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Family Dollar Stores, Inc. (NYSE:FDO)

F3Q08 Earnings Call

July 2, 2008 10:00 am ET

Executives

Kiley F. Rawlins - Investor Relations

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

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

R. James Kelly - President, Chief Operating Officer

Analysts

Meredith Adler - Lehman Brothers

Adrianne Shapira - Goldman Sachs

Mark Miller - William Blair & Company

Charles Grom - J.P. Morgan

Patrick McKeever - MKM Partners

Michael Baker - Deutsche Bank

Deborah Weinswig - Citigroup

David Mann - Johnson Rice

John Zolidis - Buckingham Research

Wayne Hood - BMO Capital

Operator

Good morning. My name is Whitney and I will be your conference facilitator today. I would like to welcome everyone to the Family Dollar third quarter earnings conference call. (Operator Instructions) I would now like to introduce Ms. Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin your conference.

Kiley F. Rawlins

Thank you, Whitney. Good morning and thank you for joining us today. We appreciate your continued interest in Family Dollar Store.

Before we begin, you should know that our comments today will include forward-looking statements which are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act. These statements address plans and activities or events which we expect will or may occur in the future. However, a number of factors, as set forth in our SEC filings and press releases, could cause actual results to differ from our plans. We refer you to and specifically incorporate the cautionary and risk statements contained in today’s press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, July 2, 2008. We have no obligation to publicly update or revise our forward-looking statements except as required by law and you should not expect us to do so.

With me on the call today are Howard Levine, Chairman and CEO; Jim Kelly, President and COO; and Ken Smith, Chief Financial Officer. We’ll begin our discussion this morning with a review of our third quarter results and our outlook for the fourth quarter from Ken. Then Howard will discuss how we are positioning Family Dollar within the current economic environment. Following our prepared remarks, we will open the call for a question-and-answer session. As Whitney indicated at the beginning of the call, please remember that the queue for the question-and-answer session will not be available until after we have finished our prepared remarks.

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

Kenneth T. Smith

Thanks, Kiley. This morning we reported results for the third quarter that were better than we had planned. Although our sales results were at the low end of our original expectations, better-than-expected gross margin performance and tight expense control led to an appreciable improvement in operating margin. The result was a 7% increase in net income and a 15% increase in earnings per share for the quarter.

As we reported a few weeks ago, total net sales for the quarter increased 2.9% while comparable store sales were approximately flat. Sales in the quarter were driven primarily by consumables, while more discretionary categories, including apparel, home and seasonal remained challenged.

I am pleased to report that traffic and transaction trends improved modestly in the third quarter. After a decline in March resulting from the shift in Easter, customer traffic and transaction trends stabilized and we are encouraged by what we have seen since late May. Gross profit as a percentage of sales declined approximately 25 basis points, reflecting a stronger mix of consumable sales. Consumable sales increased to approximately 63% of sales in the quarter, as compared with approximately 59% of sales in the third quarter last year. Lower mark-downs helped to offset some of the impact of this mix shift. In addition, we have been successful in managing through the inflationary pressures we’ve seen from higher commodity and raw material costs, and have maintained or improved initial purchase mark-ups for most categories.

While we are selectively investing in incremental consumable inventory in support of traffic-driving initiatives, we continue to be aggressive in limiting our exposure in more discretionary categories. Inventories in all three of our major discretionary categories declined year over year and at the end of the third quarter, average inventory per store was approximately 3% lower than average inventory per store at the end of the third quarter last year. I would remind you that this is the ninth consecutive quarter of inventory improvement.

SG&A expense for the quarter increased about 1% to approximately $488 million, compared with approximately $484 million last year. Despite a flat comp, SG&A expense as a percentage of sales declined approximately 60 basis points. I would like to highlight three factors that contributed to this strong performance.

First, we continue to see the financial benefits of operational and process improvements, reflecting our ongoing efforts to lower store level inventories, increase store manager retention, and improve our operational processes. We experienced lower workers’ compensation and general liability trends for the fourth consecutive quarter.

Second, you may recall that we incurred approximately $6 million of expense related to shareholder derivative actions during the third quarter of fiscal 2007. Consequently, professional fees were lower during the quarter this year.

Finally, we have maintained strong cost controls and have continued to see the benefits of investments we have made in our centralized procurement and facility management programs. I am pleased to report that we have successfully lowered our cost structure below historical run-rates.

The tax rate for the third quarter was 36.1% compared with 35.0% in the third quarter last year. The increase in the tax rate was primarily a result of changes in state income taxes. In addition, you may recall that the tax rate in fiscal 2007 was positively impacted by a retroactive reinstatement of federal jobs tax credits.

In the first three quarters of fiscal 2008, we generated approximately $339 million in operating cash flow, more than adequate to fund approximately $109 million in capital expenditures and approximately $50 million in dividend payments.

Working capital for the quarter fell to approximately $238 million, reflecting the reclassification of approximately $234 million of auction rate securities to long-term assets. Due to the continued failure of auctions for these securities and the uncertainty regarding the timing of future liquidity, the investments were reclassified. As a reminder, our ARS portfolio included primarily triple A rated bonds that are collateralized by student loans guaranteed by the federal government. While the auction failures limit our ability at this time to liquidate these investments at par, we believe that operating cash flows and existing credit facilities will provide sufficient liquidity for our ongoing operations and growth initiatives.

