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Family Dollar Stores, Inc. (NYSE:FDO)

F2Q08 Earnings Call

April 4, 2008 10:00 am ET

Executives

Kiley F. Rawlins - Investor Relations

Kenneth T. Smith - Chief Financial Officer, Senior Vice President

Howard R. Levine - Chairman of the Board, Chief Executive Officer

R. James Kelly - President, Chief Operating Officer

Analysts

Meredith Adler - Lehman Brothers

Michael Baker - Deutsche Bank

Bernard Sosnick - Gilford Securities

Charles Grom - J.P. Morgan

Ralph Jean - Wachovia Securities

Mark Miller - William Blair & Company

David Mann - Johnson Rice

Dan Wewer - Raymond James

Operator

Good morning. My name is Britney and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Family Dollar second quarter 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, Britney. Good morning and thank you for joining us today. We appreciate your interest in Family Dollar Store.

Before we begin, you should know that our comments today will include forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act. These statements address plans and activities or events which we expect will or may occur in the future. However, a number of factors, as set forth in our SEC filings and press releases, could cause actual results to differ from our plans. 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, April 4, 2008. We have no obligation to publicly update or revise our forward-looking statements except as required by law and you should not expect us to do so.

With me on the call today are Howard Levine, Chairman and CEO; Jim Kelly, President and CEO; and Ken Smith, our Chief Financial Officer. We’ll begin our discussion this morning with a review of our recent financial performance and future expectations from Ken, and then Howard will discuss how we are positioning Family Dollar within the current economic environment. Following our prepared remarks, we will open the call up for a question-and-answer session.

Now I would like to introduce Ken Smith, our CFO. Ken.

Kenneth T. Smith

Thanks, Kiley. This morning we reported earnings per share of $0.45 compared with $0.60 in the second quarter last year. As expected, the second quarter of fiscal 2008 proved to be difficult.

Reflecting the top line challenges facing the second quarter from the shift of one week of holiday sales into the first quarter and the loss of the extra week, we had originally budgeted net income to decline approximately 20%. However, deteriorating economic conditions resulted in softer than expected sales in discretionary categories, which constrained revenue growth and pressured gross margin more than we had planned.

In a minute, I’ll walk through the income statement for the second quarter. However, with the calendar shifts and the extra week last year, there’s a lot of noise in these results. Combining results for the first and second quarter eliminates the effect of the seasonal sales shift, provides better visibility to our underlying operating trends, and offers a better foundation for our expectations for the second half of 2008.

So as we go along, I’ll provide not only a review of the second quarter but also a review of the first half of fiscal 2008.

As we reported a few weeks ago, net revenues for the second quarter declined 5.9%; again, these results include the effect of one less week of sales as compared with last year and one less holiday week. If we eliminate the effect of the holiday shift and the extra week and compare sales for the same 13-week period, net revenues increased about 3%. Comparable store sales for the same 13-week period were approximately flat, an improvement from the first quarter.

For the first half of fiscal 2008, comp store sales declined 0.5%. However, we saw steady improvement in our sales trends since November, driven mostly by our consumable category. This trend has been a result of improving customer traffic trends, which though challenged at the beginning of the quarter, improved in January and February. Year-to-date, the average transaction has been slightly higher than last year.

Gross profit as a percentage of sales declined approximately 80 basis points in the second quarter and approximately 60 basis points in the first half of fiscal 2008. For both the second quarter and the first half, merchandise markdowns were the biggest driver of the margin contraction. As customers have constrained their purchases of discretionary items, we have worked aggressively to manage inventory levels in these categories. As a result, at the end of the second quarter, inventory per store was approximately 1% lower than at the end of the second quarter last year, driven primarily by a double-digit production in apparel inventories. I would remind you that this is the eighth consecutive quarter of inventory improvement.

In the first half of fiscal 2008, we have also experienced slightly higher inventory shrinkage. A portion of the increase is due to lower sales volumes. Store team retention trends continue to improve and as I mentioned earlier, we continue to manage store inventory levels down. We believe that these positive trends will have a sustainable impact on inventory shrinkage over time.

We did a better job managing expenses this quarter. SG&A expense declined to $502.6 million, compared with $509.2 million last year. As you would expect, payroll expenses were lower, resulting from one less week in the quarter as compared to the second quarter of fiscal 2007 and most other controllable expenses were tightly managed.

During the quarter and the first half of fiscal 2008, most operating expenses were deleveraged, reflecting low comp sales performance and offsetting the benefit from lower professional fees. You may recall that we incurred approximately $16 million of expense related to shareholder derivative actions during the first half of fiscal 2007.

