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Fred's, Inc. (NASDAQ:FRED)

Q3 2007 Earnings Call

November 29, 2007 10:00 am ET

Executives

Pat Watson - SVP and Principal at Corporate Communications, Inc.

Jerry Shore - EVP and CFO

Mike Hayes - CEO

Bruce Efird - President

Jim Fennema - EVP and GMM

Rick Chambers - EVP of Pharmacy Operations

Keith Curtis - EVP of Store Operations.

Analysts

David Cumberland - Robert W. Baird

Meredith Adler - Lehman Brothers

Mark Miller - William Blair

Patrick McKeever - MKM Partners

Jill Caruthers - Johnson Rice

William Keller - FTN Midwest

David Magee - SunTrust Robinson

Dana Walker - KalmarInvestments

John Lawrence - Morgan Keegan

Operator

Good day, and welcome to the Fred's Third Quarter ConferenceCall. Today's call is being recorded. At this time, for opening remarks, Iwould like to turn the call over to Mr. Pat Watson. Please, go ahead, sir.

Pat Watson

Good morning, everyone. This is Pat Watson with CorporateCommunications. Thank you for joining Fred's to review the company's financialand operating results for the third quarter and first nine months of fiscalyear 2007, which ended on November 3rd, 2007.

Before we begin, I would like to remind everyone thatmanagement's comments in this conference call that are not based on historicalfacts are forward-looking statements. These statements are made in reliance onthe Safe Harbor provisions of the PrivateSecurities Litigation Reform Act of 1995 and are subject to uncertainties andrisks. It should be noted that the company's future results may differmaterially from those anticipated and discussed in the forward-lookingstatements. Some of the factors that could cause or contribute to suchdifferences have been described in the news release issued earlier this morningand the company's annual report on Form 10-K and in other filings with theSecurities and Exchange Commission. We refer you to these sources for moreinformation.

Lastly, I would like to point out that management's remarksduring this conference call are based on information and understandings thatare believed accurate as of today's date, Because of the time sensitive natureof this information, it is Fred's policy to limit the archive replay of thisconference call webcast to a period of 30 days. This call is the property ofFred's. Any distribution, transmission, broadcast or rebroadcast of this callfor commercial purposes in any form without the express written consent of the companyis prohibited.

With those announcements, I'll turn the call over to Jerry Shore,the company's Chief Financial Officer. Good morning, Jerry.

Jerry Shore

Good morning, Pat, and thank you. And thanks to all of youfor joining us this morning for our discussion of third quarter results forfiscal 2007. With me this morning and available for questions are MichaelHayes, Chief Executive Officer; Bruce Efird, our new President; Jim Fennema,Executive Vice President and GMM; Rick Chambers, EVP of Pharmacy Operations;and Keith Curtis, EVP of Store Operations.

As the company reported in its press release this morning,total sales for the third quarter rose 3% to $419.9 million compared with$407.9 million last year. On a comparable store basis, sales increased 1.1% forthe quarter versus 3% in the same period last year.

The sales mix for the period was 22.4% household goods, 14.8%food and tobacco, 8.2% health and beauty aids, 9.2% paper and chemical, 9.2%apparel, 33.9% pharmacy and 2.3% franchise. And this compares with thefollowing mix in the same quarter last year: 20.6% household goods, 13.4% foodand tobacco, 8.4% health and beauty aids, 9.2% paper and chemical, 12.1%apparel, 34% pharmacy and 2.3% franchise.

For the quarter, comparable store traffic increasedapproximately 0.1% over last year, while the average customer ticket increasedapproximately 1.0% to $18.35 per transactions.

For the first nine months, total sales reached $1.287billion compared with $1.232 billion in the year earlier period, reflecting a5% increase in total sales and 1.2% increase in comparable store sales.

The sales mix for the year-to-date period was 23.1%household goods, 14.4% food and tobacco, 8.2% health and beauty aids, 9.1%paper and chemical, 9.9% apparel, 33.2% pharmacy and 2.1% franchise. And thiscompares with the following mix in the same period last year: 21.8% householdgoods, 13.2% food and tobacco, 8.2% health and beauty aids, 8.9% paper andchemical, 12.6% apparel, 33.1% pharmacy and 2.2% franchise.

On a year-to-date basis, comparable store traffic was flatwith last year, while the average customer ticket increased approximately 1.2%to $18.41.

For the third quarter, Fred's net income was $4.6 million or$0.12 per diluted share compared with net income of $6.0 million or $0.15 per dilutedshare in the year earlier period.

The earnings per share of $0.12 differed from ourexpectations of $0.14 as stated in our October sales press release. The $0.02difference resulted from our actions to bring inventory in line with salesduring the quarter. Our forecasted earnings were based on higher inventorylevels, which would have capitalized cost associated with that inventory.

The effect was less capitalized cost in inventory, whichshifted $1.5 million in costs into the third quarter that has been planned forthe fourth quarter. The timing difference does not affect the full year's plan,but these costs recognized in the third quarter reduced earnings from theanticipated $0.14 to $0.12 and will benefit the previously forecasted fourthquarter earnings by $0.02. For the first three quarters of 2007, net income was$15.1 million or $0.38 per diluted share versus net income of $17.6 million or$0.44 per diluted share in the first three quarters of 2006.

