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Winn-Dixie Stores, Inc. (NASDAQ:WINN)

F2Q08 Earnings Call

February 20, 2008 8:30 am ET

Executives

Sheila Reinken – VP Finance, Treasurer

Peter Lynch – Chairman, CEO, President

Bennett Nussbaum – Senior VP, CFO

Analysts

Karen Howland – Lehman Brothers

Alex Bisson – FTN Midwest

Brian Duncan – The Boston Company

Karen Short – Friedman, Billings, Ramsey

Christopher Middleton – Atlantic

Operator

Good day and welcome to the Winn-Dixie Stores second quarter fiscal 2008 earnings call. Today’s call is being recorded. Today’s call will begin with remarks by Winn-Dixie’s senior management and will conclude with a question and answer period. At this time I would like to turn the call over to Ms. Sheila Reinken, Vice President of Finance and Treasurer for Winn-Dixie. Ms. Reinken please go ahead.

Sheila Reinken

Hello and good morning everyone thank you for joining us for our discussion of Winn-Dixie’s financial results for the second quarter of fiscal 2008, I’m Sheila Reinken, Vice President of Finance and Treasurer. Joining me this morning are Peter Lynch, Chairman, CEO and President, Bennett Nussbaum, Senior Vice President and Chief Financial Officer and Eric Harris, Director of Investor Relations.

Before we begin let me remind you that the information presented and discussed today includes forward looking statements which are made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The risks and uncertainties related to such statements are detailed in our SEC filings. Today’s call is being recorded and a transcript will be archived. A replay of the call will be available on the investor relations section of our website, www.winndixie.com. As usual, Peter and Bennett will begin with some prepared remarks and afterwards we will open up the call for your questions. Now it is my pleasure to turn the call over to Peter Lynch.

Peter Lynch

Thank you Sheila and good morning everyone. As you will see from our press release, Winn-Dixie had a strong second quarter. We generated adjusted EBITDA of $21.6 million which is an increase of $21.1 million compared with the second quarter of last year and we are very pleased with this improvement. When we began the year we knew we had a significant opportunity to improve gross margins in the first and second quarters.

However, we also knew it would be challenging. In particular, as I noted on the last call, we needed to adjust the holiday promotional activity the company had been conducting historically in the second quarter and we did it very successfully. I was confident we would show improvement but candidly, our performance this quarter exceeded my expectations and I want to congratulate everyone at Winn-Dixie who worked so hard to achieve the sales and gross profit improvements that drove our results. As a percentage of net sales, gross margin for the second quarter was 26.7%, an increase of 100 basis points from the second quarter of fiscal 2007.

For the first half of the year, gross margin was 27%, also an increase of 100 basis points. Our improvements in gross margin were preliminarily attributable to more effective management of promotional spending and operational improvements that reduced inventory shrink. We have said many times that our goal is to achieve the appropriate balance of sales and margins in order to grow profitable sales. Our second quarter results demonstrate our ability to improve margins while also growing identical store sales at 50 basis points as compared to the same period last year.

Our year to date identical store sales were up 40 basis points compared to the first half of fiscal 2007. I should note that identical store sales were impacted by the mix shift in pharmacy sales from branded drugs to generic drugs which had a negative impact of approximately 80 basis points for the quarter and 70 basis points for the first half of fiscal 2008. As we mentioned on the last quarter’s call, generic drugs are more profitable to the business than branded drugs and the negative impact of the mix shift is only on identical store sales and not on earnings or script count.

The second quarter was also a historic marker for the company as it was the fourth full quarter the company has reported since emerging from Chapter 11 in November 2006. The team has worked extremely hard during the past year and it shows. In each full fiscal quarter since emergence, we were able to achieve year over year improvements in gross margin of 100 basis points or more while driving positive identical store sales. As I look back on the progress we have made in the year since we emerged from Chapter 11, I am very proud of the broad range of improvements that we have made, not just in our financial results but through our operations and at so many of our stores. We have stabilized the business and improved sales, gross margins and operating cash flow.

