little bit in the third quarter and we expect that to remain somewhat soft until some of the housing issues go away or, at least, diminish in terms of magnitude.

Bob Ulrich

Let me put a little color around that. As you know, on average, across the last decade, our lower margin businesses have grown faster than our higher margin businesses. In an average year, that puts, give or take, 20 basis points of mix related adverse effect into our gross margin rate. We were running higher than that through the first two quarters.

But as I mentioned in my remarks, all of the gross margin rate deterioration in Q3 was mix related. So this mix issue, Q3 this year, was clearly the most significant mix affected quarter that we've had in many, many, many years running, about triple the adverse mix effect of an average quarter.

Jeff Klinefelter - Piper Jaffray

Okay. Thank you. One other question is in terms of the sourcing and inflationary pressures, there are some concerns coming, particularly out of China, with inflation on cost. Could you comment on how you see that affecting your margin trends the rest of this year and into next year on apparel and the discretionary category, but also overall, I think you're looking at some opportunities, the hard lines for sourcing benefits as we move forward?

Gregg Steinhafel

We're experiencing cost pressures right now that will manifest in the first and second quarter of this year, and it's both domestic and international. We've got a very balanced sourcing portfolio and our apparel exposure in China is rather modest, to be honest with you and we have apparel sourcing that is dispersed throughout the world.

So, we really don't expect much impact in the apparel world. We're experiencing it more in the hard line categories, raw materials, steel, wood, energy-related categories like plastics, storage and in food. In the past year or two, we have been able to pass along these costs increases in the form of higher prices. The marketplace had been receptive to that and we hope that that type of receptivity continues into '08.

Jeff Klinefelter - Piper Jaffray

Thank you.

Operator

Your next question comes from the line of Robert Drbul with Lehman Brothers.

Robert Drbul - Lehman Brothers

Hi. Good morning. I just have two questions. The first one is Doug, can you put a little bit more detail into the receivables portfolio growth, the 19.6%? And essentially, can you just give us a little bit, a few statistics around the credit worthiness of the changes in the increased credit balances that you're seeing and have given out?

Doug Scovanner

Bob, as always, there are a lot dynamics in the portfolio, but the single biggest driver of the acceleration in the growth of receivables is that of our most recent wave of executed product changes. Product changes is the terminology that we use to describe when we take a look into our Target Card profile and convert an offer to convert to the guest those cards that are having the features of our Visa card sharply higher available to buy and typically lower rates and so forth.

This has been a more efficient conversion than prior conversions. The credit quality is the same and the guests are responding by using the card both, in the store and outside the store in a typical mix of purchases. It means that, for example, our penetration rates, the percentages of our Target store sales reflected on any one of our array of cards is actually, flat to up ever so slightly in contrast to a more typical trend of being down. The increase in the balances is in a higher weighted average band of FICO scores than the weighted average in the portfolio.

Having said all of that, clearly, there are some unrelated to this conversion issues developing in our portfolio and candidly in the portfolios of everyone else we follow that are somewhat adverse. And therefore, we felt that it was appropriate in light of all of that activity, to increase our reserve this quarter, both as a reflection of the higher size of the portfolio and also as a reflection of some of these modest upticks in risks metrics.

Robert Drbul - Lehman Brothers

Okay. Thank you. And a question for Gregg on the inventory, are there any pockets of inventory that you are concerned about as you head into the fourth quarter?

Gregg Steinhafel

In all honestly, we have managed our inventories very, very well in the second and third quarter. We had anticipated somewhat of a slowdown in the sales environment and reduced our receipts in the third quarter when we were in Q1 and Q2. So, aside from being a little heavy here or there, in pockets it's even hard to describe what pockets. There are certain businesses we're a little over and certain regions where we might be a little over. But overall, it's relatively immaterial in the scheme of things.

Robert Drbul - Lehman Brothers

Thank you. Good luck.

Bob Ulrich

Next.

Operator

Your next question comes from the line of Theresa Donahue with Neuberger Berman.

Theresa Donahue - Neuberger Berman

Good morning, everyone. I just have a quick question on the expense line, which was very impressive. Could you give a couple of examples what areas that you're looking for opportunities, especially since we hadn't seen much progress prior at higher comp level?

