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Family Dollar Stores (NYSE:FDO)

Q2 2006 Earnings Conference Call

March 23rd 2006, 10:00 AM

Executives:

Kiley Rawlins, Divisional Vice President, Investor Relations and Communications

Howard Levine, Chairman and CEO

James Kelly, Vice Chairman and Chief Financial and Administrative Officer

Janet Kelley, Senior Vice President and General Counsel

Analysts:

Charmaine Tang, Citigroup

Dan Weaver, Raymond James

Mitchell Kaiser, Piper Jaffray

Christine Augustine, Bear Stearns

Meredith Adler, Lehman Brothers

Stacy Turnof, Merrill Lynch

Jack Balif, Midwood Research

David Cumberland, Robert Baird

Michael Baker, Deutsche Bank

Jeff Stinson, FTN Midwest Research

John Zolidis, Buckingham Research Group

Michael Exstein, Credit Suisse First Boston

Mark Miller, William Blair

Operator

Good morning ladies and gentlemen and welcome to the Family Dollar Second Quarter Earnings Conference Call. This call is being recorded by MCI and CCBN. If you have any objections, you may disconnect at this time. At this time, all participants are in a listen-only mode. After the prepared statement by the company, we will open the call for questions from the participants. And now I would like to turn the meeting over to Ms. Kiley Rawlins, Divisional Vice President, Investor Relations and Communications. Ms. Rawlins, you may begin.

Kiley Rawlins, Divisional Vice President, Investor Relations and Communications

Thank you Jesse. Good morning everyone and thank you for joining us today for our second quarter earnings conference call. With me this morning are Howard Levine, Chairman and CEO; and Jim Kelly, Vice Chairman and Chief Financial and Administrative Officer; and Janet Kelley, Senior Vice President and General Counsel.

Before we begin, you should know that our comments today will include forward-looking statements, which are made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act. These statements address company’s 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 statements contained in today’s press release and in our other SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this call. The company does not undertake to publicly update or revive its forward-looking statements.

In addition, this morning we will discuss non-GAAP financial measures, which are intended to help investors understand Family Dollar’s ongoing business performance. These measures include operating expenses, net income, and earning per diluted share each excluding litigation charges. A reconciliation of these non-GAAP financial measures to the comparable GAAP financial measures is included in our earnings release issued this morning and available on our website in the News Releases section of our investor page. We’ll begin this discussion with some comments on the quarter’s financial results from Jim, and then Howard will share some of his thoughts with you. Jim?

James Kelly, Vice Chairman, Chief Financial and Administrative Officer

Good morning, and welcome. As you know second quarter results included a charge of $45 million relating to an adverse jury rule. We have described this litigation in our financial reports for a numbers of years. The question addressed in this litigation is whether our store managers should be salaried or be paid hourly. The same question is being played out in various litigations across retail. Indeed other Federal Courts have ruled on two occasions that our individual store managers fully qualify as salaried employees. The Department of Labor has also consistently found our store managers to be properly classified. It is our goal at Family Dollar to always comply with the law and we believe that we have in this case. We now anticipate fully pursuing our legal remedies through the Appeals process.

In the meantime, we do not have any current plans to change the methods of compensating our store managers. We will continue to support our store managers in their efforts to make Family Dollar a more compelling place for our customers to shop, and our associates to work. Excluding this litigation charge, second quarter performance exceeded our expectations. Earnings per share, again excluding this charge were $0.53 per share versus $0.48 per share for the second quarter last year. I will now focus my comments on the details of this performance.

In retail, solid comparable stores sales performance is critical to sustainable growth. That is why last year we launched three major initiatives designed to drive comparable store sales growth even during challenging economic times. For the second quarter, our comparable stores increased sales by 3.2%. This solid sales performance was driven primarily by the cooler, urban, and treasure hunt initiatives.

Sales of softlines were down 3.6% on per store basis consistent with our plan to rationalize the hanging apparel area. Our gross margin as a percent of sales was relatively flat this quarter with no significant quarter-over-quarter changes relative to product mix, shrink, freight or markdowns. While overall gross margin performance is better than expected, we were disappointed that shrink results did not show further improvement this quarter. On the positive side, holiday sales of higher margin items along with favorable sales print in the home area mitigated the expected negative mix impact on gross margin.

Selling, general and administrative expenses as a percent of sales de-leveraged by approximately 30 basis points, roughly half of this related to current year expensing of equity-based compensation. Expenses during the second quarter were also negatively impacted by occupancy cost, more specifically utility cost and depreciation.

Now let’s turn briefly to the balance sheet. The end of the second quarter represents one of our most liquid periods as a result of the peak holiday sales and corresponding decline in inventory. Cash and investments at quarter end were approximately $330 million. On March the 6th we completed the previously announced 10 million share buyback at an average share price of $23.42. We continue to believe that our shares are at compelling value. We intend to enter into a 10B5 one plan with a financial institution within the purchase on our behalf in that very discretion up to $50 million of our stock prior to July 10th 2006. This represents a continuation of our stock buyback program under previous court approvals.