Operating income was $7.2 million or 1.7% of sales in thethird quarter compared with $9.3 million or 2.3% of sales in the year earlierperiod. For the first three quarters of 2007, operating income was $24.0million or 1.9% of sales compared with $26.6 million or 2.2% of sales in thesame period of 2006.

Gross profit for the third quarter increased 5% to $124.9million compared with $119.5 million in the same period last year. Gross profitfor the first three quarters of 2007 increased 5% to $373.4 million over the$354.4 million in the same period of 2007. Gross margins for the quarterincreased to 29.7% of sales from 29.3% of sales in the prior year period. Theimprovement is primarily a result of pharmacy department margin benefits gainedthrough the shift of branded drugs to generics, which have a lower sellingprice, but larger profit margin. Gross margin for the year-to-date period was29% versus 28.8% from last year, with the increase attributed to the samefactors I just mentioned.

SG&A expenses for the quarter increased to 28% of salescompared with 27% of sales last year. The increase is attributable to cost ofthe MRP program, the refresher program in our stores, higher utilities,additional advertising expense due to the timing of ad circulars and higherlegal and professional costs during the quarter. On a year-to-date basis,SG&A expenses have increased to 27.1% of sales in 2007 compared with 26.6%of sales in 2006. The increase is primarily attributable to the additionalcosts of our store refresher program, energy cost increases and advertising.Depreciation and amortization expense totaled $7.1 million in the third quarterand $21.7 million for the year-to-date period.

For the third quarter of 2007, net interest expense was$353,000 versus $287,000 in 2006. The increase in interest expense is primarilythe result of higher borrowings throughout the quarter for seasonal inventorypurchases and capital expenditure. On a year-to-date basis, net interestexpense totaled $494,000 in 2007 compared with $502,000 in 2006. Income taxexpense decreased to 32.6% of pre-tax earnings in the third quarter compared with34% in the third quarter of last year. The change primarily results from thepost-implementation effect of financial accounting standard boards, FinancialInterpretation Number 48 or FIN-48, which is accounting for uncertainty inincome taxes. The adjustment in the current quarter brought the year-to-dateincome tax rate to 35.9% as compared to 32.6% in the year earlier period.Again, the change results primarily from the effects of FIN-48.

We anticipate the tax rate for the fourth quarter of 2007 tobe in the range of 36% to 38%. Capital expenditures for the third quartertotaled $17.6 million compared with $8 million in the third quarter of 2006. Ona year-to-date basis, capital expenditures totaled $32.3 million compared with$19.4 million in the first half of 2006. The breakdown of the year-to-datecapital expenditures are $5.7 million for new stores and pharmacies, $11.7million for the acquisition of existing stores, $13.4 million for expenditureson existing and remodeled stores, $1 million for DC equipment, and $0.5 millionfor corporate and technology upgrades. Additionally, there was $50,000 relatedto acquisition of pharmacies as compared to $490,000 in the third quarter oflast year. Year-to-date expenditures for acquisitions of pharmacies were $800,000this year compared to $3.4 million last year.

Total inventories were $387.9 million compared with $388.1million in the third quarter of 2006. The decrease in inventory is primarilyattributable to our actions taken to bring inventory in lines with our currentsales trends. Inventory turns improved to 3.8 turns from 3.7 at the same timelast year. We intend to end the year at 3.9 turns.

Our total debt at the end of the quarter was $54.4 millionas compared to $35.9 million last year. The increase in debt is due to, first,the timing issue with our bank funds transfer at the end of the quarter, whichleft an extra $7 million in cash, the $12 million of additional real estatetransactions made during the year, and approximately $4 million in funds utilizedfor repurchase of shares of common stock.

The company operates 708 discount general merchandisestores, including 24 franchise Fred's stores. During the quarter, the companyopened 10 stores. There were no new pharmacies opened during the quarter. On ayear-to-date basis, the company opened 26 stores, 9 new pharmacies and closed19 stores and 4 pharmacies.

The company's total selling space has increased 1% so farthis year to 10.84 million square feet. Compared to the same period last year,our total selling space has increased by 3%. And the company anticipates thatit will open or upgrade a total of 32 to 34 stores and that it's selling spacewill increase in the range of 2% to 3% for the fiscal year of 2007.

This concludes our financial summary, and we will be happyto answer any questions that you may have.

Question-and-AnswerSession

Operator

Thank you, sir. (Operator Instructions)

We will go first to David Cumberland of Robert W. Baird.

David Cumberland -Robert W. Baird

Good morning. Thank you. On the shift in costs, did thatnegatively impact gross margin?

Jerry Shore

Yes, David, it did. That's where the effect came in withingross margins.

David Cumberland -Robert W. Baird

What were the actions taken to bring inventory in line?

Jerry Shore

Jim?

Jim Fennema

The overall actions included reacting to the current trendsin the sales areas, which would mean that either we cancelled orders that wereunordered or decided that we owned inventory that we could create sales out ofand had no need to make further purchases.

David Cumberland -Robert W. Baird

And then, looking at your, excluding that factor, your EPSrelative to plan, sales were at the low end of plan or the comps at the low endof the plan. But you came in slightly below on EPS. Where were you belowexpectations? Was it on this gross margin line?

Jerry Shore

No, David. It was in the SG&A line, with the lower salesnot being able to react to the lower sales with the labor and costs that we hadplanned and incurred during the quarter.

David Cumberland -Robert W. Baird

And then, my other issue or question area would be on theguidance for Q4. Does your pervious EPS guidance for Q4 still apply nowadjusted upward by $0.02?