Gregg Steinhafel

I'll start and maybe Doug wants to add some. This is a company-wide initiative. We are looking at our expense opportunities in our headquarters, supply chain property development, marketing and in-stores, both expense and productivity. So we're really taking a comprehensive view to better managing our expenses and productivity centers going forward.

Theresa Donahue - Neuberger Berman

Okay.

Doug Scovanner

There is no one issue in expenses that dominated or characterized the key driver of our ability to control this quarter. As usual, some issues up, some issues down in basis points, but we're entering a period where we are putting much more intense focus on making sure that our operating expenses grow at no faster than the pace of sales.

Theresa Donahue - Neuberger Berman

Thank you.

Operator

Your next question comes from the line of Dan Binder with Jefferies.

Dan Binder - Jefferies

Hi. Good morning. I have just a couple of questions on credit. Last quarter, I think you had cited that some of the excess receivables growth or I should say that some of the receivables growth in excess of sales was driven from purchases outside the store. It sounded like that continued a bit this quarter but you had this other issue that you talked about in terms of the product change. I was just wondering, is there a way to quantify of the receivables growth, how much of that did come from growth outside the store.

And then, secondly, in terms of thinking about reserves going forward is there a rule of thumb we should be thinking about in terms of targeting bad debt reserves? Is it going to be 25% higher than write-offs or maybe some metric that we could use in that front?

Bob Ulrich

The answer to your first question actually lies on our cash flow statement every quarter because we split the growth imbalances created by use of the cards inside our store on to a separate line from the growth imbalances attributable to use outside the store. There is some seasonality to that mix. But, generally speaking, that's a fairly constant relationship with, give or take, 25% or 30% of the charge activity on the cards taking place in our stores and imbalance taking place outside our stores, nothing new here this quarter.

Separately, on your question regarding relationships, our focus on the allowance as a percent of quarter end receivables, today, we lie at about 7%. That metric has some seasonal influence. So that metric typically, is lower in our fourth quarter than in any of the prior three quarters that will likely remain intact this year as well.

We constantly monitor the risk metrics underpinning the portfolio and will adjust that reserve as appropriate ongoing to maintain a very consistent reserve, relative to the risks that underpin the receivables. As I look forward, I don't think that this will create any kind of meaningful problem. But, yet, I would observe there's no doubt that there are some flashing yellow lights on the horizon much more broadly than just our portfolio. I think we're fully, adequately reserved today.

Dan Binder - Jefferies

Okay. And then just a follow-up to Terri's question on expenses, obviously, the biggest opportunity when sales slow would be, at least, judging from what I've seen in the past, would be that you manage the labor in the stores to those levels and during periods of very healthy comps, the stores look absolutely fantastic. I am just curious what kind of challenges, if any, you face in keeping the store's standards up as comps slow and perhaps it's necessary to cut back on some of that labor. Is there any way you can manage that and still keep the stores in as good a shape as they were let's say, a year ago?

Bob Ulrich

Yes. Clearly, we remain absolutely committed to delighting our guests with a superior shopping experience, and have no intention at all in lowering our standards. Whether it's our brand standards, our in-stock levels, our wait times, our friendly help within our stores, we remain highly committed to delivering a superior experience.

Having said that, as sales soften, we have opportunity to reduce the number of seasonal hires and just, more carefully, manage the expense line as it relates to reduced traffic levels and sales around this time of the year. So we're going to a very thoughtful process, making sure that we balance our short-term and long-term needs of the business and the guests with the expense opportunities that we identify.

As Doug said, there is a combination of things that we're going to look at. There is no one thing within our stores that we can point to say this is where we're going to singularly focus our efforts. It's a combination of many, many work centers that we're going to be looking at in terms of saving some expense out of our stores.

Gregg Steinhafel

Very specifically, lower rates of sales drive lower need for work in the areas of receiving, replenishment, cashiering. And so, we can maintain the same standards that are so important to our brand, while incurring fewer hours worked in the stores when fewer units are flowing through the supply chain inside the store.

