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Executives

Kiley F. Rawlins - Vice President of Investor Relations & Communications

Howard R. Levine - Executive Chairman, Chief Executive Officer and Member of Equity Award Committee

Michael R. Bloom - President and Chief Operating Officer

Mary A. Winston - Chief Financial Officer, Chief Accounting Officer and Executive Vice President

Analysts

John Heinbockel - Guggenheim Securities, LLC, Research Division

Daniel T. Binder - Jefferies & Company, Inc., Research Division

Meredith Adler - Barclays Capital, Research Division

Matthew R. Nemer - Wells Fargo Securities, LLC, Research Division

Joseph Parkhill - Morgan Stanley, Research Division

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Nathan Rich

Bernard Sosnick - Gilford Securities Inc., Research Division

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Laura A. Champine - Canaccord Genuity, Research Division

Patrick McKeever - MKM Partners LLC, Research Division

Denise Chai - BofA Merrill Lynch, Research Division

Mark K. Montagna - Avondale Partners, LLC, Research Division

Family Dollar Stores (FDO) Q3 2012 Earnings Call June 28, 2012 10:00 AM ET

Operator

Good morning. My name is Melissa, and I'll be your conference facilitator today. I would like to welcome everyone to the Family Dollar Earnings Conference Call. [Operator Instructions] I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin your conference.

Kiley F. Rawlins

Thank you, Melissa. Good morning, everyone, and thank you for joining us today. For those of you who have dialed in, please note that we have posted accompanying slides on the Investor Relations page of our website.

Before we begin, you should know that our comments today will include forward-looking statements regarding various operating initiatives, sales and profitability metrics and capital expenditures, as well as our expectations for future financial performance. While these statements address plans or events, which we expect will or may occur in the future, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, June 28, 2012. We have no obligation to update or revise our forward-looking statements except as required by law, and you should not expect us to do so.

Our call will begin today with some opening comments from Howard Levine, Chairman and CEO. Then Michael Bloom, President and COO, will share an operational update. And Mary Winston, CFO, will review our financial results and outlook for the rest of fiscal 2012. [Operator Instructions]

Before I introduce Howard, I'd like to remind you that we are hosting an Analyst Day in New York City on July 18. If you'd like to receive an invitation, please contact either Kevin Powers or me. Now I'd like to turn the call over to Howard Levine. Howard?

Howard R. Levine

Thanks, Kiley, and good morning, everyone. This morning, we reported another record quarter at Family Dollar. Earnings per share increased about 16.5%, marking our 17th consecutive quarter of double-digit EPS growth. In the third quarter, comparable store sales increased about 5%.

Looking at the trends in the quarter, we had a good March helped by some very good weather and an early Easter, a tough April, and then a great May. As planned, Consumables sales accelerated throughout the quarter while more discretionary categories, like Home and Apparel, continued to be challenged. It is clear that consumers continue to face difficult economic headwinds. While consumer expectations for inflation have moderated recently, unemployment rates have given up gain and consumer confidence is deteriorating.

To provide our customers with more value and convenience, this quarter, we launched a number of growth initiatives to increase our relevancy to the customer and drive greater sales productivity. As many of these initiatives began late in the quarter, they had little impact on our third quarter sales results. But as we roll out the changes to more stores throughout the fourth quarter, we expect the impact on sales to accelerate.

Let me give you a sense of what our team has accomplished in the third quarter. Food is a significant driver of shopping trips. And over the last several years, we have invested significantly in this category to capture more of our customers' trips. This year, we plan to expand coolers in about 1,400 stores that are not part of this year's renovation program. In the third quarter, we expanded coolers in about 700 stores and expect to complete the rollout by the end of August. This quarter, we also began to introduce Pepsi products in our stores. In addition, this month, we began to expand our food assortment again, adding about 250 new items.

And in mid-September, our new supply chain partner, McLane, will begin to service our stores. And we will enhance our selection of refrigerated and frozen food even further. As a reminder, in May, we announced an exclusive 6-year partnership with McLane, a leading provider of grocery, tobacco and food service supply chain solutions. Our partnership with McLane will enable us to establish a national supply chain for refrigerated and frozen merchandise that will provide both the scale and service to support this growing segment of the business. Once these improvements are in place, I believe we will offer our customers a very competitive selection of food.

While we have been investing in food for the last several years, the health, beauty and personal care category has been a more recent focus for us. Last year, we expanded our HBA assortment in most stores by about 25%. Building on this foundation, in May, we began to expand our HBA assortment in stores by an additional 25%. Once these expectations -- once these expansions are complete, I believe we will offer customers a more relevant selection of health, beauty and personal care items. And finally this quarter, we introduced tobacco products in about 1,300 stores to drive more traffic. The rollout has gone very well. And we are pleased with the results so far.

I can't stress enough the complexity of managing thousands of projects across thousands of stores. And I'm really impressed at how well our teams have executed these initiatives. We are on schedule and have executed these changes with very few operational issues. When these initiatives are complete, we will offer customers a more compelling assortment and will be well positioned for strong growth in fiscal 2013.

To support our long-term goals, this quarter, we made important progress in strengthening our supply chain. Earlier this month, we began shipping from our 10th distribution center in Ashley, Indiana. And by the end of the summer, Ashley will serve about 600 stores in the Midwest. To help support our growth out West, we also announced that St. George, Utah will be the home of our 11th DC. We'll break ground later this summer and should be operational the following summer.