Now, let’s talk about our expectations for the remainder of the year. We believe that the strength we saw at the end of May reflected the investments we have made in our consumable assortment, warmer weather conditions, the effects of our promotional strategy, and some early benefit of stimulus checks. That strength has continued, and as we mentioned in the press release, sales for June are trending above our expectations. Although the upcoming holiday weekend will impact our final results, we now estimate that comp store sales will increase around 6% in June. We will report final results for the June period next week.

For the quarter, we expect comparable store sales to increase 4% to 6%. We believe the fourth quarter will benefit from the tax stimulus checks but projecting the full impact and the duration of the benefit is difficult. We expect that strong sales of consumables, combined with continued tight expense control, will result in earnings per share of between $0.30 and $0.35 in the fourth quarter of fiscal 2008, compared with $0.26 last year.

These expectations, combined with our performance through the third quarter, result in an earnings per share expectation for the full year of between $1.58 and $1.63.

Now I would like to turn the call over to Howard. Howard.

Howard R. Levine

Thank you, Ken and good morning, everyone. Today we announced earnings per share growth that exceeded our guidance and as Ken noted, we now expect June sales to exceed our original plans. Although the current macro conditions are clearly making it difficult to project performance, I am pleased with the fundamental strategic improvements we have made in the way we execute our business.

After a challenging first half, our results for the third quarter and our outlook for the rest of the year reflect how quickly our team has adapted to the changing and challenging macro environment. The investments we have made to drive top line growth are delivering strong results and our team has done a great job managing expenses and inventory risk in this uncertain environment.

Today, Americans are looking for ways to manage household budgets that are increasingly challenged. Value and convenience are more important than ever, and I believe that those retailers who can offer customers both will increase market share in this environment.

Our strength in assortment of consumables and our easy-to-shop small neighborhood stores position us well in these difficult times. Our consumable business has been strong this spring, increasing more than 9% in the third quarter. However, our discretionary business, which represents a heavier mix of sales than some others in our channel, has been more negatively impacted by environmental factors.

Our customers, more so than higher income customers, make purchases when driven by need. While the rising cost of energy has certainly affected our customer spending capacity, the shift of Easter and a cooler spring also impacted demand in the third quarter for more discretionary categories like apparel and seasonal items. I would note that where warmer temperatures have settled in, our performance in these categories has improved.

Despite the softness in these discretionary categories, our team has done a good job managing inventory levels. Our project accelerate investments have provided us with greater visibility to underlying business trends, enabling us to make better decisions. As a result, this quarter we delivered an improvement in inventory productivity despite a flat comp.

Most companies today are challenged by an environment of intense pressure from rising commodity prices, energy costs, and inflation. The pressures we face today are some of the strongest headwinds I’ve seen in my 25-plus years in retailing. So far, the competitive environment has been mostly rational and our merchandising and global sourcing efforts, in conjunction with our strong vendor partnerships, have enabled us to manage inflationary pressures well.

In the face of increasing cost pressures, we are reaping returns from our investment and are becoming more efficient and effective in the way we operate our business. Through our investments in centralized procurement, facilities management, and energy savings programs, we have lowered our cost of doing business in a sustainable way. These investments, combined with the strong discipline of expense control, have enabled us to manage our cost structure below our historical rates. We are now positioned to leverage the short-term benefit we are seeing from the stimulus and also to manage expenses better in a more challenging environment.

There has been much discussion in the market regarding the potential impact from the stimulus checks on consumer spending. As Ken mentioned, we expect our results in the fourth quarter will benefit from the additional income. However, quantifying the full impact and the duration of the benefit is difficult.

We expect many of our core customers to spend most of their checks rather than save or pay off credit card debt. Economic pressures have been building for several months now and with gasoline at more than $4 a gallon, we can be sure that some of the funds will be absorbed by the gas tank.

With a strong understanding of our core customer, we have positioned Family Dollar to get our fair share of that spend while also managing inventory risk. As we have discussed, we have expanded our assortment of basic consumables and have also improved our in-store presentations of home to family apparel and strengthened our opening price points. We have ramped up our customer communications to emphasize the values we offer on both consumables and discretionary items, and we are making additional investments in advertising to help customers stretch their stimulus dollars.

While we are pleased with the results of these investments so far, I want to emphasize that we expect that the benefit of the stimulus checks will be relatively short-lived. This month’s minimum wage increase should bring some relief. However, we continue to expect that our customers will be financially challenged post stimulus. As we look out into fiscal ’09, we remain concerned about the economic pressures our customers will face and we are taking a conservative approach to controlling expenses and managing inventory as we head into the holiday season.

Having expressed caution about the health of customers post stimulus, I want to reiterate that we have improved our ability to manage through these uncertain times. We have strengthened our assortment of consumables, we have reduced our cost structure, and we are aggressively managing inventory risk.

