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Executives

Pat Watson with Corporate Communications.

Jerry A. Shore - Executive Vice President and Chief Financial Officer

Michael J. Hayes - Chairman of the Board, Chief Executive Officer

Bruce Efird - President

Rick Chambers - Executive Vice President - Pharmacy Operations

Dennis K. Curtis - Executive Vice President, General Merchandise Manager

Analysts

Unidentified Analyst - William Blair & Company, L.L.C

William Keller - Ftn Midwest Securities Corp.

Jillian Caruthers - Johnson Rice & Company

John Lawrence - Morgan, Keegan & Company, Inc.

Patrick Mckeever - Mkm Partners Llc

Charles Grom - J.P. Morgan

David Magee - Suntrust Robinson Humphrey

Andrew Wolf - BB&T Capital Markets

Joan Storms - Wedbush Morgan Securities Inc.

Fred’s Inc. (FRED) F1Q08 Earnings Call May 29, 2008 10:00 AM ET

Operator

Good day everyone and welcome to the Fred’s First Quarter Conference Call. (Operator Instructions) At this time for opening remarks and introductions I would like to turn the call over to Mr. Pat Watson.

Pat Watson

Good morning everyone, this is Pat Watson with Corporate Communications. Thank you for joining Fred’s to review the company’s financial and operating results for the first quarter of fiscal year 2008, which ended on May 3, 2008.

Before we begin, I would like to remind everyone that management’s comments in this conference call that are not based on historical fact are forward-looking statements. These statements are made in reliance on the Safe Harbor Provision of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks.

It should be noted that the company’s future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued earlier today, in the company’s annual report on Form 10-K, and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information.

Lastly, I would like to point out that managements remarks during this conference call are based on information and understandings that are believed accurate as of today’s date. Because of the time sensitive nature of this information, it is Fred’s policy to limit the archive replay of this conference call webcast to a period of 30 days. This call is the property of Fred’s; any distribution, transmission, broadcast, or rebroadcast of this call for commercial purposes in any form without the express written consent of the company is prohibited.

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

Jerry Shore

Thank you for joining us this morning for our discussion of the first quarter of fiscal 2008 results. With me this morning and available for questions are Michael J. Hayes, Chief Executive Officer; Bruce Efird, President; Keith Curtis, Executive Vice President and General Merchandise Manager; and Rick Chambers, Executive Vice President of Pharmacy Operations.

As the company reported in its press release earlier this morning, for the first quarter of fiscal 2008 total sales rose 5% to $464.3 million compared with $442.3 million last year. On a comparable store basis, sales increased 2.1% for the quarter compared with 1.9% in the first quarter last year.

The sales mix for the period was: 24.4% household goods; 15.5% food and tobacco; 8.2% health and beauty aids; 9.2% paper and chemical; 8.7% apparel and linens; 31.8% pharmacy; and 2.2% franchise and this compares with the following mix for the same quarter of last year: 23.1% household goods; 14.2% food and tobacco; 8.2% health and beauty aids; 8.8% paper and chemical; 10.4% apparel and linens; 33.2% pharmacy; and 2.1% franchise.

For the quarter comparable store average customer tickets increased approximately 4/10 of 1% to $18.87 while the customer transactions increased 1.7% for the quarter.

Gross profit for the first quarter of 2008 was $132.5 million compared with $127 million in the same period last year.

Gross margin for the first quarter was 28.5% compared to 28.7% last year. During the quarter pressures from sales mix changes, inflationary pricing, and freight cost increases were partially offset by higher margins in the pharmacy department due to the continuing shift from branded to generic drugs.

SG&A expenses for the first quarter favorably decreased to 26% of sales compared to 26.2% last year. The 20 basis point improvement in expenses as a percent of sales results primarily from controlling labor and other expenses in the stores.

Depreciation and amortization expense in the first quarter was $7.1 million as compared to $7.2 million in the same period last year. For the first quarter of 2008 net interest expense was $173,000 or less than 1% of sales as compared to a net interest income of $96,000 in the first quarter of last year.

Income tax expense increased to 37.3% of pretax income for the first quarter of 2008 compared to 33.9% last year. The increase in the tax rate resulted from the expiration of Jobs Tax Credit in the hurricane-affected areas as well as in the state of Georgia, which were available to the company in the prior year.

For the first quarter operating income increased 5% to $11.7 million or 2.5% of sales, compared to $11.2 million or also 2.5% of sales last year in the first quarter.