We continue to renovate stores this quarter, providing our customers with a more consistent shopping experience and a broader assortment of merchandise. So far this year, we've completed about 600 renovations, and these stores continue to outperform the rest of the chain. As a reminder, by the end of fiscal '12, just under half of our stores will offer customers an improved, more competitive shopping experience.

Finally, we've made further changes to strengthen our management team. In April, we announced that the hiring of Mary Winston as our new EVP and CFO. With more than 25 years of financial management and leadership experience, Mary is an excellent addition to our team. We also made some additions to our merchandising team during the quarter and welcome Debra Remme, our new Vice President of Apparel; Jim Tague, our new Vice President of Merchandise Planning; and Tammy DeBoer, our new Vice President of Private Brands. So again, this was another strong quarter for Family Dollar as we continue to execute across multiple fronts.

Now I'll turn the call over to Mike for an operational update. Mike?

Michael R. Bloom

Thanks, Howard, and good morning, everyone. I'll start with an overview of our third quarter sales, and then I'll update you on the progress we've made with the sales driving initiatives that we announced on the last earnings call.

As I've said before, we are focused on becoming more relevant, so our customers can complete her shop at Family Dollar. We are laser-focused on driving incremental trips and getting at least our average basket size with that incremental trip. We have increased our food, health, beauty and personal care assortment over the last year to gain market share from our current customers, as well as to attract new customers. These investments continue to drive strong sales results.

In the third quarter, Consumable sales increased more than 12% over last year. Clearly, our customers like the changes we are making and they are voting with their wallets. I am pleased to report that our market share in Consumables has continued to grow, both in terms of dollars and units over the last 12-, 24- and 52-week periods.

Sales in the Seasonal and Electronics category were strong again, increasing more than 15% over last year. We benefited from great weather in March and had nice sell-throughs in fans, Easter toys, outdoor toys and lawn and garden. Seasonal remains a significant growth opportunity for Family Dollar as our customers love the value and fun that we offer.

Sales of Home and Apparel continue to be volatile. Buoyed by warm weather early in the quarter, Apparel delivered its strongest performance in 5 quarters while Home continued to be pressured. It is worth noting that we have delayed our annual Home planogram resets to enable our teams to focus on our Consumable expansion. As we position our new planogram in August, we expect that the sales trends in the Home will improve.

Now let me give you a quick update on the sales driving initiatives that we introduced last quarter. As Howard indicated, refrigerated and frozen food is one of our biggest trip drivers. And we are investing to expand our assortment capacity.

This year, we are taking the coolers set from 5 doors to 10 doors in about 1,400 stores that are not being remodeled but have the space for these coolers. Through the third quarter, we completed expansions in about 700 stores. The balance of the stores will be complete by the end of this fiscal year. In addition, all of our new stores will open with 18 cooler doors and all renovated stores will get between 10 and 18 doors depending on space. By the end of fiscal 2012, we expect to have an average of about 8 cooler doors per store. And in addition, as we ramp up our relationship with McLane, we will leverage this new capacity even further.

We continue to look for innovative ways to drive impulse sales. And in late March, we began rolling out new impulse fixtures to the chain. These fixtures are upfront, near the checkout and carry impulse merchandises like candy, salty snacks, gift cards and magazines. At the end of the third quarter, about 5,000 stores had at least 1 impulse fixture and some stores had 2 depending on space. At year end, we expect to have these fixtures in about 5,500 stores.

In mid-April, we began adding Pepsi and their portfolio of beverages to our stores for the first time in our company's history. At the end of the quarter, nearly all stores carried warm Pepsi products. And in early May, we began rolling out Pepsi coolers. At the end of the third quarter, about 500 stores were selling cold Pepsi products. And we expect to have Pepsi coolers in all stores by the end of the fiscal year. While it is still early, we are very pleased with the sales results especially as the cannibalization rate with Coke products has been less than we expected. As I'm sure you are aware, customers are very loyal to both Coke and Pepsi, and we are driving trips with both brands.

In early May, we began another health, beauty and personal care assortment expansion. This expansion adds about 600 new SKUs to the assortment. At the end of the third quarter, about 2,600 stores were complete. And by the fiscal year end, nearly the entire chain will carry the full assortment. This exciting new assortment now includes brands like Schick, L'Oreal, Maybelline, Pantene, Nice 'n Easy and NIVEA, just to name a few. While it's still very early, our customers have responded extremely well to the new assortment. And we are seeing significant sales lifts.

In early May, we began rolling out tobacco products to our stores. At the end of the quarter, about 1,300 of our stores were selling tobacco. And by the end of the fiscal year, we expect about 6,000 stores will offer tobacco products. While it's still early, we are very pleased with the initial response from our customers.

Finally, earlier this month, we launched our second food expansion this year. Food drives trips and trips drive sales. And as a reminder, back in February, we added about 150 SKUs to the assortment. And this month, we are adding an additional 250 SKUs. We are adding customer favorites like Velveeta, Gerber, Wise Snacks, Gatorade and Russell Stover boxed chocolates, just to name a few. We expect to have the latest expansion completed in most stores by the end of July.

