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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 - Kalmar Investments

John Lawrence - Morgan Keegan

Operator

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

Pat Watson

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

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

Lastly, I would like to point out that management's remarks during this conference call are based on information and understandings that are believed accurate as of today's date, Because of the time sensitive nature of this information, it is Fred's policy to limit the archive replay of this conference call webcast to a period of 30 days. This call is the property of Fred's. Any distribution, transmission, broadcast or rebroadcast of this call for commercial purposes in any form without the express written consent of the company is 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 you for joining us this morning for our discussion of third quarter results for fiscal 2007. With me this morning and available for questions are Michael Hayes, 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% for the 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 the following mix in the same quarter last year: 20.6% household goods, 13.4% food and 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 increased approximately 0.1% over last year, while the average customer ticket increased approximately 1.0% to $18.35 per transactions.

For the first nine months, total sales reached $1.287 billion compared with $1.232 billion in the year earlier period, reflecting a 5% 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 this compares with the following mix in the same period last year: 21.8% household goods, 13.2% food and tobacco, 8.2% health and beauty aids, 8.9% paper and chemical, 12.6% apparel, 33.1% pharmacy and 2.2% franchise.

On a year-to-date basis, comparable store traffic was flat with 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 diluted share in the year earlier period.

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

The effect was less capitalized cost in inventory, which shifted $1.5 million in costs into the third quarter that has been planned for the fourth quarter. The timing difference does not affect the full year's plan, but these costs recognized in the third quarter reduced earnings from the anticipated $0.14 to $0.12 and will benefit the previously forecasted fourth quarter 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 the third quarter compared with $9.3 million or 2.3% of sales in the year earlier period. For the first three quarters of 2007, operating income was $24.0 million or 1.9% of sales compared with $26.6 million or 2.2% of sales in the same period of 2006.

Gross profit for the third quarter increased 5% to $124.9 million compared with $119.5 million in the same period last year. Gross profit for 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 quarter increased to 29.7% of sales from 29.3% of sales in the prior year period. The improvement is primarily a result of pharmacy department margin benefits gained through the shift of branded drugs to generics, which have a lower selling price, but larger profit margin. Gross margin for the year-to-date period was 29% versus 28.8% from last year, with the increase attributed to the same factors I just mentioned.

SG&A expenses for the quarter increased to 28% of sales compared with 27% of sales last year. The increase is attributable to cost of the MRP program, the refresher program in our stores, higher utilities, additional advertising expense due to the timing of ad circulars and higher legal 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 additional costs of our store refresher program, energy cost increases and advertising. Depreciation and amortization expense totaled $7.1 million in the third quarter and $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 primarily the result of higher borrowings throughout the quarter for seasonal inventory purchases and capital expenditure. On a year-to-date basis, net interest expense totaled $494,000 in 2007 compared with $502,000 in 2006. Income tax expense decreased to 32.6% of pre-tax earnings in the third quarter compared with 34% in the third quarter of last year. The change primarily results from the post-implementation effect of financial accounting standard boards, Financial Interpretation Number 48 or FIN-48, which is accounting for uncertainty in income taxes. The adjustment in the current quarter brought the year-to-date income 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 to be in the range of 36% to 38%. Capital expenditures for the third quarter totaled $17.6 million compared with $8 million in the third quarter of 2006. On a 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-date capital expenditures are $5.7 million for new stores and pharmacies, $11.7 million for the acquisition of existing stores, $13.4 million for expenditures on existing and remodeled stores, $1 million for DC equipment, and $0.5 million for corporate and technology upgrades. Additionally, there was $50,000 related to acquisition of pharmacies as compared to $490,000 in the third quarter of last year. Year-to-date expenditures for acquisitions of pharmacies were $800,000 this year compared to $3.4 million last year.

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

Our total debt at the end of the quarter was $54.4 million as 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, which left an extra $7 million in cash, the $12 million of additional real estate transactions made during the year, and approximately $4 million in funds utilized for repurchase of shares of common stock.

The company operates 708 discount general merchandise stores, including 24 franchise Fred's stores. During the quarter, the company opened 10 stores. There were no new pharmacies opened during the quarter. On a year-to-date basis, the company opened 26 stores, 9 new pharmacies and closed 19 stores and 4 pharmacies.

The company's total selling space has increased 1% so far this 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 that it will open or upgrade a total of 32 to 34 stores and that it's selling space will increase in the range of 2% to 3% for the fiscal year of 2007.

