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Executives

Emma Jo Kauffman - Senior Director of Investor Relations

Richard W. Dreiling - Chief Executive Officer

David Tehle - Chief Financial Officer

Analysts

Grant Jordan - Wachovia

Mary Gilbert - Imperial Capital

Karen Eldridge - Goldman Sachs

Mike Shritka - LongAcre

Carla Casella - J.P. Morgan

Emily Shanks - Lehman Brothers

[Colleen Burns] - Unidentified Firm

Charles Grom - J.P. Morgan

[Ann Wareheimer - Van Campen]

Dollar General Corporation (DG) F1Q08 Earnings Call June 17, 2008 10:00 AM ET

Operator

This is the Dollar General Corporation first quarter 2008 conference call. (Operator Instructions)It is now my pleasure to turn the call over to Emma Jo Kauffman, Dollar General's Senior Director of Investor Relations. Ms. Kauffman, you may begin.

Emma Jo Kauffman

Thank you, Operator. Good morning, everyone. In a moment Rick Dreiling, our Chief Executive Officer, and David Tehle, Chief Financial Officer, will discuss the company's 2008 first quarter financial results and update you on our operating priorities.

After they speak you will have an opportunity to ask questions, but before they begin let me take a moment to reference the safe harbor provisions under the Private Securities Litigation Reform Act of 1995.

Our comments on this call will include forward-looking statements such as those about future operating and financial performance and expectations regarding store growth and capital expenditures. Although we believe the forward-looking statements are reasonable, they are subject to significant risks and uncertainties. Accordingly, we cannot assure you that they will prove to be correct or that any trends noted in today's call will continue.

Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our Form 10-K filed with the SEC on March 28, 2008 and our press release issued June 16, 2008 and in the comments that will be made on this call.

Statements made in today's call are accurate only as of today's date. You should not assume that the statements will remain correct at a later time. Dollar General undertakes no obligation to update any information discussed in this call.

In addition, we will refer to certain measures not derived in accordance with GAAP, including EBITDA and adjusted EBITDA. Reconciliations of these measures to net income are included in our press release issued yesterday, which can be located on our website at DollarGeneral.com under Investor Information - Press Releases. EBITDA and adjusted EBITDA should not be considered alternatives to net income, operating income, operating cash flows or any other performance measure determined in accordance with GAAP. Because not all companies use identical calculations, these presentations may not be comparable to other similarly titled measures of other companies. We encourage you to consult our Form 10-Q filed with the SEC on June 16, 2008 for our definition of EBITDA and adjusted EBITDA along with the limitations on the use of these measures as analytical tools.

Now I'll turn the call over to Rick Dreiling. Rick?

Richard W. Dreiling

Good morning and thank you for joining us. We've had a very busy start to 2008. Since our last call I've had the opportunity to become more fully immersed in the Dollar General culture, and I'm happy to say that everything I've seen so far confirms my original impressions. We have a strong and compelling business model, a solid foundation on which to build, and great opportunities are ahead of us.

I will begin today's call by sharing some of the key financial highlights from the quarter, and then David will go over the first quarter financial results in detail. Following that, I will return to update you on our operating initiatives and our plans for the rest of the year.

Turning to the first quarter highlights, we reported a 5.4% increase in same-store sales with positive comps in every geographic region in which the company operates.

We expanded gross margin to 28.8%, which represents a 102 basis point of year-over-year improvement.

We reduced SG&A expense by 150 basis points year-over-year.

And we generated year-over-year adjusted EBITDA growth of 28%.

We are encouraged by this strong start to our year. Some of our initiatives have begun to take hold, and we are developing momentum across the business as we move forward.

I cannot say enough about our team here at Dollar General. Everyone has pulled together, and we are collectively focused on addressing the challenges and maximizing our opportunities.

Despite the recent changes, we still have a lot of work to do. We are mindful of the difficult economic environment that is impacting retailers and customers alike. Macroeconomic conditions are continuing to be challenging across the country. We are monitoring these trends carefully and recognize that retail trends could get worse. In particular, consumers have been delaying or avoiding discretionary purchases as they battle high fuel prices and inflation. We believe that this is putting pressure on sales of our higher margin non-consumable products.

That said, it's worth noting that with 18 years of consecutive annual same-store sales growth and a strong start to 2008, Dollar General has proven itself to be a resilient company, one that has performed well in both good and bad economic times.