Fred’s net income in the first quarter decreased 3% to $7.3 million or $0.18 per diluted share compared to $7.4 million or $0.19 per diluted share in the first quarter of 2007 and as discussed just earlier, the reduction is attributed to the higher income tax rate.

First quarter 2008 pretax earnings increased 3% over the same period last year.

Moving to the balance sheet, total inventories at the end of the first quarter 2008 decreased 4% to $334.1 million compared with $348.8 million at the end of the first quarter 2007.The decrease in inventory is primarily attributed to the reduction in inventory at stores that were closed, as well as the beginning of the going out of business sale taking place at the end of the first quarter. Additionally, inventories at existing stores have been well controlled to improve in stock levels coupled with a higher comparable store sale. We continue to believe that the quality of our inventory is strong.

Capital expenditures and pharmacy acquisitions for the first quarter of 2008 totaled $5.5 million compared with $6.3 million in the first quarter of 2007.

Capital expenditures were spent as follows: $3 million for new stores and pharmacy; $1.3 million for other existing store expenditures; and $1.2 million for technology, corporate and other miscellaneous expenditures.

Total debt at the end of the first quarter was $34.9 million compared to debt of $17.9 million at the same time last year. The increase in debt is primarily attributed to the cash increase of $9 million. The timing difference is the calendar shift at the end of the quarter and lower accounts payable at the end of the quarter. We anticipate decreasing sharply in the second quarter as cash flow improves due to the closing of the planned stores.

During the first quarter the company opened 8 stores and closed 17 stores. Also during the quarter, the company closed 21 pharmacies. At the end of the quarter there were at total of 683 company owned stores, 24 franchise stores, and 275 pharmacies.

The company’s total square footage at the end of the quarter was $10.1 million square feet. This amount is 1% higher than the same time last year, but 1% lower than at the beginning of the year. The decrease from the end of last year is due to the net drop of nine locations in the first quarter.

The company plans to open 18 stores and 15 pharmacies in fiscal 2008 and as announced earlier, the company will close 75 stores and 22 pharmacies during the year.

Selling square footage in 2008 will decrease in the range of 7% to 10%.

Now moving to earnings guidance:

In the second quarter the company expects total sales to increase in the range of 1% to 3%. Comparable store sales are expected to increase in the range of 2% to 4%. The total sales projections include the effect of closing 70 stores and 22 pharmacies by the end of the second quarter, in line with the company’s planned restructuring program.

Excluding the effect of these store closings, earnings per share on a diluted basis are forecasted to be in the range of $0.07 to $0.10 in the second quarter. The financial effect of the store closings in the second quarter is anticipated to negatively affect earnings by approximately $0.07 to $0.10 per share and so accordingly total earnings per diluted share are projected to be approximately flat in the second quarter, including the effects of the store closings.

Looking ahead, the company continues to expect total earnings per diluted share for 2008 to be in the range of $0.52 to $0.58 including the cost in 2008 related to the announced closings. Excluding the one time store closing charges, that are estimated at $11 million on a pretax basis, earnings per share for 2008 are forecasted to be in the range of $0.70 to $0.76.

Our earnings projections include the following significant events affecting the balance of the year beyond these discussed store closings: a minimum wage increase on labor expenses, which is anticipated to be approximately $5 million; a decrease in the Mississippi state Medicaid reimbursement rate, which was imposed on May 1 of this year, which is expected to be in the range of $2 to $2.5 million; the continued product mix shift and inflationary impact negatively affecting general merchandise gross margins; and the positive impact of initiatives to drive traffic into our stores.

This concludes our financial summary. We will now address any questions that you might have.

………..

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Unidentified Analyst with William Blair & Company, L.L.C

Unidentified Analyst - William Blair & Company, L.L.C

Jerry, you had talked a little bit about the inventory being down 4% year-over-year. It looked like the payables on your balance sheet year-over-year also fell by a much greater amount, almost 19% I believe I calculated. Can you comment on what is taking place there and maybe it has something to do with the store closings, but if there is other color you can add.

Jerry Shore

Yes, Eric, it has to do with the store closings, but as large a factor is our product mix shift that we’re seeing and the drive to keep our inventories in stock on those WG items, the most popular items. It’s really driven towards the basic and consumables which have brought those payables down. It is partially a timing effect, but there is the effect of those two items.

Unidentified Analyst - William Blair & Company, L.L.C

It just sounds like this is something that we should continue to see on the balance sheet for the next couple of quarters, is see the payables down like that year-over-year.