In addition, I would like to highlight two offsetting expense items reflected in our results. First, as we have worked to lower store level inventory, increase store manager retention and improve our processes, we have experienced lower workers’ compensation claims. This trend has been consistently better for several quarters. Working with our outside actuary, we have reduced our workers’ compensation liabilities to better reflect our claim experience.

Offsetting the impact of lower workers’ compensation trends was an adjustment related to store rental expenses, primarily property tax, insurance, and common area maintenance expenses. As we have discussed previously, we are creating a more proactive facility management platform which includes the implementation of a new lease management system. The utilization of this system will enable us to manage occupancy costs better over the longer term but has created some timing differences during the implementation period as we refine our accrual estimates for certain store rental expenses.

The tax rates for the second quarter and first half of fiscal 2008 decreased to 34.4% and 35.6% respectively. The decline in the second quarter was primarily a result of a decrease in our FIN-48 liabilities and changes in state income taxes. The tax rate for the first half reflects the benefit of federal tax credits and changes in state income taxes.

In the first half of fiscal 2008, we generated approximately $275 million in operating cash flow, more than adequate to fund approximately $64 million in capital expenditures and approximately $32 million in dividend payments.

As of March 1, 2008, we had approximately $317 million in cash and investment securities, which included approximately $237 million of auction rate securities, which recently have experienced failed auctions.

Substantially all of our portfolio of auction rate securities are tax exempt, triple A rated securities, which are collateralized by student loans guaranteed by the Federal Government. At this time, we do not believe that any of the underlying issuers of the securities are presently at risk and we do not believe that the underlying credit quality of the assets backing the investments has been impacted by the reduced liquidity of these investments.

We believe that we will be able to liquidate these auction rate securities at par within a reasonable time period. However, the current condition of the auction rate securities market makes it difficult to predict the timing of future sales. Reflecting the failed auctions, we have booked a temporary, unrealized loss of approximately $2.4 million net of taxes as an accumulated other comprehensive loss on the balance sheet.

I would note that the unrealized loss had no impact on the income statement and that the issuers of these securities continue to make interest payments at the maximum contractual interest rate per the offering statement for each security.

We do not believe that the current lack of liquidity relating to the auction rate securities will have an impact on our ability to fund our operations and growth initiatives. As you know, we have strong operating cash flows which we expect will continue to support our 2008 capital expenditure program of $140 million to $150 million, fund future dividends, and support our stock repurchase program. In addition, we have borrowing capacity in place today in excess of $400 million.

As I mentioned at the beginning of my comments, the first half of fiscal 2008 has some comparability issues due to some significant calendar shifts. Consequently, we do not believe that the 140 basis points in operating margin erosion that we experienced in the first half is indicative of what margin trends will be in the second half of fiscal 2008. Although we believe the economic environment will remain challenging near-term, we expect operating margins to stabilize. Let me give you four reasons why we expect the second half of fiscal 2008 to improve.

First, our consumable business is solid and historically, the second half of the year has been less dependent on discretionary sales than the holiday sensitive first half.

Second, markdowns played a significant role in gross margin deterioration in the first half. We have adjusted our merchandise purchases to reflect the current economic environment and are managing inventories better. Consequently, we believe our markdowns in the second half will be more consistent with historical levels.

Third, we have lowered our cost structure and expect to continue to tightly manage expenses to leverage SG&A below our historical comp rate of 3% to 3.5%. We are targeting a comp break even point of 1% to 2%.

Finally, in May the government will begin to distribute payments related to the stimulus package. While we believe that our customers will benefit from these payments, quantifying the impact is difficult.

To recap, we expect our sales trends to improve modestly in the second half of fiscal 2008, driven primarily by sales of consumables. While the Easter shift creates comparability issues for the March and April period, overall we expect the comp store sales trend for the third quarter will be flat to up slightly. We expect that strong sales of consumables, combined with continued tight expense control, will result in earnings per share of between $0.39 and $0.44 in the third quarter of fiscal 2008, compared with $0.40 in the third quarter of fiscal 2007.

Reflecting continued strong sales of consumables, disciplined expense control, and the benefit of the tax stimulus package, we expect earnings per share for the fourth quarter to be in the range of $0.29 to $0.34, compared with $0.26 in the fourth quarter of fiscal 2007. This range is wider than we have historically provided and reflects the economic uncertainties we face and the challenge in predicting the impact of the tax stimulus package.

In providing our initial guidance for fiscal 2008, we expected the economic environment to stabilize. As conditions have continued to deteriorate, we are modifying our expectations to reflect continued challenges near-term. For the full year, we expect earnings per share will be between $1.50 and $1.60.