Inventory levels on a per store basis at quarter end were relatively flat indicating through the modest productivity improvement. Importantly Softline inventories were down over 7% on per store basis as we continue to focus on improving Softline inventory productivity and managing markdown exposure.

Now lets turn to the outlook for the remainder of fiscal 2006. Our original guidance for 2006 was for earnings per share to be in the range of $1.30 to $1.39. This did not take into account the $0.18 per share litigation charge incurred this quarter. Considering performance during the first half of the year and plans for the next two quarters and excluding the litigation charge, we now believe that earnings per share would be in the $1.37 to $1.42 range. Including the litigation charge, we expect to report earnings per share for fiscal 2006 in the range of $1.19 to $1.24.

While we do expect continued sales growth from our treasure hunt initiative, we expect sales on the back half of the year to show continued improvement driven primarily by core consumables, both the ongoing cooler rollout in the comparison against last year’s disrupted schematic changes are respected to contribute to the acceleration of core consumables.

As most of the sales growth is expected in lower margin areas, we expect to see some decline in the gross margin percent for the remainder of the year. On the other hand, we are also seeing continued expense improvement and with higher comp levels, we expect to see expense leverage by the fourth quarter. As relates to the third quarter, we believe that earnings per share will be in the $0.33 to $0.36 range with comp sales in the 4% to 6% range. Its range also reflects an expectation that gross margin will decline as a percent of sales and expenses will deleverage modestly. And now Howard has a few remarks. Howard.

Howard Levine, Chairman, Chief Executive Officer

Good morning and thank you for joining us. Second quarter results were better than we’ve originally expected, and reflect the hard work and efforts of all of our associates, excluding the litigation charge non-GAAP diluted earning per share increased 10% to $0.53. While we expected to generate earnings growth in fiscal 2006, we had budgeted a more methodical progression of earnings improvement throughout the year as we anniversary some of our key investments we made last year. The last several years have been increasing difficult for our customers: inflation, energy costs, and lack of real wage growth that’s had a significant impact on their discretionary spending. We anticipated these challenges, and that is why we decided 18 months ago to invest in four key initiatives to drive sales and traffic. While I am still concerned about the macro-economic environment, I believe that we are better positioned today to capitalize on our opportunity than we have been in some time. We are more optimistic about the sales opportunity in the second half, but remain cautious about the margin impact of stronger consumable sales. Our associates did an excellent job controlling expenses in the second quarter, and we must continue that momentum to meet our earnings expectations.

Our key initiatives have positioned us to better provide customers with more value and convenience, and to capitalize on the growth opportunity that exist for our niche. Let me give you a brief business update. Meeting the basic needs of our customers becomes more important in challenging economic period. That is why we are very interested in understanding the need to drive frequent shopping trips. Our cool rollout is part of the broader food strategy designed to better satisfy these needs. Last year we began the cooler rollout in January, and we had coolers in about 250 stores at the end of the second quarter.

At the end of the second quarter this year, we had coolers in approximately 2000 stores, and we are on plan to have coolers in 3500 stores by the end of August. Our customers clearly appreciate the cooler program as these stores continue to generate mid single-digit comp store sales. As I mentioned, the cooler rollout is the first phase of our broader food strategy. We are testing an enhanced food assortment and EBT in a limited number of stores to better understand their impact on our sales in customer traffic trends. What we learned from these test will support the next phases of our food strategy and will enable us to drive comp store sales in the future. Last year we made significant strategic investments in our urban initiative because we’ve recognized the tremendous opportunity from long-term growth and improved returns that exist in urban market. Few retailers have undertaken this challenge, but we view the opportunity as a chance to establish a competitive advantage in specific markets.

While challenges remain, we are uniquely positioned to capitalize on the urban opportunity. Last year we undertook aggressive cultural change in about 1200 stores as we created a more flexible and fluid organization to respond to the rapidly changing dynamics of an urban market. This year we are focused on three primary goals: improving financial returns, reducing shrink, and improving store manager retention.

The financial returns of the urban initiative continued to improve. Last quarter we indicated that 80% of our stores in the program generated better profits than the first quarter of fiscal 2005, and that about 60% of the stores generated better profit margins. In the second quarter, comp stores in the urban initiative continue to produce mid single-digit sales increases, and the profitability trends have continued. While we still have the limited number of more challenging markets, we have clearly defined plans to address and improve the performance of these stores, and we remain confident that we will improve their profitability.

Both shrink and managed retention are indicators of our longer-term success, and we are experiencing encouraging trends in both. While shrink results for the company overall did not show improvement in the second quarter, the stores that implemented the urban initiative first last year have reported significantly lower shrink results. These stores are also increasing store manager retention, and we are encouraged that we will see similar improvement in shrink and retention, and other urban initiative stores as the program matures.

The urban initiative is not a short-term project, rather it is a multi-year strategic initiative that involves developing a more fluid and flexible organization enhancing our pricing strategy, improving the merchandized flow processes to better accommodate high volume small box stores and creating customized assortments for urban markets. As we implement these changes over the next three to five years, we intend to drive even better returns.