Jerry Shore

Yes, I do believe to a certain extent we will continue to see that.

Unidentified Analyst - William Blair & Company, L.L.C

You think in the same magnitude as well, double-digits, or should it moderate?

Jerry Shore

It should moderate.

Unidentified Analyst - William Blair & Company, L.L.C

Mike if you could talk a little bit about where you think you guys stand in terms of the adjustments you made in the store in terms of labor an controlling other expenses. What ending do you think you guys are in? How much more runway is there for you guys to go down and continue to cut costs in addition to, outside of the planned store closings, I guess the other remaining stores that will be in the base, how much more room is there for continued improvement?

Michael Hayes

I’m going to let Bruce answer a key part of that, but one of the things that is happening as we’ve been driving store traffic, and we are seeing real high-end store traffic in the consumable sides. I think that the ability to cut the store labor significantly more, once we get to second and third quarter we’ll re-mitigate it. It’s not going to be one of our big upside potentials.

Where I see the aversion of that potential comes as a result of the fact that our comps and the continuation of our traffic patterns going up, we still should see the leverage though.

Bruce Efird

We have been, in the first quarter, doing a better job of managing our labor at a lower rate and we see that continuing; however to Mike only this reinforces the minimum wage impact with this and starting in mid-third quarter through the fourth quarter. We’re also doing a better job with Chambers and his team in the pharmacy expenses, as well for better managing the labor and some of the more controllable expenses such as supplies; everything continues to do well.

Unidentified Analyst - William Blair & Company, L.L.C

Ricky, maybe you can just talk quickly about where you see the largest opportunity, as well as the biggest risk, as you look at you pharmacy business today. What keeps you up at night and what gets you excited about terms of future growth here?

Rick Chambers

As far as opportunities, I mean we continue to see our unit, our strip comp going strongly versus planned. We see that as an upside. Obviously, I guess the opposite of that in terms of the risks that we see, we continue to see pressure being put on our comps, on a comp store basis, because of the full hour programs are branded to generic shifts that we continue to see, but we don’t anticipate slowing down significantly the balance of the year. Probably those two are hand in glove in terms of both risk and opportunities that we see.

Unidentified Analyst - William Blair & Company, L.L.C

I recall that you guys had tested some $4.00 type of product in a few select stores around Memphis. Has there been any reconsideration of that program? As I recall, you put it in and then you took it out. Has there been any change in that?

Rick Chambers

No. Well we put it in and then we backed off of it and putting out probably a different way to put it, I guess, we had changed the program more to a full-blown prescription plus discount card, is the name of our program, and it offers discounts not only on $4.00 generics, but on the entire offering that we have for the customer. We have expanded that on a limited basis where needs have arisen in certain markets, to respond to competitive pressures, but as far as a chain-wide roll-out we are still not at that point right now.

Unidentified Analyst - William Blair & Company, L.L.C

Mike, maybe you can talk a little bit about, you know here we are in May; I guess it’s never to early to start thinking about the holiday season coming up. Maybe you can talk a little bit about how you’ve thought about buying ahead for the upcoming holiday season given the macro conditions in the economy and $4.00 gas etc… etc…

Michael Hayes

I’ll flip that one over here to Keith Curtis who is a gem in all divisions.

Keith Curtis

For the holiday season, obviously we’re being very careful and trying to anticipate everything that is going to come our way for those shipments that we’ll be leading the second half of the year. One of our main initiatives was to make sure that we were in constant contact with our key vendors to insure that we get shipments on time.

There are a lot of pressures in a lot of different areas for us, raw material costs, and things like that and our costs are fluctuating from, even week-to-week, a lot of things have been said about cost of goods in 30 days, but at times we get week-to-week cost pressures. The big thing is making sure that you’re with the right people to get your shipments in on time and we feel comfortable that we’ve attacked that issue.

Operator

Your next question comes from William Keller with Ftn Midwest.

William Keller - Ftn Midwest Securities Corp.

First off, it was several months ago that you first mentioned the possibility of some strategic alternatives. Can you give us any update or color on where that stands at this point?

Michael Hayes

I think Moe is coming in for our presentation of the board, probably around the shareholder period of time, to give us, a lot of the processes that have been implemented now are in place and so, I think the stakeholder meeting to the early shareholder meeting, where we’ll give any updates.

William Keller - Ftn Midwest Securities Corp.