To help communicate these merchandising initiatives, we are optimizing and expanding our marketing efforts. Our circulars are becoming more relevant as we improve the assortment and value in our ads. And we are making them easier to shop for our customers. We are also adding new avenues of communication. Beginning next month, Family Dollar ads will be in Sunday newspapers in most major markets. We will continue to reach select customers by shared mail where the newspaper just doesn't have the reach. Our customer is clearly using the Sunday newspaper for the coupons and to plan her shopping trips for the upcoming week. As we expand our assortment, it's crucial that we effectively communicate the improvements to our customers, and let her know that she can complete her shopping trip at Family Dollar.

Before I turn it over to Mary, I just want to echo Howard's comments. And I'd like to thank our field teams across the country. They've done a fantastic job implementing a lot of changes in our stores in a very short period of time. I couldn't be more pleased with our team and their efforts. And more importantly, I know that our customers appreciate their efforts and the expanded assortments.

And with that, I'll turn it over to our new CFO, Mary Winston, who will review our financial results. Mary?

Mary A. Winston

Thank you, Mike, and good morning, everyone. I've only been here for about 2 months, but I'm delighted to be part of the Family Dollar team. Family Dollar is a great company with a long record of success. The channel is growing. The customer base is expanding. And I believe we have further opportunity to take Family Dollar to new levels of profitability and drive even stronger shareholder returns.

Before we discuss our outlook for the fourth quarter, let's review our third quarter financials. As Howard mentioned this morning, we reported our 17th consecutive quarter of double-digit earnings per share growth. Net income in the third quarter increased 12.1% over last year to $124.5 million. And diluted earnings per share increased 16.5% from $0.91 to $1.06.

Although comp sales came in at the low end of our previously provided guidance, we achieved our earnings per share target. Total net sales in the quarter grew 9.6% to about $2.4 billion driven by the addition of 244 net new stores this year and a 5% increase in comp store sales. Customer traffic and the average customer transaction values both increased in the quarter.

Gross profit in the third quarter increased by 8.4% to $845.3 million. As expected, gross margin continues to be pressured by the acceleration of Consumables sales. In the quarter, gross margin declined 39 basis points to 35.8% of sales compared with 36.2% of sales in the third quarter last year.

In the quarter, we delivered higher markups resulting from our continued investments in private brands, global sourcing and price management capabilities. We also incurred lower freight expenses as a percent of sales. These improvements were more than offset by stronger sales of lower-margin Consumables, higher markdowns and increased inventory shrinkage. The increase in markdowns during the third quarter was mainly due to the changes in our Consumables assortment.

In the quarter, we cleared out underperforming merchandise ahead of our HBA expansion. And we promoted new merchandise additions like Pepsi. As expected, inventory shrink increased over last year. This has primarily been a result of our merchandise changes and transitions as we have significantly increased our HBA and food assortment by about 50% over the last year in most stores. While we anticipate continued pressure, I would note that shrink remains near all-time company lows.

Moving to SG&A. Our expense rate in the third quarter declined 28 basis points from 27.7% to 27.4%. Most expenses were leveraged as a result of the 5% increase in comp store sales. As a percentage of sales, 25 basis points of lower insurance expense was mostly offset by 20 basis points of higher legal fees related to ongoing litigation.

In addition, store payroll cost leveraged about 20 basis points due to better work workforce productivity resulting from improvements we have made to reengineer many of our core store processes. The income tax rate during the quarter was 35.8% as compared to 37.5% last year. The lower tax rate was primarily due to a change in the estimate of uncertain tax positions and lower state income taxes.

At the end of the third quarter, average inventory per store increased about 17%. As we discussed last quarter, we are aggressively investing to expand our Consumables assortment to drive traffic and sales. These additions, including our food and HBA SKU expansions and new merchandise introductions, like tobacco and Pepsi, drove virtually all of our inventory growth. Inventory productivity will remain under pressure during this investment phase. But we believe these additions will ultimately drive higher comps and increased store productivity.

Capital expenditures through the third quarter were $391 million compared to $230 million last year. The increase was primarily due to more new store openings, the construction of our 10th distribution center and our renovation program. Year-to-date, we've spent about $134 million on new stores including $70 million for stores that have been opened as part of our fee development program.

As a reminder, this year we created a new fee development program. Under this program, we work with developers to build new stores using our capital to achieve lower occupancy costs. Upon completion of construction, we own the stores. While we are expanding our fee development program, our goal is not to own more stores. We prefer the flexibility of operating leases and do not believe that investing in real estate is an optimal use of our capital. Our goal is to convert these owned assets into leased assess through a series of sale-leaseback transactions.

In May, we closed the sale-leaseback transaction, generating net proceeds of $178 million. In addition, earlier this month, we closed the second transaction, generating an additional $179 million. In the future, we intend to combine these sale-leaseback transactions to monetize the new stores as a source of capital for the ongoing fee development program.

Finishing up the cash flow discussion. Through the third quarter, we purchased 1.7 million shares of our common stock for $91.6 million and paid $66.8 million in dividends. At the end of the quarter, we have the authorization to purchase up to an additional $246 million of our common stock.

Now, let's discuss our financial outlook for the fourth quarter. We continue to expect that earnings per diluted share in the fourth quarter will be between $0.71 and $0.81 as compared to $0.61 in the fourth quarter last year. We expect the comp store sales will increase between 5% and 7%. We expect that our sales driving initiatives will result in continued acceleration of Consumables. But we also believe that sales trends in more discretionary categories will continue to be volatile near-term.