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

Question-and-Answer Session

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 that negatively impact gross margin?

Jerry Shore

Yes, David, it did. That's where the effect came in within gross 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 trends in the sales areas, which would mean that either we cancelled orders that were unordered or decided that we owned inventory that we could create sales out of and had no need to make further purchases.

David Cumberland - Robert W. Baird

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

Jerry Shore

No, David. It was in the SG&A line, with the lower sales not being able to react to the lower sales with the labor and costs that we had planned and incurred during the quarter.

David Cumberland - Robert W. Baird

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

Jerry Shore

David, the reason why we didn't put the guidance in and inform 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 this point than what we had out there. But other than that business goes on as usual inside 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 a little bit on your refresher program. I assume that's completed now and, obviously, the economy is not good, but are there any particular surprises? Are you disappointed in the refresher program or do you feel that it's essentially done what it was supposed to do?

Mike Hayes

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

But in the categories that we expanded, the categories that we focused on, they did quite well. Electronics did well for us, okay, that area did very well for us. And we're still working out the impacts of the kids departments 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, was neutral at that.

Meredith Adler - Lehman Brothers

Okay. And if you think about the impact that the refresher program had on the negative side because of some disruption, when would you say that 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 that could show up in this quarter because of some minor impacts in November, but after that we are not anticipating expenses related to the refresher program.

Mike Hayes

Right. And as far as the departments that you're saying exited, 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 the pharmacy business. I've heard from other retailers that we are still much lower on the flu categories than we were last year. You know, last year wasn't a great flu year and I was wondering if you are seeing the same thing. And then I have another question.

Jerry Shore

Ricky?

Rick Chambers

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

Meredith Adler - Lehman Brothers

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

Rick Chambers

So far, because of the last two years, they have been not following our historical trend. We have seen a significant shift in our generic dispensing, year-over-year, the last two years. So a tougher comparison will probably be next year. There is really not a lot of blockbuster drives that are coming off patents in 2008, you start kicking back up in 2009 and beyond. So we would expect, from this point going forward, to see more of a historical trend that 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 on patent.

Meredith Adler - Lehman Brothers

Okay. Thank you.

Operator

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

Mark Miller - William Blair

Hi, good morning. Just hoping you could elaborate on the comments about consumers' conservative shopping patterns and is this something that applies across the store or are you seeing it guessing more acutely in categories 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's affecting 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 to wait till December (inaudible), we believe that our customer is going to be more buy now, wear now, than in the past. We have had a couple of cold days and we 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 home furnishing.

Mark Miller - William Blair

Yeah.

Jim Fennema

Mark, our task in hands still remains in home furnishings categories which would be your furniture, wall décor, and domestics, but not necessarily in the electronics or in the appliance areas. Even though there are no home categories, those are actually performing pretty solid for us. Consumables remain solid for us and continue to do well. And then, you can see from the numbers even in the quarter, that the apparel area still is a strong struggle. To Mike's point, on the buy now, wear now part, our business shifts significantly when the weather actually gets to where we need it to be. And I think that's indicative of two things, it's our customer base as well as the fact as you mentioned too, the amount of money on the street. There is no really forward buying that I see in our customer base right now.

Mark Miller - William Blair

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

Jerry Shore

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

Mark Miller - William Blair

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

Mike Hayes

Hi, Mark, this is Mike Hayes.

Mark Miller - William Blair

Hi, Mike.

Mike Hayes

These inquires that came in were definitely from different types of players. What triggered it, as you can understand Mark, is our stock is trading around book value, and probably appeared on every screen in the continental United States and 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 - William Blair

Right. That's the key development here obviously. So, just my general thought walking away is what do you see is your greatest opportunity to enhance shareholder value? I don't if you can elaborate that way or not, but if 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 Merrily Lynch is to ensure that we are doing everything possible to enhance shareholder value and we have received the enquires. So the Board has a fiduciary responsibility to evaluate the options. And that's why we retained Merrily Lynch to help us do that, and again, enhance or meet the shareholder value.

Mark Miller - William Blair

Okay, thanks. Good luck.

Operator

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

Patrick McKeever - MKM Partners

Hi, everyone.

Jerry Shore

Hi, Patrick.