To clarify on the comps number for the quarter, because I think you presented it a couple different ways during the month, but does that include stores that are slated for closure, but have not yet started the process?

Jerry Shore

We keep the stores in as comp only until they go into the going out of business mode. Once they go into the going out of business sales we take them out of our comparable store sales calculation.

William Keller - Ftn Midwest Securities Corp.

Can you say how many then have started the process, of the ones that are not yet closed, I think it’s 50?

Jerry Shore

There are 50 stores that are currently in the going out of business sale mode and then there are 17 that have been closed already, prior to today. Those have been taken out of our comp store calculations.

William Keller - Ftn Midwest Securities Corp.

The closed stores and then the 50 that are in process?

Jerry Shore

That’s correct.

William Keller - Ftn Midwest Securities Corp.

Then the cadence of closings in the quarter was that pretty much a fairly standard pace?

Jerry Shore

No, we started the 50 all at one time using an outside liquidator. They’ll be completed by the end of this week; we’re way ahead of schedule.

Bruce Efird

Yes, we’ve accelerated the process. The plan was to close the stores through out Q2 and Q3 and we evaluated the benefit of accelerating the closure from an expense standpoint and from an asset protection standpoint, so we chose to accelerate that whole process.

William Keller - Ftn Midwest Securities Corp.

But they should all be done by the end of the second quarter it sounds like?

Jerry Shore

Yes.

Bruce Efird

The majority, there will still be a few that will be lingering on that are continuously being evaluated. By next week we’ll have 67 of the 75 planned closures that will be closed.

William Keller - Ftn Midwest Securities Corp.

The cash balances have increased year-over-year and I think is up slightly from the fourth quarter. Any other plans for that, other than the debt pay down it sounds like is in process?

Jerry Shore

At the end of the quarter, there is a timing difference. Our quarter ended last year on May 5, this year it ended on May 3 and as you understand our sales and cash cycle, there is a lot of cash that is applied that comes in and is applied to our loan on that fourth and fifth and that really, those days caused really that shift in that cash that you saw on the balance sheet, but as you saw there still was the $35 million revolver debt that was still there.

Now in the second quarter, we do have positive cash flow. Currently our debt is down to nothing, but we will get back into a borrowing mode as we get into the seasonal inventory purchases, as well as some of the lease buy outs that we’ve set that will take place in the second quarter.

William Keller - Ftn Midwest Securities Corp.

The tax rate that jumped up in the first quarter, is that expected for the rest of the year?

Jerry Shore

It is expected for the rest of the year unless some of the tax rates are reinstated by federal and state governments.

Operator

Your next question comes from Jillian Caruthers of Johnson Rice.

Jillian Caruthers - Johnson Rice & Company

I was just wondering if you could talk about some of the changes you’re doing on your marketing program. I know you were kind of tweaking around the timing of your circulars, kind of moving them more around events versus just first of the month. If you could just kind of give us an update on that.

Bruce Efird

During the first quarter we did add one incremental distributive add, mainly due to the shift in Easter and also we added two incremental mid-month in store promotions. We have seen success in those in helping us drive traffic and also increase our [basket] size, while at the same time coming in under plan on our advertising budget, because as we shifted dollars from electronics predominantly TV and some radio into print.

That’s one of our key initiatives, which is to improve the overall effectiveness of marketing and advertising. In addition to that, one of the things is that we’re shifting our message to put much more emphasis on price and rolling out a new campaign starting in mid-July of this year.

Jillian Caruthers - Johnson Rice & Company

So this change you’re expecting to continue through the duration of the year and into holiday and what not?

Bruce Efird

We will add some incremental activity through out the balance of the year.

Jillian Caruthers - Johnson Rice & Company

I know that you did say that it did increase traffic around these events. How are your traffic trends going on a monthly basis? Is it still very much concentrated around the first of the month and kind of fading off through out the month or is that…?

Bruce Efird

It’s just the opposite.

Jerry Shore

We have seen more of an evening out. There is still an end of the month somewhat, but nowhere near the patterns…

Bruce Efird

These last four days have been the strongest that we’ve seen.

Jillian Caruthers - Johnson Rice & Company

Could you maybe comment, I know your sales minimum has definitely been building. What are the biggest drivers you see there and kind of opportunities?

Bruce Efird

On the sales side I’ll start with the internal initiatives. One is our in stock really focusing in on our service level and in stock position, which we’re running 800 basis points above last year on our service level and even higher than that on the top 750 items that comprise a higher percentage of sales.