We see an opportunity to show both new and existing customers what our company is all about and to solidify Dollar General as the value retailer of choice. During this period of uncertainty we are focused on staying relevant to our customers by providing the quality products, convenient locations, low prices and customer service that they prize. Thus far our efforts in this difficult environment have proven successful. In fact, in the first quarter our stores generated growth both in customer traffic and average transaction size.

I will be back in a minute to give an update on our operating priorities that we outlined on the last call, but now I'd like to turn it over to David for a detailed overview of the quarter's financial results.

David?

David Tehle

Thank you, Rick, and good morning, everyone.

Sales for the first quarter were $2.4 billion, up $128 million or 5.6% from last year with a same-store sales increase of 5.4%. That compares to a 2.4% increase in same-store sales in the first quarter of '07. Same-store sales accelerated through the quarter, with comps of 4.6% in February, 2.3% in March, and 10.4% in April. Because of the complexities of the Easter shift, we are providing monthly comp numbers to give additional insight into our business, but we do not intend on giving this level of detail on a going forward basis, i.e., we don't want to get back in the business of giving monthly comp sales.

We've had a very strong start in the second quarter, too, with 9.3% comps for the month of May, continuing the recent trend of increases in both traffic and ticket.

Gross profit as a percentage of sales increased to 28.8% in the first quarter from 27.8% in the first quarter of '07. The most noteworthy components of our gross profit rate improvement were lower markdowns and decreases in shrink and damages.

As you know, fuel prices have been high and continue to rise. In the first quarter of '07 last year, diesel fuel averaged $2.66 per gallon. This year in the quarter they averaged $3.78 a gallon, and the average price of diesel today is $4.69. We have been able to offset much of the impact of the fuel price increase through better trailer space utilization, expansion of backhaul opportunities, and improved fleet management.

SG&A for the quarter increased $4.8 million from the prior year, but decreased as a percentage of sales to 24.2% in the '08 quarter from 25.4% in the '07 quarter or 115 basis points of improvement. SG&A in the '08 period includes $10.3 million of noncash amortization of leasehold intangibles capitalized in connection with the merger with KKR, as well as approximately $6.8 million of severance costs. SG&A also includes about $3.2 million of other new ownership related costs, such as the KKR management fee and certain consulting and legal expenses.

In comparison, SG&A in the '07 period included about $29.3 million of Project Alpha store closing and inventory clearance expenses and $6.3 million of transaction and other merger-related expenses incurred prior to the merger.

Excluding the impact of the items I've mentioned, SG&A improved by 44 basis points, primarily attributable to our ability to hold tight on variable expenses even with an increased rate of sales. We also have lower advertising expenses in the quarter.

As expected, interest expense increased by $95 million due to the interest on long-term obligations incurred to finance the merger.

For the first quarter, we reported net income of $5.9 million compared to net income of $34.9 million in the first quarter of '07, and our reported EBITDA increased by $62.9 million to $168.8 million. After adjustments as defined in our credit agreements, adjusted EBITDA increased $39.8 million or approximately 28% from last year's first quarter.

We continued to have good news on inventories. As of May 2, the quarter end, total inventories at cost were $1.32 billion, down $127 million or about 9% from the first quarter of '07. On an average per store basis this is a decrease of 10% from a year ago, reflecting the elimination of pack-away inventories in our home, seasonal and apparel in addition to improvements in our merchandise planning and allocation.

Our accounts payable inventory ratio increased to 45% in the first quarter of '08 versus 34% in the first quarter of '07. As you can see, we have made considerable progress in our working capital management.

We had total outstanding debt at the end of the quarter of $4.18 billion, including the current portion of long-term obligations. This includes $2.3 billion outstanding under our senior secured term loan. We paid off our asset-based revolver in February and have had no additional revolver borrowing since then. We currently have excess availability under the revolver of $857 million, and we also have approximately $212 million of invested cash.

In the quarter, we generated $151.6 million of cash from operating activities. This reflects our strong operating performance in the quarter and improvements in our working capital management, particularly in accounts payable. We believe our cash flow from operations and existing cash balances, combined with availability under our credit facilities, will provide sufficient liquidity to fund our current obligations, our projected working capital requirements, and capital spending over the foreseeable future.

Given our success in debt paydowns and EBITDA growth, our ratio of long-term obligations to adjusted EBITDA has fallen from 7.1 times to 5.8 times since the merger closed in July of '07.