For almost 50 years, we have provided customers with value and convenience in a small, easy-to-shop environment. Throughout our history, we have remained true to our core values and stayed focus on our longer term vision, even after we have adjusted to changing economic conditions.

I am confident that as we have continued to meet our customers need for convenience and value, maintained strong cost controls and effectively mitigate risk, we have positioned Family Dollar to be more competitive and accelerate return.

And now, Operator, we’d be happy to open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Meredith Adler from Lehman Brothers.

Meredith Adler - Lehman Brothers

Hey, guys. Congratulations. I was wondering if you could just talk to us a little bit about some of the particular components of expenses. You’ve obviously brought the overall run-rate and cost structure down, but some of the benefit did come from workers’ comp and other insurance, and you said I think there were four quarters of improvement. Should we anticipate that there will be further sequential improvement in those expenses?

Kenneth T. Smith

Well, Meredith, I think we are very pleased with the expense leverage we’ve seen. The components, the call-outs when we looked at expenses, you know, the first being the sustainability of our work-force has driven several benefits to include positive trends in our workers’ comp and GL insurance lines, and we have seen positive trends that have continued for the last four quarters.

You know, we are going to continue to work on store manager turnover trends and continue to work to improve that retention rate, which has a direct link to insurance claims, along with continuing to work on lowering our inventory levels, both of which can have a positive impact on insurance.

So it’s very difficult to predict insurance trends and actual claims out into the future, but we are pleased with the results we’ve seen certainly in the last -- this year and for the last four quarters.

Meredith Adler - Lehman Brothers

Okay, and then a question about -- I forget what you call it, but I hear others call it strategic sourcing, and I know you’ve been working very hard to sort of centralize the procurement of a lot of things, not just products but services. Can you talk a little bit more about how much more of that there is to do? I think when I was with you, you said there was still lots of opportunity but I just want to confirm that.

Howard R. Levine

Yeah, Meredith, we have had our central procurement operation in place now for a little over a year, so we are working our way through our major spends and as we do that, we continue to identify opportunities to drive costs down. So we see some further legs there.

Meredith Adler - Lehman Brothers

Okay. And then the final question, and I don’t know if you can answer this, but you said that the weather did get warmer in some places in June. I don’t know how much of your geography it was warmer, certainly warmer here in New York, but I was wondering if you could -- I think you start your markdowns for apparel in early July. Any comment about how you are feeling about the apparel inventories going into that markdown period?

Howard R. Levine

Meredith, I can’t comment currently on where we are in apparel inventories and how that’s going but we have taken our markdowns on spring and summer this week, in fact, and the way I think we can position this is we talked about last call that apparel inventories were down double-digit as we cleaned out the fall and winter season and positioned ourselves for spring and summer. So we continue to manage our apparel inventories effectively, or on a more conservative basis and in fact, at the end of the third quarter, apparel inventories were down in the high-single-digit area, so we continue to be conservative there and manage and mitigate risk on some of those more discretionary but still important treasure hunt categories within our mix.

Meredith Adler - Lehman Brothers

Great. Thank you very much.

Operator

Your next question is from the line of Adrianne Shapira with Goldman Sachs.

Adrianne Shapira - Goldman Sachs

Thank you. You know, very impressive on the cost control. I’m just wondering, could you give us a sense, now that you are working to lower the cost of doing business, what sort of comp you need to lever expenses, where it had been and where it is today?

Kenneth T. Smith

Well, I think that the history of -- you know, our break-even comp point, we go back a quarter ago, we would have been -- we talked about our historical run-rate for a comp break-even point of 3 to 3.5. In the last quarter, we discussed an aspirational goal to lower that into the 1% to 2% for the second half, so we are pleased with the results we’ve seen from working to achieve those targeted numbers in the third quarter, and will continue to work on the cost structure out into the future. But those were our goals for the second half.

Adrianne Shapira - Goldman Sachs

So in light of that, since you are looking for sort of 4% to 6% comp next quarter, I’m just wondering, given your guidance, the conservatism would suggest there -- there seems to be a fair amount of conservatism, since you are looking for that 4% to 6% comp, and now that you are potentially able to lever the much lower comp, can you give us a sense where perhaps the source of upside could be coming from?

Kenneth T. Smith

I think our 4% to 6% comp links pretty well with the earnings guidance. I think the two big -- we are going to continue to work on the expense side, as we’ve discussed for the second half, and we would expect from a margin perspective that the consumables will still have strength and could put some slight amount of pressure on the margin in the second half.

Howard R. Levine

I think the big variability in the fourth quarter will be the sales of discretionary items, and that creates variability in the comp guidance as well as our gross margin expectation.

Adrianne Shapira - Goldman Sachs

Thank you.

Operator

Your next question is from the line of Mark Miller with William Blair.

Mark Miller - William Blair & Company

Good morning. My question is on the merchandising changes you highlighted. I would like to get a sense overall for the assortment. You indicated consumables are being expanded. How much is that assortment increasing? And then what’s the overall change in the SKU offering at the company?

And then you talked about also strengthening opening price point. Can you elaborate on that? I understand the need to I guess accentuate the value image but what about middle income consumers that might be increasingly trading down? Will they find as much product that’s enticing for them?