I would note that these expectations do not reflect additional stock repurchases. As we have mentioned before, our top priorities for use of capital are to invest in our business and to support our dividend program. We will continue to use stock repurchases as a vehicle to return excess capital to shareholders.

I would note that the markets remain volatile and while we certainly want to be opportunistic with our repurchases, we also recognize the value of taking a more conservative approach to our capital management in today’s environment.

Now I’d like to turn the call over to Howard. Howard.

Howard R. Levine

Thank you, Ken and good morning, everyone. At Family Dollar, we have provided customers with the compelling combination of value and convenience for nearly 50 years, weathering many different economic cycles. Our success has been the result of reacting effectively to near-term challenges while maintaining our commitment to longer term objectives.

Over the last several months, economic conditions have deteriorated, which has resulted in our customers limiting their discretionary spending this past holiday season and focusing more on basic consumable needs. As a result, our performance for the first half was not as strong as we had planned.

While the first half has been challenging, I am pleased with our ability to adapt quickly to the weakening conditions and there are encouraging trends in the second quarter that I would like to highlight.

As Ken mentioned, we had seen improving sales and traffic trends since November. Despite softer than expected sales, we have maintained control of our inventory, resulting in lower store level inventories at the end of the second quarter. We have managed expenses better and are well on our way to building the infrastructure to leverage expenses at a 1% to 2% comp.

We continue to drive improvement in store manager retention, aggressively managing store manager turnover in the mid-30s. This focus has enabled us to manage shrink reasonably well despite a softer sales environment and more challenging economic conditions.

Finally, as I outlined on the last quarter’s conference call, we have made significant investments to strengthen key consumable categories with limited disruptions to the shopping environment.

With the first half behind us, we are looking forward to the second half of fiscal ’08. Much has been said about the current economic environment and many have debated about how long these conditions will last. While we believe that the upcoming minimum wage increase and the impending tax stimulus package should bring some relief, we continue to expect that our customers will be financially challenged near term.

Consequently, we will continue to adapt our assortment to meet our customers’ increasing need for value, maintain strong cost controls, and effectively manage inventory risk. I believe that this disciplined approach will result in stronger financial performance in the second half of fiscal ’08.

In today’s environment, our customers are continuously looking for ways to fulfill the needs of their families within a shrinking budget. In response, we are leveraging our strengths and investing in initiatives to drive sales.

As food is an important shopping trip driver, we continue to expand and refine our food assortment to leverage the opportunity to provide both value and convenience to customers, especially in today’s environment of rising energy and food costs.

Continuing the initiatives we began last year, we have expanded the selling space for food in an additional 2,700 stores this year and approximately 1,500 stores now accept food stamps.

In addition, we have strengthened our every day assortment of quick prep and ready-to-serve products in all stores, introducing larger family sizes and emphasizing private label and value brands. Clearly our customers appreciate the changes we have made in our assortment as food continues to be the biggest driver of sales.

In addition to strengthening our assortment of food, we have also made investments in other key traffic driving consumable areas, including household paper and home cleaning products. In February, we introduced a new fixture for household paper products in about 3,400 stores that is easier to shop, merchandise, and restock. Although it has not been in these stores very long, we are very pleased with the initial results.

In addition, as with most other retailers, our laundry assortment is moving to smaller but more concentrated formulations, an industry move sometimes referred to as compaction. During the second quarter, we completed the change in 2,700 stores, enabling us to broaden our laundry assortment within the same selling space. Today, approximately 83% of our stores carry the more concentrated laundry detergent formulations and we expect to complete the conversion in the rest of our stores later this spring.

While we expect that consumables will continue to drive sales, we are also making investments in select discretionary categories. Although our customers remain cash constrained, quality merchandise at compelling price points has strong appeal.

Last holiday season, we introduced a limited assortment of Bugle Boy apparel for men and ladies and we were pleased with its performance, especially in light of the overall softness in the apparel category. This spring, we are expanding our Bugle Boy selection. For those of you that have been in our stores recently, you may have seen our new Bugle Boy presentation, which includes fresh, eye-catching signage and new, more space efficient fixturing. Although our spring assortment has only been in stores for a few weeks, we are pleased with the early response from our customers. They clearly recognize and appreciate the quality and value of this brand.

In addition, after conducting an expansive test last fall, we decided to link the acceptance of credit with the rollout of our store of the future technology program. We expect that strengthening our assortment of basic consumables, expanding our payment options and continuing to emphasize quality and value will drive stronger top line growth. However, to deliver stronger financial performance, we cannot depend solely on revenue driving initiatives. We must also maintain a lean cost structure.