Last year we launched our treasure hunt merchandizing initiative. Treasure hunt items are higher margin goods that create customer excitement, differentiate us from our competition and require better merchandizing and marketing. Last year, we continued to challenge ourselves on how we can better link marketing, merchandizing and in-store presentation to support our treasure hunt initiative. Robert George, our Chief Merchandizing Officer, and Barry Sullivan, our Head of Store Operations are working together to coordinate these efforts. In this quarter, our comp store sales and margins benefited from better execution of our strategy. Both our home and seasonal departments performed well supported by our in-store presentation efforts and our advertising and marketing programs.

We utilized a limited number of circulars to highlight treasure hunt merchandize, and to reinforce our strong assortment of consumables. In the second quarter this year, we distributed two circulars, one in December and one in February. This compares with one circular distributed in the second quarter last year in December. Last year we also distributed circular in early April to coincide with Easter. This year with the change in the timing of Easter, we had an opportunity to reposition the circular to drive higher returns. After analyzing last year’s results, we decided to distribute a circular in February to a limited number of stores that could have the most impact. We are pleased with the results and will continue to adapt and refine our advertising programs to drive increased sales of treasure hunt merchandize and consumables.

As we have discussed on previous conference call, this year we are slowing our new store growth so that we can focus on process improvement to create a smoother flow of more productive stores in the future. We had created more efficient processes and tools to support better capital decision, and we are taking a more proactive approach to market optimization and aligning our real estate organization to fully capitalize on long-term opportunities for our model.

While we are slightly behind our expectations year-to-date, our plan is to open 400 new stores this year. Our new store productivity is improving but it is still slightly below last year’s level. This year is a developed year for our new store processes but we are building the foundation to reaccelerate our new store growth in the future.

As a growth company, we are continuously pursuing management talent. We continued to blend outside expertise with seasons Family Dollar bettering to build a management team that will capitalize on the opportunity that exists for our company. We recently named Mike Kvitko as Senior Vice President of Softline. As we continue to focus on maximizing our returns to shareholders, we must improve the productivity of our inventory investment. Better management of our apparel assortment is essential to attaining this goal. For the last several quarters, we have reduced our apparel inventory and managed our markdown risk better, and we are pleased with our progress. We have an opportunity to better meet our customers’ apparel need, utilizing Mike’s extensive experience in apparel, we intent to sharpen our assortment while driving even better returns from our inventory.

We have a great business model with significant growth opportunity, and I believe this will only limit on our potential as our ability to attract and retain talented associates. That is why we strive to be a compelling place to work, and we recently named Kathi Child as Senior Vice President of Human Resources to help us achieve this goal. Kathi comes from a major retailer, and had considerable experience in all facets of Human Resource. Under Kathi’s leadership, we intend to improve our ability to retain and develop the talented associates we need to fully capitalize on our growth opportunity.

Before I wrap up, I would like to share a few thoughts on the recent litigation in Alabama. We operate more than 6000 stores, and our store managers are critical to our success. They are an important part of our management team, and are entitled to be compensated as salaried managers because of the important role they perform and the responsibility entrusted to them.

As Jim mentioned, our classification of store managers as salaried managers has been reviewed and supported by other courts and agencies. We are disappointed with the outcome of the recent litigation in Alabama, but we are optimistic that our policies will be supporting in the pallet review process. In summary, the second quarter exceeded our expectation and I am pleased with the progress we have made. While challenges remain; our key initiatives have positioned us to better provide customers with more value and convenience and to capitalize on the growth opportunity that exist in our niche. Now operator, we would be pleased to take your questions.

Question-and-Answer Session

Operator

Thank you sir. At this time, we will begin the question and answer session.

Operator Instructions

So we have our first question coming from Charmaine Tang from Citigroup.

Q - Charmaine Tang

Hi, good morning, congratulations on a good quarter there. Couple of quick questions. Could you guys provide some color on your SG&A expense improvement expectation for third and fourth quarter, and just what you would expect to be the key drivers of that?

A – James Kelly

I think directionally what we have talked about now throughout the year is that we expect to leverage expense by the fourth quarter, and we continue on that path, so it was 30 basis points de-leveraged this quarter and I would suspect that it will be moving directionally through the second quarter. The extent of leverage or lack thereof in the second quarter will be impacted by the opening of our Rome distribution center, as a reminder our distribution center cost are expense as incurred as opposed to capitalized into inventory by many retailers. As a result of that the opening process does have little pressure to our expense in the quarter in which it is open. But the Rome distribution center is opening very smoothly as we speak so we are pleased with the overall expected impact in the progress today so with Rome, so I think you will see some modest de-leverage in the third quarter with expense leverage in the fourth quarter.

Q - Charmaine Tang

Great, and then just one follow-up question if you guys could share your thoughts on the current promotional environment, particularly in light of the competitive landscape as you guys did?