Patrick McKeever - MKM Partners

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

Mike Hayes

I think I'll be a little redundant here. The program was designed on a long-term basis. Remember, we had three goals that we outlined at the beginning of this and one is we are working to build our program to be a national chain. And we wanted conformity throughout all of our stores, so that the 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 we were getting ROIs. In departments that we're not really getting the ROIs, we were looking for to departments that we felt would be demographically consistent with our customers and also with where we saw the economy demographics going.

So when we went into the program, we hit two big areas. We saw electronics moving up. We see that still being there. And in the format of even when we look at the toy category, we're moving. A large percentage of our mix is moving over to electronic type toys versus the conventional areas. But we 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 done outstanding. It has exceeded the plan substantially. We were seeing comps in extraordinarily high double-digits in that area. The electronics, again, I've already talked about. When we eliminated the kids and boys and girls, that's a discussion 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 address that. That's a 2008 because the soft line, overall, have not performed very well at all throughout the course of the last six months.

Now, having said that, we think that a lot of it has to do with our customer's economic status right now, they are clearly into the buy-now, wear-now area. And soft line tends to be a secondary purchase right across the line. Overall, I guarantee you that, from my perspective, we feel very good about the refresher program. Keith, maybe you'll give us a quick word as 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 refresher stores. I'm in the stores quite a lot. And the in-house mix of merchandise out there, I talked to a lot of customers, hundreds of customers out here that the customer response is very good to our cleaner refresher stores. And those areas that you just mentioned are the areas that our customer talks about.

And I believe the Bargain Center, and speaking with our managers and the management teams out there, we've been able to do a lot with some of our older merchandize and clearing those things out. But the most thing I hear from our customer base is that they're really proud of our cleaner refresher stores, and most of our emails, letters that we get, talk about the store 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 the toughest. And are you saying, Mike, that would consider going back into boys and girls or maybe consider just getting out? Would you consider getting out of apparel 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 strategic initiatives this year, we started and we put three big ones out there in front of everybody. First one we did and maybe Bruce is going to be managing that process, 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 expensive project. We are talking about interviewing 25,000 or more of our customers and it's going to help us build a refresher program for 2008. It's a very in-depth analysis to take a look and see what they think that we should be doing more of or less of. That program is going to be instrumental. The second one we did is we took another look at our locations of our stores and [whether] we were doing the smartest thing to look at it. The fourth one really was that we went and looked at our advertising program that we outlined in last year. We were not satisfied with the success of our branding campaign at all last year. We broke them 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 that they're going to be a substantial improvement in that program in 2008. So when we started this program, the big elements were the consulting process that we will have finished up and the tacticians program for our store locations, which is 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 we have good demographics, but do, we have good psychographics in our store locations. And all of these programs, along with the refresher programs are coming to a head by the end of this year.

Patrick McKeever - MKM Partners

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

Mike Hayes

It's too early for me to give you any real intelligent response to that question. I would like to, but I can't. And I am not concerned about the internal distraction. Our people are well informed and they know that the company has an extraordinarily good balance sheet. They know the company has an opportunity and they are also aware that we are looking at that. We have to continue to look at all of the options that would be investment [spruce] to the company. I think the best option that we did was when we bought Bruce aboard. He has really quirked up the leadership around here and the morale couldn't be at a higher level and I think everybody is really looking forward to 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? I know in '07 one of your strategies was with the refresher program. You closed a number of stores. Maybe if you could talk about now, what your existing portfolio looks like, if you are pleased with the level of profitability of the stores 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 did buy 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 most important 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, as stores that you want to clean up. But with the program, we should have initiated before, we need to be more proactive in doing that. So, I think the portfolio is better than it was last year, but it’s not where it needs to be in the next three years. We will continue the process of cleansing and that's why we have been so diligent with the tacticians and the study and analysis of the future locations. It's a very important part of our growth strategy and making sure that that location selection process is truly a first class upgrade. That's why we'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 in that low single digit type square footage growth?

Mike Hayes

Mostly likely that's a realistic position right now. We don't believe that the development process of the tactician program and the psychographic, demographic program, and with Bruce working on really, a lot of strategic changes that he is focusing on implementing, that we would probably reaccelerate it dramatically in the first half of this year. If it happens, it will happen at the latter half of next year that we would pull the trigger and blow it.

There are so many issues that we want to make absolutely certain that we walk a clean path on. I think we'd all feel better if we actually knew where the economy was going to land next year. But we seem to be reacting 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 is where we're going to take our stance in 2008.