For the last several years, we have invested in initiatives designed to lower our longer term operating cost and we are beginning to see the benefits of these investments. In 2007, we developed a new centralized procurement organization to help us better leverage our buying power. Our initial focus has been on reducing non-merchandise indirect purchases, such as supplies and services.

Through the utilization of our online procurement tool and a careful review of our processes, I am pleased to report that despite inflationary pressures and operating 200 more stores, we have been able to lower or keep flat with last year many of our store level spends. As we continue to develop and refine our procurement processes, I am confident that we will continue to harvest savings from this investment.

Last year, we also began testing a new energy management system. Using this tool, we have been able to lower our usage of electricity in stores without impacting the shopping environment. This year, we have expanded the implementation to an additional 1,600 stores and we expect that this program will continue to lower our energy usage and help offset rising energy costs.

In addition to our investments in centralized procurement and energy management, our team is reacting to the current environment with a heightened focus on controlling all other expenses. Throughout our organizations, our associates are working hard to limit spending and to closely monitor every expense. The result of this discipline is evident in our expense control this quarter and I expect that our continued diligence will enable us to lever our costs in this more challenging sales environment.

Successfully navigating through the difficult economic conditions not only requires prompt adjustments to a changing environment but also requires effectively managing risk. Our project accelerate initiative is providing a stronger foundation for managing inventory and pricing risk through the creation of an improved framework for decision making.

Over the last 18 months, as part of our project accelerate initiative, we have made organizational changes, implemented new processes, and begun utilizing new analytical and forecasting tools. We have aligned our merchandising and supply teams around our category management framework rather than purely functional responsibilities and we have created groups of operational specialists to provide our category teams with institutional expertise.

We have created improved planning processes to include financial planning and category management and last fall, we began utilizing a new merchandising and financial planning tool that provides us with greater visibility to underlying business trends, enabling us to make better decisions with greater understanding of financial considerations and customer impact.

In addition, as part of our project accelerate work, we have created a structured framework for pricing decisions that enables us to better balance the need for profitability with the customer’s perception of value.

In today’s environment, having an appropriate pricing strategy is critical, both to reinforce value to the customer and to manage profitability, especially in the face of increasing inflation. The underlying premise of our pricing strategy is based on the understanding that not all prices are equally important and not all markets have the same competitive environment.

Using market CPI data, demand elasticity studies, and competitive information our pricing teams and buyers can now effectively manage profitability while reinforcing our strong price perception.

To ensure our success, we use periodic customer research to continuously evaluate our pricing strategy and I am pleased to share with you that our customer research continues to confirm our strong value image.

The first half of fiscal 2008 has proven to be more challenging than we expected, but we have made the appropriate adjustments to drive better performance in the second half. Our customers recognize and appreciate the value and convenience we offer and we are leveraging our strengths to drive better top line growth. We have adjusted our merchandising plans to minimize fashion risk and we have lowered our cost structure to leverage SG&A at a more moderate level.

Although the near-term will most likely remain challenging, I continue to be excited about the long-term opportunity of our business. We have a long, successful history of providing customers with convenience and value in a small, easy-to-shop environment and our management team remains focused on the long-term vision even as we have worked to adjust to changing economic conditions.

I am confident that as we continue to fulfill our customers’ heightened need for value, maintain strong cost control and effectively manage risk, we can successfully navigate through this economic downturn and position Family Dollar to accelerate returns when the economy improves.

Now, Operator, we would be happy to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Meredith Adler with Lehman Brothers.

Meredith Adler - Lehman Brothers

I have a couple of questions for you. I would just like to talk a little bit about shrink for a second. My understanding is the way you account for shrink, you actually get some visibility kind of ahead of time. It takes a while to roll in. Do you believe that you have some information now that tells you that shrink could be better in the second half?

R. James Kelly

Meredith, I think the primary data that we look at is forward -- in terms of forward indicators are basically the management of inventory levels per store and the turnover of our staff at the stores. Those things continue to show some strength.

The other point I’d like to make is that during difficult economic times, it’s very common to have shrink pressure. The amount of our relative shrink deterioration over the last two quarters has been very, very minor when you look at the overall shrink. And indeed, I would remind you that in seven of the last 10 quarters, we have had shrink reduction. So we believe that by consistently focusing on the underlying factors that cause shrink and by executing the toolkits that we have effectively in the field, we are going to be able to manage shrink during this more difficult time and in the long-term, we are going to see improved results.

Meredith Adler - Lehman Brothers

Great, and then a question about implementing credit cards. I might have missed -- I assume you don’t have the credit card capability in every store. Would you -- is there any evidence that that is making it easier for more middle class customers to shop at Family Dollar? Those things are really hard to know but do you have any indication?