Bob Ulrich

I would also point it out that we have made major investments in logistics and technology in our stores over the last several years and that those are enabling us to become significantly more productive going forward. So we remain committed 100% to a great guest experience and we're confident we can deliver that at the same time we're reducing expense.

Dan Binder - Jefferies

Great, thanks.

Operator

Your next question comes from the line of Charles Grom with JP Morgan Chase.

Charles Grom - JP Morgan Chase

Thanks. Good morning. Doug, I was wondering if you can comment on what your inventory growth was in the quarter, if you would exclude the calendar shifting, and also, if you'd be willing to quantify the actual mix of home and apparel in this quarter versus a year ago as a percentage of sales.

Doug Scovanner

About two thirds of that growth differential is due to the calendar shift. So there really isn't anything significant about the relationship between growth and inventory and sales, absent that shift. And I'm afraid you'll have to repeat the second question.

Charles Grom - JP Morgan Chase

Just the overall mix in the quarter as a percentage of sales if you were to combine home and apparel, just how much did it increase year-over-year?

Doug Scovanner

In terms of inventories?

Charles Grom - JP Morgan Chase

Just in terms of sales, the actual sales mix.

Doug Scovanner

In terms of our sales mix, those two categories represented a lower portion of our sales this year than last year. As I mentioned, slower growth in those categories was responsible for, on a net basis, all of the decline in gross margin rate.

Charles Grom - JP Morgan Chase

Okay. I got you. And then, just switching to the balance sheet, in order to fund the buyback program, could you speak to how high you're willing to take up some of your leverage ratios maybe adjusted EBITDA or leverage part of the overall debt-to-cap?

Bob Ulrich

I always marvel when people translate what is a very complex set of discussions across three ratings agencies into a handy metrics like that. We are not specifically focused on any one individual credit metric. I believe the pace of this program, the size of this program has been specifically designed after discussions with all three agencies to maintain the credit profile that we seek to maintain. But it's not a straightforward as focusing on one key metric. If we did so, and blindly ran our business to that metric, I don't think any of us would be very happy with the outcome.

Charles Grom - JP Morgan Chase

Alright, fair enough. And then, one more question for Gregg. Yesterday, you announced that November was on plan. I am wondering if there is an improvement. It sounds like the environment is giving you more confidence and if you could speak directly to trends in some of those areas that were weak in October, home, apparel and toys?

Gregg Steinhafel

Well, even though they are on plan, they are still somewhat more modest in terms of sales expectation compared to our original plan three and six months ago and we're seeing balanced sales across the chain. We've seen apparels strengthen as weather patterns normalized. Our home businesses are performing about where they have in the past and the balance of the businesses has been performing well. We expect the electronics business to continue to outpace the company that has been strong all year and continues to be very strong. So we expect it to be a bellwether season there.

Our toy business has been somewhat volatile. There has been a lot of recall activity that has caused our consumer to be somewhat cautious in this particular category with sourcing strength in other categories, as they migrate to less traditional toys. But, having said that, the toy business started to strengthen this month as well, so, we're cautiously optimistic that, overall, we're going to have a decent holiday season.

Charles Grom - JP Morgan Chase

Thanks. Good luck.

Operator

Your next question comes from the line Christine Augustine with Bear Stearns.

Christine Augustine - Bear Stearns

Thank you. Doug, could you talk about just overall expense trends, benefits, utilities, maybe real estate costs, what you might be seeing so far this year versus the average of the last few? And then, if possible, could you give us your preliminary thoughts on where those expense trends might go in '08?

Douglas Scovanner

Well, the great news is year-to-date this year not only our expense is well-controlled as a percentage of sales, there really isn't any significant category that's moving the needle meaningfully in either direction. We're down to single digit basis point movements across the board. And one of the reasons that I'm quite encouraged about that is that, of course, we're operating in an environment where sales have slowed to a pace below of what we had forecasted at the beginning of the year, said differently, that is sometimes the recipe for hitting our dollars budgets and missing the mark in terms of a basis point analysis.