We have also developed a new prototype for our remodels, jump started the remodel program, improved corporate brand penetration and achieved a higher mix of perishables in our stores. Our progress over the last year has made me very confident about what we can achieve in the years ahead. We still have a lot to accomplish and there may be some ups and downs along the way but I remain very optimistic about our future. In addition to the work of our management team, I am particularly proud of the effort that has been made by our associates. I continue to be impressed by their hard work and the culture of team work that has been created throughout the company.

Now let me update you on our store remodel program. Our program is well underway and continues to be the centerpiece of our long term strategy. Our plan is to remodel the entire store base over the next several years to provide a shopping experience across the chain that is clean, fresh, friendly and local. As we move forward with the program, we will increasingly have more and more stores that will enable us to compete more effectively leverage the strength of our brand and drive the organization’s financial performance.

Since the program commenced, we have remodeled a total of 47 stores or roughly 9% of the footprint. Nine of those 47 stores are still in the grand reopening phase and are therefore not included in our reported results. Of the remaining 38 stores, 24 were offensive remodels. As of the end of the second quarter, these 24 stores had experienced a 12% weighted average sales lift following the grand reopening phase. As you know, our goal with the remodels is a 10% weighted average sales lift in the first year of operation following the grand reopening phase and we are pleased that the remodels are performing ahead of that target.

We remain on schedule to continue with our plan to remodel 75 stores by the end of the fiscal year, of these about 80% will be offensive remodels. Including the 20 stores we completed in fiscal 2007, we will have 95 stores remodeled or approximately 18% of the chain by the end of the fiscal year. Our plan is to continue to remodel 75 stores a year, thereby completing roughly half the chain by the end of fiscal 2010. We are also focused on improving the performance of the stores not slated for remodel in the near term through operational efficiencies, better merchandising and cosmetic improvements that are less capital intensive than a remodel.

Another issue I know is of concern to many of you is the current economic environment and how it may affect Winn-Dixie. Frankly, for us, the prospect of a struggling economy is not new. Given our large presence in Florida, we have been facing these challenges for several months now and we continue to perform well. You know I’ve been working in the industry for decades and have been through several economic cycles and whenever there’s a downturn like this, there are challenges, however there are also opportunities. For example, customers looking to stretch their food dollars tend to spend less at restaurants and eat at home more often.

In addition, with gas prices so high, consumers tend to shop closer to home which also helps Winn-Dixie. And finally, customers tend to migrate toward private label products as a means to stretch their dollars which creates a great opportunity for Winn-Dixie. Expanding our private label products is a top priority for our management team and a great way to build customer satisfaction and loyalty. We are reinventing the Winn-Dixie brand through three tiers of quality products that offer better value and cater to our different customers and their varying needs.

Our customers can choose between three brands, Thrifty Maid, which corresponds to the national and regional value brands in terms of quality, Winn-Dixie, designed to be equal or better than the comparable national or regional brand category and Winn & Lovett, our premium quality brand line. As of the end of the second quarter we have over 700 SKUs with the new packaging on our shelves.

This puts us on pace to comfortably exceed our original goal of having at least 1,000 SKUs with the newly redesigned package on the shelf by the end of fiscal 2008. The change in our packaging is dramatic and our customers are clearly responding favorably to the new brands. We are making significant progress with our corporate brand penetration. In fiscal 2007, our penetration rate for these categories we measure was 19.1%. For fiscal 2008, our target is to increase this penetration by 140 basis points and year to date we are exceeding that goal.

Finally, before turning the call over to Bennett, I’ll comment on our financial guidance for the remainder of the year. Given that we have exceeded our expectations for adjusted EBITDA in the second quarter, we are raising our guidance for the year. We now expect adjusted EBITDA to be in the range of $105 million to $125 million for fiscal 2008, which is up from our prior guidance range of $90 million to $115 million for fiscal 2008.

As I noted earlier, we came into the year knowing that we had significant opportunity to improve margins in the first half of the year and we are pleased with the improvements that we have made. As we look toward the second half of the year, our challenge will be to maintain margins as we seek to grow sales. Our guidance is based on the expectation that we will maintain gross margin levels consistent with the second half of 2007 while gradually improving sales over time through our remodeled store program as well as our other strategic initiatives. And now I’d like to turn it over to Bennett to review the financial results in more detail. Bennett.