We spent $35.4 million for capital expenditures in the first quarter, including $15 million for improvements and upgrades to existing stores, $7 million for remodels and relocations, $6 million for new stores, $4 million for distribution and transportation-related Capex, and $3 million for systems-related capital projects.

In the first quarter, we opened 73 new stores and relocated or remodeled 125, bringing our total store count at the end of the quarter to 8,265.

Now turning to our outlook, we are committed to achieving our previously announced operating initiatives. We intend to grow sales, expand gross margin and manage expenses in 2008. We continue to plan to open 200 new stores and to relocate or remodel 400 stores. Lastly, we continue to anticipate our capital expenditures will be in the range of $200 to $220 million for the year.

With that, I will now turn the call back to Rick for an update on our operating priorities.

Richard W. Dreiling

Thank you, David. As you can see, we've had a solid start to the year and our customers are responding to our efforts.

As outlined in our last call, we are focused on executing four very basic operating priorities to maximize Dollar General's potential. I'd like to briefly detail the progress we're making on each of these priorities. I want to continue to stress that while we've accomplished a great deal, there's much more to do.

Our first priority is to drive productive sales growth. As we mentioned, we were successful in both driving traffic and basket size in the second quarter, and this trend has accelerated into the second quarter.

We are intently focused on improving store standards. In the first quarter we instituted a model store program to demonstrate what a Dollar General store should be -- bright, clean, well-stocked, properly merchandised, and reflective of the new Dollar General standards. Through a series of in-person group conferences, the management team and I have met with all 550 of our district managers to outline the company's four key operating priorities and introduce the model store program and how it will be executed.

In addition, we worked to increase shopper frequency by adding more consumable items to our shelves. We have also timed and distributed ad circulars more strategically. We continue to focus on driving basket size and are evaluating our offerings in home, apparel, sundries and seasonal goods to maximize the potential in these areas.

We continue to recognize the need to be more trend relevant to better meet our customers' aspirational needs. As we move into the back part of the year, you'll begin to see this reflected in the stores.

And finally, we continue to work at improving square foot productivity by freeing up end displays, eliminating flex space, and improving merchandise adjacencies. We've completed the planning and product selection for 70 new planograms and have begun to roll them out into our stores. We expect this will be completed by late fall.

Our second priority is to enhance our gross margin through a variety of targeted initiatives. During the quarter, we continued to work on reducing shrink by managing our inventory more efficiently and implementing processes to identify the sources of shrink. While we are definitely seeing results from our efforts, there is certainly room for more improvement. We continue see shrink as an opportunity.

We have also made strides to improve our sourcing. For example, we have begun participating in on-line auctions to find and source better products at better values. To date we have utilized the auction process for approximately $100 million of merchandise, supply and service purchases. This has resulted in significant cost savings.

We're also taking a fresh look at how and where we source all of our merchandise. In particular, we believe we can enhance our sourcing efforts in our non-consumable categories.

We have continued to move forward on plans to enhance our private label offering. During the first quarter we worked to refine our private label strategy, carefully choosing products and labeling and establishing a rigorous quality control protocol to ensure that our private label products are all of comparable quality to the brand name products that we offer. By the end of 2008 we expect to have about 800 private label products available in our stores. That's a net increase of 112 SKUs that will be visible throughout our highly consumable category.

And finally, we are continuing to refine our pricing strategy. We are closely monitoring our competitor's price changes, and we are also partnering with our vendors to leverage those relationships and manage product cost. In addition, we are working to improve our price optimization and our price management process.

Our third priority is to leverage process improvement and information technology in order to reduce cost. During the quarter, our cost savings workgroup was tasked with identifying and removing expenses that are not critical to our customers or our operations.

To give you just a few examples of our progress, we have worked to eliminate unnecessary store expenses and have started planning a companywide green initiative to recycle cardboard which we expect will reduce our waste management cost. Additionally, we have worked to reduce the cost of taking store inventories and transportation costs. We are pleased that our initiatives are helping keep expenses down, and as David mentioned, to date we have been able to successfully battle the increased cost of diesel fuel.

Also, we continue evaluating the work processes of the retail team. We are looking for additional ways to better engineer value-driven protocols and streamline our store operations.