R. James Kelly

Well, we performed a fairly extensive test of our -- of the use of credit cards and certainly there were indicators that certain sectors of the population and yes, more upper low income, low middle income use credit cards more frequently, so yes there is pretty good evidence that by introducing credit cards, we are going to have greater overall customer appeal.

Howard R. Levine

And Meredith, if I could add, one of the other things that I think gives us some optimism regarding the middle income customer is some of the work that we’ve done surrounding our concept renewal format. For those of you that have been in that store, what that has done to create a better shopping environment is really strong and as we’ve talked about before, we are actually testing different renovation strategies to understand what different levels of investments would be in the remainder of the chain. So you are right, it’s difficult to manage and over the years, I’ve been asked that question often and I think with the positioning of some of the things that we are doing, that we are more eligible for a little more middle-ish income than we have been historically.

Meredith Adler - Lehman Brothers

Great, and then just one final question; the stock buy-back, you said you are being prudent with your use of cash but you also have a lack of available cash because of this AR situation. Are those two related?

Howard R. Levine

The position with the auction rate securities does not preclude us from buying stock back. It just becomes another factor in the decision-making process and what we’ve -- as we look forward, we look at the volatility in the market, current economic conditions, as well as the auction rate securities and we’ll be making decisions as we go forward. Our guidance assumes no buy-back, just from a more cautionary approach as we look forward. So we will be -- we continuously evaluate opportunities to buy back stock and we’ll continue to do so. Just our current status is to pull them out of our guidance.

Meredith Adler - Lehman Brothers

Great. Thank you.

Operator

Your next question comes from Michael Baker of Deutsche Bank.

Michael Baker - Deutsche Bank

A couple of questions, if I could; one is you said that your traffic was better in January and February. Is that up year over year better or just better, less down than it was in the November/December time frame? And then I guess the second part of the question would be it doesn’t appear as if that held in March, where March is down 4% to 5%. We know March has the issue with being closed on Easter, so how much of March is because of that being closed in Easter and how much is a give back with some of this traffic improvement? Thanks.

R. James Kelly

I think that what we are indicating with the traffic flow is that we’ve seen gradual improvement. It’s been down modestly now for some time and what we are a little -- we are optimistic about is that we are seeing that trend improve. So it was more flattish in January and then slightly positive in February. That’s a time period in which we executed a lot of our major consumable initiatives, so we are seeing a direct tie-in with the success of our consumer initiatives and the improved traffic flow.

Howard R. Levine

And Mike, in terms of March, let me just make a few comments to give a little color to what we had talked about. First, when looking at sales thus far with March, consumables remain good. Consumables continue to perform. We actually had better sell-throughs and performance on some of our Easter related product, things like candy, Easter baskets, and toys. I think that’s a reflection of the way we bought the category, knowing and understanding more of some of the difficulties that our customers are facing. So we had good sell-throughs on seasonal product.

Where we were hurt was in the apparel and some of the other weather-related categories, such as lawn and garden. I don’t like to talk about weather but when you’ve got economic conditions that are challenging, an Easter shift, and different weather conditions in the month of March as compared to last year, it does put a different slant on March and frankly, and I’ve said this for years, as we look at March and April with Easter shifts, I think it’s important to look at March and April together and not make too many conclusions, you know, based on one month of sales when you have all the things going on that we do.

So we continue to believe in the initiative. We saw some traction in February and I would hope and expect that to resume as we move into the month of April.

Michael Baker - Deutsche Bank

Okay, thanks.

Operator

Your next question comes from Bernard Sosnick with Gilford Securities.

Bernard Sosnick - Gilford Securities

Good morning. With regard to apparel, there are two many issues that I would like to ask you to address. First, the apparel assortment has changed with the new personnel that was brought in and now you are talking about reducing fashion risk. So could you amplify a little bit on that and how the assortment changed and how you want to modify it?

And secondly, going into Wal-Mart stores, I see signs, apparel $10 and less, $5, $6 tank-tops, shorts and stuff like that, and I’m wondering how Wal-Mart’s changes might be influencing what you are seeing.

Howard R. Levine

The first part of your question, Bernie, regarding the apparel assortment, we’ve continued to explore and try to determine what the appropriate roll apparel is in our business and I think we’ve made a lot of progress with that. When we talked currently about reducing our investment in apparel, it has to do primarily with the deterioration of the economy and the fact that our customer today is focused on basics and consumables. We think it’s prudent to manage the fashion risk appropriately and have incorporated that into our plans in the back half of the year.

We still believe in the apparel business. The apparel business is something that’s been important to us. It probably creates a little more volatility in our business but think that it’s something that over the long-term helps the margin issue and helps differentiate us.