Jerry Shore

David, the reason why we didn't put the guidance in andinform numbers is really the volatility of the market right now. And I think,that the way we feel internally is the range, is a little bit lighter at thispoint than what we had out there. But other than that business goes on as usualinside the company.

David Cumberland -Robert W. Baird

Thank you.

Operator

Thank you. We'll go next to Meredith Adler, Lehman Brothers.

Meredith Adler -Lehman Brothers

Thanks very much. I'd like to just start by focusing alittle bit on your refresher program. I assume that's completed now and,obviously, the economy is not good, but are there any particular surprises? Areyou disappointed in the refresher program or do you feel that it's essentiallydone what it was supposed to do?

Mike Hayes

Hi. This is Mike Hayes. To be honest, we are slightlydisappointed in November. As far as the refresher was concerned -- why I pressand say, to be honest, think about that -- we were slightly disappointed.However, I use the word slightly because I think our customer is working muchcloser to the buy-now, wear-now scenario. And I think that December will end upbeing where the strength of the sales ends up occurring and definitely closertowards the end of the period.

But in the categories that we expanded, the categories thatwe focused on, they did quite well. Electronics did well for us, okay, thatarea did very well for us. And we're still working out the impacts of the kidsdepartments that we took out last year. So the refresher program itself, in November,which we were looking for probably more of a boost than we got so far, wasneutral at that.

Meredith Adler -Lehman Brothers

Okay. And if you think about the impact that the refresherprogram had on the negative side because of some disruption, when would you saythat we will have fully cycled that? Over the next year really that --

Jerry Shore

I don't think we had any expense impacts. We have some thatcould show up in this quarter because of some minor impacts in November, butafter that we are not anticipating expenses related to the refresher program.

Mike Hayes

Right. And as far as the departments that you're sayingexited, when will we cycle through those? May.

Meredith Adler -Lehman Brothers

Great, May?

Mike Hayes

Yeah, May.

Meredith Adler -Lehman Brothers

Okay. And then I have a couple of questions about thepharmacy business. I've heard from other retailers that we are still much loweron the flu categories than we were last year. You know, last year wasn't agreat flu year and I was wondering if you are seeing the same thing. And then Ihave another question.

Jerry Shore

Ricky?

Rick Chambers

Yes, Mary, this is Rick. That is correct. We are seeing thesame thing. We track it with two or three different reports. There is an internalreport we use as opposed to the plan report and the flu star report and all ofthose are very indicative of what you are talking about, but it is lower thanlast year. We saw our first spike around December of last year with the mainspike coming in February. So, we are still anticipating a month or two offbefore we start seeing any relevant flu activity.

Meredith Adler -Lehman Brothers

Okay. And finally, last year was a pretty good year forgenerics and generic profitability, but you did talk about generics drivingyour gross margin. Are you seeing a tough comparison, say, this past quarterand this coming quarter because generics were so profitable last year?

Rick Chambers

So far, because of the last two years, they have been notfollowing our historical trend. We have seen a significant shift in our genericdispensing, year-over-year, the last two years. So a tougher comparison willprobably be next year. There is really not a lot of blockbuster drives that arecoming off patents in 2008, you start kicking back up in 2009 and beyond. So wewould expect, from this point going forward, to see more of a historical trendthat we saw before the last two years because the last two years, as you said,have been very generous to us only on the generic side with what's come onpatent.

Meredith Adler -Lehman Brothers

Okay. Thank you.

Operator

Thank you. We will go next to Mark Miller of William Blair.

Mark Miller - WilliamBlair

Hi, good morning. Just hoping you could elaborate on thecomments about consumers' conservative shopping patterns and is this somethingthat applies across the store or are you seeing it guessing more acutely incategories like home and apparel? You talked about electronics being strong,but if you can just elaborate on what some of those trends are and how that'saffecting the mix?

Jerry Shore

Well, maybe Jim can give you an update or insight into this.Where the categories are right now and again, Mark, we believe we will have towait till December (inaudible), we believe that our customer is going to bemore buy now, wear now, than in the past. We have had a couple of cold days andwe have had some decent reactions all of a sudden again in software top line.But the key categories that were slower than anticipated, except were homefurnishing.

Mark Miller - WilliamBlair

Yeah.

Jim Fennema

Mark, our task in hands still remains in home furnishingscategories which would be your furniture, wall décor, and domestics, but notnecessarily in the electronics or in the appliance areas. Even though there areno home categories, those are actually performing pretty solid for us.Consumables remain solid for us and continue to do well. And then, you can seefrom the numbers even in the quarter, that the apparel area still is a strongstruggle. To Mike's point, on the buy now, wear now part, our business shiftssignificantly when the weather actually gets to where we need it to be. And Ithink that's indicative of two things, it's our customer base as well as thefact as you mentioned too, the amount of money on the street. There is noreally forward buying that I see in our customer base right now.

Mark Miller - WilliamBlair

Your gross margin is very solid overall. It’s impressive howit's up here. And I guess, I want to be clear, is that all coming from thepharmacy, so that the margin uplift is even greater than what you have shownhere? We're at not for a down front-end. My question is, is the generalmerchandise margin roughly stable or is that down year-to-year given the mixshift?