Although the first week of June got off to a slow start, we have seen nice sales momentum in the last few weeks and as our initiatives have had a larger impact. We expect that the increasing impact of our initiatives and the resulting acceleration of Consumables sales will drive additional gross margin dollars but will increase the pressure on merchandise mix. While we expect that our ongoing investments in global sourcing, private brands and pricing initiatives will continue to benefit merchandise markups, we expect that near-term, the mix pressure will offset these benefits. As a result, we expect the gross margin rate in the fourth quarter will continue to be pressured.

In addition, we face a challenging expense comparison in the fourth quarter. As a reminder, in the fourth quarter last year, we experienced 90 basis points of benefit from lower insurance expense and lower incentive compensation. As we anniversary last year's benefits, we expect that SG&A growth in the fourth quarter will be around 9% to 10%. Reflecting these expectations and our earnings year-to-date, we now expect earnings per diluted share to be between $3.60 and $3.70 for the full year.

Now I'll turn the call over to Howard for some closing remarks. Howard?

Howard R. Levine

Thanks, Mary. Our game plan remains on track, and I'm very pleased with the progress we are making towards our long-term goals. Our investments are delivering results and we are moving in the right direction. Most of our recently announced sales driving initiatives will continue to roll out this quarter and they remain on schedule from both a timing and sales perspective. Over our 52-year history, Family Dollar has continued to evolve and change to serve our customers better. And this commitment to consistent, continuous improvement has resulted in strong shareholder returns.

Before we take your questions, I want to reiterate how pleased I am with the progress we are making. We are investing to increase our relevancy to the customer to capture more trips. We are completely renovating our store base and significantly expanding our Consumables assortment. And we are accelerating our new store growth and expanding into new markets. I am confident that these efforts will help us be a more compelling place to shop, work and invest.

And now operator, we would be happy to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question we have comes from John Heinbockel, Guggenheim Securities.

John Heinbockel - Guggenheim Securities, LLC, Research Division

So I guess, a couple of things maybe for Mike. Where do you think we are with progressing Apparel and Home to where you'd like it to be? Because quite frankly, Apparel looks pretty good in the stores in terms of fashion content and presentation, but its sales is still lagging a little bit. So where are you? And why do you think we’re not -- you're not seeing a customer response yet? Is it solely the macro or something you're doing?

Michael R. Bloom

So I guess, a couple of things. Let me maybe talk about discretionary in general, and you know how important discretionary is for our business. We think about it in 2 separate sort of categories, Home and Apparel. And as you heard me mention, Home was delayed for the right reason to make sure our stores could execute the Consumables expansion. And with the new planogram coming out in July, which we'll start seeing it completed by the August timeframe, we're actually excited about the changes we're making in the Home segment. In Apparel, we had a great quarter in Apparel. It's the best in the last 5 quarters, happy with the mix. As you know, we've managed the markdowns there with reduced receipts. And you heard Howard mention, we hired a new Vice President of Apparel. And that's under Paul White's leadership. And you know his apparel background. I'm actually excited about where we're going with Apparel and I feel good about it. I feel good about our mix. And as you've mentioned, it looks great in the stores. It looks great in the new fixtures that we consolidated to make room for Consumables. It actually shows the product better. It's a relevant mix, so I feel good about it. I think we're on the right track.

John Heinbockel - Guggenheim Securities, LLC, Research Division

All right. And then I guess, to transition over to the Consumable then, how do you -- when you look at where comps progress over the next -- over 2 to 6 quarters, how much of a benefit do you think you're going to get, getting people in right with tobacco and coolers and getting them to shop the discretionary part? Do you think that's -- is that going to be a much bigger lift here? Or the environment we're in, you're not going to get as much translation to that side of the store?

Michael R. Bloom

Yes. Again, John, I think if you go back to what I've been saying and sort of what's core to this strategy, it's about becoming more relevant and driving more trips. And it's early, right? And you heard the number of stores we completed with tobacco and Consumables, et cetera. But we're doing it because we believe there's going to be that attachment. So it's a little early. I think we'll have more information as we execute more stores and have more time to allow the customer to understand we've got the products and -- but we feel good about it, John. I mean, again, it's all about driving trips and becoming relevant. And I think you're seeing that in the progression of our comps.

Operator

[Operator Instructions] The next question we have comes from Dan Binder, Jefferies & Company.

Daniel T. Binder - Jefferies & Company, Inc., Research Division

I have 2 questions. Obviously, a pretty big competitor out there that's talking about a lot of price investment. Just curious if you can give us a sort of your bird's eye view on what you're seeing in the marketplace as it pertains to products that you compete with them on. And then secondly, you said that June was a little bit mixed with better results more recently. Are we sort of starting off the quarter here kind of playing catch up to get to the comp range? Or are we within the range at this point?

Howard R. Levine

Now first of all, let me talk about June. We've talked about that June got off to a slow start, primarily based -- related around the timing of the first and the third money, but it’s progressed nicely. And we've incorporated where we anticipate being in the month of June in our sales guidance and things that we just talked about that the Consumable initiatives will continue to contribute more significantly as the quarter progresses. So we feel pretty good about where we are there. In terms of pricing, that's something that is very near and dear to our heart. And we spend a lot of time investing in price and understanding how our customer thinks of us. We continue to enjoy a very strong price perception with our customers. In terms of pricing with other competitors, it's something that we look at every quarter and more regularly on the key KPIs out there. And from what we're hearing, from what we see, we think we're very competitive. I would remind you that from some of the bigger-box retailers, the shopping trip into a Family Dollar is a little bit different. And we do not try to match price on every single item. But overall, when we look at the basket, we're extremely competitive and we'll continue to look to make sure that we maintain that type of competitiveness.