Bennett Nussbaum

Thank you Peter and good morning everyone. Before I begin my review of our operating results, please keep in mind that fresh-start reporting was required upon our emergence from Chapter 11 and accordingly, the company’s consolidated financial statements for periods prior to November 16, 2006 are not comparable to consolidated financial statements presented on or after November 16, 2006. Additional details about the fresh-start accounting treatment are also provided in the 10Q.

I’ll begin with some P&L items for the second quarter of fiscal 2008 which was the 16 week period ending on January 9, 2008. As Peter mentioned, identical store sales increased by 0.5% in the second quarter compared to the same period last year. The increase in our identical store sales was the result of an increase in basket size of 2.7%, offset by a decrease in transaction count of 2.1%. We believe the increase in basket size is due to various factors, including overall food price inflation, offset primarily by the impact of a shift towards generic pharmaceutical products. As we have said in the past, we are working hard to improve transaction count by executing our strategic initiatives, namely our store remodeling program and enhancing store operations and merchandising.

We believe that these initiatives will improve our overall identical store sales over time. Our gross profit on sales increased $25.3 million for the second quarter compared to the same period last year. As a percentage of sales, gross margin was 26.7% for the second quarter versus 25.7% last year, an improvement of 100 basis points. The improvement of 100 basis points in the second quarter consisted of more effective management of our promotional spending in the current fiscal year which accounted for 80 basis points, operational improvements that reduced inventory shrink which accounted for 20 basis points and other items which accounted for 25 basis points and include a favorable claims development on the company’s self insurance reserves of $2.8 million or 12 basis points.

This adjustment for the company’s self insurance reserves was primarily related to worker’s compensation claims based on independent actuarial studies conducted during the quarter. The improvements in gross margin of 125 basis points were partially offset by an increase in the company’s LIFO charge which accounted for 25 basis points and was due primarily to an increase in food inflation in the current fiscal year and inventory liquidations in the prior fiscal year. Operating and administrative expenses for the second quarter decreased by $30.1 million compared to the same period last year. As a percentage of net sales, other operating and administrative expenses were 26.3% in the second quarter compared to 27.9% in the year ago period.

The decrease of $30.1 million in operating and administrative expenses was primarily related to Chapter 11 emergence related expenses of $18.2 million that occurred in the prior fiscal year only and also by the adjustment to the company’s self insurance reserves in the fiscal 2008 second quarter which decreased operating and administrative expenses by $15.5 million. The company reported net income of $4.1 million or $0.08 per diluted share for the second quarter of fiscal 2008. Excluding the adjustment to the company’s self insurance reserves in the fiscal 2008 second quarter, which totaled $18.3 million, the company would have reported a net loss of $7.2 million or 13 [per cents] per share for the quarter.

Income tax expense for the second quarter was $4.3 million as compared to an income tax benefit of $13.4 million in the year ago period. The effective tax rate on continuing operations was an expense of 51.2% for the second quarter, which differs from statutory rates primarily due to non deductible expenses primarily related to bankruptcy related professional fees and a prior year tax provision adjustment. As a reminder, we do not pay cash taxes due to our NOLs. This reported tax expense will first reduce intangible assets to zero and will then increase shareholder’s equity. For the first half of fiscal 2008, which was a 28 week period, identical store sales increased by 0.4% in the first half compared to the same period last year.

The increase in our identical store sales was the result of an increase in basket size of 2.5% offset by a decrease in transaction counts of 2.1%. Our gross profit on sales increased by $47.2 million for the first half of the fiscal year compared to the same period last year. For the first half of fiscal 2008, gross margin was 27.0% versus 26.0% for the first half of fiscal 2007.

The first half improvement consisted of more effective management of our promotional spending in the current fiscal year that accounted for 80 basis points in the first half, operational improvements that reduced inventory shrink which accounted for 15 basis points in the first half and other items which accounted for 20 basis points include the favorable claims development on the company’s self insurance reserves that I mentioned earlier. These improvements of 115 basis points were partially offset by an increase in the company’s LIFO charge which accounted for 15 basis points and was due primarily to an increase in food inflation in the current fiscal year and inventory liquidations in the prior fiscal year.