We’re seeing some improvement as related to our focus store, our top performing store program, or we call it our battleship program, we’re seeing better comps there and an accelerated focus on specific categories in consumables such as the pet department, food and beverage, and paper and chemical departments continue to grow.

Some of the external factors obviously would be we believe that we’re getting a modest benefit from the economic stimulus checks that are going out. We haven’t been able to fully quantify what we’re getting from that and I also continue to get a lot of feedback, especially when I’m in the stores. Customers are consistently commenting on the higher gas prices and where our format is positioned to take advantage of sugar trips for customers.

Jerry Shore

One thing I’d add to Bruce’s comment is the stimulus package we don’t think is driving traffic. The stimulus package is helping in the basket size.

Bruce Efird

As far as the stimulus package is concerned, we do believe that we’re seeing an impact in more of the discretionary spending areas. We’ve seen improvements through out the quarter and specifically come in categories such as bedding, window, bath, and small appliances have improved overall in performance, which again is an indicator that there may be some benefit of the economic stimulus.

Jillian Caruthers - Johnson Rice & Company

Are you doing any kind of promotions around kind of to grab more of the stimulus check sales?

Jerry Shore

Yes, actually we have a economic stimulus promotion that’s in place as we speak and it has three major components: one is leveraging our competitive advantage of the fact that we do have layaway programs in most of our stores, so we’re giving customers 10% off any layaway item; we’re also, when a customer purchases $200.00 worth of Fred’s gift cards then they get a free $30.00 gift card; and then we have an early back to school component in which teachers can get a $5.00 Fred’s gift card when they purchase $50.00 or more of school supplies; and the last part of that is really helping our customers and educating our customers and providing forms for them to ensure that they re getting the rebates that they are qualified for.

So there is a customer service element that really differentiates our program from a lot of programs that are out on the street.

Operator

Your next question comes from John Lawrence with Morgan, Keegan.

John Lawrence - Morgan, Keegan & Company, Inc

Bruce would you comment a little bit on, you touched on it a little bit there on that question regarding the battleship stores. Can you take it one step further and indicate, have you seen, obviously with the increased leveraging of that increased sales and better in stock, sort of another level of productivity curve of what did that operating margin on that group of stores do? Can you go that far?

Bruce Efird

Again, we’ve seen increase in sales; however, we did not leverage our expenses to the extent that we would like to. Our goal is not only to drive sales, but also really focus on contribution, even though we had the higher sales, we did not leverage the expenses. So, we got the team refocused on our battleship store initiatives.

Jerry Shore

Part of that program, Rick can comment on the pharmacy flag ship program, which is similar to the store battleship and he has the top 40 pharmacy stores that he’s focused on. He did in fact leverage the expenses and exceeded our contributions expectations.

Rick Chambers

Now that’s our top 40 pharmacy performances within the company as Bruce said and we did, as I mentioned earlier, the comp sales has been a struggle just because of the brand to generic penetration even in those stores, but we did see the gross margin come in favorable in those stores and exceed the first quarter plan that we had out there; so, we were excited about that most definitely.

John Lawrence - Morgan, Keegan & Company, Inc

Just to follow with that, how would the cadence go forward? I realize some of the big things such as in stocks, but Bruce, how do you move some of these programs and initiatives to the rest of the chain over the course of the year?

Bruce Efird

It will be a combination of rolling some of the initiatives that we see working well, rolling them out chain wide, and then others will be rolled out selectively to the next group of or volume group of stores, for example. There are initiatives that we put in place in the battleship stores such as green label in store on our top selling items and the stores can identify them. We rolled that immediately out into all stores.

Others, such as, Keith can comment on some of the special buys that we’ve seen success in the battleship stores that we’re rolled out to the next group of 100 stores.

So, it’s a combination of rolling them out chain wide and it all depends on the initiative.

Keith Curtis

To further comment on the treasure hunt or the surprise in the light initiatives that we have, we’ve reestablished ourselves with the vendor community out there and we’ve had some good short-term successes in the first quarter in our battleship stores. We’ve taken some specific special buys now into 100s stores and 150 stores and increased the level of that and look forward to doing that more in the second quarter and in the second half.

John Lawrence - Morgan, Keegan & Company, Inc

Plenty of opportunities out there to find that merchandise.

Keith Curtis

Well we’re doing it in a very controlled atmosphere and that’s been very good for us.

Operator

Your next question comes from Patrick Mckeever from Mkm Partners.