Our final priority is to strengthen and expand Dollar General's culture of serving others. We are on a passionate mission to make Dollar General a retailer and employer of choice. During the quarter we worked to develop more consistent store standards and execute them across the chain. We want to ensure that our customers have a good and consistent shopping experience in every store across the chain, including the look and feel of our stores, the delivery of service, and the availability of merchandise at every day low prices. As new initiatives are rolling out, we continue to explore and develop meaningful ways to measure customer satisfaction.

In addition, our employee turnover level has decreased significantly. We continue to see reduced turnover throughout the organization and are most proud of the fact that turnover among our store managers is down to 37%, the lowest level in over 10 years. We believe that our recent process improvements, commitment to higher store standards, and clearly defined expectations have not only made our stores easier to run, but have also increased the manager's sense of pride in operating them.

Finally, we have continued with our rich history of being active in responding to the needs of our communities. In fact, I'm sure you have seen that our literacy foundation recently donated $4.9 million to nonprofit organizations, leading the effort to support adult literacy. This is a long-standing focus for our company, and we are delighted to be committed to supporting such a worth cause. With over 8,200 retail stores in 35 states, we are able to reach out to a broad base of our customers and provide support in many of their communities.

We believe our strategic initiatives are beginning to have a positive impact on our employees, our customers and our results. We sense that our continued attention to the overall customer experience in our stores through service, quality, convenience, value and consistency will protect and strengthen our retail leadership position and our brand.

Our team continues to be cautiously optimistic about the remainder of 2008. We are continually working to maximize the opportunities that each of our priorities presents, and we look forward to updating you on our progress throughout the next several quarters.

With that, I'd like to open the call up for questions. Operator?

Questions-and-Answer Session

Operator

Thank you very much. (Operator Instructions) Thank you. Your first question will come from Grant Jordan - Wachovia.

Grant Jordan - Wachovia

It seems like there's a lot of positive things going on in Q1, particularly given the increase in margins and revenue. You talked about a number of things, what's working. I was wondering if you could just kind of call out what were the two or three main drivers in the big jump in profitability in Q1. Was the reduction in shrink, was that a huge move for you? Just trying to get a handle around what are the main drivers here.

Richard W. Dreiling

Yes, Grant, I think as you look at us, we are not silver bullet operators. We have a lot of initiatives in play right now. And we're very fortunate in that we're seeing a lot of growth in the initiative.

Shrink, I can't say enough about the retail team and the progress we're making on shrink, however we've got a long way to go on it. David called out the work on damages that we've been dealing with in the stores. We're doing a much better job of managing markdowns.

When you look at the sales side of the equation, I believe the lower turnover we're seeing in the retail stores is helping driving more consistent look and feel in the stores. We've made a lot of advances in store standards, but we have a long way to go. And it's very basic things, like freeing up end displays so promotional merchandise can be put on them, timing of our ads.

So we have a lot of positive things moving in our way right now.

David Tehle

I think the other thing, Grant, we were able to leverage our SG&A very nicely in the quarter, and that was due to both the volume being up as well as very tight expense control across the board, so we're starting to see the positives of that.

The other thing in the stores, obviously, our stores are much cleaner, much more organized. We have a much more exciting presentation within the stores, and our turnover rate of the employees is as low as it's been in 10 years. And as you well know, when you have low turnover in your employees, you tend to have better performing stores.

So as Rick said, I think we have many, many items coming together here to give us the positive that we're seeing in the business right now.

Grant Jordan - Wachovia

The second question, maybe if you could just help us think about how Dollar General in particularly the consumable category works in the inflationary environment we're in. I think you mentioned that you're continuing to examine your price strategy. Have you actually moved prices up as we've moved through this period?

Richard W. Dreiling

You know, we are - as we work with the manufacturer community and the vendor community, we're working really hard on keeping our costs in line.

We are re-engineering our consumable mix as we need to in order to hold cost down, retails down. We're also working very hard on private label, which is a great alternative to our consumer.

And we feel that we're doing a better job of managing the cost of goods, doing a better job of interacting with the manufacturer [break in audio].

Grant Jordan - Wachovia

What kind of priorities do you have in terms of how to use your cash?

David Tehle

We have two priorities. The first one is to take care of the operating needs and the capital needs of the company, and the second one is to pay down debt.