For the first half of fiscal 2008, operating and administrative expenses decreased $38.8 million compared to the year ago period. As a percentage of net sales, operating and administrative expenses were 26.9% for the first half of the fiscal year compared to 28.1% in the year ago period. For the first half of the fiscal year, income tax expense was $4.2 million as compared to income tax benefit of $14.8 million in the year ago period. The effective tax rate on continuing operations was an expense of 56.1% for the first half of the year which differs from statutory rates primarily due to non deductible expenses relating to bankruptcy related professional fees and the prior year tax provision adjustment. As I mentioned earlier, we do not pay cash taxes.

Net income for the first half of the fiscal year was $3.3 million or $0.06 per diluted share. Excluding the adjustment to the company’s self insurance reserves in the fiscal 2008 second quarter, the company would have reported a net loss of $8 million or $0.15 per share for the first half of the fiscal year. As of January 9, 2008, our net operating loss carry forward for Federal income tax purposes or NOL is approximately $500 million. We continue to expect that our NOLs will increase as we settle the remaining outstanding bankruptcy claims and distribute approximately 7.7 million additional shares of our stock.

This amount of the increase will be determined based on the then current market value of our stock at the time these additional shares are distributed. As we have noted previously, these 7.7 million shares are included in the 53.9 million shares we had outstanding as of February 6, 2008. We expect to file our 2007 Federal tax return in March and make an election that will allow us to fully utilize our NOLs to offset our taxable income as we generate it.

Moving on to the balance sheet, as of the end of the quarter on January 9, 2008, Winn-Dixie had $588.4 million of liquidity comprised of $446.6 million of borrowing availability under our credit agreement and $141.8 million of cash and cash equivalent and marketable securities. Moving on to the results of our remodel program, as Peter noted, our plan to remodel 75 stores this fiscal year is on schedule, we have completed 27 in the first half of fiscal 2008 and 47 program to date. We have two types of remodels, offensive and defensive.

About 80% of the remodels we plan to complete this fiscal year are offensive. The weighted average sales lift for the 24 offensive stores is 12%. The sales lift in the remodels is a result of increases in both transaction count and basket size of 5.2% and 6.8% respectively. We are pleased that we are exceeding our 10% annualized sales lift target for this program. The target is based on aggregate year over year sales lift achieved in the group of remodeled stores that are in their first year of operation following their grand opening.

Let me also note as I did last quarter, that although we have seen encouraging results overall and a positive sales lift from our remodels, the impact on our bottom line may not be apparent to you right away. The bulk of our fiscal 2008 remodels will be completed in the second half of the year. In addition, there are onetime costs associated with reopening the stores that will temporarily offset the incremental EBITDA from the sales lift we expect to achieve.

Once we get past the period in which we incur these costs, we expect to see the benefit of the increased sales flow down through the P&L. Finally, let me say a few words about our 2008 guidance. As Peter noted, we expect to maintain approximately the same gross margin in the second half of fiscal 2008 as in fiscal 2007. We also expect our identical store sales for fiscal 2008 to be slightly positive. We continue to expect that our financial results for fiscal 2008 will include certain non cash and cash items which amount to approximately less than $115 million.

The non cash items include less than $95 million in depreciation and amortization expense and less than $15 million related to non cash share based compensation. The cash items primarily post bankruptcy legal and professional fees, are estimated to be less than $5 million. Our projected capital expenditures in fiscal 2008 declined from $250 million to approximately $230 million due primarily to payments related to fiscal 2008 projects that will not be made until fiscal 2009. We anticipate that our capital expenditures for the remainder of fiscal 2008 will be funded substantially by cash flows from operation and working capital improvements. Now, let me hand it back to Peter. Peter.

Peter Lynch

Okay, thanks Bennett. In summary, we had an outstanding quarter and one which capped a very successful year since we emerged from Chapter 11. I again want to thank the Winn-Dixie team and our vendor partners who have supported Winn-Dixie this past year. We all know there’s much left to do and there are challenges ahead, but we have made significant progress in building a strong foundation for long term growth and I am very optimistic about the future of our company. Thank you again for joining us this morning, we greatly appreciate your interest and your support. Operator we’re now ready for the Q&A session. Thank you.