Operator

The next question we have comes from Meredith Adler from Barclays.

Meredith Adler - Barclays Capital, Research Division

I want to sort of rephrase the question that John Heinbockel asked. He was talking about discretionary. But I'm just wondering, given that the company has increased its Consumables mix over time more than once, there have been an increase in the number of SKUs. Do you have any sense of sort of what the pattern is or the timing of when customers start to recognize that you've broadened the assortment and become more relevant? Because I think people have expected everything to happen instantaneously. And I don't think it works that way, but I was just wondering what your thoughts are.

Howard R. Levine

Yes. Thank you for the question, Meredith. No, you're absolutely right. The day we put the merchandise in the store, we do not immediately sell it. And it's different across different categories. So for example, in the HBA area, given that, that trip is not as frequent, it takes a little bit longer to build. But we have seen in the past with other additions that after several weeks to sometimes a month or so, we do see traction there. In terms of food, it's more quick. It's more -- it's faster. Not instantaneous, but that trip is a more frequent trip made by the customers, so we see more traction with food. And if you heard our comments, we talked about doing the HBA first and getting completion with that and are now well on track on our food. So our anticipation is the past patterns will continue and we'll still slowly start to see a build in acceptance from our customer. I'll also add that some of our marketing efforts will help that. One of the things that Mike and his team has spent a lot of time on is addressing the relevancy of our circulars, not only in terms of the timing of the events and using Sunday inserts but just the actual event in the way we've built that and trying to drive traffic. In addition to that, letting our customers know what's new and has changed in our stores. So we're trying to do some things to accelerate it. But your point is a good one, it takes some time to build.

Meredith Adler - Barclays Capital, Research Division

And then if I could just ask a question about the new approach to advertising. Is it putting those circulars in the newspaper, is that costly thing? Is that going to boost your spending on advertising? Or is it not significant or balanced in some way against something else?

Michael R. Bloom

Yes. Actually, Meredith, it costs more money to do share mails than it does to put ads in the Sunday paper. So now we're doing a little bit of increased advertising, so we're going to -- it will net out. It will net neutral.

Operator

The next question we have comes from Matt Nemer from Wells Fargo Securities.

Matthew R. Nemer - Wells Fargo Securities, LLC, Research Division

I'm just wondering if you could talk about the cooler opportunity on a longer-term basis. How many stores can you get to above that 8-door average over time? And are there certain -- is there a certain group of stores that just don't have the size or have other restrictions that prevent you from adding coolers? And then secondly, could you talk to the reasons behind the increase in CapEx guidance?

Howard R. Levine

I'll take a stab at the first part of that, Matt. One of the things that we've seen over time is the growing importance of having a strong cooler both in the refrigerated and freezer assortment. When we started back several years ago, we had a 5-door cooler assortment. And we saw some nice traction with that. And we've quickly grown that by the end of this year to an average of about 8 doors. But our current thinking, I think, is more -- is shown in our new stores as well as the stores that we renovated, where we're going somewhere in the neighborhood of 15 to 20 doors in those stores. And that will enable us to really more broadly capture that trip and have a much larger assortment. But what we're most excited about, in addition to having the space to merchandise, we were going to have a much improved assortment with our investment and partnership with McLane. We will have a national assortment. These stores will be serviced every week with this merchandise and think that, that will only continue to improve the sales of the coolers and the importance to our customers in terms of driving trips on a regular basis. In terms of the CapEx, I'll let Mary address that, please.

Mary A. Winston

Thank you for the question on CapEx. As you know, we're focused on investing back in the business. So the increase that you see in the CapEx comes from our new stores that we're opening. We're opening between 450 and 500 new stores this year. We have plans underway to renovate, relocate and/or expand about 1,000 stores. We've also got some investment in the new fixtures associated with the SKU expansions in our stores and refits that we're doing. So basically, the CapEx increase is predominately going to invest in our stores to support the sales driving initiatives and the expansion plans that we have in place. In addition to that, we opened the 10th distribution center this year so that was a capital investment. And we are planning for our 11th DC to open next year. So those are the biggest drivers of CapEx.

Operator

The next question comes from Joseph Parkhill, Morgan Stanley.

Joseph Parkhill - Morgan Stanley, Research Division

I was just wondering if you could help us think about the inventory growth since you haven't rolled out cigarettes and additional SKUs to the entire base. Is inventory going to grow even faster next quarter? Or is this the high-water mark that's spread between inventory and sales?

Michael R. Bloom

Yes. So as far as the inventory goes, and you've heard Howard mention, of course, the sales lag the inventory. But if you think about the cadence of the initiatives that we're going out and the way that I laid it out in my prepared remarks, a lot of that inventory is sitting in our DCs today, ready for these stores that are being executed today, this week and into July. So most of the inventory for initiatives is sitting here. And of course, you've got the 250 new items in food going out this month. I'm sorry, yes, this month. So the inventory is here. And as Howard mentioned, the sales will lag that.

Joseph Parkhill - Morgan Stanley, Research Division

Okay. That's helpful. And I was just wondering if you could talk a little bit -- I mean, everybody's focused on the incremental SKUs, but back to kind of the remodels. How are this year's batch of remodels performing? And how are them versus last year? And how is the second year of the remodels coming out versus your plan?