Having said all of that backup, certainly, there are some inflationary drivers in the expense base, utilities and property taxes, and to a lesser extent medical expenses would be among the more onerous drivers. The single biggest variable, of course, always remains the number of hours of labor that we choose to employ with our teams in our stores. There are a couple of things that are beneficial as well. Marketing expense, for example, on a year-to-date basis is actually, slightly favorable despite the fact that it was unfavorable in the quarter due to timing issues.

Christine Augustine - Bear Stearns

And would you be willing to give any preliminary thoughts on '08 as you look to your planning process? Do you think there will be any material changes in these line items?

Doug Scovanner

No. I don't. I think that as Gregg indicated, we're taking our time to perform an intensive review across the board, and there are no fundamental changes that we are intending to dial in here. We're just carefully focusing on making sure one line item at a time that we're dialing in the right expenses relative to the pace of our business, while paying particular attention to maintaining the brand standards that are so important to us.

Christine Augustine - Bear Stearns

How about your views with regard to new store openings? As the environment softens, would you maybe try to take advantage of that and, perhaps, accelerate, or in this kind of environment, do you look to maybe scale back a bit? I'm just wondering how you view at this time around versus prior downturns in the economy.

Doug Scovanner

We have a very, very steady hand on the throttle at the real estate helm. Obviously, if there were substantial bargains to be had in the kind of real estate that we seek, we'd be delighted to accelerate our store opening program. There are lead times that need to be respected. So that certainly wouldn't affect '08 or even hypothetically, '09. But I think that's a false premise. There is no discernable reduction in commercial real estate prices for the kinds of land that we seek to develop, quite the contrary is in the case for some period of time.

We are very unlikely to materially, or even meaningfully, change the pace of capital reinvestment that we think is the right pace for our business. That would take a very sustained period of softer performance to have us rethink the value of those kinds of strategically important investments.

Christine Augustine - Bear Stearns

Thank you.

Operator

Your next question comes from the line of Mark Husson with HSBC.

Mark Husson - HSBC

Yeah. Back to procurements a little bit, you have said that individual categories had quite good gross margin performances. Could you also tell us what you did to get them? And from our metrics, it looks like you've spread your sourcing out to other countries away from China, more India and other Asia, and perhaps you've gone direct more. Can you update us on the direct percentage and other sourcing, including USA, by the way?

Gregg Steinhafel

Direct import percentage remains around 30% to 31%. We had ramped that up aggressively over the last four or five years. And we have now reached a point where it's going to grow at a much slower rate, probably in the neighborhood of 50 to 100 basis points a year. So, I would not expect large changes in our direct import percentage. And as we've said, we've got a balanced portfolio of sourcing, both domestic and internationally and we shift and make adjustments based on a variety of conditions.

Our gross margin rates were well-balanced across all of our categories. So we made our gross margin rate expectations in home, apparel, food and hard lines. And so that's the combination of a lot of different things that we do to manage the margin rates, whether it's saving markdowns or focusing on cost reductions or investments in our promotional markdowns. It's combinations of things that enabled us to make our gross margin rates by business segment.

Mark Husson - HSBC

And it sounds like fuel price inflation and also the generic environment has not been damaging in the quarter as far as gross margin rates are concerned.

Gregg Steinhafel

It wasn't that. We've seen inflationary pressures kind of ebbing and flowing throughout the year. We faced more pressure early in the year. It somewhat abated in the second, third and fourth quarter. But we are expecting that to accelerate again in the first and second quarter of next year.

Bob Ulrich

It's only a slight oversimplification for all of us to think about our gross margin rate in the lower middle 30’s, as simply being the algebraic blend of, give or take, 40% of our sales with gross margin rates category-by-category that are in excess of 40% and about 60% of our sales category-by-category with gross margin rates of 25% more or less. The entire gross margin rate issue year-over-year in this quarter is the algebra behind that blend. Across the board, we enjoyed, give or take reasonably similar gross margin rates to last year's gross margin rate category-by-category. This is all a sale mix issue in the quarter.

Mark Husson - HSBC

Given that they're quite different from each other, those two gross margin groups, are you doing something overtime that is going to meaningfully accelerate the amount of gross margin you'll get from the 25% category and does that have any implication for the return on invested capital overtime?