Question-and-Answer Session

Operator

Thank you, if you would like to ask a question, please signal us by pressing the star key followed by the digit one on your touchtone telephone. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach us. Once again that is star one for questions. And we’ll hear first from Karen Howland with Lehman Brothers.

Karen Howland – Lehman Brothers

Good morning, congrats on the good quarter. I had a question about the remodel program, I believe last quarter you had indicated that the 12 offensive stores that have been remodeled were comping closer to a 15% lift, it’s obviously decreased now to a 12%. Do you want to talk a little bit about what where that decrease is coming from? Is it the stores that you remodeled last quarter or the new stores just aren’t comping as high?

Peter Lynch

Karen, first of all we’re very, very pleased with our performance of our remodels. And as you noted, we are down a little bit from where we were in the first quarter that we reported them. But overall, we continue to fine tune these and I think what you note in this quarter was and we talked about it, you know we actually fine tuned our promotional spending in the entire company and that had an umbrella effect with the remodel stores as well because some of the things that we’re doing a year ago we didn’t do this year which impacted those. So I think you can parallel what’s happened with the entire company as we fine tune this thing to the remodel stores as well. But quite frankly I think as you know, we’re spending less on these remodels than the industry and we’re getting more for them and I’m very pleased with our performance.

Karen Howland – Lehman Brothers

So, just to make sure I understand, along with the rest of the business, you scaled back on the promotions for the remodeled stores.

Peter Lynch

Yeah because these stores Karen, this is after we do the initial promotional activity because we don’t include the first four weeks of heavy so once they come out of that, they’re just getting the normal promotional activity the rest of the chain gets. So as we reduced it for the rest of the chain, they were affected by it as well versus a year ago. But again that was in our target of achieving profitable sales for the company and we hit our targets and I feel very, very good about the balancing that we did it during the quarter.

Karen Howland – Lehman Brothers

Thanks for that color and then you said you’ve doing small upgrades to the non remodeled stores, as far as improving the mix, things like that, are you surprised to see that you haven’t, I mean traffic continues to be down at the same level for the past two quarters, there hasn’t really seemed to be any sort of improvement in those stores despite the fact that they’ve gotten I guess, don’t know facelifts the right word but capital added to them?

Peter Lynch

They haven’t gotten a lot of capital added to them quite frankly. A lot of what we added to them probably goes back over a few quarters, we’ve been, you know, slowly opening up the faucet on those stores. I think as you know, traffic is down in the entire industry, not just Winn-Dixie. The good news is when we remodel our stores with you know the full remodel, we’re getting good traffic lift and good lift on the basket. So I’m not surprised that the rest of the company traffic is down because we see that in the entire industry out there.

Karen Howland – Lehman Brothers

Great and then when you look, when you actually do the remodel, what sort of expenses do you actually incur during the grand reopening time period?

Bennett Nussbaum

Karen we estimate that our onetime expenses are about $150,000-$160,000 made up primarily of non capitalizable supplies and equipment, higher shrink as we put in new perishable items, store labor for the grand reopening and also for additional promotions during the four week grand reopening period.

Karen Howland – Lehman Brothers

Great, so 150-160 per store.

Bennett Nussbaum

Yes, that’s where we believe it’s running right now.

Karen Howland – Lehman Brothers

And have you seen any of your competition adjust their capital spending or their promotional spend after you do these remodels?

Peter Lynch

You know Karen I can’t tell you [the SG&A thing], large [stash in change]. From time to time I might see something a local market where someone has reacted but I can’t tell you that there’s a major push reacted to our remodels at this time.

Karen Howland – Lehman Brothers

Okay great, I’ll let someone else ask questions, congrats on the good quarter again.

Operator

Our next question will come from Alex Bisson with FTN Midwest.

Alex Bisson – FTN Midwest

Good morning everyone and thank you for taking my question. My question really revolves around the gross margin guidance. You guys said you think you can keep the margins roughly flat with a year ago but given all the remodel activity that will be incremental to this year I think that would be tough. So maybe you could add just a little more color around margins?