And one of the things we’re most excited about is the introduction of Bugle Boy. If you’ve been in our stores, you’ve seen some of the new Bugle Boy product and we are very excited about what the outcome and the results will be of that.

I am reluctant to comment on any specific competitor’s changes and what they are doing within their stores. We’ve been in a competitive business for many, many years, have been competing against all the top retailers for a number of years, and have demonstrated our ability to compete.

We are focused on opening price points at Family Dollar. We are focused on primarily $10 and under in our assortment of apparel, so think that we are positioned appropriately in that regard. So we are going to continue to navigate carefully through the apparel business for the rest of the year but think that we’ve positioned it correctly when you consider some of the challenges that our customers are facing today.

Bernard Sosnick - Gilford Securities

Thank you.

Operator

Your next question comes from Charles Grom of J.P. Morgan Chase.

Charles Grom - J.P. Morgan

Good morning. Just to follow-up to that last question, DT reported some pretty healthy numbers last Friday year-to-date. Do you believe it’s possible that you could be losing some share to them? I believe there’s a high degree of store overlap between both companies.

Howard R. Levine

We do not believe that and I’m not going to comment on any specific retailers, as I just mentioned before but as Jim commented earlier, we are seeing improved traffic trends. January was flattish, February started to show improvement, so we think we are on the right track and do not believe that we are losing share.

Charles Grom - J.P. Morgan

Okay and just on that, do you think your March traffic has continued to improve relative to Jim’s comments on January and February?

Howard R. Levine

We haven’t evaluated March traffic at this point. March is not over yet and as I’ve said, we are going to evaluate March and April together. If you didn’t know, Easter has shifted this month and that does create some noise in the March period alone.

Charles Grom - J.P. Morgan

Okay, I understand. And could you speak to the success of your five for 25 promotion that you’ve been running I think since the fall? And I guess how you plan to utilize this tool over the next couple of quarters.

Howard R. Levine

No, Charles, we’re not going to comment on any specific promotional or marketing plan that we’ve implemented for competitive reasons.

Charles Grom - J.P. Morgan

Okay, fair enough and then just a last question; it was interesting to see that you are going to be comping or you expect to be able to lever on a lower comp about 200 bps lower than your historical level. Could you just walk through -- maybe this question’s for Ken -- could you just walk through what cost you are actually going to be reducing or stripping out to be able to accomplish that? And if you could comment on how much would come from in-store expenses that you may be reducing as opposed to corporate overhead?

R. James Kelly

Let me take you through a macro piece of that. We’ve said over the last several years the key to managing costs is to change the actual structure and processes. Several years ago, we invested in centralized procurement. We also invested in a facility management program and numerous other process change that we indicated would drive down our costs.

We are realizing the benefits from those programs, so yes, when you look at the store level, what you are seeing is many of the individual items from window cleaning, floor care to bags and paper have been managed to a flat or even lower than prior year level. By attacking facility costs through our facility management team, we’ve also been able to reduce the consumption of energy and to reduce maintenance costs in various areas. So we’ve made the structural investments over time that now are driving some cost reductions.

The individual groups of our company are each participating in various ways. I think our store operators have done an incredible job of looking across our company and leveraging specialists. I mentioned two, facility area and the centralized procurement area. They’ve also worked very effectively with our risk management group in the development of safety programs. They worked very effectively with our HR team to improve retention at the store level, which has a rippling impact in terms of the cost of training store managers and the benefits of having a more experienced team in place.

I would also highlight that our distribution team, in spite of inflationary pressures, have managed at a case level costs flat with last year, which is pretty darn strong. And then you have to look at the transportation team, which in the face of some fairly significant diesel cost increase, have actually managed that on a flat basis. In other words, productivity increases and increases such as managing [cubalization] and more effective management of that inbound traffic to leverage full truck load versus partial truck load, are having a measurable impact on us.

So I think it is structural in nature. We have good momentum now. We see a lot of opportunities to drive some further structural improvements and intend to do so. So the macro view is these changes have aggregated in such a way as to shift us from a 3 to 3.5 comp level leverage to closer to a 1 to 2 range. So we are very pleased with where we are but there’s a lot of future improvement yet to be harvested.

Charles Grom - J.P. Morgan

Okay. Thanks very much, Jim.

Operator

Your next question comes from Ralph Jean of Wachovia.

Ralph Jean - Wachovia Securities

Just one thing, a modeling related question -- you talked about consumables being a key driver of sales in the back half. So typically that mix shift leads to a lower gross margin, so can we assume that for the back half of the year?

Kenneth T. Smith

Yes, you can assume some slight margin pressure in the back half.