Howard R. Levine

Sure, Joe. We continue to be extremely pleased with the results that we're getting from our renovated stores. What we're finding is we're expanding our share of wallet with both the lower- and middle-income customers, and we're also showing some increasing trip frequency. As we've discussed before, we continue to see about a 10% lift in these stores, when you think about the actual remodel as well as the assortment changes. Most importantly, by the end of this fiscal year, we'll have about half of the stores done. And we're very excited about what that means to our customers. It's a better customer experience, it's a much better brand experience and a much more competitive format. As we circle year 2, we're continuing to see some benefits there. It is not a one-and-done type of situation. I'm not going to comment specifically on it because it's still very early. But we invested in these stores and expect it to be a multiyear benefit to our business.

Operator

The next question we have comes from Scot Ciccarelli, RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

Howard, you comment that consumers in your opinion remain under pressure. And frankly, I don't think that's much different than what your viewpoint has been. But obviously, as I'm sure you guys are aware, you're not the only ones to have seen some heightened sales volatility over the last couple of months. I guess, what I'm asking is you get to see a lot of customer transactions. Is there any change you can talk about in terms of consumer behavior that might be helpful for the group?

Howard R. Levine

Sure, Scot. Just from a broad picture standpoint, the lower-income consumer continues to be very stressed. We see continued paycheck cycle volatility probably growing in significance. The customer is very focused on value. But at the same time, I would add, we were very pleased with some of our Seasonal results. Our Memorial Day holiday was outstanding. We had a great event and the customers really enjoyed what we're doing there. So we are seeing some signs of life out there, which are very positive. But it is volatile to your point and we're experiencing it. Sometimes it's weather-related, sometimes it could be shift in holiday. I will add that I think lowering gas prices is a benefit. Again, like merchandise changes, I'm not sure as to when that becomes a more positive impact to us, but I think that is a positive trend for a customer that is living paycheck-to-paycheck. So it's interesting out there. You read the same headlines I do. Consumer confidence continues to deteriorate. Job growth, particularly for lower-income consumers, customers are still lacking out there. So we'd like to see things pick it up hopefully with the political election coming up and some other things settling down, we'll start to see some more comfort there.

Scot Ciccarelli - RBC Capital Markets, LLC, Research Division

The paycheck cycle is actually exaggerated versus what it's been?

Howard R. Levine

It feels that way to us, yes.

Operator

The next question we have comes from Adrianne Shapira, Goldman Sachs.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

A lot of these initiatives that you're focused on clearly focused on driving trips. Perhaps you could shed some light on the composition of the comp? I think you mentioned that both traffic and ticket were up. But any sort of trend that you could share with us that suggests that, in fact, the initiatives are starting to move trip activity higher?

Howard R. Levine

Sure, Adrianne. Right now, we're seeing a pretty good balance between trips and transaction size. Our expectation would be that trips would continue to build as the Consumable rollouts get more complete and average transaction size, we would hope, would start to gain a little bit as well.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Okay. But as of yet, it's still pretty much balanced the same as you've seen in the last 2 quarters.

Howard R. Levine

Yes.

Kiley F. Rawlins

Let me just jump in and add that -- and this is Kiley. Now that we have 2 women on the phone, let me differentiate voices. I think, as Mike said in the call, we started a lot of these initiatives pretty late. But we did see some momentum building from a traffic standpoint in May and would expect to add more of the initiatives rollout and take hold that we see that continue and accelerate.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Great. Thank you, Kiley. So question for the other woman on the call, Mary, welcome. And I was just wondering, could you spend some time on the sale-leaseback activity? Was that earlier than planned? And perhaps shed some light on plans in the back half. What should we expect?

Mary A. Winston

Okay. Thanks for the welcoming remarks, first of all. As far as the sale-leaseback transaction, I think the timing of it was about as we had planned it. The 2 tranches that we've done so far covered about half of our own store base, so we do still have some opportunity to execute additional transactions. But we don't have any plans at this point to do anything further in the fourth quarter. We're still looking at what we're planning to do in FY '13, but that could be one component of it.

Adrianne Shapira - Goldman Sachs Group Inc., Research Division

Okay. So no further timing in terms of when in '13 the other half will be completed?

Mary A. Winston

No. No timing as of yet. But we'll be prepared to talk about that when we give our FY '13 guidance and get into our plans for that year.

Operator

The next question we have comes from Debra Weinswig, Citi.

Nathan Rich

This is Nathan Rich filling in for Deb. First, I wanted to ask about the tobacco rollout. You said that you were pleased with the initial results. I was wondering if you could comment specifically on shrink and how that's trending versus your expectations.

Michael R. Bloom

Yes. It's Mike. I guess, a couple of things. Overall shrink, I'll talk to that first, and then I'll drill down to tobacco and tell you what we've done there. But I guess, we should first remind that we've had a great 5-year trend. We're at historical lows with shrink as an organization. And we believe shrink in total, while there remains a little headwind, we will certainly get it under control on the next several quarters. From a tobacco-specific perspective, I am real pleased with the processes that we have in place and the early results of shrink. And tobacco is going to be internal shrink primarily. And many of you have heard me say this before, but we're actually doing before and after counts after every shift in the store, which really helps us zero in on if we have an issue or not at a very specific time and shift change. So we think we've got that under control.

Nathan Rich

Great. And then if I could also ask on the price management side, what inning are you guys in with regards to zone pricing?