We're in continuous discussions with our Board on the second piece of that in terms of what to do with paying down the debt. Obviously, we have a little bit of cash on the balance sheet right now, and we have a tendency to be, again, a little bit conservative on that. It's hard to say you're conservative when you have $4 billion of debt on your balance sheet, but we do our best to try to hold the line there in terms of our conservative nature on our cash.

So that's really what our plans are for it.

Operator

Your next question comes from Mary Gilbert - Imperial Capital.

Mary Gilbert - Imperial Capital

I wondered if you could tell us what was the May 2007 comp increase so we can see what that 9.3% increase is going against?

And where does average ticket stand currently? I guess at one point it was $9.31. Is it closer to $10 now?

Richard W. Dreiling

Yes. Our average ticket came in right around $10. I'd rather not be any more specific than that, Mary. It's [up] about 4% over last year.

And the comp number is -

David Tehle

It's 4.1. We're up against a 4.1 comp in period four from last year.

Mary Gilbert - Imperial Capital

Okay, 4.1. Yes, so strong comps against strong comps.

David Tehle

That's correct.

Mary Gilbert - Imperial Capital

And also the same trend in May, where consumables is driving it and seasonal merchandise and basic clothing and health, you know, home goods are down, those categories?

David Tehle

No, we're seeing in May more of a balance between the categories. Clearly, consumables is still leading the way, but we're seeing a little more performance out of the other three categories.

Mary Gilbert - Imperial Capital

Okay. Okay, so now you're starting - so were the other categories up or down less or flat?

David Tehle

Versus last year?

Mary Gilbert - Imperial Capital

Yes.

David Tehle

In general they were up a little bit versus last year.

Mary Gilbert - Imperial Capital

Okay. All right, so now some of those categories are starting to improve. Okay.

And then when I look at cash on the balance sheet, as you pointed out, you don't really need all this cash that you're showing on the balance sheet, right?

David Tehle

That's correct.

Mary Gilbert - Imperial Capital

How much of it is cash used in operations actually that you need to sort of keep, you know, to support the business, and then how much of it represents really excess cash?

David Tehle

Well, the $212 million is all cash that we're investing right now. I mean, that's cash that we could use to, again, pay down debt or to use for our capital expenditures as we move forward in the business.

So again, as we move forward, we're going to look for ways to invest that cash. And we were probably a little bit overly conservative in the quarter with how much cash that we kept on hand.

Mary Gilbert - Imperial Capital

Okay. So is there like a certain amount, like $30 million or something like that, that you need to keep just to keep it in the stores and keep it -

David Tehle

Probably about $70 million.

Mary Gilbert - Imperial Capital

$70 million is the quote.

David Tehle

Yes.

Mary Gilbert - Imperial Capital

And then the $7.8 million of merger-related costs, is that primarily the severance that you disclosed in the SG&A?

David Tehle

Yes.

Mary Gilbert - Imperial Capital

And then how much of that is going to sort of continue as we move forward? Are we going to continue to see that number in that magnitude?

Richard W. Dreiling

Yes. I would look at you and say, Mary, that when a new CEO comes in, they build a team. And I'm building what I would consider to be a crackerjack team here of really high potential people. And I don't really want to say there'll be any more or any less, but we're going to concentrate on building our team. It's a cost of doing business to get the right players in here.

Operator

Our next question will come from Karen Eldridge - Goldman Sachs.

Karen Eldridge - Goldman Sachs

First, I notice on your website you have the rebate program for the stimulus checks. Curious to see kind of how that was formulated, what the vendor involvement is, and if you think it is driving business into the stores? Obviously, May comps are amazing, even in any environment, and how much of that do you think is a lift from the stimulus checks?

Richard W. Dreiling

Karen, as I look at our comps, they started to accelerate prior to the rebate checks going out. The rebate checks came out toward the middle or end of May. They'll run all the way until the middle of July. So we started seeing improvement in comps prior to that.

The other thing I would say is there's no doubt that people are spending that. I wish I could tell you exactly how much I thought they were spending, but I do know that our traffic's increasing. I believe it's increasing because people are looking for inexpensive quality alternatives to where they've been shopping. I believe Dollar General provides that.

And I also believe that with 8,200 stores we are incredibly convenient, and we're fulfilling the need of someone having to drive a long distance to get the products we offer.

Karen Eldridge - Goldman Sachs

And what kind of vendor partnership did you have for the rebate program? Did you have a lot of vendors that were particularly eager to participate?