Jerry Shore

Mark, the store gross margins have held up pretty well thisyear. We are seeing the product mix shift as you can tell in the salesbreakdown. But the stores gross margins have held up pretty well. Obviously, asI said, the pharmacy margins are the basic contributor to the increases. But,overall, the store margins have held up well.

Mark Miller - WilliamBlair

On the comment about the qualified parties making increase,can you just add anything to that? Does that, both, include strategic as wellas financial parties, or could you categorize it as one or the other?

Mike Hayes

Hi, Mark, this is Mike Hayes.

Mark Miller - WilliamBlair

Hi, Mike.

Mike Hayes

These inquires that came in were definitely from differenttypes of players. What triggered it, as you can understand Mark, is our stockis trading around book value, and probably appeared on every screen in thecontinental United Statesand throughout the world, particularly with the strength of our balance sheet.So, there is really no more that I'm at liberty to talk about right now.

Mark Miller - WilliamBlair

Right. That's the key development here obviously. So, justmy general thought walking away is what do you see is your greatest opportunityto enhance shareholder value? I don't if you can elaborate that way or not, butif there's anything more to add on to that, that would be great.

Jerry Shore

Bruce Efird?

Bruce Efird

Yes. Actually, therein lies the reason for retaining MerrilyLynch is to ensure that we are doing everything possible to enhance shareholdervalue and we have received the enquires. So the Board has a fiduciaryresponsibility to evaluate the options. And that's why we retained MerrilyLynch to help us do that, and again, enhance or meet the shareholder value.

Mark Miller - WilliamBlair

Okay, thanks. Good luck.

Operator

Thank you. We'll go next to Patrick McKeever of MKMPartners.

Patrick McKeever -MKM Partners

Hi, everyone.

Jerry Shore

Hi, Patrick.

Patrick McKeever -MKM Partners

On the refresher program, it sounds like things may haveslowed a little bit from where they were, but it sounds like business is slowacross this space. I'm just wondering if you could maybe break it down a littlebit and talk about which categories are working right now and which onesaren't. And, where are you most happy that you've made the investment thus far,just from both the incremental sales and also incremental profitabilitystandpoint.

Mike Hayes

I think I'll be a little redundant here. The program was designedon a long-term basis. Remember, we had three goals that we outlined at thebeginning of this and one is we are working to build our program to be anational chain. And we wanted conformity throughout all of our stores, so thatthe people walked into one, saw the [sign in] or another that we had conformity.

The second one was to reduce areas that we did not feel wewere getting ROIs. In departments that we're not really getting the ROIs, wewere looking for to departments that we felt would be demographicallyconsistent with our customers and also with where we saw the economydemographics going.

So when we went into the program, we hit two big areas. Wesaw electronics moving up. We see that still being there. And in the format ofeven when we look at the toy category, we're moving. A large percentage of ourmix is moving over to electronic type toys versus the conventional areas. Butwe still have a really rock solid business. I think it will stay there in the$10 category which we focus around in the toy area.

The second, of course, was the vet which has doneoutstanding. It has exceeded the plan substantially. We were seeing comps inextraordinarily high double-digits in that area. The electronics, again, I'vealready talked about. When we eliminated the kids and boys and girls, that's adiscussion that I think Bruce and Jim will probably be refocusing on in 2008,whether that was really one of our better decisions and how we might addressthat. That's a 2008 because the soft line, overall, have not performed verywell at all throughout the course of the last six months.

Now, having said that, we think that a lot of it has to dowith our customer's economic status right now, they are clearly into thebuy-now, wear-now area. And soft line tends to be a secondary purchase rightacross the line. Overall, I guarantee you that, from my perspective, we feelvery good about the refresher program. Keith, maybe you'll give us a quick wordas to what the stores feel about the refresher program and the building of the Bargain Center.

Keith Curtis

Yes, Mike. I believe that we have much cleaner refresherstores. I'm in the stores quite a lot. And the in-house mix of merchandise outthere, I talked to a lot of customers, hundreds of customers out here that thecustomer response is very good to our cleaner refresher stores. And those areasthat you just mentioned are the areas that our customer talks about.

And I believe the Bargain Center, and speaking withour managers and the management teams out there, we've been able to do a lotwith some of our older merchandize and clearing those things out. But the mostthing I hear from our customer base is that they're really proud of our cleanerrefresher stores, and most of our emails, letters that we get, talk about thestore being easier to shop and more attractive.

Jerry Shore

Does that help?

Patrick McKeever -MKM Partners

So, on to apparels, still the big area, the area that is thetoughest. And are you saying, Mike, that would consider going back into boys andgirls or maybe consider just getting out? Would you consider getting out ofapparel altogether or do you feel like you really have to be in that business?

Mike Hayes

I think you're aware, that when we started our strategicinitiatives this year, we started and we put three big ones out there in frontof everybody. First one we did and maybe Bruce is going to be managing thatprocess, as we hired the consulting firm that will be getting the results in,what the 13th?

Jerry Shore

Yeah. December 13.

Mike Hayes

December. We brought (inaudible) and it's a very expensiveproject. We are talking about interviewing 25,000 or more of our customers andit's going to help us build a refresher program for 2008. It's a very in-depthanalysis to take a look and see what they think that we should be doing more ofor less of. That program is going to be instrumental. The second one we did iswe took another look at our locations of our stores and [whether] we were doingthe smartest thing to look at it. The fourth one really was that we went andlooked at our advertising program that we outlined in last year. We were notsatisfied with the success of our branding campaign at all last year. We brokethem down, we interviewed. How many we interviewed, Bruce? Six?