Bob Ulrich

Well, I think this mix issue is actually misleading more than it's helpful because this chain remains very healthy financially overtime to the extent that we can maintain 3% or 4% same-store sales growth in the higher margin categories. But, of course, the lower margin categories enable us to be able to do that. And so, I'd be thrilled with the horrible mix problem of 10 comps in the lower margin businesses and five comps in the higher margin businesses, because even though those that follow rates would be disturbed, the bottom-line would be gushing profitably.

Mark Husson - HSBC

That's helpful. Thank you.

Operator

Your next question comes from the line of Mark Miller with William Blair.

Mark Miller - William Blair

Hi. Good morning. I just wanted to clarify the inventory on a same calendar basis. Are you saying that inventory would be up 4% were it not for the calendar shift? And then, I know sometimes there are other anomalies with inventory on the boats coming across, what would be the same calendar same-store inventory growth?

Gregg Steinhafel

First half of your question, yes, our inventories would have grown slower than sales if it were not for the calendar shift. That's how important a week is in our inventory picture at this time of the year. Your question about the boats was not clear to me. Try me again.

Mark Miller - William Blair

Well, just on a same-store basis, I know in the past, as you had timing of receipts, product coming across from outside this country that had impacted the inventory levels, what's the same-store inventory growth looking at that?

Gregg Steinhafel

Well, our picture of inventory, at any point in time, includes inventory that's in transit on the ocean by and large because we already own substantially, all of that inventory. So the balance sheet includes all inventory that we own regardless of where it is in the globe. So it's straightforward to answer your question by correlating the 4% increase in inventories to the slightly higher increase in our store counts to observe that inventories on a comp per store was slightly down, flat to down.

Mark Miller - William Blair

Great, thanks. And then, could you talk about the trends across the good, better, best spectrum, particularly in home and apparel? And as you've seen the slowing, is that slower rate of unit off take or you're seeing any change in the rate at which the consumers are willing to trade up?

Gregg Steinhafel

It's somewhat of a mix bag. We are seeing actually the consumer trading up slightly in apparel. The same dynamics are true in the hard lines and food side of our business, and there is somewhat of a slight trade down in the home area. For example, we see stronger performance in our basic bedding area rather than our collection bedding area. So more of the trade down is happening in the home but the balance of the business we don't see any trade down whatsoever.

Mark Miller - William Blair

And then, final question, Gregg, can you talk how that recent experience would impact the way you think about assortment for 2008 and are you making changes at this point?

Gregg Steinhafel

We're not making material changes to our assortment. We've worked really hard in getting the appropriate balance of good, better, best. We think this is more temporary in nature and that, over the long-term, our current mix of assortments is about appropriate for what the business potential is. So, we're going to make some adjustments, but overall, we're pretty confident that we have the right mix.

Mark Miller - William Blair

Great, thank you.

Operator

Our next question comes from the line of Adrianne Shapira with Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Thank you. Just first-off, talking about the more challenging environment, could you share with us any regional differences you're seeing in performance?

Bob Ulrich

Really, there are just a few parts of the countries that are a bit slower. Florida has been a little bit slower, a little bit of the inland southern part of California has been a little bit slower, and a touch in the Ohio, Michigan, Indiana area. But overall, the rest of the country is pretty well-balanced.

Adrianne Shapira - Goldman Sachs

Okay. Doug, you had mentioned, obviously, the initiatives focusing on expenses. Could you remind us the level of comps you needed to begin leveraging expenses what that was, and perhaps, going forward, what the opportunity in terms of that number coming down?

Doug Scovanner

Well, this is a very crude shorthand. But with that spirit in mind, the answer to your question is, I think, we have historically operated with the need for about a 4% to 5% same-store sales performance to neutralize SG&A as a percent of sales. And clearly, we're working very hard to bring that range down by 100 to 200 basis points.

Adrianne Shapira - Goldman Sachs

Okay, great and then just the last question. I know you described qualitatively direction of the segments we are heading into the fourth quarter, but in light of the third quarter performance and perhaps, the buyback activity, could you just update, perhaps, your view on the year? I think the last we have heard is lower than 360, but perhaps, any update on guidance for the year?