Patrick Mckeever - Mkm Partners Llc

Could you talk about the months in the second quarter? I know the month of May doesn’t have a first of the month in it, so should we expect that one to be maybe at the low end of your guidance range for the quarter, or is that not the right way of looking at it?

Bruce Efird

That would be the right way to look at it in the sense that it does not have a first in the month. Our expectations though are, would not to be at the low end of the range.

Patrick Mckeever - Mkm Partners Llc

For the month of May?

Bruce Efird

Yes.

Patrick Mckeever - Mkm Partners Llc

Then I know the focus is more on closing stores right now, but you’ve also been opening new stores as well. Can you talk about the performance of some of the new stores that you’re opening? What are you doing from a prototype standpoint with the newer stores? Are there any categories that have been changed significantly from the stores that you opened last year? And, where are you opening your new stores that are going into smaller markets or mid-sized markets, what parts of your footprint?

Bruce Efird

On the 18 stores that we’re opening this year, you’ll recall the discussions that we had earlier, these 18 stores were stores that were actually in progress where leases had been signed and the development had begun when we developed our restructuring plans that we went through with those stores.

The performance of the store we’re watching and I would say that there’s not a lot of difference from what we have been seeing. There are winners in those as we go. We’re watching it closer. They are doing somewhat better. They are not doing significantly better than the new store performance we had seen in the past and that was really in line with what we had planned.

We now are, they still are locations not a lot different, they’ve not changed the prototype, so we are watching that and now we’re going forward utilizing our predictive modeling program, and that’s really the update on new stores.

Patrick Mckeever - Mkm Partners Llc

Last question on the minimum wage: Jerry you quantified the impact to expenses. I think previously you had said that, in your prior same store sales guidance for the back half of the year you had said that you thought you would see some benefit from the minimum wage. Is that still the case?

Jerry Shore

Are you talking about sales versus expenses, the benefits?

Patrick Mckeever - Mkm Partners Llc

Right. Just thinking with gas at $4.00 a gallon and some of the other things that have, kind of the macro items that have changed since you last guided for sales for the year.

Jerry Shore

Remember that these sales are a double-edged sword when you look at the minimum wage. We feel real strong that the minimum wage will end up being a stimulus. It takes about 45 days historically, for that to kick in and we didn’t put any bonus in there for that, but we have the expectation.

Now going back to gas, even though gas is a real hard driver to hurting dispensable income to the consumer, the fact that every time you drive a mile today it costs you $0.25, the fact is that that’s one of the drivers that we believe is going to continue to encourage the customer into our stores.

We’re looking at, when they’re spending $8.00 to $15.00 shortening that trip in the convenience aspect of the Fred’s is one of the real strong features we expect to see really going on and continuing on for the next two or three years. Unless you believe gas is going backwards, this is going to continue to be a positive in the sense of, on the short trip, where the consumer goes.

Patrick Mckeever - Mkm Partners Llc

So you think it’s gotten to a point where, I mean you go back a year and gas prices were a lot higher than they were the prior year and the number of the discount store companies retailers were talking about their customer really being pinched and just pulling back and not seeing a lot of trade downs.

It sounds, Mike, like you really feel as if consumers are starting to trade down in a more pronounced way?

Michael Hayes

Absolutely, I mean you see it all through the sectors in our group, whether it be a TJ Max or a Fred’s, you are seeing the trade down function that is occurring and on top of that it’s much more and I really said it about the third level that Bruce has put together for our price initiative and our price program, because the combination of the proximity of the store and the price program, I really believe you’ll see a continuation of the traffic counts we’ve done. I mean I’ll give you just one number out of a gazillion, all right, but yesterdays traffic counts were up in the 2.8, 2.9 category. Those are strong numbers for us.

Patrick Mckeever - Mkm Partners Llc

Okay, it’s good to hear.

Operator

Your next question comes from Charles Grom with J.P. Morgan.

Charles Grom - J.P. Morgan

I was just wondering if you could comment on the competitive environment, largely a Dollar General, what you’re seeing from them from a promotional level as well as Wal Mart. I know Jerry, a couple of months back you were saying you were losing some Saturday traffic to Wal Mart. Is that still the case or do you think you’re getting it back?

Bruce Efird

Yes, we’re seeing, I guess relative stability in the promotional cadence that we’re seeing in the marketplace. We have seen, however, recently in the first quarter, an improvement in our Saturday sales, in our overall weekend Saturday and Sunday sales; so, we are seeing improvement there.