Bruce Efird

Yes.

Mike Hayes

Six different firms and we have it down to two. I think thatthey're going to be a substantial improvement in that program in 2008. So whenwe started this program, the big elements were the consulting process that wewill have finished up and the tacticians program for our store locations, whichis going to go not into demographics, but will go past demographics into more.There is a term that they use and it’s escaping me at the moment. Psycho?

Bruce Efird

Psychographics.

Mike Hayes

Psychographics, ways of determining whether not only do wehave good demographics, but do, we have good psychographics in our storelocations. And all of these programs, along with the refresher programs arecoming to a head by the end of this year.

Patrick McKeever -MKM Partners

Okay. And then just on the Merrill Lynch subject, withhanding Merrill Lynch and so forth, any timeline there Mike, for when we mighthear something one way or the other? I am sure it's difficult to say, but justgiven the timing right in front of the holidays, I would imagine it might be alittle bit of a distraction internally for the employees and so forth. And areyou looking to reach some kind of a decision relatively soon or do you thinkthis could be something that carries over, just the unknown factor into earlynext year?

Mike Hayes

It's too early for me to give you any real intelligentresponse to that question. I would like to, but I can't. And I am not concernedabout the internal distraction. Our people are well informed and they know thatthe company has an extraordinarily good balance sheet. They know the companyhas an opportunity and they are also aware that we are looking at that. We haveto continue to look at all of the options that would be investment [spruce] tothe company. I think the best option that we did was when we bought Bruceaboard. He has really quirked up the leadership around here and the moralecouldn't be at a higher level and I think everybody is really looking forwardto 2008 with some of the opportunities we have out there for us.

Patrick McKeever -MKM Partners

Okay. Thanks very much.

Operator

Thank you. We will go next to Jill Caruthers of Johnson Rice

Jill Caruthers -Johnson Rice

Good morning. Could you talk about your store portfolio? Iknow in '07 one of your strategies was with the refresher program. You closed anumber of stores. Maybe if you could talk about now, what your existingportfolio looks like, if you are pleased with the level of profitability of thestores as in, you don't have the a small group underperforming?

Mike Hayes

Jill, there are two pieces to that that we can do. We didbuy in 13 of our locations last year. We have an option to pick up some more.So we are trying to get the control of our locations there. I think the mostimportant thing is that we probably will see over the next four or five years,as we go out, a continuation of looking at 2% to 3% to 4% of your base, asstores that you want to clean up. But with the program, we should have initiatedbefore, we need to be more proactive in doing that. So, I think the portfoliois better than it was last year, but it’s not where it needs to be in the nextthree years. We will continue the process of cleansing and that's why we havebeen so diligent with the tacticians and the study and analysis of the futurelocations. It's a very important part of our growth strategy and making surethat that location selection process is truly a first class upgrade. That's whywe've invested so much money in the program this year.

Jill Caruthers -Johnson Rice

Would we look for '08 to be somewhere to '07 and kind of inthat low single digit type square footage growth?

Mike Hayes

Mostly likely that's a realistic position right now. Wedon't believe that the development process of the tactician program and thepsychographic, demographic program, and with Bruce working on really, a lot ofstrategic changes that he is focusing on implementing, that we would probablyreaccelerate it dramatically in the first half of this year. If it happens, itwill happen at the latter half of next year that we would pull the trigger andblow it.

There are so many issues that we want to make absolutelycertain that we walk a clean path on. I think we'd all feel better if weactually knew where the economy was going to land next year. But we seem to bereacting a little bit to $100 [oil], and then, it's going back down to $90 oil.We have a credit crisis going on. So I think conservatism and upgrading iswhere we're going to take our stance in 2008.

Jill Caruthers -Johnson Rice

Okay. And then just last question, maybe if you could talk alittle bit more about the November trends that you're not pleased with over theweek and kind of Black Friday sells. You've seen more weakness in your largeticket items perhaps or maybe in the toy category, just a little bit moreclarity on that.

Mike Hayes

Definitely not in toys.

Jim Fennema

No.

Mike Hayes

Toys did fine. Right, Jim?

Jim Fennema

Yeah. Overall Jill, actually, our electronics business, ourtoy business was good and our higher ticket items, which obviously don't matchup to the industry because our higher ticket items start at $50, but thosecategories actually were really strong. The normal trends really followedthrough. The soft line was still weaker than what we would have hoped and thehome furnishing area was the other one that was a little more of adisappointment.

To a degree, that does have some higher ticket items inthere, and they did not respond as well as what we would have hoped. And thatcould be indicative of what's out there as far as our customer's ability topurchase. But in the electronics arena it seems that everybody is willing tospend it there.

Jill Caruthers -Johnson Rice

Okay. So that would imply most probably, traffic wasprobably the biggest drag?

Mike Hayes

Right.

Jill Caruthers -Johnson Rice

Okay. Thank you.

Operator

Thank you. We'll go next to William Keller of FTN Midwest.

William Keller - FTN Midwest

Good morning. Thanks for taking my call. Bruce, going backto the strategic initiatives you mentioned could you give us a little bitbetter idea of the timeframe for each? I think you said that mid December wasthe result for the consulting for the '08 refresher. Is that of a similarmagnitude to '07?

Jerry Shore

Bruce?