A – James Kelly

Sure, Charmaine, we do view the environment very promotional and as I indicated in my comments, 18 months ago we not only thought that there was going to be a more promotional environment, we also thought it was going to be a challenging environment for our customers, and we outlined four initiatives, three of which were to drive customer traffic, and gear our mix to better satisfy our customers needs during those times. We have made significant progress in our treasure hunt strategy, of that holiday season and our holiday season in fiscal ’04 were very successful, and that was primarily due to our treasure hunt product and our merchandising and marketing and advertising programs. As we look out over the next several months, we will continue to adapt and refine more advertising programs to utilizing our circulars to continue to show our customers what is new in our stores, as well as driving traffic with our strong assortment of consumables. So while we do view it as promotional out there and expect that to continue, we think that we are positioned with the experiences that we have gained over the last several months to take advantage of the opportunities that are out there.

Q - Charmaine Tang

Great, thanks a lot.

Operator

Thank you. We do have our next question coming from Dan Weaver from Raymond James.

Q – Dan Weaver

Howard just indicated that stores with the cooler initiative continued to show about 5 percentage points better same store sales gains and the stores of the urban initiative are also tracking about 5% better. What’s happening to stores that have both of the initiatives in place, are they improving about 10% year-over-year?

A – Howard Levine

Dan, we have – just have a limited number of stores that have both the coolers and the urban initiatives in them. So it really would be premature to give too much guidance about that, but as you outlined we remain very excited about that opportunity, and we are looking forward to gaining more learning from that

A - James Kelly

By the end and within six months every urban initiative store will have a cooler program.

A – Howard Levine

Dan, what we have said is about 10% to 20% of the urban stores now have coolers, and that what we are seeing is in an accreted impact of having both initiatives, it is not necessarily a one-for-one but it is accreted to the mid single-digit number.

Q – Dan Weaver

Great, and then one other question Jim, on the gross margin guidance, I understand how the mixed change is impacting but they are some offsets, I guess potential benefits is on pricing, potential benefits a lower shrink, benefits of the treasure hunt program, do you think those will potentially be enough to offset the adverse impact of the mix change?

A - James Kelly

I think clearly, they will be taking a longer-term view. The thing that one has to consider is that the consumable impact in the next two quarters would be disproportionate to what they have been historically. And the reason for that were the two things that I called out, we are rolling out the coolers but if you recall in the back half of last year, we had some schematic issues, which really resulted in a very negative impact on our trends in the consumable area. So we expect somewhat higher comps with consumer consumables relative to the discretionary items for the next two quarters.

Q – Dan Weaver

Okay, and then just as a follow-up, as part of the enhanced food strategy, are there any plans in changing the distribution strategy instead of using third party distributors to do that internally?

A – Howard Levine

No Dan, the capital investment required on that, you were referring to the DST, direct stores delivery, its something that we plan to continue out to outsource. On the other hand, what we are testing is not an expansion of our cooler program as much as better capitalizing on our overall food assortment as it relates to what we are doing in the cooler program, so that merchandise would be distributed to our distribution center network.

Q – Dan Weaver

Okay, thanks and good luck.

A – Howard Levine

Thank you.

Operator

Thank you. We do have our next question coming from Mitchell Kaiser from Piper Jaffray

Q - Mitchell Kaiser

Good morning guys. I was curious if you could talk about, it looks like, yeah I know there are a number of factors that you were talking about another year of operating margin declines as we take out kind of longer-term, where do you think that operating margins will stabilize and when do you think we might actually start to see some expansion?

A – Howard Levine

Mitch, we do believe, we have a very strong operating margin model and are looking in many ways to how we can improve upon that as outlined with the four initiatives that we have talked about and the continued improvement of those as well as what we are talking about on the expense side, over you know the long-term we do believe that we can see continued improvements in our operating margins and are striving very hard to get there.

Q - Mitchell Kaiser

Okay, and then I guess you talked about coolers being Phase I of a broader food strategy or consumable strategy with EBT maybe being Phase II. Does that suggest there might a Phase III and Phase IV to that as well and could you give us ahead time what that might look like?

A – James Kelly

I think yes there could be Phase III and Phase IV, and no I am not, unfortunately able to talk to you about those, yet it still very very early.

Q - Mitchell Kaiser

Okay, alright, thank you.

Operator

Thank you. We do have our next question coming from Christine Augustine from Bear Stearns.

Q - Christine Augustine

Thank you, I am wondering on your plans or as you are starting about ’07. Do you anticipate rolling out the urban initiatives to additional doors and do you have any preliminary thoughts about your square footage growth in ’07 that you could share with us? Thank you

A – Howard Levine

Christine, thank you for your question. It would be pre-mature for us to discuss our plans for fiscal ’07 both on the urban initiative and on new store growth. We are pleased with the improvements that we are seeing in the urban initiatives, but as we talked about this year we were slowing it down, we were trying to improve upon it, get it right, as we talked about on our new store growth as well. We are making progress on both and stay tuned for update.