Michael R. Bloom

Yes. So we've had zone pricing for quite some time. And I think the inning that we're in right now is that it's evolving. And I would suggest if you think about the way we're using it today, you could call us in the seventh inning. However, we're continuing to evolve. And as we learn more about our markets and how our customers are using our stores and some of the new initiatives, I think we'll see that tweak and be evolved to even be better than we're using it today.

Operator

The next question we have comes from Bernard Sosnick from Gilford Securities.

Bernard Sosnick - Gilford Securities Inc., Research Division

I'm going to ask a very basic question about pricing policy. Could you just give us a synopsis of your commitment to EDLP, how that relates to weekly circulars and coupons and zone pricing?

Michael R. Bloom

Yes, sure. I'll take that. It's Mike. So let me first explain and maybe clarify for you our view of what EDLP is and what it isn't. For us, I believe there are very few EDLP retailers out there today, really if any. By the sheer nature of everyday low price all the time, I can tell you that we are a hybrid model, when we have a hybrid strategy, using both great values every day. But then we certainly promote. And you can see on the front pages of our circular and the back pages of our circular, that a lot of those items are reduced even lower than our great everyday low prices, and a lot of times subsidized by suppliers. So I think we've got a hybrid model of the great values everyday and then even better values during some of our promotional periods. But not every item in our circular is reduced price either. A lot of times, we just advertise our great everyday low prices. So I would tell you it's a hybrid model.

Bernard Sosnick - Gilford Securities Inc., Research Division

And what about zone pricing? How does that fit in when you have weekly circulars?

Michael R. Bloom

Yes. Zone pricing, right now, we're actually not zone pricing our promotions, I don't believe. We're not zone pricing our circular events today. Again, as we evolve, it doesn't mean we won't do that in the future. But right now, it's same price everywhere in our circulars.

Howard R. Levine

And Bernie, we are not running weekly circulars, just to correct. We're something about twice a month right now. And again, what I would say, in this kind of environment, one of the things that a lot of retailers are looking to do and why we promote is to drive traffic into our stores, given the difficult economic environment as well as all the changes that we're making in our store, not just the Consumables growth but the Seasonal events, the new Apparel items and some of those things to let our customers know what's new and different and changing in our stores.

Operator

The next question we have comes from Anthony Chukumba, BB&T Capital Markets.

Anthony C. Chukumba - BB&T Capital Markets, Research Division

Just wanted to see if you have any comments on the early results from your California stores and what you think the store retention was in California.

Michael R. Bloom

Yes, Anthony, it's Mike. I'm actually very excited about our entry into this market. California, a great market, very dense population. It's still early. I think we've got about 20, 25 stores in that marketplace today. But I'll tell you, our customers have responded really well. And I think it's because we bring consistency and, of course, all of our convenience and our great values. But like any market, we'll continue to tweak and learn from that customer as we move along and as we collect additional information. Right now, it's pretty balanced approach out there throughout the store. But I think one of the keys to California -- and we do see significant growth in California from a store perspective. But I think one of the things -- one of the keys for us is opening that 11th DC and getting those stem miles down. Right now, we're shipping those stores from Odessa, Texas. And so as we open Utah, middle of next year, we'll get those stem miles down, that will help us even more. But lots of room for growth in California.

Operator

The next question we have comes from Laura Champine from Canaccord Genuity.

Laura A. Champine - Canaccord Genuity, Research Division

I had a question on the inventory. I certainly understand that inventory is trending up because of your merchandising initiatives. But with the comp coming in at the low end of the guidance for Q3, is there any inventory that's excessed because of the way sales trends presented themselves through the quarter?

Michael R. Bloom

No. Actually, and as we stated, all of the inventory growth is sitting in Consumables. And so no, we don't see any excess inventory at all that we're concerned about. It's all in those growth categories.

Laura A. Champine - Canaccord Genuity, Research Division

Got it. And certainly, I see the acceleration of what you're doing in Consumables and in HBA through the end of this fiscal year. Does that mean, Mike, that we'll be able to gauge the results of your first wave of changes in the products when we see the November and February quarterly sales numbers coming in?

Kiley F. Rawlins

I'm sorry, Laura. Can you repeat the question?

Laura A. Champine - Canaccord Genuity, Research Division

Will the merchandising initiatives that you've undertaken be fully reflected? Will we be able to judge the success when we see the first half sales next fiscal year? Meaning, are you getting all ramped up so that we'll see the benefit of Pepsi and tobacco and the impulse items early enough for the November and February quarters?

Michael R. Bloom

Yes. Actually I think you'll continue to see the cadence of our comps -- of our comp growth throughout next year. So yes, I think that's accurate.

Operator

The next question we have comes from Patrick McKeever, MKM Partners.

Patrick McKeever - MKM Partners LLC, Research Division

So just a question on store growth for the year, reaffirming 450 to 500, which looks like at the midpoint of the range would imply about 190 stores for the fourth quarter. So the question is just how do you feel about hitting that number that would be the biggest absolute number in some time now in the midst of all that's going on at the store level?

Howard R. Levine

Patrick, we feel good about it. We know the numbers we have to open in the fourth quarter and are on track and on plan to hit the midpoint of that range.

Patrick McKeever - MKM Partners LLC, Research Division

And then just a second one. I was in the stores very recently, and seeing some apparel, I guess, markdowns in effect, but buy 2 items and get the third for $0.01. Is that -- have you done that before? Is that something entirely new? And how does it all net out relative to, let's say, some of the percentage off markdowns that you've taken in the past in Apparel around this time of the year?