Bruce Efird

Yes. Let me just clarify on the customer research that we'llsee on December 13th. That's pulling together the customer data,financial data, and then the transactions data, as Mike alluded to earlier, tohelp us make better decisions with areas within the store that we want toexpand and contract. So, that will be the starting point for developing thosestrategies for next year. And then, over the next month, I'll be presenting andgetting input from the Board on the strategic plan for next year.

Some components of that strategic plan will be to focus moreon areas that remain strong for us, which is consumable. Our focusing is wellon some of the fundamentals of the business where we're really focused on, ourservice level and better in-stock position, again, specifically on consumables.And then leveraging the strength of our pharmacy, we're focusing in on(inaudible) and really driving that business, not only the pharmacy business,but leveraging that business across the store.

And then another area that we'll be focusing in as well, asMike mentioned, reviewing our marketing/advertising agency. And I believe thereis an opportunity to really leverage out our value message and be moreaggressive in communicating our pricing and value message to the customer.

So those are just a few of the components of the go-forwardstrategy. And the input to develop these strategies will be a more robustconsumer research as well as the tacticians' piece that will go into drivingthat research. Again, with the balance sheet, we're positioned well for thecurrent economic environment, and we're very confident about the long-termprospects for 2008 and beyond.

William Keller - FTN Midwest

So those initiatives enumerated earlier, those are allthings that the output is coming presently and then we should see some changesin '08, is what it sounds like.

Bruce Efird

Yes.

William Keller - FTN Midwest

Okay. And then, Mike, when you said you were not pleasedwith the branding campaign last year, you mean the '07 year-to-date?

Mike Hayes

Yeah. The correlation of what the performance standards wesetup, it did not achieve the recognition that we were looking for. It's reallytough to blame, but it's good to be on the campaign. What we concluded was thatwhen we brought in the new firms, one that having the dollars already builtinto our budget like we did last year, gives an opportunity as we look to 2008,to say we have [then] the most effective use of dollars given the economic environment.And I think the consensus across the Board was no, and that we can be much moreeffective and create a much better campaign using the same dollars that werebuilt into last year's budget in 2008. And particularly, since we have seensome pretty interesting [chess]. The first one we saw was Wal-Mart, typically,only did it on the first of the month. They have consistently now come out atleast twice a month. We have seen an increase to advertising development withsome of the drugstore chains. So, it was imperative that we commend and reviewthat situation and maximize that and I think that's what Bruce is referencing.

William Keller - FTN Midwest

Okay, great, last thing. Do you have any update or thoughtson the timing of the shift to AMP? I think it is still expected for January'08?

Rick Chambers

Yes, Will and this is Rick again. As far as AMP wasconcerned, we are still looking at that late January, early Februaryimplementation. We did receive a word this week that CMS is committed to notrelease any of the data publicly until at least December 17. There is apreliminary or a court date set on 14th of December to hear a preliminaryinjunction that you may be aware. There was a lawsuit that was brought againstCMS, by NACDS and NCPA. So all that said, on the earliest we would see to that,it would be the 17th of December. But we are still planning with a February 1implementation date. So, at this time, no change from what we have previouslycommunicated.

William Keller - FTN Midwest

Great. Thank you very much.

Operator

Thank you. And we will go next to David Magee of SunTrustRobinson.

David Magee -SunTrust Robinson

Yeah, hi. Good morning.

Mike Hayes

Good morning.

David Magee - SunTrustRobinson

I just want to circle back to the gross margin issue if Icould. The stability that you see in stores, we are hearing about (inaudible)promotions went into the holiday period and you all mentioned more volatilityof late in terms of patterns and stuff. Are you anticipating having to becomemore promotional, more price aggressive in the fourth quarter, just to keep itup and because your margin composition seems to be doing so?

Mike Hayes

David, the short answer is yes. We are evaluating Jim Fennema. We are looking at some options given the increasedintensity we are seeing out on the street right now from our core competitors,key competitors and peripheral competitors. We are all dealing with the sameeconomic issues and soft sales environment, which will, as you know, stimulateadditional promotional activity. So, yes we will be reviewing that and mostlikely increasing the intensity of promotions through the balance of theholiday period.

David Magee - SunTrustRobinson

So these are actions that are still more ahead of us thanwhat you have taken so far?

Mike Hayes

Yes.

David Magee - SunTrustRobinson

Okay. And then, secondly, with regard to your refresherprogram, and below the surface you are seeing some improvement because of thoseare tech categories. How do you anticipate those categories to comp next year?You anticipate this will be again, a multiyear benefit for these categories orany early thoughts about that?

Mike Hayes

Yeah, that's really - well, you are asking for, a swag hereif there was one. Most of these programs are incubated in all throughout theyear, so you are not talking to - you are going to reach first quarter beforeyou would be cycling around the complete impact of them. And each of theprograms that were put in that we have accelerated and expanded, were areaswhere we believe the demographic shift has occurred from the consumer. And wedon't see that slowing and that's why these guys were selected. We don't seethe tech category at all slowing down over the next five to six years, we seethat as a continuation of a trend, as you look the population that areaccounting for the majority of the growth. So, they are departments thatcontinue to accelerate and of course, as they continue to go, the ones that webacked out of will cycle through those. So I don't think it will have a dynamicshift in our comp comparisons next year.

David Magee - SunTrustRobinson

And to the degree there is the impact that you are citing anegative impact and you're continuing to receive a positive impact maybe to alesser degree. Is that fair?