Q - Christine Augustine

Howard, I know its just a test but in the stores where you have tried EBT, what are you finding with regard to the customer shopping habit, because I am kind of wondering is they actually are using the food stamps in yours stores or they kind of running out of them at the beginning of the month when they get them and using them like at a supermarket?

A – Howard Levine

Christine, we are testing that in such a limited number of stores and there is some noise even in those stores that we are testing today, so as we continue to progress we will get more learning, but again it would be premature to talk about what we are on learning thus far.

Q - Christine Augustine

Okay, thank you.

Operator

Thank you. We do have a next question coming from Meredith Adler from Lehman Brothers.

Q - Meredith Adler

Hi guys, I have some questions; you were very successful in controlling your fuel cost. I was just wondering if you could talk a little bit about what might have allowed that to happen, the new distribution center or is that what?

A – James Kelly

Well I think in the second quarter the starting point for an understanding is that we move less straight in the second quarter, there is a lot of straight moment, a lot of inventory buildup and contemplation of the holidays, but we try to minimize the amount of freight that was sent to the stores during the holiday season. So that makes the whole area of freight movement a little less sensitive to a change in the second quarter then you will see in some other quarters. Secondly, I think the year-over-year increases have diminished slightly, well fuel costs are still at a very, very high level historically, the year-over-year increases have diminished. Going forward, we are looking at fairly significant some more reductions as we move into the fourth quarter, I would say in the neighborhood of 6% to 8% some more reduction going into the fourth quarter, so that should help us control break cost in that particular quarter. We’ve also installed the new transportation optimization software that will enable us to be a bit more efficient in how we manage freight on an ongoing basis.

Q - Meredith Adler

Great, and then you’ve talked about, switching the Easter ads that you had last year to February but I think you said it with more targeted to certain market, could you just talk a little bit about what the criteria were, what markets were you focusing on and particularly why?

A – James Kelly

Meredith, for competitive reasons, I am really not able to give any more color in that. What we have done though is really try to take what we have learned from the years that we have been running advertising circulars and try to get the biggest name for the buck and it was just a number of things that we looked at to try to do that, and as I said we were pleased with the results of the February circular, and we will continue to modify and adjust our plans as the year progresses.

Q - Meredith Adler

Okay great, and then there’s a question about real estate, there is obviously a lot of stress going on in how you are looking at it, could you maybe talk a little bit about on what it was that – what made you decide you need to make these changes and where do you think you are coming out, changing where the stores have been located in terms of strip centers or freestanding, or where they are located in a community or, I want to understand those changes?

A – Howard Levine

Sure, there are some location attributes that we are considering as part of our whole process and real estate but, what its mostly about is just improving our overall process, trying to improve the blow of the deals to get them more consistent throughout the year. The reason we decided to slow it down was we were just opening too many stores at the end of our fiscal year, and the burden that put on the entire company was just not right, so we really made some progress on improving our processes. It is a slow ship to turn if there are, it’s a long lead time particularly with all the bill pursues that we are doing today, on a positive note I am and we are beginning to see some improvements in our new store productivity, we would like to see that continue, and at the end of the day that the whole thing behind what we did was trying to get the processes right, get our people situation improved and be in a position to reaccelerate growth in the future.

Operator

Thank you. We have our next question coming from Stacy Turnof from Merrill Lynch.

Q - Stacy Turnof

Hi everyone, question on urban initiatives, a while back you have said that you have been working on pricing and looking around 10% of your market, and within those markets, I think that you were just looking around 10% of – I am curious if you could share with us some of your learnings and if you are planning to increase some of that percentage on zone pricing testing?

A – James Kelly

Sure Stacy, what we’ve said as we have zone pricing in a limited number of stores on a limited number of items, so we do believe though that there are still more opportunities particularly in urban stores and we expect to gradually begin to realize some of those benefits over the next several years. One of the things we are most sensitive to is measuring the results to understand what the impact is on our sales, but we do believe that over the next several years that there will be a nice benefit to us from our zone pricing opportunities.

Q - Stacy Turnof

Any idea what the if that 10% number can go up to 20 or 30 or is that really just to be a small percentage at a higher price point?

A – James Kelly

It would really be premature to comment on that at this point, we are still very early in the game there and are trying to learn more about what the impacts are.

Q - Stacy Turnof

And I have got one more question, COO position any update if you are going to fill that?

A – James Kelly

We are very, very pleased with the way our management team is operating today, one of the things that I have seen over the last several months and that’s indicated by the performance improvements that we have seen is the way we are working cost functionally, I kind of indicated in our treasure hunt the way the merchandising group is working hand in hand with our store operations group, is one of the keys of treasure hunt merchandise is once its brought and shipped to the stores it has to be presented in a way that our customers can shop it and be able to see the value and the opportunities that we are offering there. So, very pleased with the way everyone’s working together, we simply added the Softlines seem to be at top of that, Mike is on board recently Kathi Child in the Human Resource area is with us recently, and so we will continue to look for top talent and to support, to support our company, and but right now we are very pleased with the way things are working and look forward to continued improvements.

Q - Stacy Turnof

Okay great, thank you.