Howard R. Levine

Sure, Mark, I’ll take a stab at that. You know, first on the consumable part of that, you know, as we discussed earlier on in the calendar year, our plan was to grow and improve the efficiency of our consumable offering. You know, the food strategy was the biggest change that we had talked about and we grew our assortment in about 2600 stores earlier on in the year. And that’s positioned us very nicely with our customers. As you recall, you know, the first leg was our cooler program. The second leg was trying to link what we were doing inside our store with what we were offering in our coolers, and we continue to make nice progress on our store of the future offering, which will enable us to accept food stamps in about half of the chain by this holiday season, which I think is important in that that’s about more than double the number of stores that were able to accept food stamps last year. So the food program is doing well and we are enjoying some nice comps there and would expect that to continue through the quarter.

The second part had to do with the consolidation of the laundry detergent, referred to as compaction. And with the smaller put-ups that some of the manufacturers are going to enabled us to grow that assortment, offering some bigger values, our larger sizes, which are more value, which was really playing into the trip consolidation issue that all of us are facing with high gasoline prices.

And the final leg of the consumable categories was in the paper area, and while we did add some SKUs there, that primarily had to do with the better presentation of that merchandise. With the bulk of those categories, we felt that by improving some of the presentations at the store that we could do a much better job of showing the customer what we had, enabling our stores to better merchandise those categories into cycle count the categories in a more appropriate way, so I applaud our team for those changes, as it was a significant amount of change for us to take on in such a short period of time and I think we did a very good job of that without having too many slip-ups, so that positions us very nicely going into this quarter and the next year, and we are pleased with the progress there.

The -- and you’ll correct me if I’m not getting all your questions, Mark, but the second question had to do with opening price points and growing our opening price point categories, and that is simply just going back to our roots and the strength of our business. You know, I think what happens sometimes is as we grow categories and continue to move down the timeline of merchandising our stores, we’ve tried higher price points to explore what we could do and right now, we are really focusing on just satisfying the opening price point with our customer today. That’s the heart of our business, it has been the heart of our business and we think that that’s the appropriate strategy in the environment that we are in today.

Your other comment about the middle income customers I think is a good one and I’m often asked about trading down with the customer, and I think we’ve done a lot of things to try to capture some of that business. While it’s very difficult to measure those things, I think some of the things that we’ve done as it relates to our quality improvements in all merchandise categories, as well as the improvements that we are making in our stores in terms of shop-ability and store standards should position us very nicely to capture some of that business. So we are excited about what that opportunity might be for us as well.

And help me with what the third --

Mark Miller - William Blair & Company

Well, the only other aspect that you didn’t address is overall assortment in the stores, has the SKU count expanded with consumables in aggregate then? Or are there other -- you know, how much rationalization has there been elsewhere? So just the aggregate picture.

Howard R. Levine

No, there wasn’t much SKU expansion in the categories that -- in the consumable categories, Mark. I think while we did add some categories, as I mentioned, in paper and in the compaction from the laundry compaction, but it was just getting more efficient with our assortment and I mentioned that we still think there’s a lot of life to that as it relates to project accelerate capabilities and our ability to look at SKU rationalization even further.

Mark Miller - William Blair & Company

My other question, I guess briefly, is have you done additional research with your customer base to determine what proportion are impacted by this next $0.70 increase in minimum wage? And also looking out to next year, kind of the proportionality of each increase would be helpful. Thanks.

Howard R. Levine

I don’t know if I can address that particular aspect of it, but I think the minimum wage increase that we are going to be seeing in the next few weeks will be a benefit to us. You know, it was muted somewhat last year and I think that had to do with the fact that a lot of states had already exceeded what the federal minimum wage was. This year, there is a bigger increase and I’ll mention that there’s a further -- there’s another increase coming next year, but we clearly believe that’s a benefit to us, like a lot of things, difficult to quantify but are looking forward and I know some of our customers were looking forward to some of that additional income.

Operator

Your next question is from the line of Charles Grom from J.P. Morgan.

Charles Grom - J.P. Morgan

Thanks. Good morning. Just on your balance sheet, I noticed that your accrued liabilities declined a little bit more than $10 million sequentially. I was just wondering if you can explain that trend, because the past couple of years, we noticed that sequentially from 2Q to 3Q, they rose.

Kenneth T. Smith

The biggest impact on the accrued liabilities line is the impact of the insurance accruals, so that would be the one call-out from a balance --

Charles Grom - J.P. Morgan

Is there any way you could -- could you quantify that? Is that possible?

Kenneth T. Smith

I don’t have that -- I can’t give you a specific number on that right now.

Charles Grom - J.P. Morgan

Okay. Anything in addition to that, or is it just the insurance?

Kenneth T. Smith

I think that’s probably the main call-out we have on the accrued line. Nothing else stands out.

Charles Grom - J.P. Morgan

Okay, great. Thanks. And then just in terms of the consumables category as a whole, is there any way you could quantify for us what the inventory turns are in that category in this third quarter relative to a year ago? Just curious -- obviously you are adding more of a lower margin product into the mix. I’m just wondering if you are able to capture or maintain the same sort of trend in gross profit margin dollars.