Jill Caruthers - Johnson Rice

Okay. And then just last question, maybe if you could talk a little bit more about the November trends that you're not pleased with over the week and kind of Black Friday sells. You've seen more weakness in your large ticket items perhaps or maybe in the toy category, just a little bit more clarity 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, our toy business was good and our higher ticket items, which obviously don't match up to the industry because our higher ticket items start at $50, but those categories actually were really strong. The normal trends really followed through. The soft line was still weaker than what we would have hoped and the home furnishing area was the other one that was a little more of a disappointment.

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

Jill Caruthers - Johnson Rice

Okay. So that would imply most probably, traffic was probably 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 back to the strategic initiatives you mentioned could you give us a little bit better idea of the timeframe for each? I think you said that mid December was the result for the consulting for the '08 refresher. Is that of a similar magnitude to '07?

Jerry Shore

Bruce?

Bruce Efird

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

Some components of that strategic plan will be to focus more on areas that remain strong for us, which is consumable. Our focusing is well on some of the fundamentals of the business where we're really focused on, our service 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, as Mike mentioned, reviewing our marketing/advertising agency. And I believe there is an opportunity to really leverage out our value message and be more aggressive in communicating our pricing and value message to the customer.

So those are just a few of the components of the go-forward strategy. And the input to develop these strategies will be a more robust consumer research as well as the tacticians' piece that will go into driving that research. Again, with the balance sheet, we're positioned well for the current economic environment, and we're very confident about the long-term prospects for 2008 and beyond.

William Keller - FTN Midwest

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

Bruce Efird

Yes.

William Keller - FTN Midwest

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

Mike Hayes

Yeah. The correlation of what the performance standards we setup, it did not achieve the recognition that we were looking for. It's really tough to blame, but it's good to be on the campaign. What we concluded was that when we brought in the new firms, one that having the dollars already built into 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 more effective and create a much better campaign using the same dollars that were built into last year's budget in 2008. And particularly, since we have seen some 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 at least twice a month. We have seen an increase to advertising development with some of the drugstore chains. So, it was imperative that we commend and review that 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 thoughts on 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 was concerned, we are still looking at that late January, early February implementation. We did receive a word this week that CMS is committed to not release any of the data publicly until at least December 17. There is a preliminary or a court date set on 14th of December to hear a preliminary injunction that you may be aware. There was a lawsuit that was brought against CMS, 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 1 implementation date. So, at this time, no change from what we have previously communicated.

William Keller - FTN Midwest

Great. Thank you very much.

Operator

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

David Magee - SunTrust Robinson

Yeah, hi. Good morning.

Mike Hayes

Good morning.

David Magee - SunTrust Robinson

I just want to circle back to the gross margin issue if I could. The stability that you see in stores, we are hearing about (inaudible) promotions went into the holiday period and you all mentioned more volatility of late in terms of patterns and stuff. Are you anticipating having to become more promotional, more price aggressive in the fourth quarter, just to keep it up 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 increased intensity we are seeing out on the street right now from our core competitors, key competitors and peripheral competitors. We are all dealing with the same economic issues and soft sales environment, which will, as you know, stimulate additional promotional activity. So, yes we will be reviewing that and most likely increasing the intensity of promotions through the balance of the holiday period.

David Magee - SunTrust Robinson

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

Mike Hayes

Yes.

David Magee - SunTrust Robinson

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

Mike Hayes

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

David Magee - SunTrust Robinson

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

Mike Hayes

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

David Magee - SunTrust Robinson

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

Mike Hayes

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

David Magee - SunTrust Robinson

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 the steps that Wal-Mart took to be more competitive in pharmacy, could you appraise what they've done and how you've responded and what you believe the lasting impression they've left has been?

Jerry Shore

Rick?

Rick Chambers

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

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

Dana Walker - Kalmar Investments

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

Rick Chambers

If we're talking the month of November, let me go back to a comment we made before on this. Historically, it took three months before we saw any real pattern shift as well as the [weight shift]. So right now, I can't say that we've seen a spending pattern shift at all.

Dana Walker - Kalmar Investments

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

Mike Hayes

It was not one of the questions in the survey. The survey was 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 to talk about our consumer and their wellbeing and their buying patterns. It doesn't get into emotional state. It gets into tangibles.