Ralph Jean - Wachovia Securities

Okay, and then what’s the right tax rate to use going forward? Is it 37% or something lower now?

Kenneth T. Smith

Looking forward, our historical rates have been between the 36% to 37% range, and within that range would be reasonable looking forward.

Ralph Jean - Wachovia Securities

And then lastly, just given your guidance, do you think you’ll have an outstanding balance on your revolver at year-end or do you think it will be flat?

Kenneth T. Smith

We would estimate that we probably would not have a balance in the revolver at year-end at this time.

Ralph Jean - Wachovia Securities

Thanks, guys.

R. James Kelly

Let me tack on one other comment -- I think sometimes what is said is important and sometimes what is not said is more important. If you look at our gross margin performance over the first half and you listen to what we’ve said, it’s been driven by consumables and customers have refrained and been very limited in discretionary spend, then the obvious conclusion is that you’ve had a fairly significant shift from the more discretionary items, i.e. higher margin items, to lower margin items. Yet that shift did not create the kind of margin impact that led us to a discussion of declining margins as a result of mix shift. Indeed the adverse impact to the mix shift was largely overcome by improvements in other areas.

Our global procurement group is working with the buyers on the margins within products that are being obtained overseas are better. In fact, when you look at each of our six divisions, we have seen along individual product lines some improvement in the IMU. Now, the pricing team working with the buyers is another element.

So investments in both pricing and global procurement on the first half of the year have been mitigating an existing merchandise mix shift. In the back half, we will continue to see that shift and we will continue to be challenged, but I don’t want you to think that simply the mix shift in and of itself will be the driving factor. It will be a negative factor. There will also be a number of positive factors which should have some mitigating effect.

Ralph Jean - Wachovia Securities

Jim, I appreciate that. I’m just wondering though, you’ve expanded your commitment to frozen and perishable food and your quick prep and ready to serve stuff. Those are typically the lowest margin categories in the store, are they not?

R. James Kelly

Those are lower margin items. That is true.

Ralph Jean - Wachovia Securities

Okay. Thank you.

Operator

Your next question comes from Mark Miller of William Blair.

Mark Miller - William Blair & Company

Good morning. I was hoping you could share with us your experience a little bit even further beyond the sales line, back from 2001 with the distribution of tax rebates. Obviously we can see that value retailers, including Family Dollar, gained share during that period but can you give us a further window of insight into some of the mix experience that you had?

And then how much I guess benefit are you anticipating from the stimulus? Your guidance for the fourth quarter is much stronger than for the third quarter and so I don’t know if that’s partially what’s driving that. Thanks.

Howard R. Levine

Sure, Mark. Good morning. Let me start off by saying that we -- our strategy group has spent quite a bit of time analyzing what happened in 2001 when the stimulus package was implemented. And underlying the work that they did gave us a range of the benefit to even specific categories of those benefits. And while the range was pretty large, which did influence the guidance because of the uncertainties as to the benefits of the stimulus package, we do believe that there will be some benefit to our customers. We did see some of that in ’01 and would expect to see some of that in the next few months here.

That being said, the environment I think is significant different today than it was in ’01, again compounding the difficulties of placing a benefit to the package that is going to be implemented shortly.

So what I would like to leave you with is that we have spent some time looking at that and did develop a range of what that benefit would be. It being so large we did broaden the range in the fourth quarter but do expect most of that benefit to begin as we go into the fourth quarter and that’s why we are a little more optimistic about the fourth quarter.

Mark Miller - William Blair & Company

Howard, you talked about some of the more recent customer research in some of that delving into perceptions of pricing. I was hoping you could expand a bit further on that. And then particularly as it relates to your pricing strategy, are you indicating that Family Dollar is now set to move more aggressively? Can you give us a sense for how far along you are implemented in that in terms of geographies or number of items? Thanks.

R. James Kelly

Let me talk a little bit about that, Mark. You know, managing the tug between profitability and price perception is one of the toughest polarities in retail. We have invested significantly over the last 24 months in building a structure to help our merchants make better pricing decisions. We are in a period of inflation and have been forced to make more pricing decisions than ever before.

And we have also, as part of that investment, recognized that that balance of price and profitability is across thousands of items, so we’ve created a three-tier structure to enable us to make decisions more effectively. We’ve created a data warehouse and have tools to manage demand elasticity. We’ve created a team that monitors each and every price change, so that we can understand where we’ve properly read the customer and where we haven’t and make changes.

We have looked at our price changing processes and reduced the time by over 25%, so we are better positioned today to manage the environment of today. As a result of that, thus far that balance has enabled us to navigate through a difficult time and maintain initial markups throughout our six divisions.