Richard W. Dreiling

Yes, that program is vendor supported.

Karen Eldridge - Goldman Sachs

And also my channel checks, I've noticed extended hours on some of the stores. I was curious to see, is that something you're testing or is it more widespread, kind of how long that's been going on.

Richard W. Dreiling

Yes, we have a lot of initiatives under way as we seek to play on the convenience angle that we offer, Karen, and it's one of many initiatives. And, hey, we're experimenting.

Karen Eldridge - Goldman Sachs

And final question, also my channel checks, I actually was pleasantly surprised to see no markdown tables, particularly in spring. So do you have - if anything, it looked like seasonal was actually out of stock. Do you think you were a little too conservative in your ordering? It's a high-class problem to have, but it definitely looked that way to me.

Richard W. Dreiling

I think I'll say two things. I think as you look at the fact that the company went through the Alpha exercise last year, I think we might have been a little conservative on the placement of some seasonal ordering. And you also have to take into account that we're seeing a nice increase in comps at the same time.

Operator

Your next question comes from Mike Shritka - LongAcre.

Mike Shritka - LongAcre

I was just wondering if you could talk a little bit about, you know, historically I think the dollar store segment has been negatively impacted by rising gas prices, and now we're seeing, maybe it's the rebate checks which are obviously helping out right now. But, I guess, how are you addressing, when you look backwards, what happened with rising gas prices in the past, and how are you applying it now?

Richard W. Dreiling

You know, one of the incredible things about Dollar General, it has 18 years of same-store sales growth, Mike, irregardless of the economic conditions. And that's something that I think has to do because of the quality products we offer, the consistency in pricing, the everyday low price, and I believe when you roll into 8,200 stores in convenient locations, I actually believe that, while gasoline is a large part of our consumers' spend from their income, the fact that we are so convenient, we're not a long way away. And I think that's why the company's probably done so well over the last 18 years.

Mike Shritka - LongAcre

And then just one other question was with regard to the inventory per store, how much longer, I mean, it was a very good display this quarter on how far it came down. How long is inventory per store going to be, you know, declining in let's call it mid single digit range?

It seems like also on top of that, when I look at your competitors and where sort of days in payables range, you guys versus some competitors, you seem to have a big opportunity to maybe increase days in payables, which would be favorable to cash flow. Can you just talk about that also?

David Tehle

Sure. On the inventory side, our inventory turns are at 5 right now, 5.0 versus 4.3, where they were in this same quarter last year, so we have made substantial progress.

Now a piece of that obviously is the Alpha Project, where we got away from the pack-away strategy, so I think the biggest lump of inventory, so to speak, has probably come out, although we continue - it's a continuous process for us in terms of looking at inventory, and we're always trying to be more efficient in our allocation and how we take care of the stores on inventory.

On payables, again, we made some changes late last fall and last winter on the payables side with our vendors. And again, we're always trying to adjust that and see what makes sense and benchmark ourselves with our competitors and what people do on a world class basis in the industry. So I think we've made some changes there, and there is some potential for some further changes and some further work there.

However, I will say on both fronts that we're very pleased with what we've done on working capital, and I wouldn't expect huge changes like you've seen over the last six to nine months.

Mike Shritka - LongAcre

And then just, with the rise in gas prices, with regards to deliveries how often are you delivering to a store and has that changed at all, whether, you know, you're dropping four days a week, five days a week?

Richard W. Dreiling

No, most stores are delivered once a week. There are some stores that are delivered once every two weeks. Obviously, that's something we look at. Clearly, we have to balance that out with making sure that the stores are in stock and that they have the appropriate inventory, so we really haven't made many changes to our deliveries in terms of the number of deliveries to the stores.

We've done a lot on the transportation side to address the gas prices in terms of cube on the truck and trying to reduce stem miles and things of that nature, but we're very careful not to impact the stores in any negative way. It's something that might hurt our sales.

Operator

Your next question comes from Carla Casella - J.P. Morgan.

Carla Casella - J.P. Morgan

I wondering in this current interest rate environment whether you've hedged any of your bank line now at the lower rates?

David Tehle

We have two hedges in place, Carla. We've got a $1.6 billion hedge that's a five-year hedge that was actually put in place right when the deal closed last July, and that's at 7.683%. And then recently, last quarter, we did a $350 million hedge at 5.58%, and that's a two-year hedge.