R. James Kelly

The relative productivity of our consumable inventories are up year over year, and we would expect that trend to continue as we become more efficient and productive through several of our consumable initiatives.

Charles Grom - J.P. Morgan

Okay. And then last one for Howard, just longer term when you look at the mix, obviously it’s come up a lot and the same trend happened at DG before they went private. I’m just wondering what you think is the right long-term mix for the company, relative to where it is today?

Howard R. Levine

Sure, Chuck. I think, as I’ve said for many years now, when we look at our inventory mix, we have always tried to balance the appropriate amount of consumables and that offering, along with the treasure hunt components of our inventory. You know, right now as our consumer is financially stretched, we are seeing some nice improvements in the consumable business, which we are very pleased with. You know, I would expect as the economy improves that we will see our treasure hunt categories also start to show some improvements.

But the way we’ve always thought about this, and we manage this over the long-term, is that it’s important to have the appropriate balance between consumables categories and the treasure hunt categories, and we would expect to continue to manage that in that way.

Charles Grom - J.P. Morgan

Okay, and one more, sorry, Ken, if I could, just on the accrued liability question I had earlier; how sustainable do you think that is when you look to the fourth quarter and into the first quarter of ’09? Was that a one-time benefit or do you think you will have lower insurance accruals over the next couple of quarters? Thanks.

Kenneth T. Smith

On the insurance side, I think what we do know for a fact is we’ve seen a positive trend for the last four quarters and we do, as we monitor the claims and we look at those each week, actually, we see the claim history but it’s very difficult to project into the future what insurance claims and occurrences are going to have, so it’s very difficult to look into the future and make predictions on continuation of insurance claims.

Charles Grom - J.P. Morgan

Fair enough. Thanks very much.

Operator

Your next question is from the line of Patrick McKeever with MKM Partners.

Patrick McKeever - MKM Partners

Okay, thanks. You mentioned products cost inflation and you are doing a good job managing through that. You are seeing it but managing through it pretty well. What are you doing right now with zone pricing? How far have you gotten with that particular initiative? I feel like I’m seeing a lot more price points at the stores, and also just wondering what percent of the mix at this juncture in time is priced at the dollar price point, and then what percent of the mix is priced at even ballpark, even dollar price points? Thanks.

R. James Kelly

I think we have managed the inflationary pressures fairly well so far, but that’s -- that isn’t simply a pricing mechanism, as you know. A lot of it is around an ability to deliver value to the customer by looking at alternative vendor sources, alternative value propositions that are more appropriate during difficult times. For example, Howard mentioned the emphasis on opening price points, which is really just trying to deliver them value that they can afford.

From a pricing perspective, we do have zone prices. We have operated with zone prices now for a number of years. We continue to refine our pricing models. We established a pricing group, what, a little over a year ago and made them very, very helpful to our buying organizations as we manage through this.

You mentioned the, by nature of your question, the importance of dollar price points. It is very, very significant so part of our pricing strategy incorporates the protection of particular price points, such as the $1 dollar price point. We are not prepared to get much more granular than that in terms of our exact pricing model and the mix of our merchandise.

Patrick McKeever - MKM Partners

But Jim, have you had to decrease the number of SKUs that are priced at the dollar price point, or just maintaining that number?

R. James Kelly

I think so far we’ve been able to protect sensitive price points fairly effectively.

Patrick McKeever - MKM Partners

Okay. And then just one question on the June comp trend, the 6% that you talked about -- is it fair to assume that because the weather has not been as favorable in the Midwest and to some extent, the Northeast, certainly been a little on the cool side and wet in the Midwest, is it fair to assume that some of the current comp strength is coming from the Southeast or the west, where it’s -- the more favorable weather places?

Kiley F. Rawlins

Patrick, I will have all of that detail for the full period when we report next week. I’m not prepared to comment about it at this time.

Patrick McKeever - MKM Partners

Okay. Thanks.

Operator

Your next question is from the line of Michael Baker with Deutsche Bank.

Michael Baker - Deutsche Bank

Thanks, guys. So a couple of questions, one’s following up on a previous question -- for the gross margin next -- so you’re down 30 basis points this quarter. In the fourth quarter, so I understand you talked about some gross margin pressures from consumables, et cetera, should the gross -- is there any reason to believe the gross margin will be vastly different in terms of down 30 basis points as a trend? In other words, are you adding more consumables and/or are you still going to have the benefit of fewer markdowns in the fourth quarter?

R. James Kelly

I think I said earlier the big challenge in predicting the gross margin in the fourth quarter is the amount of discretionary sales that will be in the fourth quarter. The fourth quarter has a significant range there from a comp perspective and the largest part or the most difficult part of that to predict is the impact of the stimulus program, particularly as it relates to discretionary expense. So I think that’s the big variable. Obviously there’s continued margin pressure resulting from the mix shift as well as increased diesel fuel, but we continue to work with our global sourcing, our pricing initiatives, our shrink initiatives, our private label initiatives and other avenues, such as markdown optimization to try to mitigate the markdown pressures. That’s an area that we can’t really be too precise going into the fourth quarter.