Mike Hayes

I apologize. You were breaking up on this and could you saythat one more time?

David Magee - SunTrustRobinson

Yeah, Mike, to the degree that you had some negative impactcategories you've exited. That will be cycled again in that business as far asthe negative impact, but the categories you've expanded will continue to growmore than one year in effect.

Mike Hayes

Absolutely. That was the rationale behind the decision. Anddynamically, I believe, it's turning out to be true.

David Magee - SunTrustRobinson

Great, best of luck to you all.

Mike Hayes

Thank you.

Jerry Shore

Thanks.

Operator

Thank you. We'll go to Dana Walker, Kalmar Investments.

Dana Walker - Kalmar Investments

Good morning. I have two questions. For a year plus past thesteps that Wal-Mart took to be more competitive in pharmacy, could you appraisewhat they've done and how you've responded and what you believe the lastingimpression they've left has been?

Jerry Shore

Rick?

Rick Chambers

Yes, Dana, this is Rick. Only the $4 program that they cameout was in September of last year. We talked on prior calls, we have about 40or 50 stores that we have on our prescription plus program that has a $4component to that. We have seen those stores respond favorably versus allcompany stores in terms of a comp performance on unit growth.

If you go back and look, we've seen a lot of market shareshift from our Wal-Mart market that we're in. We've not seen that to asignificant effect. We've been able to hold our own there with that. But again,obviously, they come out continually with different programs or deviations ofthat program, but today we've been able to compete fairly well with that goingforward -- in the past. So, we would anticipate that going forward.

Dana Walker - Kalmar Investments

Second question is this, the minimum wage increase went inseveral months ago to my knowledge, recognizing that the environment is tricky.Nevertheless, what evidence do you see that spending patterns are changingpositively?

Rick Chambers

If we're talking the month of November, let me go back to acomment we made before on this. Historically, it took three months before wesaw any real pattern shift as well as the [weight shift]. So right now, I can'tsay that we've seen a spending pattern shift at all.

Dana Walker - Kalmar Investments

Is it part of your market study that you would expectresults back from in mid December to ask your customers whether they feel morefinancially secure and tend to raise their household budgets?

Mike Hayes

It was not one of the questions in the survey. The surveywas directed in a fascinating way to watch. The way the survey was directed,it's a series of questions that breaks itself downwards. But it's directed totalk about our consumer and their wellbeing and their buying patterns. Itdoesn't get into emotional state. It gets into tangibles.

Dana Walker - Kalmar Investments

One last question on the branding, I presume a fair amountof forethought was used in the way you approached the branding and either youare unhappy with the work that your outside firm has done or perhaps you areunhappy with the premise that you let the outside firm work with. Can you helpus better understand why you think that this has misfired?

Mike Hayes

I don't think that it would be fair to blame the outsidefirm. In fact, it would be unfair to blame them. I think the most importantthing that happened was that we've seen the competitors shift the nature oftheir advertising dramatically.

And what you're seeing now in the marketplace, and Bruce youor Jim can jump right in on this, what you're seeing is a much more now type ofadvertising processes. And to highlight that, remember, Wal-Mart never wasgoing to ever go to multiple circulars that (inaudible), now they'reconsistently in on the mid month circular. You saw Dollar General never ontelevision, now you see Dollar General breaking items on TV consistently.

So, I think that the shifting of the economy and the needfor us to be a now scenario suggest that maybe the timing into the brandingcampaign wasn't a good timing. We need to make those dollars more productiveand more now, and that's the real focus of the 2008 campaign.

Dana Walker - Kalmar Investments

Since we're near the end of the call, let me direct aquestion to Bruce. Bruce, Fred has put a lot of money and reorganized stores tobe in the cooler program in hopes of being a part of more shopping trips on thepart of the customer. Now what's your appraisal of the cooler and the way itplays a role in the Fred's concept?

Bruce Efird

Well, currently, this is Bruce, our perishable or the frozenand dairy sales continued to grow and remained strong in our scenario thatKeith and his operations team has been focused on. And as I mentioned earlier,our consumables business continues to remain solid, and I envision for thefuture, capitalizing on the strength of that business and growing thatbusiness, coupled with one of our key opportunities is where we are currentlyunderdeveloped in our private label business, specifically in consumables. So,that's an area that we will continue to evaluate and position that, not only ina way to drive traffic, but also developing our private label to mitigate anypotential margin loss as we drive into some of those lower margin categories.

Dana Walker - Kalmar Investments

I presume that when you used the word solid, you are talkingabout sales tone rather than margin comparability to where you think the marginshould be?

Mike Hayes

Yes, sales have been solid and our margin remains solid inthat category. Jim, do you have something to comment on that.

Jim Fennema

Yeah, just to take another step, the coolers, they are intotheir second year now. That was part of the part of the MRP two years ago andas Bruce mentioned, we continue to see solid growth in there and we have beenable to attain the margin requirements that we wanted to, even in light of someof the current inflationary pricing like in milk and eggs. But even outside ofthat the growth has been really good for us and obviously we have been tryingto utilize that with our consumables for traffic and continue to make sure thatthat will be an effective program as we go forward.

Dana Walker - Kalmar Investments

Thank you very much.

Operator

(Operator Instructions). We will return to Meredith Adler,Lehman Brothers.