If you look in total, about 92% of our debt is fixed right now and about 8% of it is floating.

Carla Casella - J.P. Morgan

And then I'm wondering if any of your stores are either positively or negatively impacted by the flooding?

David Tehle

We have four stores that have been impacted, but only two of them have actually sustained any real damage.

We have, you know, we service a lot of customers. There's a lot of customers of ours out there that have been impacted and some employees as well.

We are, Carla, working with the Red Cross to raise some money in the stores for the relief and recovery efforts, and we're also donating some cleaning and other supplies to the victims.

Carla Casella - J.P. Morgan

And then you have a free cash flow sweep. Do you have an estimate of - actually, I don't think you have a payment this year, but do you have an estimate of how much you may have to pay in '09? Or you should trigger that this year, shouldn't you?

David Tehle

Well, that's something, obviously, we'll take a look at as we get further along in the year. We'll do that calculation in January. It's a rather complicated calculation. There are a lot of pieces to it, and it can vary based on our leverage ratio at that time, also. So at this point I don't have an estimate on that, but we'll certainly take a look at that.

Carla Casella - J.P. Morgan

And then if you were to prepay a term loan this year, would that reduce the amount you would have to sweep for next year?

David Tehle

Yes.

Operator

Your next question comes from Emily Shanks - Lehman Brothers.

Emily Shanks - Lehman Brothers

It looks like you guys made a nice improvement on shrink. Can you speak at all about which categories this was in and also if you're seeing any improvement particularly in the deodorant and Axe line?

Richard W. Dreiling

The shrink improvement that we've seen has been very broad based. You are actually calling out two categories that are very sensitive, and we have seen improvement in them.

Emily Shanks - Lehman Brothers

And then in terms of the outstanding [BC] lease negotiations, I notice that it was noted in the Q that those discussions are ongoing. Is there any timeframe that we should expect to see a resolution?

Richard W. Dreiling

Yes, I wish I could say there is. We're still in negotiations with the various players there, and no, there actually is no particular timeline on that. Obviously it's been going on for awhile now, and because of the nature of those negotiations there's really not a whole lot more I can say except we're doing our best to get that closed out. But we have no time period when that's going to happen.

Emily Shanks - Lehman Brothers

And then if I could just ask around the - actually River Insurance Co. - we noticed that some of those [bonds] became short-term investments. Can you just remind us how exactly that particular entity works within the DG operation?

David Tehle

Right. We use that entity to pay our workers comp, and recently the State of South Carolina is in the process of allowing us to take money out of that entity; we had balances that we were holding. And we're in the process of moving that, and because of that we have the treatment now on the balance sheet where we've reclassified where that is from geography point of view on the balance sheet.

Emily Shanks - Lehman Brothers

And what type of instrument is that invested in now?

David Tehle

The same, government securities, yes, money market funds, things of that nature.

Emily Shanks - Lehman Brothers

And then if I could just ask one final question, I know last quarter we heard a lot about the new Coke offering and we certainly have seen it in our channel checks. Can you speak at all about how much you think that's boosting your comps?

Richard W. Dreiling

You know, I couldn't begin to make that guess, but what it really reflects is our commitment to having the right items in the store that consumers are looking for. We're pleased with the results. There's no doubt that it attracts a different customer from [inaudible]. And it's like everything else; we have a lot of balls in the air.

Operator

Your next question comes from [Colleen Burns].

Colleen Burns

The supply chain initiative that you mentioned that benefited gross margin in the first quarter, do you expect those benefits to continue in subsequent quarters and believe they'll be sufficient to offset the higher fuel costs?

David Tehle

You know, we're being very proactive on managing costs all across the board, not just diesel fuel, not just transportation costs. And, you know, our diesel fuel was up 65% in the first quarter versus the same quarter last year. So we're very focused, very committed to managing the costs, and we're just going to have to let it play out as the year goes on.

Colleen Burns

Then I guess just broadly on gross margin, I mean, obviously, a nice improvement in gross margin. Do you see this level as sustainable just generally speaking?

David Tehle

Yes, as we continue to work on shrink, the opportunities that exist in pricing, as we continue to work with the vendor community on cost of goods. We're really focused on sourcing, particularly overseas. We see opportunities for margin expansion.

Colleen Burns

And then the increase in accrued expenses in the first quarter, what's driving that increase? Was that just timing or anything in particular?