Operator

Thank you. We have our next question coming from Jack Balif from Midwood Research.

Q - Jack Balif

Hello, I have a few things; one is, in terms of the new merchandise shopping your assortment in apparel, what plans you have in the area of adult apparel?

A – Howard Levine

Hi Jack how are you?

Q - Jack Balif

Hi.

A – Howard Levine

Jack, we talked about apparel now for a long time, and I am – one of the things that we are looking on in adult apparel as well as well as kids apparel is how we can better meet the needs of our customers that are coming in our store everyday. We are very fortunate that we have very good traffic coming in and purchasing our consumables, and one of the things that we are trying to do was link that with a better appeal strategy. What we have done over the last several years is continue to call out assortments, reduce inventory levels to improve the productivity over inventory, and we’ve made some nice progress there, but we are looking for the next step as to how we can still take advantage of all of the traffic that we have in servicing the needs of our consumer in the apparel area. Mike is working on that, we believe and we are very optimistic about what those things are, but it’s a tougher business. One of the things that we have done to support that is continued to grow our planning and merchandize control departments to support some of those areas, and also doing a lot more customer research to try to better understand what the customers wants. So stay tuned, we are optimistic about where we are going there, and look forward to talking to you about that in the future.

Q - Jack Balif

Okay, regarding stores that are in more rural type areas that compete more with Wal-Mart and with people consolidating their trips. Are any particular strategies there in terms of how you might become more competitive?

A - Howard Levine

As I talked about the cooler rollout is primarily in the non-urban stores.

Q - Jack Balif

Okay.

A - Howard Levine

And that’s probably the biggest opportunity, but also continuing to tweak and improve our entire consumable assortment to better leverage those trips.

Q - Jack Balif

Thank you.

Operator

Thank you. We do have our next question coming from David Cumberland, from Robert Baird.

Q - David Cumberland

Good morning, on advertising you moved the circular from last Q3 to the quarter you just reported. What are your advertising plans for the second half?

A - Howard Levine

David, we are not going to discuss that at this point for competitive reasons.

Q - David Cumberland

Understood, and another topic features about the EBT opportunity, is EBT tied to the test of the expanded food assortment, in other words do you need more food for EBT, will it be viable for you?

A - Howard Levine

David, the primary product in the coolers is what makes us eligible for EBT. And so we are testing EBT in those stores as we continued to rollout the tests and get more learning, and we will link that with the coolers with the enhanced food strategy to understand what impact that has on the business.

Q - David Cumberland

Thank you.

A - Howard Levine

You are welcome.

Operator

Thank you. We do have our next question coming from Michael Baker from Deutsche Bank.

Q - Michael Baker

Hi thanks guys. Two questions, one on the gross margin, into the last two quarters I think you’ve guided down gross margins, and you’ve actually had up gross margins so close something surprise in the upside, why should we, why should that not continue in the third quarter, is it simply, what you talked about that the cycling disruptions from last year. And then my second question on the advertising so you guys did circular last April, your competitors did not, this April it sounds like you are not going to do a circular, is that incorporated in your guidance at all, how do you think about that, if you could do it all over again. Would you do on this April also, if General was going to etc.?

A - Howard Levine

Michael, I’ll go first with the advertising, then I’ll let Jim respond to the gross margin question once again. When we look at our promotional plans, and as I indicated in my comments before. We design these initiatives to build sales not just for a year or two but for the long-term, the investments that we made in the urban initiative are beginning to pay, the investments that we have made in our treasure hunt which continued to mature and develop and one of the things that Robert in merchandizing is working very aggressively on, is coming up with the items and the product to be in our stores during the key times, along with the cooler program and consumable sales. So we look at this as a long-term project and are very comfortable with our plans in April, have made some plans, which we think will be very competitive, service our customer needs very nicely, and look forward to the upcoming Easter’s period. Jim.

A - James Kelly

I think in addressing, Dan Weaver’s question we talked about a lot of the individual elements of the gross margin, its not always as easy to predict as one would like, we did talk about the second quarter that we are very successful with our treasure hunt initiatives and that success is something that we were very proud of but we would like to get little more experience in a different season. The holiday season is somewhat unique and that the percent of the sales that can be attributed to more discretionary spending is dramatically higher. So even with continued success of the treasure hunt initiatives during the next several quarters, it will not have as large a impact because discretionary spend has a much lower impact in the back half of the year.

We certainly are working hard to offset the mix shift that we see in the back half of the year, but there will be a pronounced growth in our core consumable sales as we continued to rollout the coolers and as we proceed this season against the lower consumable comp that we had last year as it relates to the disruptive schematic changes. So if you look at the mix of discretionary versus core consumable sales in the back half, you will see a more severe shift, mixed shift than what you saw in the first couple of quarters. We did call out for the year that we were working hard to reduce our shrink, and we think we will be successful, but we were not successful in the second quarter of this year. So we are not necessarily building in success until we can see a more visible trend there. Again in the longer run, we do see expansion of our operating margin as we give guidance for ’07, we will provide further details later.