Michael Baker - Deutsche Bank

Okay, but nothing specific that makes it a tough comparison or something that helped this quarter that won’t help next quarter, or anything along those lines it sounds like?

R. James Kelly

No.

Michael Baker - Deutsche Bank

Just the general, tough to predict -- second question and I’ll make it the last question and then pass it on, is what do you do with your cash? You haven’t bought back stock here. Is that a function of the -- and I know that that was what you had said earlier in the year, but just an update on your thinking there -- is the lack of buy-backs a function of the auction rate security situation or is there something else going on there? And I guess what point do you feel comfortable to begin resuming buy-backs? Thanks.

Kenneth T. Smith

I think the buy-back question is -- it’s an area we monitor, have used historically as a tool and we continuously monitor the market and we’ll continuously evaluate the opportunities to buy back. In this economy, we are clearly taking a more cautious approach with the current macroeconomic environment. You mentioned the auction rate securities. That doesn’t preclude us from buying stock back but it is a factor in our decision process, so we will continuously, ongoing monitor the market as we look to make those decisions.

I will say that, similar to the third quarter, the guidance that we put out for the fourth quarter assumes that we do not buy any stock back.

Michael Baker - Deutsche Bank

Okay, great, thanks and I’ll pass it along.

Operator

Your next question is from the line of Deborah Weinswig from Citigroup.

Deborah Weinswig - Citigroup

Congratulations on a great quarter. In terms of -- you had spoken about kind of as a result of merchandising and global sourcing efforts in conjunction with your strong vendor partnerships, they have really enabled you to manage the inflationary pressures well. Can you elaborate on that a little bit? Because I think you are one of the few retailers that really has been able to make a dent there.

R. James Kelly

Well, I think it’s no silver bullet scenario. Everyone is faced with the same challenges. We have discussed over the last six to 12 months that the inflationary pressures coming through our various vendor supply chains has been significant. I think fortunately we have a lot of tools that we are working with simultaneously that each have helped. Our global procurement group has been very helpful in finding alternative sources. For example, in the apparel area we are now sourcing about a dozen countries, so that has enabled us to counter some of the pressures in some parts of the world.

I think our pricing group has been very, very helpful. We’ve also had a lot of vendor coordination and cooperation as we’ve sought to develop a value proposition that our customers would appreciate.

So to date, knock on wood, we have been successful. Our initial markup throughout most of our categories have been either maintained or slightly improved, but it’s an ongoing continuous battle.

Deborah Weinswig - Citigroup

Okay, well, keep up the good work. And then also, I think you guys have talked about four long-term investment priorities of project accelerate, store of the future, global sourcing, and concept renewal. This is going to be a long question, but can you help us understand where you are in each of those in terms of kind of what inning? And also at this point in the game, kind of how are you prioritizing investments in those four priorities?

Howard R. Levine

I’ll start with that and maybe Jim will chime in. You know, the first one, project accelerate, I think is a work in progress. We this year rolled out the financial planning tool, which I mentioned in my formal comments which has enabled us to look at our business in a more refined way, and I think has shown some benefit in managing and helped mitigate inventory risk in some of those discretionary categories. That team is working strong today and that’s making -- we continue to make progress there, as well as get some of the benefit from some of those things. I mentioned the financial planning tool but there’s the pricing benefit that we are starting to see and the timing for that could not have been better going into this inflationary area. We are still early on in that and we’ll look to continue to invest in that for this year and next year.

In terms of store of the future, I think the key point there is, as I did mention earlier but this holiday we will have twice as many stores, or double the amount of stores that we have taking store of the future this year as we did last year. We added 1900 -- we have 1900 stores at the end of the third quarter and still have a few more to go to get approximately half of the chain covered which, as I said, is twice the number of last year. That team continues to make significant progress. We are taking food stamps in those stores, we are taking credit card in those stores, we are taking debit in those stores, so we are more convenient to our customers there and I think that will continue to work -- we continue to work until we complete the chain with that investment.

You know, one of the things that is often missed in the store of the future is how we approach that, and it’s more than just a POS system to Family Dollar. We looked at things like how we can hire better. Part of that rollout is enabling us to take applicants and process new associates electronically to help mitigate and eliminate in some cases the amount of paperwork processing that goes along with that, along with some training tools, online training tools and many other things that will help our store managers do a better job of executing the initiatives that we have going on in our stores.

So again, that’s making progress and we will be halfway through at least the POS aspect of that by this holiday.

Global sourcing has ramped up also. Global sourcing, as Jim mentioned, has been a key component of helping us mitigate some inflationary risk, as well as opening new sources for us to do business. This group also helped establish better quality control and specs for us, to being managed more centrally as opposed to each individual buyer. Clearly those things are going to be real important to us as we grow our private label program, and private label will be linked very closely to global sourcing.

But you know, as we’ve been importing goods for many, many years and import about 40 -- about 40% of what we sell is imported, think that that probably is one of the most significant opportunities that we have as we continue to grow.