Peter Lynch

Well, as I stated, for the second half of the year we plan to be on target with the margins that we produced a year ago. As I’ve said many times we’ve got very good transparency into this business. We know on a week to week basis exactly where we are with promotional activity and I feel very, very confident that we can maintain those throughout the second half of the year.

Alex Bisson – FTN Midwest

Peter I know in the past the second quarter has been traditionally the most promotional quarter and so I’m curious as you look to the second half of this year, will the 80 basis point of benefit that you got from more effective promotions, will that carry through or should we expect a little less there?

Peter Lynch

As I said before you know we expect to have the second half margin similar to a year ago. What we benefit from in the second half of the year for primarily the third quarter is a lot of heavy [snow bird] activity because our average weekly sales are up during this time period which helps us greatly so again we’re going to have the same level of margins as we did a year ago and my expectation is that our [IB] sales should be better in the second half than they were in the first half.

Alex Bisson – FTN Midwest

Alrighty, thank you very much.

Operator

Next is Brian Duncan with The Boston Company.

Brian Duncan – The Boston Company

Hi everybody, great quarter. I had a question about the insurances reserve. Is this all onetime or does it change or does it increase your recurring [costs] going forward as well?

Peter Lynch

Actually we’ve been working on improving our claims processing for the last several years. There’s an outside independent actuary who evaluates the future cost of those claims. As we’ve gotten better, he’s recognized our better performance in the reserve. We had a similar favorability in the end, in the fourth quarter last year as you know, this was the next actuarial evaluation we did. He also brought the reserve down by $18 million. I think he’s gotten confidence in our new program and I think he’s pretty well reflected it. I would not expect to see further reductions of that or any significant magnitude.

Brian Duncan – The Boston Company

Great but I guess you know if I think about the $18 million [ANOA] line, I mean is that $4 million a quarter basically going forward, [unintelligible] reduction or is it just more this is just a onetime thing.

Peter Lynch

More of, it’s a onetime.

Brian Duncan – The Boston Company

Okay, thank you.

Operator

Once again if you would like to ask a question please press star one on your telephone keypad. We’ll hear next from Karen Short with Friedman, Billings, Ramsey.

Karen Short – Friedman, Billings, Ramsey

Hi everyone, great quarter. Just a couple questions, I don’t know if maybe you could elaborate a little bit on the mix shift that you’re seeing in the remodeled stores now that you have a few more under your belt.

Peter Lynch

Well I think Karen we’ve talked about this now for a couple of phone calls that we’ve been getting the mix shift that we anticipated. It’s about 2% that we’re seeing and it’s been consistent and we’re very pleased with that progress.

Karen Short – Friedman, Billings, Ramsey

Okay and then wondering what your expectations are for the LIFO charge for the back half of the year, I mean I know you talked about your gross margins for the back half but wondering what your thoughts are on LIFO?

Bennett Nussbaum

I think LIFO is gonna run at about $1 million a period.

Karen Short – Friedman, Billings, Ramsey

Okay and then just on your cap ex, you know you commented that there was a $20 million deferred I guess kind of pushed into 09, so if you guys end up with a 75 remodel program in fiscal 09 does that imply that cap ex kind of goes up to 270 for 09 or what are you thinking on that?

Bennett Nussbaum

Well it means that with our remodels finishing up in the fourth quarter we believe a lot of the cash for this year’s remodels will go out in fiscal 2009. Now the answer to your question will depend on the sequencing of our remodels in fiscal 2009 and how much of that carries over, how much of that cash carries over to 2010. So our basic capital program hasn’t changed, there’s just a timing of cash that we wanted to let you know based on what time of the year the remodels are completed.

Karen Short – Friedman, Billings, Ramsey

Got it, okay and any thoughts on ramping your cap ex or your remodel program in 09 given that you were a little light in the first quarter?

Peter Lynch

Well Karen, this is Peter, you know it’s coming later this year however we will get the 75 done that we talked about doing. That with the 20 we did last year will give us 95 or 18% of our company. I did take a hard look, because they are very successful about doing more but quite frankly at this time I think 75 is probably a load that’s probably appropriate for this company.