Howard R. Levine

Sure, Patrick. The capability to be able to do that is more recent. We've done them, though, for probably a year or so, where we have buy ones, get ones, and we've shown a lot of good success with that. And what you saw or what you see this week and last week was just one of the promotions that we've run to move through some goods. It's been very helpful and was part of our planning process at the beginning of the season.

Patrick McKeever - MKM Partners LLC, Research Division

But do you think it will net out to a better markdown realization versus what you were doing this time a year ago?

Howard R. Levine

Yes. I think things are different this year than last year. One of the things that we talked about at the second call was, given the volatility of Apparel and some of the discretionary categories, we did curtail receipts there. The teams did a very good job with that. So inventories in Apparel are in very good shape. This was just part of our plan. I'm always a believer the first markdown is the best markdown. And I think some of this that we're doing and what you're seeing in our stores now is just to facilitate sell-throughs and get to where we need to be at the end of our season.

Operator

The next question we have comes from Denise Chai, Bank of America Merrill Lynch.

Denise Chai - BofA Merrill Lynch, Research Division

I had a question on the McLane partnership. I know it's early days, but can you give us a sense of how big you think that might be able to become in terms of the categories it will touch? Obviously, you're starting with tobacco and the cooler doors. But what else do you see on the horizon? And also as you open up a couple of new DCs, how does outsourcing some of your distribution kind of affect the efficiency of your supply chain?

Michael R. Bloom

Yes. So Denise, as far as McLane goes, I can tell you we are really excited about that partnership. And you know they've got a portfolio of over 40,000 SKUs. But right now, I can tell you we're just laser-focused on doing the refrigerated and frozen really, really well, making sure that we dot the Is and cross the Ts and it goes smooth for our stores and our customers. So right now, we're not thinking about expansion into other businesses. But we know it's out there.

Kiley F. Rawlins

And Denise, just as a reminder, we have always outsourced our refrigerated and frozen. We just had a much more fragmented network of suppliers. So moving to McLane really consolidates it in one very efficient, very -- for lack of a better description, powerful provider.

Denise Chai - BofA Merrill Lynch, Research Division

Okay. So categories like candy and other items will not be coming from McLane at this point?

Michael R. Bloom

Yes, sorry, candy will be coming from McLane. Yes, candy, refrigerated, frozen.

Kiley F. Rawlins

And that's not much of a change because McLane has always done our summer chocolates.

Michael R. Bloom

Yes. McLane gives us the refrigerated resource to be able to distribute chocolate and other candies that need refrigeration throughout the year, which is a really big win for us.

Operator

The question comes from Mark Montagna, Avondale Partners.

Mark K. Montagna - Avondale Partners, LLC, Research Division

A question on your SG&A. The improvement was a bit lower than I expected. I'm just wondering if you can you explain how much SG&A might have been hindered by the incremental cost related to the freezer rollout, adding 25% more HBA and the new foods SKU counts.

Mary A. Winston

Mark, this is Mary. Clearly, we have a lot of activity going on in the business. But I wouldn't say that our SG&A growth was related to the items that you just mentioned. I think you have to think about that we do have rapid store growth and our square footage is up 5% to 6%. Our core expenses are growing the way they usually would, which is about 2% to 3%. But with all the activity that we have going on, we do have pressure on SG&A. And I would remind you of the comments I made in my remarks about the fourth quarter so that, that’s just on everyone's radar screen. We do have a fourth quarter coming up where we have some tough comparables because we had some real positives flowing through the fourth quarter last year with the benefits that we got from insurance and from incentive compensation. So those are just things for us to keep our eye on. One of the things I've been impressed with, though early days, is the company's focus on cost and expense management. So we're obviously keeping our eye on the ball. And as we grow the business and roll out the initiatives, this is top of mind for us, and we'll be keeping our eye on it.

Mark K. Montagna - Avondale Partners, LLC, Research Division

Okay. And then just as a quick follow-up, regarding gross margin, looking into next year, is it fair to expect an acceleration in gross margin as next year rolls along?

Mary A. Winston

Well, I think as we've talked about, certainly going into the fourth quarter, we do have some pressure on gross margin for the reasons we've talked about. As our Consumables sales continue to ramp up, that's going to add pressure. And then when we look at the next layer of that, even within Consumables, the sales growth is in lower-margin Consumables. So that's added pressure. We will be doing a number of things that we've already talked about that will continue to alleviate some of the pressure on margins so that's the continued focus on the pricing initiatives, the global sourcing initiatives, our private brand initiatives. And those things will be providing some benefit as we go throughout FY '13. Now we do have to acknowledge that those things are not lined up from a timing standpoint precisely. We're focused on leveraging our initiatives for the benefit of the customer. And so some of the pressure on margins, we'll see that in the fourth quarter and the early part of FY '13. And we'll see some of the benefits offsetting that as we go throughout the year.

Operator

Thank you. And that ends the question-and-answer session. I will now turn the call over to Ms. Rawlins for final comment.

Kiley F. Rawlins

Thank you, Melissa, and thank you, everyone, for joining us today. If you have any questions following the call, please don't hesitate to call us. And I hope you have a great rest of the day. Thanks.

Operator

Thank you. And this does conclude today's conference. All parties may disconnect.

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