Doug Scovanner

Well, as you know, we have not provided specific guidance for any quarter this year and the fourth quarter is no different. The best I can do to answer that question is to have you take our year-to-date performance and add to it the outlook for the fourth quarter that I gave earlier, specifically, that we expect a very modest EPS increase in the quarter.

Let's not lose sight of the fact that we have talked many times in the past about the $0.02 to $0.04 per share that we earned in the extra week last year. That missing week means that our year-over-year sales growth in total, not comp, in total during the fourth quarter, will be a low to mid single digit figure. So that's a very important feature in understanding what's going on with our EPS growth this quarter, both in our core retail operations and in our credit card operations, that extra week created profitability last year.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

Your next question comes from the line of Uta Werner with Sanford Bernstein.

Uta Werner - Sanford Bernstein

Good morning. Doug, I wonder if you could please comment on how new stores have done over the past two months and specifically, the productivity ramp-up that you've observed?

Doug Scovanner

Typically, our experience in the last couple months is no different from our experience in the past. Our new stores typically, are an exaggerated example of what's happening in the rest of the chain. When the rest of the chain is healthy, our new stores typically open much more strongly and when sales are weak, our new stores open even weaker. This is not a new issue, nor at all disturbing. These new stores are terrific investments that will pay splendid dividends moving forward.

Uta Werner - Sanford Bernstein

Could you also maybe remind us on how remodeled stores are comping, relative to un-remodel stores?

Gregg Steinhafel

Well, we really look at our remodels in a couple of different ways. In remodels, where we expand the footprint of the building itself, we are seeing dramatic increases, consistent double-digit increases in our comp store sales before and after the remodel. In remodels that occur within the shell of the building and we are not dramatically expanding the sales, but we see more modest, but still the kinds of sales growth necessary to support the investment in that remodel. So we're pleased with both the in-the-box and expansion remodel program.

Uta Werner - Sanford Bernstein

Thank you. I have a different question related to gross margin, specifically, on consumer electronics. I wondered if you can update us on what's the current level of service contract attachments, want to have your levels of returns be and how do you recover on the returns?

Gregg Steinhafel

The attachment rates, we've now had our ESP program in place for about a year and we continue to see gains in our attachment rates on average. When you're across the board in all categories, we're seeing attachment rates in the low double-digit area, and when you specifically zero-in on categories like LCD or more expensive LCD televisions, we're seeing very healthy attachment rates of over 30%.

Uta Werner - Sanford Bernstein

And in terms of return?

Gregg Steinhafel

We're not seeing any appreciable change in our return rates in any product categories.

Uta Werner - Sanford Bernstein

Great. On the same line of question here, to what extent do you expect significant revenue to come from selling pre-owned electronics on the Internet?

Gregg Steinhafel

That is a test program for it. And it's very, very, very tiny and totally insignificant as it relates to the sales impact on either at the dotcom business or the corporation's business.

Doug Scovanner

I'll add two more verys to that answer.

Uta Werner - Sanford Bernstein

Is that pre-owned merchandise, fundamentally returned merchandise?

Gregg Steinhafel

It is returned and refurbished and it is a test that was initiated, I think, approximately 30 days ago. And we have not made a decision whether or not we're going to continue this or not. Early indications are it's been very positive. But again, it's very, very, very insignificant.

Doug Scovanner

Borne out of the fact that a substantial portion of returned merchandise is in perfect working order.

Gregg Steinhafel

It was very [smart to answer]. It was really only an iPod thing. So it's just not relevant.

Uta Werner - Sanford Bernstein

Great and my last question in the same spirit, to what extent can you comment on how the Internet has been doing?

Gregg Steinhafel

Our Internet and dotcom business has been having a very, very good year. We're very pleased with the business. But like the stores business, we have seen it slow down. And our sales rates have moderated somewhat compared to the very robust increases we were seeing in the early parts of the year.

Bob Ulrich

Okay. We have time for questions from two more people.

Operator

Your next question comes from the line of Gregory Melich with Morgan Stanley.