And the fourth item you mentioned was concept renewal, something that I’m real excited about. When I go in those stores and I see the offering and the presentation and the shop-ability of those stores, it makes us fully competitive with some of the best retailers out there today and we talk about a tough economy and the fact that there will be some trading down, I think those stores are positioned very nicely to capture some of that trading down. And when you go into those stores, it’s just a tremendously pleasant shopping experience and think that we will continue to make progress in that initiative. You know, we’ve talked about all of our new stores have the concept renewal format in them and we are currently testing and understanding some roll-back strategies for that initiative, but something that we are clearly excited about and something that our customers have told us they are really appreciating, so a lot of things we’re working on, and sorry for the long answer but we are pretty passionate about all of these initiatives and while there’s a lot going on, we have a great team that are working on all of these and think that we will continue to make progress in spite of the difficult economy out there.

R. James Kelly

I would add that you’ve seen us over the years, when we take on these projects, they tend to be defined very broadly with extensive process change, as well as technology changes. So we look at these projects, particularly the first two, store of the future and project accelerate, as only being in the middle innings right now. So we’ve got clearly another three or four years to drive further benefit from those.

The global procurement, as well as concept renewal, are both in even earlier stages. I would say the first and second inning of those. We are seeing some benefits today but when we look at where we are going, we feel very confident that there’s a lot of legs left in both of those initiatives.

I think roughly from a macro perspective, we are enthusiastic about what these projects have delivered to date but even more enthusiastic about their future potential.

Deborah Weinswig - Citigroup

That’s incredibly helpful, and then just one follow-up on global sourcing. I don’t know if you’re comfortable at this point in the game, but how should we think about not for resale that you are sourcing versus for resale? And where do you think you have the greatest opportunity going forward?

R. James Kelly

Could you repeat that question? I’m sorry.

Deborah Weinswig - Citigroup

Yes, on the global sourcing side, in terms of what you are buying that’s kind of not for resale, so either paper bags or kind of, you know, store versus for re-sale.

R. James Kelly

Yes, actually that’s been an area that the central procurement group has worked very effectively with our global procurement team to surface opportunities in things like our shopping bags, as well as carts and fixtures and other things. So we are beginning, as we evolve into that particular area of our business to identify further opportunities.

Deborah Weinswig - Citigroup

Great, well, thanks again and congratulations.

Operator

Your next question is from the line of David Mann from Johnson Rice.

David Mann - Johnson Rice

Thank you. Good morning. My question, just to clarify the factors that are helping you on initial mark-up, would you rank the global sourcing initiative as being the main driver, or is the pricing an equal or more important driver of some of those, of helping offset inflation?

R. James Kelly

David, in this inflationary period, it is incredibly difficult for us to pinpoint the relative impact of each of these. We certainly attempt to measure it but I think there’s a lot of cross winds blowing, so at the end of the day, I congratulate the buyer for great negotiating, global procurement for helping find the vendors, pricing to help us set the price right, and acknowledge that the IMU is still intact, so I’m just happy without having the precision of saying which one is really driving the greater benefit.

David Mann - Johnson Rice

Similar to how you answered the last questioner’s questions about where you are in the ballgame, where do you think you are in terms of pricing? Have you seen any kind of sensitivity there in terms of some of the pricing increases where you’ve seen some drop-off in some product sales?

R. James Kelly

Oh, absolutely. You know, one cannot make the number of pricing changes that we are making and others in retail are making without making some mistakes, so the real key is to acknowledge that you will never bat a thousand in this business but to have processes in place that you can measure the results of your price change on your consumers, and we do that both by looking at sales fluctuations and by performing independent market studies. And we are now positioned that when we do make mistakes, we rectify them fast. So yes, we do see customers’ reactions. Overall, our customers are telling us through customer surveys that we continue to deliver great values in their perception of our prices is very, very positive.

David Mann - Johnson Rice

Okay, great. In terms of the advertising you talked about doing, can you just elaborate a little bit more on how -- you know, what you are doing, the spend this quarter versus recent quarters, whether you actually took it up? And then do you expect to expand it at all in the fourth quarter?

Howard R. Levine

Sure, David. You know, advertising has played a changing, an ever-changing role over time in our channel and we saw over the last 18 to 24 months was an intensified promotional environment. You know, when you look at how customers have consolidated trips in response to the economic pressures, we have increased our advertising and promotions to drive traffic, primarily to reinforce the value and convenience proposition that we offer.

In the future, we expect to continue to be flexible and adapt to these changing market conditions.

David Mann - Johnson Rice

But in terms of your spend year over year, any comment there?

Howard R. Levine

No.

David Mann - Johnson Rice

Okay, and then one last question -- can you just talk about, on the expense side, what you are seeing in terms of shrink and your freight cost trends?

R. James Kelly

Well, I think what we are seeing in terms of shrink is our operators are doing a heck of a job in a very difficult environment. Shrink is flattish in a tough time, so we are very pleased with what they are delivering.

In terms of freight, we see diesel prices continuing to go up. We have, knock on wood, so far been able to through optimization of routing, back haul improvement, and improved cubilization largely offset diesel increases, but that remains a challenge for us.

David Mann - Johnson Rice

Great. Thank you very much.

Operator

Your next question is from the line of John Zolidis of Buckingham Research.