Charles Grom - J.P. Morgan

Then it seems to me that you’re probably the first retail that I’ve heard actually say that the rebates are beginning to help out tickets, so I’m curious if you could elaborate if the ticket has improved sequentially as we’ve come in from April 20 to today as the number of people receiving the bonus rebates. I think it’s close to 50 billion having been distributed at this point. If you could just give us a little bit more color on that because it is very intriguing.

Bruce Efird

Again, as I started out it’s very, very hard to quantify, but again, evidenced by not only the comp increase in store traffic, but also by the basket size, that’s one piece of evidence that we believe we’re getting some additional stimulus, but also in the mix that we’re seeing.

Again, our consumables continue to be very strong, but we are seeing more strength in home categories that is more discretionary in nature.

Charles Grom - J.P. Morgan

Have you done any survey work that suggests that consumers are citing the rebate checks and feeling more comfortable as a result, or is it just you’re just seeing the change in ticket?

Bruce Efird

The change in mix and the change in ticket.

Charles Grom - J.P. Morgan

Then just moving down the P&L, just on your comments on pricing pressure: I was just wondering if you could elaborate a little bit more both on terms of what you’re seeing from domestic vendors on the consumable side as well as what you’re seeing coming in from China on the import side and I guess not only what happened in 1Q, but expectations for particularly the back half of the year.

Keith Curtis

As I mentioned before, the costs of basic raw materials and commodities, there’s a pressing need for us to be much more diligent in our competitive side awareness and we’re staying on top of the two distinct areas.

I believe that, in answer to the import question, the one thing that we have learned is that we need to be on time with our orders and place our orders very strategically and our buyers are in tune with that. The second half shipment again, will depend on that we’re with the right vendors and that we do have our orders in place at the right time and we’ve been very attentive to that through the first quarter.

Operator

Your next question comes from David Magee from Suntrust Robinson Humphrey.

David Magee - Suntrust Robinson Humphrey

I have a question regarding the more of a bigger picture, longer-term question. When you look at your operating margins this year, I’ve got a number around 2.5% built in our forecast and I’m looking at that number versus your peak of the years have been closer to 4%. Your gross margins are about the same, so it looks like it’s more of an expense ratio opportunity there. Do you see anything that’s structural that prevents you from getting back to that 4% level or even higher over time?

Keith Curtis

I believe that one of the key elements was getting our more productive stores lined up correctly, which is part of the battleship program. The second one was eliminating some wood that was hurting our expense structure dramatically with the 75 closed stores. The third is, of course we’re looking at our cost increases and our product increases and a lot of the initiatives that have been put forward, so absolutely not.

Our forecast as we go out, we feel strongly that we should be driving ourselves back into the core to the five range and doing it over the next several years.

Michael Hayes

Right and David I would remind you that as part of our restructuring we have said and the first quarter bears it out, the first and second quarter until the stores get closed your operating expenses will leverage 20 basis points, but you’re really going to see it more in the back half and that continuing on on an annualized basis in the upcoming years; but, also the corporate reductions that we made earlier in the year, as well as the initiatives just driving our sales, but maintaining our leverage in corporate and other areas.

Keith Curtis

One side note that everybody should pay attention to is that as we go through is transition and we pick up market share, we will see margin pressure, substantial margin pressure as the consumables are the key element if the drivers that are out there in the market place and as you watch the evolution of the consumer getting re-stabilized after minimum wage and other events occur, we would expect to see and look forward to in the first quarters of next year to see discretionary sales start to reaccelerate from the lows that they’re at now.

Operator

Your next question comes from Andrew Wolf from BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

I have a few essentially follow-ups: first, I’m thinking of your same store sales on a pro forma basis to 2.5%, do you have the ticket and the transaction numbers on that same basis? I think you only gave those two numbers on the reported comp, 2, 1.

Jerry Shore

I don’t have that with me and have not done that calculation. I definitely can’t do that for you.

Andrew Wolf - BB&T Capital Markets

It would be interesting to know. I guess, you know how Mike said a few minutes ago about how your transactions have been recently. It would just be interesting to get that pro forma number.

The other thing is, I heard and I just want to check I heard this right and I want to ask if it is, abut the rebate checks. Are you giving a 15% add on to rebates; so was it $30.00 free if somebody brought $200.00 worth of rebate checks to Fred’s and transferred that to a gift card?

Keith Curtis

That’s a controlled promotion.