Operator

Thank you. Our next question comes from Jeff Stinson from FTN Midwest Research.

Q - Jeffrey Stinson

Good morning guys. Jim, could you talk a little bit last year about what happened in the third quarter as it relates to the schematic reset you had in consumables and how that directly impacted the gross margin performance that you had last year, I was just trying to get a perspective on the expectations that you have for this year in the third quarter?

A - James Kelly

Well, in fact for the first several quarters of last year we discussed the fact the core consumables were coming in the mid single-digit range. In the back half of the year, they actually went into the flatish to down slightly to up very slightly, but clearly a significant falloff from the historical mid single-digit range that we were accustomed to. Much of that seems to be directly tied to a very ambitious schematic change in which we a) took on significantly more change than we had historically done, and b) we made certain shifts to include, in some cases movement from branded to unbranded merchandise. The magnitude of the shift as well as some of the individual items involved, we were very disruptive to our customers, and had negative impact on the sales. We call that out in terms of the third quarter and we discussed that we had analyzed in detailed the impacts of each individual change, and that we would make changes or further changes to reverse the negative consequences. In July, we went ahead and made further changes, which resulted in actually a negative comp in some of the consumable areas, that is a second major disruption in July. But by the time we got into August we started low single-digit comps and those continued to build through the fall. So that is what we are looking at and looking at this year’s schematic changes, they are most consistent with our historical efforts that is more limited, and scope and are not expected to have the unusual adverse impact of last year. So we are going over very low comp basis last year and we expect to have significantly improved execution this year in addition there to it.

Q - Jeffrey Stinson

Jim, I guess just to follow on to that, were there one-time markdowns that needed to be taken for some of that unbranded product last year in the second half, and if so when were those taken?

A – James Kelly

Well, that was during the transitional impact, some markdown impact, I think when one puts the markdown impact in the current tax of our ongoing March year-over-year for all of our items, they were relatively models, we did have larger March in the third, but that was primarily driven by apparel, which is a much, much higher percent of our March as you might have imagine so, some modest impact but not significant.

Q - Jeffrey Stinson

And just one last question, is it relates to the systems necessary to effectively carry or handle EBT, where do you stand with that today, Jim?

A – James Kelly

I think that the primary system that is needed is a very robust point of sale system, we have acquired that system and that’s part of the EBT test that we have and its part of the ongoing refresh of our technology, so technology will not be the limiting factor as we move forward.

Q - Jeffrey Stinson

Is that going to be a software or hardware upgrade?

A – James Kelly

It would be a planned software upgrade as it relates to point of sales.

Q - Jeffrey Stinson

Thank you.

Operator

Thank you sir. We have our next question coming from John Zolidis from Buckingham Research Group.

Q - John Zolidis

Hi good morning, a quick question on the new store productivity. When you talk about new store productivity, are you referring to sales productivity or to store level contribution margin, and if I have heard you correctly, you said that the productivity of new stores was down slightly year-over-year in the second quarter, can you talk about the reasons for that? Thank you

A – James Kelly

I think that, when we look at the productivity of new stores, we look at it from a number of angles as you might imagine, clearly we have disclosed in the past and some analysts have followed the sales productivity as a percent of average store sales. So that number is down slightly, if you will, from the prior year but the trend line is going up there. To some extent that is being impacted by a mixed shift as we opened a few more rural stores relative to urban stores so far this year. So I think that’s one measure but its really Howard’s remarks were directed towards a broader measure, and that is we are improving the performance of the new stores to include their operating results.

Q - John Zolidis

Thank you.

Operator

Thank you sir. We do have our next question coming from Michael Exstein from CSFB.

Q - Michael Exstein

Hi, its actually Credit Suisse these days. Good morning everyone, can you just fill a little more detail on how the SG&A dollar sort of decelerated either quarter-over-quarter, year-over-year, but what was playing out in this quarter? And secondly, as I visit stores I noticed a bunch of stores that have absolutely no apparel in them any longer, except for basic underwears and no apparel, what percentage of your stores there and so what’s the plan longer term? Thanks so much.

A – James Kelly

I think in terms of SG&A expenses, you have a number of things playing out in the second quarter. Clearly one of them as we yet to anniversary some of the major initiatives so we had roughly 1400 stores under the urban initiative this year during the second quarter versus a few hundred or so last year in the second quarter. So that kind of anniversary is putting some pressure on our expense structure, and so one of the reasons that as we anniversary those initiatives cost in the fourth quarter we see some further leverage. On the other hand, we’ve also talked candidly about the fact that in launching the initiatives of the magnitude that we’ve launched last year, it was somewhat disruptive to many of our core operations. For example most of our store operational regions had to be modified to accommodate the urban initiative, that disruption I think led to some inefficiencies throughout the organization that we are working hard now to try to manage more efficiently and more effectively, and as a result we are offsetting some of the incremental program cost with some more controlled expense processes throughout our overall change.