Gregory Melich - Morgan Stanley

Hi, thanks. Gregg, earlier in the year you mentioned that you got pretty conservative on the buying for the second half and that seems to, at least, help control the inventories. How do you see the buyings early next year and we'll take a look past Christmas right now, but what's your plan there?

Gregg Steinhafel

Well, we're looking well past Christmas at this particular of point in time based on the lead times in our business. So, we're expecting that, at least, what I would say for first quarter for sure and probably into the second quarter, we expect the soft sales environment to continue, and that the discretionary categories like apparel and home will be under more pressure than the hard lines and food categories. So, we pulled back our receipts in those businesses to reflect rates of sale that are going to be more modest than what we've experienced in the past.

Gregory Melich - Morgan Stanley

And so, I guess as a follow-up on that, if gross margin is made to improve from the shift as it was all mix in this quarter, how does that happen, if we expect home and apparel will continue to just stay comp zero, for example?

Gregg Steinhafel

Well, this is where we're planning the business. We have ample inventory as part of our base inventory that can support sales growth into the mid comp range. And so, we're very confident that we can be in-stock and can support an increased sales activity. Secondly, we will experience greater sell-through levels in our apparel and home areas if we perform better. So rather than selling through three quarters of our assortment before markdown, we'll see greater sell-through rates which yield higher profitability rates, if this should happen.

Bob Ulrich

In addition, as you know Greg, we're never satisfied with simply maintaining gross margin rates other than mix. So we will continue to have significant focus on all of the core drivers of margin rate within categories ranging from benefits to markup associated with global sourcing, penetration increases to programs designed to control markdowns and inventory shrink and so forth. The fact that we're net even on all of the rest of that activity in this quarter doesn't mean that we are satisfied with being net even excluding mix.

Gregory Melich - Morgan Stanley

That's great. And just to make sure I'm clear on that, when you say the softness will continue, that means you would expect comps to continue to run three to four into the first and second quarter or would it be another downtick?

Gregg Steinhafel

Well, we haven't issued specific guidance for that timeframe. So I think that's a little premature to get that specific, but we expect continued pressure in categories like apparel and home.

Gregory Melich - Morgan Stanley

Okay, great. Thanks.

Bob Ulrich

Last question, please.

Operator

Your final question comes from the line of Wayne Hood with BMO Capital.

Wayne Hood - BMO Capital

Good morning, Doug. I guess I wanted to come back to credit a second. Everybody can't agree on the economics or control in this transaction, would you be willing to let go and just to do a big securitization of that portfolio or would you just keep it as…

Doug Scovanner

I missed the front half of your question. I understood the back half.

Wayne Hood - BMO Capital

Yeah. I was just wondering, everybody can't come to an agreement on shared economics and control and things like that, would you be willing to let go and just do a large securitization of those receivables that you continue to manage with through that structure.

Doug Scovanner

In the hypothetical event that we do not find the economics to be attractive while shifting a substantial amount of the risk of ownership of this portfolio through a third-party, in that event we would, of course, pay careful attention to what is the most effective way to fund this portfolio moving forward given that in that event we would continue to own all of the risks. I would expect to continue to own all of the profitability out of the portfolio as well. But we would, of course, look at an array of financing alternatives relative to the status quo. But the status quo has proved to be a very effective method of funding that portfolio in the past.

Wayne Hood - BMO Capital

Second question is kind of related to that, if you look at the aging of the portfolio in the current quarter, it looked relatively flat. Yet, as you talked about the reserve is up, write-offs were up. Are you seeing the current files, the ones that are not falling pass due filing for bankruptcy are charging off? That's unexpected because that's one thing that kind of surprises you, those current accounts going past towards (inaudible) charge them off or no.

Doug Scovanner

There is nothing surprising going on there and I'm afraid we're into double overtime. I'd be more than happy to follow-up with anyone on the line with more detail on that issue or any other issue as the day progresses. I think Bob has a few closing remarks.

Bob Ulrich

Well, that concludes our third quarter 2007 earnings conference call. As Doug mentioned, he, Susan and John are available anytime during the day to answer any additional questions. And I would like to thank you all for your participation.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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