Dana Walker - Kalmar Investments

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

Mike Hayes

I don't think that it would be fair to blame the outside firm. In fact, it would be unfair to blame them. I think the most important thing that happened was that we've seen the competitors shift the nature of their advertising dramatically.

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

So, I think that the shifting of the economy and the need for us to be a now scenario suggest that maybe the timing into the branding campaign wasn't a good timing. We need to make those dollars more productive and 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 a question to Bruce. Bruce, Fred has put a lot of money and reorganized stores to be in the cooler program in hopes of being a part of more shopping trips on the part of the customer. Now what's your appraisal of the cooler and the way it plays a role in the Fred's concept?

Bruce Efird

Well, currently, this is Bruce, our perishable or the frozen and dairy sales continued to grow and remained strong in our scenario that Keith and his operations team has been focused on. And as I mentioned earlier, our consumables business continues to remain solid, and I envision for the future, capitalizing on the strength of that business and growing that business, coupled with one of our key opportunities is where we are currently underdeveloped in our private label business, specifically in consumables. So, that's an area that we will continue to evaluate and position that, not only in a way to drive traffic, but also developing our private label to mitigate any potential 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 talking about sales tone rather than margin comparability to where you think the margin should be?

Mike Hayes

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

Jim Fennema

Yeah, just to take another step, the coolers, they are into their second year now. That was part of the part of the MRP two years ago and as Bruce mentioned, we continue to see solid growth in there and we have been able to attain the margin requirements that we wanted to, even in light of some of the current inflationary pricing like in milk and eggs. But even outside of that the growth has been really good for us and obviously we have been trying to utilize that with our consumables for traffic and continue to make sure that that 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 little confused about what you said about inventory and the $0.02. Were there increased markdowns or just simply a decision not to complete some orders? You actually canceled orders?

Jerry Shore

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

Meredith Adler - Lehman Brothers

Okay, got it. My next question is about the tactical program. The tacticians program you are talking about is strictly related to real estate. But I think you have said that you really need to upgrade generally, 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 or what --?

Meredith Adler - Lehman Brothers

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

Jerry Shore

That might be, I would say the answer is that's fair. The question was where we've been penny-wise and pound-foolish. That is part of the analysis that is undertaken and that is a key part of the analysis. The second part was that we didn't get deepened up both into the demographic, and again, I hate to keep using this silly word, psychographic analysis to make certain that we had both of those lined up correctly when we had a location. Because all too often, 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 buying out landlord's leases?

Jerry Shore

No. Meredith, we bought their king properties that had been owned 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 lease them?

Jerry Shore

These were properties that one of our developers was planning to get rid of, to go towards other opportunities. He is continuing to work with the company however, but these were properties that were good properties for Fred's, good locations and fit well within the company. So, we acquired 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 need to really do a major upgrade of the store base, I don't know what kind of lease commitments you have now, but couldn't that be very costly, or would you just wait until a lease expires before you would consider moving it?

Jerry Shore

Well, first of all, our leases typically have an average life of five to seven years. So our average leases that are out there much more than seven years. And Meredith, when we are talking about upgrading and going with the process that we are really looking at is the growth cycle, not our historic positions, because it's where we locate the next 60 stores. It's not that 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, but its' ROI is maybe 5%, but we have a positive [RNI]. The thing that we want to be able to do is go back and study that and say, is that us? Is it the location? And if so, is that a location that when we move that when that lease expires, we want to be a year ahead of the lease to be able to go out and relocate that store to a higher upgraded area, but debasing it on a more defined and reliable answer than the intuition of our real estate people.

Meredith Adler - Lehman Brothers

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 on this, but it doesn't sound like you solicited the interest from these various parties. 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's objective is to maximize shareholder value and protect our employees. It will continue with that. There are opportunities that have come our way. So I think they will evaluate it and release the information at the time that's appropriate.

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 that are very strong and the things that are working, such as electronics? The buying process, what are you seeing out there in the marketplace of maybe getting some of those special buyers, etc? Is that helping in those categories at this point?

Mike Hayes

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

As we go forward, as far as opportunity buys, etc, based on what I see out there now, there is now, and I think will be throughout the first half of next year, significant opportunities for product because of the amount of goods that are actually piling up out there and will be pushed off even going in the next spring. So, we will be reacting to those as they present themselves to us, and we'll make sure that they fit into what we are trying to do. 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 have money 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's conference. You may disconnect at this time.

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