I would also mention that our stock option expensing in the second quarter was new for us as we had no option expenses historically. Utility cost were the largest single driver in the second quarter as I called out in my comments as well as depreciation, so in most of the other areas we are showing a modest control and modest improvement and we anticipate continuing to do that and as comps increase we anniversary the cost of special programs and we continued to tightly control our expenses in an efficient way, then we see expense leverage again in our future around that three, three and a half comp level, and obviously expense leverage higher should comp succeed that level.

A – Howard Levine

Michael, on the stores that do not have apparel, that’s something that we have talked about for a few years and its just a few hundreds stores and what was driving that primarily was trying to better tailor the mix of inventory to the neighborhood that that particular store was in, and in some cases and some of the urban markets where we were unable to get a desired amount of space in some of those stores we decided to take some apparel out of the stores as well but its not many towards but it primarily falls under the category trying to better tailor the merchandize to the neighborhoods of the stores.

Kiley Rawlins

Operator I think we will take one more call. One more question.

Operator

Thank you miss. We have our last question coming from Mark Miller from William Blair.

Q – Mark Miller

Hi good morning, I was wondering in your comment on the improving returns for the urban stores, is that simply due to a maturation of these stores, i.e. more than coming into a payback mode or is it, are you saying that your expectation now the program is for higher financial returns, until we extent it for latter I guess which would be the biggest factors driving that, is it reduction in shrink to sales mix or ability to manage the cost there?

A – Howard Levine

Mark, I think we called out initially with the urban initiatives that our strategy would be phased so that initially we would hurt operating profitability both in terms of dollars as well as percent, then we would go through a phase in which we would see more operating dollars being generated from the same capital investment in our store, and then the third phase was to actually see an improvement in the operating margin. In some cases that has proceeded very smoothly as we expected, in other cases it’s been more challenging. So as we noted with the first quarter, about 80% of our urban stores are reporting higher levels of profitability than they had prior to the program and about two-thirds of them are actually showing a higher level of profitability as a percent of sales.

We see though the urban initiatives as an ongoing program with much, much more upside potential as we move into the establishment of the pricing policy, as we begin to realize more of the benefits from a more compelling place to work, that is we see more significant reductions and turnover which will then lead to reductions in shrink, with also see that we would be able to manage the flow of our merchandise and urban markets more effectively, and what that will result in as greater visibility to our merchandise particularly those items that represent the most compelling values or the treasure hunt items, which also higher margin items. So when we look at it today, we are realizing some benefits in each of those areas, we see some sales benefits, we see some benefits within the shrink area, we see some benefits in the ability to accelerate sales of higher margin merchandise, but we also see a lot more upside opportunity as we tweak the processes, improve upon them, initiate Phase II, Phase III things like the pricing initiatives, some of the technology to make the stores well easier to operate there, we are still in the 2B mode, so we are excited about where we are and even more excited about where we are going.

Q – Mark Miller

Great that’s helpful, and my other question is on the sales mix. In your comments today I’ve heard you talk a lot about consumables and then discretionary items, would at some point it be appropriate to breakout comps that way, and that I guess I am curious if you look at the last quarter ballpark numbers, how would the business have trended consumables versus discretionary, and as you look ahead I am wondering if you are expecting a deceleration in discretionary since you recalled out that you have done better than expected?

A – James Kelly

Well I think that how we breakout the sales to buy more useful data, its something that we are continuously addressing and have discussed your specific point there because you spot on Mark, the look at just softlines versus hardlines doesn’t provide the one to understand the margin. If you look at the home area, the margins are every bit they are strong, if you look at any of our seasonal departments they are as strong as some of our highest margin apparel department, so we will continue to consider how we can present you and other investors with greater visibility into the margin area, the thing that we tried to emphasize is as relates to our treasure hunt, is that it is continuing to grow and show momentum, so we are very optimistic that our stores are becoming compelling places to shop and we are featuring these higher margin items and we will continue to be successful.

I think the issue of mix is not an issue that should imply that the treasure hunt items are losing strength, but we have something somewhat uniquely impacted last year and that is the schematic change which grow consumable comp so well that you are going to have a proportionate mix, adverse mix impact over the next couple of quarters that we would not anticipate on an ongoing basis. So I think its more of a short lived adverse mix as opposed to ongoing, the primary purpose of the treasure hunt initiative was to anticipate the mix shift that would be driven by coolers and to provide an appropriate financial offset so we do think that we are going to realize on that objective so in the longer run perspective, we see the mix impact more neutral.

Q – Mark Miller

Thanks Jim, I appreciate the color.

Kiley Rawlins, Divisional Vice President, Investor Relations and Communications

Thank you all for joining this morning, I know we have run a little bit over and I your appreciate your patience, I also know that we didn’t get to everyone’s question, as usual I will be available after the call to answer any questions we didn’t get to. So thank you for joining us and have a nice day.

Operator

Thanks everybody for joining the conference call today, have a good day, you may disconnect your lines at this time. Thank you.

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Source: Family Dollar Stores Q2 2006 Earnings Conference Call Transcript (FDO)
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