John Zolidis - Buckingham Research

Good morning. Could you just talk a little bit about the Bugle Boy product that’s out in the stores, and some of the I guess fixturing and merchandising you’ve put around the consumable area, the archways? Is that fixturing in all of the stores? It certainly makes the area seem more attractive to me when I go through the store visits, so can you comment on those two things, the Bugle Boy and the fixturing on the consumables? Thanks.

Howard R. Levine

Sure, John. At a high level, both of those initiatives, whether it’s Bugle Boy and the fixturing surrounding that and some of the things you saw in terms of the archway over the food area, are really part of what we are attempting to do in concept renewal, and that is to create more of a store within a store environment, with improved adjacencies and positioning the product. So that’s really where those, both of those fall under and I will mention that we are very pleased with what we are doing in Bugle Boy and the customer reception that we have received thus far from our Bugle Boy merchandise.

John Zolidis - Buckingham Research

Is that Bugle Boy product selling better than the previous product that you had in the same categories?

Howard R. Levine

Absolutely, yes.

John Zolidis - Buckingham Research

Okay, great. And then, I’m sorry, did you quantify the impact on SG&A of the two items that you called out, the insurance reserve and the other thing?

Kenneth T. Smith

No, we -- I mean, the two call-outs in our release are we mentioned the insurance but we didn’t put a number on it. And the other specific number was the $6 million related to the derivative action in last year’s -- that affected last year’s number.

John Zolidis - Buckingham Research

Okay, so that just didn’t repeat but can you -- I mean, are you willing to quantify how much the insurance -- was it a reversal of a previous accrual?

R. James Kelly

You know, what’s happening there is we’ve over the last three years fundamentally changed a number of things that impact both healthcare and workers compensation. That ranges from stabilization of the workforce to safety process improvements, et cetera. What that has done has led to about four or five quarters now in which the claims history has improved. So as we continue to see improvement in the claims history and continue to improve our practices relative to the settlement of prior year claims, we are seeing a favorable overall trend. And I think this is something that we’ve seen now for four straight quarters. We had another very favorable trend this year. I think you will see it somewhere fairly significant in terms of 60, 70 basis points but it is fairly consistent with where we have been progressing and trending and knock on wood, hopefully that trend will continue for a while.

John Zolidis - Buckingham Research

Okay. Thank you.

Kiley F. Rawlins

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

Operator

Okay, your last question is from the line of Wayne Hood with BMO Capital.

Wayne Hood - BMO Capital

Howard, I was just curious about, you know, as we get into the latter part of the first quarter and second quarter, the mix shifts back towards discretionary merchandise. And I’m wondering whether or not we’d see a down shift in comps from call it four to six to flat again, or up low single digit. And what you are buying to in apparel and home inventory into that back half of the first quarter and into the second quarter, particularly in light of the promotional activity that surfaces during that period?

Howard R. Levine

Sure, Wayne. I think first of all, we are still finalizing some of the final details of our ’09 plan, but the way I would characterize our purchase plans as we go into the holiday is one of conservatism as it relates to discretionary merchandise. One of the things that impacted us last holiday season was we were pretty aggressive in the purchase plan. This year we are taking a more conservative approach and as I mentioned in my comments, would not anticipate and do not anticipate, although we would like to see the 4% to 6% continue, you know, have really pinned some of that on the stimulus and as that falls and begins to lessen, we would expect that to impact comps.

Nevertheless, I don’t want to take away from the other things that we have done to impact the excitement that will surround this holiday season. You know, we’ve talked a lot about consumables but Bugle Boy, as was mentioned earlier, is a key part of our strategy and I think that we will be positioned to compete in a very positive way this holiday.

Wayne Hood - BMO Capital

So you’re not telling the buyers to buy it down? With Bugle Boy, you would think you would buy it up but the other businesses, you may buy flat to down?

Howard R. Levine

Yeah, I don’t want to talk about each category and how we are addressing our buy plan there. I think as you’ve heard us say quite a few times, we are trying to mitigate inventory risk in an uncertain economic environment and I think that’s really the underlying philosophy that we took as we approached not only the spring and summer season but as we go into next fall and winter as well.

Wayne Hood - BMO Capital

And then my final question was how much of the lower break even comp is due to back burner projects that would normally be there in a better economy, and therefore when things do stabilize or improve, that really the break even comp is probably more like three to five, because you would accelerate those projects back up again?

R. James Kelly

I think very, very low. Clearly we have curtailed some of our lower cost C priority items, but as we went through earlier in this conversation, I am very pleased with the amount of investments we are making in our future -- project accelerate, store of the future, the global sourcing concept renewal are all initiatives that are requiring funds today, but they are also driving return. So we are trying to be very, very focused on how we invest but have not curtailed those investments significantly.

Wayne Hood - BMO Capital

All right. Thank you, guys.

Kiley F. Rawlins

That is all the time we have for this morning and unfortunately, we did not get through all of the Q&A. As always, I will be available after the call if you have additional questions. Thank you and have a safe holiday.

Operator

Thank you for joining today’s conference call. You may now disconnect.

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Source: Family Dollar Stores F3Q08 (Qtr End 5/31/08) Earnings Call Transcript
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