Andrew Wolf - BB&T Capital Markets

Is that the maximum or could somebody bring more of their rebate money to Fred’s and get more than $30.00 on $200?

Michael Hayes

It is a $200 minimum, but it does go up from there.

Andrew Wolf - BB&T Capital Markets

Oh it’s a $200 minimum, I’m sorry.

Michael Hayes

You have to buy a $200.00 gift card; you don’t get it if you buy a $10.00 gift card.

Andrew Wolf - BB&T Capital Markets

So if they bring the $300 or the $600, they’re going to get 15% extra dollars on a Fred’s gift card?

Michael Hayes

Yes.

Andrew Wolf - BB&T Capital Markets

Just a little bit about that. I’m familiar with some 10% matches, or bonuses I guess you would call them, but is that something that, is there anybody else in your marketplaces doing 15% or is that just where Fred’s wanted to be?

Bruce Efird

Well there’s a number of, as you stated, a number of 10% options out there, but we elected to go with a lower threshold of $200.00 and a higher pay out. One of the things that you typically see is that your margin is higher on gift card spend, because most customers spend gift cards more fortuitously then paying with their own cash. That’s why we’ve seen minimum redemption or customers taking advantage of our program. We’re ensuring that we control that program.

Andrew Wolf - BB&T Capital Markets

Is Wal Mart still at, they don’t have on right; they’re just doing a free cashing of the check?

Bruce Efird

Yes, to our knowledge.

Andrew Wolf - BB&T Capital Markets

I don’t know if you have this either, but I’d be interested: on the 75 stores that are slated to be closed fairly shortly in the program, do you have the average, you might have given this out and if you did I’m sorry to make you repeat yourselves, but do you have the average age of those stores versus chain average?

Bruce Efird

No. We discussed that there was a trend towards newer in outlying areas, but not a specific age. It was somewhere in the 4.5 range.

Andrew Wolf - BB&T Capital Markets

So those tended to be either outliers and/or newer stores?

Bruce Efird

Yes, they tended to be stores which had higher cost structures and higher distribution costs.

Operator

Your last question comes from Joan Storms with Wedbush Morgan.

Joan Storms - Wedbush Morgan Securities Inc.

I was wondering if we could get an update on the kids apparel program and the expansion of the private label and are you still on track for that for the third quarter and how that’s ramping up?

Jerry Shore

Yes, we are going to re-introduce a limited program in the children’s apparel. We’re going to have about 100 stores. We’re going to be very selective. The stores that we’re using were chosen by a merchandising operation and marketing team and just taking into consideration our sales history and store size and you add the distribution feasibility to go with that.

We’re being a very limited program much like we were speaking a while ago on our treasure hunt item. We want to get back in there and we want the focus to be what does the children’s apparel business mean to us and that the halo affect that it has on the rest of the apparel business.

We won’t be entering the children’s apparel business again just to be entering children’s business. We want to understand what it means to our Fred’s business and we’re very far along with that and we expect September to be in there and it is test again. It’s just a test and a limited program that we’re doing for the fall of this year. We look forward to, we have good measurement criteria developed, and we want to see what it means to the other categories in the other soft line categories that we had discussed earlier in a previous conference call.

Joan Storms - Wedbush Morgan Securities Inc

Then, on the private label?

Bruce Efird

We are on plan with our initiatives to grow private label penetration increased ½% overall, penetration of our consumables was ½ point better and we’re on track with our label design and we did have our first total private label in store ad that we ran that performed very well. We’re on track overall with our private label growth program.

Joan Storms - Wedbush Morgan Securities Inc

Jerry, can you comment maybe a little bit more on the diesel prices? I may have missed that, but there was a bowl of retailers that were in your category and they were talking about significant increases and how that impacts you and, on a go forward basis, you know what you can try and do to offset that?

Bruce Efird

This is Bruce. We are painfully experiencing the higher cost of diesel fuel. We, I think year-over-year it’s up above 60; you know paying in the 460 ranges as most everyone out on the street, but we are doing some things to mitigate that. We’ve reduced our idle time or a truck shut off when the truck is not on the road, reduced the idle time and also we’ve reduced the element speed on the highway, so that’s helped offset some, but not 100% of that increase.

We are offsetting some of the energy costs by more efficient control or management of our labor in the end stores.

Bruce Efird

Thank you and thank everyone for joining us today. Have a good day.

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Source: Fred’s Inc. F1Q08 (Qtr End 5/3/08) Earnings Call Transcript
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