Meredith Adler -Lehman Brothers

Yeah. I was just wondering I have to say, I am a littleconfused about what you said about inventory and the $0.02. Were thereincreased markdowns or just simply a decision not to complete some orders? Youactually canceled orders?

Jerry Shore

No Meredith, it's the canceling of orders, but it's notrelated to markdowns and it's the freight, warehousing etc costs that arecapitalized as inventory. That is part of your inventory. So with inventorybeing lower, those costs associated with that were not capitalized, they wereexpensed.

Meredith Adler -Lehman Brothers

Okay, got it. My next question is about the tacticalprogram. The tacticians program you are talking about is strictly related toreal estate. But I think you have said that you really need to upgradegenerally, the locations. Is, that fair and how much effort will that take?

Jerry Shore

Well, is that fair, you mean is that a fair summation orwhat --?

Meredith Adler -Lehman Brothers

Yeah. I mean is it a fair assessment of when you look out atyour store base, have you been going for very cheap real estate at the expenseof the best location for your format?

Jerry Shore

That might be, I would say the answer is that's fair. Thequestion was where we've been penny-wise and pound-foolish. That is part of theanalysis that is undertaken and that is a key part of the analysis. The secondpart was that we didn't get deepened up both into the demographic, and again, Ihate to keep using this silly word, psychographic analysis to make certain thatwe had both of those lined up correctly when we had a location. Because all toooften, the impact of what we were looking at was the cost of the land.

Meredith Adler -Lehman Brothers

You talked about buying properties. I think you meant buyingout landlord's leases?

Jerry Shore

No. Meredith, we bought their king properties that had beenowned by a landlord, but we actually bought the real estate and the store.

Meredith Adler -Lehman Brothers

But you have been leasing them before?

Jerry Shore

Yes. We had been leasing those. Now we own them.

Meredith Adler -Lehman Brothers

Why would you want to own the properties rather than leasethem?

Jerry Shore

These were properties that one of our developers wasplanning to get rid of, to go towards other opportunities. He is continuing towork with the company however, but these were properties that were goodproperties for Fred's, good locations and fit well within the company. So, weacquired those and at an advantageous cap rate. Yes.

Meredith Adler -Lehman Brothers

So, it wasn't just opportunistic?

Jerry Shore

Right, definitely.

Meredith Adler -Lehman Brothers

But I guess my real question is, if you decide that you needto really do a major upgrade of the store base, I don't know what kind of leasecommitments you have now, but couldn't that be very costly, or would you justwait until a lease expires before you would consider moving it?

Jerry Shore

Well, first of all, our leases typically have an averagelife of five to seven years. So our average leases that are out there much morethan seven years. And Meredith, when we are talking about upgrading and goingwith the process that we are really looking at is the growth cycle, not ourhistoric positions, because it's where we locate the next 60 stores. It's notthat we have to go back and redo them.

But, for example, let’s just take a location put it anywhere"X". Let's say it's a marginal store with positive cash flow, butits' ROI is maybe 5%, but we have a positive [RNI]. The thing that we want tobe able to do is go back and study that and say, is that us? Is it thelocation? And if so, is that a location that when we move that when that leaseexpires, we want to be a year ahead of the lease to be able to go out andrelocate that store to a higher upgraded area, but debasing it on a moredefined and reliable answer than the intuition of our real estate people.

Meredith Adler - LehmanBrothers

Okay, thank you. That makes sense to me. I appreciate it.But I do actually have one final question and I don't know what your comment onthis, but it doesn't sound like you solicited the interest from these variousparties. Is there a philosophy at the company about remaining independent?

Mike Hayes

I don't want to speak on behalf of the Board. The Board'sobjective is to maximize shareholder value and protect our employees. It willcontinue with that. There are opportunities that have come our way. So I thinkthey will evaluate it and release the information at the time that'sappropriate.

Meredith Adler -Lehman Brothers

Okay, I understand. Thank you very much.

Operator

Thank you. We'll go next to John Lawrence of Morgan Keegan

John Lawrence -Morgan Keegan

Hi, good morning guys.

Jerry Shore

Hi, John.

John Lawrence -Morgan Keegan

Can you just speak very quickly as far the categories thatare very strong and the things that are working, such as electronics? Thebuying process, what are you seeing out there in the marketplace of maybegetting some of those special buyers, etc? Is that helping in those categoriesat this point?

Mike Hayes

John, I won't change my tune on what's working. As far asthe categories, still our consumables are the solid part of our business.Electronics is doing well. The MRP category of the pet area is very, verystrong for us. And our challenges remain in apparel and home furnishings partof our business.

As we go forward, as far as opportunity buys, etc, based onwhat I see out there now, there is now, and I think will be throughout thefirst half of next year, significant opportunities for product because of theamount of goods that are actually piling up out there and will be pushed offeven going in the next spring. So, we will be reacting to those as they presentthemselves to us, and we'll make sure that they fit into what we are trying todo. But I do believe there will be opportunities there. And strategically,we've already set up our purchase program for next spring to be able to havemoney available to react through those as they are available.

John Lawrence -Morgan Keegan

Great. Thanks a lot.

Operator

Thank you and with no further questions holding, Mr. Hayes,would you like me to turn it back over to you.

Mike Hayes

Yes, please, and thank everybody for being on board,appreciate it, and have a great holiday season.

Operator

Thank you for your participation. That does conclude today'sconference. You may disconnect at this time.

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Source: Fred's Q3 2007 Earnings Call Transcript

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