David Tehle

Yes, I think that's more timing than anything having to do with interest payments and things of that nature. Interest can swing us on our accrueds pretty heavily, obviously.

Colleen Burns

Okay, then just broadly, your expectations for working capital this year. Do you expect to have a [source] given the accounts payable payment terms and your focus on inventory management?

David Tehle

You know, I'd rather not be that specific. I will say we continue to work for continuous improvement, both in inventory and payables. We're always looking for ways to be more efficient. And again, I believe the biggest pop has occurred, particularly on the inventory side with what we did with the Alpha Project.

Colleen Burns

And then just lastly, I think you said you had lower advertising expenses in the first quarter. What's your expectation regarding advertising expense for the remainder of the year?

Richard W. Dreiling

You know, we really don't go and really comment on our advertising spends until the end of the year, particularly this year as we're really evaluating where we want to spend our money. We're an EDLP operator. Word of mouth is probably the best advertising we can look for or encourage. We are shifting circulars around to hit the proper timing in the month more.

So I would like for you to say hey, stay tuned and we'll give you an update toward the end of the year on it.

Operator

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

Charles Grom - J.P. Morgan

Just on that question, could you speak to your ad circular strategy in the first quarter? Did you do more circs or was it just more efficiently managing the process?

Richard W. Dreiling

It was more efficiently managing the process and timing the release of the circulars better.

Charles Grom - J.P. Morgan

And then on your model store program, could you quantify how many stores you've rolled it out to, the comp lift that you've seen in those stores and expectations going forward on that program?

Richard W. Dreiling

When I talk about model stores, I need to clarify that. I don't want anybody on the call to believe that we're rolling out a new generation of store. What a model store is is really us standing up and saying today as the state of play, this is exactly how the store should look. It's what should be in it, how it should be merchandised and how we're executing.

We would probably have anywhere from two to three model stores in every district in the company right now, and this is a process that we're going to work on and roll through as we get toward the end of the year.

Charles Grom - J.P. Morgan

And then the last question would be on mix, 70% consumables this quarter. Historically, you guys have been much higher than your direct peers. Just wondering, Rick, if you could comment what you think the right mix is for Dollar General going forward over the next couple of years?

Richard W. Dreiling

You know, that's an excellent question and one that we're continuing to work on and focus on. I really don't know. I do know that we don't want to turn ourselves into a grocery store long term, that we want to be a general store. And what I'd like to do is have you give me the chance to work on the sourcing side and the nonconsumable side before we commit to what we think it should be.

Operator

Your last question comes from [Ann Wareheimer - Van Campen].

Ann Wareheimer - Van Campen

I have a few questions. The first one, just on your pricing strategy, are you still using a national pricing model or have you moved to market pricing?

Richard W. Dreiling

We are currently still using a national model.

Ann Wareheimer - Van Campen

And is a market pricing model something that you're still considering rolling out? Any kind of timeframe associated with that?

Richard W. Dreiling

You know, we're doing a lot of research and a lot of work in pricing right now, and I'd like to leave it like that if I could.

Ann Wareheimer - Van Campen

And then just looking at the home category, I know in previous quarters you'd mentioned that you felt the underperformance was more related to the company [inaudible] product mix in that category, and I was just wondering if that's still your view and if you are still expecting it to rebound later in the year?

Richard W. Dreiling

We are really focusing on being more trend relevant. And we have a lot of initiatives under way as we look at that category and some of the other nonconsumable categories, and we need to see how the year plays out.

Ann Wareheimer - Van Campen

And then lastly, just on your traffic, wondering if you think the increases are more as a result of your current customers increasing their shopping frequency or if you think that you're benefiting more from customers trading down and coming to Dollar General instead of going to Target or other higher-priced places?

Richard W. Dreiling

Yes, I actually think it's a combination of both. I don't think there's any doubt in these economic times people are looking for EDLP pricing. They're looking for consistent quality. And I think we are attracting a segment we haven't before.

I also think with the increase in gas prices, our 8,200-plus convenient locations, that we're an easy stop for the other customers that we have or current customers.

Well, with that, I'd like to thank you all once again for joining us today. We appreciate your interest in Dollar General, and I look forward to updating you on our progress throughout the year. Thanks again.

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Source: Dollar General Corporation F1Q08 (Qtr End 5/2/08) Earnings Call Transcript
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