You’ve got to remember, when you’re doing 75 it’s just not the 75 you’re doing but you’ve got to be behind these things, making sure you’re driving the appropriate return on invested capital, so really our operators out there focus on about 150 of these things at any given time. So I think the load right now for this company is about right, its 75, we’ll continue to fine tune these things going forward, but at the end of the day, I’m very pleased with the remodels. We’ll continue to fine tune them and I the 75 level is the appropriate level going forward.

Karen Short – Friedman, Billings, Ramsey

Okay and then I guess just a last question, you know obviously Wal-Mart made a big announcement on their rollbacks around Super Bowl weekend, I was just kind of wondering what you’re seeing you know now in the market.

Peter Lynch

Well you know, once again I told you we’re not going to walk into the Wal-Mart territory. We’re in a different quadrant that we’re operating in. We’re focused on fresh and clean and great variety and better service. What I will tell you is we’re halfway through our third quarter right now and our sales have improved in the third quarter over the second quarter. So to the extent that they’ve made their changes, we’re doing better.

Karen Short – Friedman, Billings, Ramsey

Okay, great, congratulations, thanks a lot.

Operator

We have a follow up question from Karen Howland with Lehman Brothers.

Karen Howland – Lehman Brothers

Thanks, just following up on your cap ex program, I know you indicated during your script that you expect to fund the capital this year mostly through cash from operations. I was wondering if you could maybe comment about next year if you think that’ll continue or do you expect that you’re going to have to pull down on your credit facility?

Bennett Nussbaum

Well Karen, this year we’ll be able to fund it. Next year, I think will bring us down to just about the end of our free cash and we’ll be somewhere around, if I had to guess, slightly positive to slightly in the line when we finish next year.

Karen Howland – Lehman Brothers

Great, thanks so much.

Operator

We’ll go next to Christopher Middleton with Atlantic.

Christopher Middleton – Atlantic

Peter, just wanted to ask on the O&A side, could you just remind me, do you feel that O&A as you look at it in dollar terms is relatively sort of fixed. If you could just remind me about the [first] buckets of the O&A, you know whether the investment in labor is behind you now, that’d very kind, thanks.

Bennett Nussbaum

This is Bennett, with regard to O&A, it’s a fairly fixed number because we have a high level of rents, taxes and base utilities in there against a fixed number of stores and so as we can grow sales we can leverage that. More specifically with your question to labor, we do have the big infusion of labor behind us and we will have operating leverage against what labor we do have to add against volume gains going forward. So I would expect O&A to grow dramatically less than volume and inflation over time.

Christopher Middleton – Atlantic

And how should we think about, I mean [a team sensitive] store based remodeled by the end of the year is a good [surmastin], when do you feel on sort of [unintelligible] square foot basis, you know that operating leverage through the O&A is going to really kick in to get your you know that margin down to near where some of your peers.

Bennett Nussbaum

That’ll depend on how fast we can build sales per square foot. As you know our sales per square foot have run traditionally, are running about $300 a foot. Our competitors are running about $450 and that’s the leverage we have on the upside. So I imagine it’ll be fairly linear as we bring up the sales per square foot over time.

Christopher Middleton – Atlantic

Okay, great and just on the competitive situation, any change in approach by publics or the [Ablertson] stores or any of those guys.

Peter Lynch

This is Peter we [march] that every single week and I haven’t seen anything dramatic with any of them. I mean from a week to week they may do some small things but there’s not dramatic changes in this current quarter.

Christopher Middleton – Atlantic

Great and it’s all fairly rational in terms of food price inflation ability to pass that through, I know we talked about you know milk prices in the past.

Peter Lynch

We’ve been able to pass through the increases and that’s worked very, very well for us.

Christopher Middleton – Atlantic

Thank you very much, that’s great, thanks.

Operator

And there are no further questions at this time, I’d like to turn the conference over to Mr. Lynch for closing remarks.

Peter Lynch

Well again I’d like to reiterate that I feel very, very good about the quarter and I’m very optimistic about the future and I appreciate you guys tuning in this morning and I appreciate the questions. Thank you very much.

Operator

Thank you that does conclude today’s conference call, we thank you all for your participation, have a great day.

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