In terms of where we want to be, we want to balance that polarity in a way that is appropriate for our shareholders -- that is the profitability side -- and appropriate for our customers because the value perception in the minds of our customer is one of the most important assets that we have. That’s why as Howard indicated, we do look at third party independent customer research to provide additional moorings to ensure that we are properly balancing this area.

So I wouldn’t characterize it that we are out of balance today on those two ends. We will continue to make decisions that protect our value image and we will continue to make decisions that protect our relative profitability.

Mark Miller - William Blair & Company

Thanks for that.

Operator

Your next question comes from David Mann of Johnson Rice.

David Mann - Johnson Rice

Thank you. Good morning. On store growth, it looks like you’ve slightly lowered that. Can you just update us on your thoughts there and what’s behind that?

R. James Kelly

Well, the store growth is basically a by-product of our decision to balance investments in a very challenging time. As we’ve said, several years ago we were going to slow down that particular investment area and we continue to be open to new store opportunities, a little bit more opportunistic, if you will. But our primary focus in terms of our investment dollars today is improving the performance of our existing chain.

David Mann - Johnson Rice

Okay, and can you give an update on your treasure hunt strategy, how you felt it performed in the holiday period and how you -- you know, do you expect to expand it, reduce it going forward?

Howard R. Levine

Sure, David. Good morning. You know, as we talked about, despite the difficulties that we are facing with our consumer today, treasure hunt remains an important part of our overall strategy. You know, when we talk about treasure hunt, we are talking primarily apparel, seasonal, and the home area. Those areas are quite challenged today and based on the fact that they quite challenged, we are watching our inventory investment in those areas very closely at this time.

Over the long haul, we’ll continue to build and refine and develop those strategies as it is a very important part of our business today.

David Mann - Johnson Rice

Okay. Thank you.

Kiley F. Rawlins

Britney, I think we have time for one more question.

Operator

Your final question will come from Dan Wewer of Raymond James.

Dan Wewer - Raymond James

Thanks. Howard, with the 10% reduction in the apparel inventory, are you reducing the number of apparel fixtures in your stores and then allocating that space to hard lines where you can increase sales productivity? Or is it a strategy of reducing the amount of garments per fixture?

Howard R. Levine

More of the latter. There always are some tweaks to stores throughout the chain as we monitor our investment in apparel, but at this point if you are referring back to some of the things that we’ve done in the past, this is not a space reallocation program as much as it is an inventory risk management program.

Dan Wewer - Raymond James

Would it make sense to reduce the number of fixtures and reallocate that space?

Howard R. Levine

You know, as I’ve said, that part of our business remains important to us. We have made some substantial moves historically in that area but at this point, we do not have plans to do so but we are going to continue to evaluate all of our merchandising strategies as we move forward.

R. James Kelly

I would add that one of the elements of project accelerate is to provide additional assortment planning tools. That will give us much more visibility throughout groups of our stores in terms of inventory productivity and space productivity and can facilitate then decisions, space decision-making as you suggested.

Dan Wewer - Raymond James

The second question I had is going back to shrink, I understand your comments that soft economic environment increases the incentive for things like theft, but trying to get an understanding -- has there been a breakdown in theft prevention strategies at Family that’s enabling those with this incentive to create this problem?

R. James Kelly

No, I wouldn’t say that, Dan. I think the first arena is that if you look at the deterioration and its impact on gross margin, it’s single digits, not double-digits, so it’s been fairly modest in the overall scheme of things.

Secondly, I would say that we are finding issues much faster today than we ever have. Our tools are more granular. We are looking at transactions very quickly but sadly, I will report while we are finding things faster, there has been an increase in things to find. So I think we are getting better. We’ll continue to get better and we’ll mitigate the downward pressure of the economy.

Dan Wewer - Raymond James

Does it look like its internal or external?

R. James Kelly

I think you see it across the board. Obviously the things that are easiest to detect are the internal, so that’s certainly -- we have visibility to that issue.

Dan Wewer - Raymond James

And then just the last kind of housekeeping question; Jim, we have the average share count for the fourth quarter. Can you give us the ending share count?

Kenneth T. Smith

The ending share count is just slightly south of 140 million shares.

Dan Wewer - Raymond James

Fully diluted? Okay, great. Thank you.

Kiley F. Rawlins

It’s a little past eleven o’clock. We’ve gone for our full hour and unfortunately we have not gotten through all of the queue today. As usual, I will be available for questions this afternoon but we appreciate your joining us this morning for this discussion and your continued interest in Family Dollar. Thank you.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Family Dollar Stores F2Q08 (Qtr End 3/1/08) Earnings Call Transcript
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