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Executives

Mary Winn Gordon - IR and Public Relations

Rick Dreiling - Chairman and CEO

David Tehle - CFO

Analysts

John Heinbockel - Guggenheim Securities

Matt boss -JPMorgan

Meredith Adler - Barclays Capital

Colin McGranahan – Bernstein

Scot Ciccarelli - RBC Capital Markets

Dan Wewer - Raymond James

Deborah Weinswig - Citi

Charles Grom - Deutsche Bank

John Zolidis - Buckingham Research

Joseph Parkhill - Morgan Stanley

David Mann - Johnson Rice

Mark Montagna - Avondale Partners

Aram Rubinson - Nomura Securities

Anthony Chukumba - BB&T Capital Markets

Denise Chai - Bank of America Merrill Lynch

Patrick McKeever - MKM Partners

Joe Feldman - Telsey Advisory Group

Dollar General (DG) Q2 2012 Earnings Call September 5, 2012 10:00 AM ET

Operator

Ladies and gentlemen this is the Dollar General Corporation Second Quarter 2012 Earnings Conference Call on Wednesday September 5, 2012 at 9:00 a.m. Central Time. Good morning and thank you for participating in today’s call which is being recorded by Conference America, no other recordings or rebroadcast of this session are allowed without the company’s permission.

It is now my pleasure to turn the conference call over to Ms. Mary Winn Gordon, Dollar General’s Vice President of Investor Relations and Public Relations.

Mary Winn Gordon

Thank you Lindsay and good morning everyone. On the call today are Rick Dreiling, our Chairman and CEO; and David Tehle, our CFO.

We will first go through our prepared remarks and then we will open up the call up for questions. Our earnings release for the quarter can be found on our website at dollargeneral.com under investor relation press releases.

Let me caution that today’s comments will include forward-looking statements about our expectations, plans, objectives, anticipated financial and operating results and other non-historical matters. Our 2012 forecasted financial results and initiatives, expectations regarding share repurchases and capital expenditures and comments regarding expected consumer economic trends are some examples of forward-looking statements.

Important factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our earnings release issued this morning, our 2011 10-K, which was filed on March 22, 2012 and in the comments that are made on this call that we encourage you to read that. You should not unduly rely on forward-looking statements, which speak only as of today’s date. Dollar General disclaims any obligation to update or revise any information discussed in this call.

We will also reference certain financial measures not derived in accordance with GAAP. Reconciliations to the most comparable GAAP measures are included in this morning’s earnings release. This information is not a substitute for the GAAP measures and may not be comparable to similarly titled measures of other companies.

Now, it’s my pleasure to turn the call over to Rick.

Rick Dreiling

Thank you Mary Winn and good morning and thank you all for joining us today. We had another record second quarter and we are on track for a great year at Dollar General as we once again raised our earnings outlook for 2012. David will provide more details on our financial results in a moment.

First, I want to share few highlights from the second quarter. Our total sales increased 10.4% over last year to $3.95 billion. Same store sales grew 5.1%. Both customer traffic and average ticket in our comp stores increased for the 18th consecutive quarter.

Operating profit excluding secondary operating expenses in the 2012 quarter increased 11% to $388 million or 9.8% of sales up slightly from last year due to 17 basis points of SG&A leverage offset by a 13 basis point decrease in gross margin.

Interest expense was down $25 million. Our adjusted net income increased 27% to $231 million. And adjusted earnings per share increased 33% to $0.69 which includes a benefit of approximately $0.04 from the cash settlement of an income tax audit. Same store sales in all four major categories, consumables, seasonal, home and apparel were positive in the second quarter with consumables once again leading the way. This was the first time in 12 quarters, that all categories comp positive which we believe in part is attributable to the changes in our apparel merchandising and pricing strategy.

As we mentioned in our first quarter earnings release, there was some benefit in the first quarter that may have been a pull forward from the second quarter due to the early spring weather. With the quarters behind us, we now believe that that pull forward was about 40 basis points to the first quarter coming out of the second quarter. On a two year stack, we were up a 11% for quarter two which is essentially on part with quarter one two year stack of 12.1% and for the first half of the year, our same store sales were up 5.9%.

As we discussed at our investor day in June, our core customers are depending on us more than ever and our base is run to include many more faithful customers with higher incomes than we've seen in the past. We continue to be excited about the progress we have made in attracting and retaining these customers as we built our brand across new geographies. For example, back in 2008, 23% of our customers view Dollar General as "not for me quality or image". Today that number is only 7%. Our customer centric business model drives our strategy. Knowing our customers helps us serve us better as she looks to stretch her household budget and the most recent syndicated Nielsen data suggests that we are achieving success in this effort. Dollar General continues to yet again make impressive market share gains and consumables with high single digit growth in unit sales and dollar market share on a four week, 12 week, 24 week and 52 week basis.

I'd like to turn the call over to David to discuss the details of our second quarter performance and our outlook for the rest of the year. I'll talk more about our operating initiatives when he's finished.

David Tehle

Thank you Rick and good morning everyone. We're pleased with our second quarter results. Across the board, it was a strong quarter for Dollar General. As Rick said, all four merchandise categories had positive comps. Consumables were strong, Home continued the favorable trends we've seen for the past few quarters, seasonal sales were up as well even with the early weather shift and finally Apparel was positive primarily as the result of very strong performance and accessories and (inaudible) other garments. Our gross profit rate was 32% for the quarter down 13 basis points from last year's second quarter rate. Our mix of sales in the quarter continued to trend more towards consumables which generally have a lower gross profit rate than non-consumables. Our price increases year-over-year were lower and mark-downs were modestly higher. Factors partially offsetting these margin pressures include higher initial markup, leverage on transportation expense in part due to lower fuel costs and the impact of LIFO which resulted in a $0.5 million benefit in the 2012 quarter compared to a $10.7 million provision in the 2011 quarter.

SG&A excluding secondary operating expenses improved by 17 basis point to 22.2% of sales. Leverage was primarily due to additional labor efficiencies enabled by our workforce management program and engineered labor standards as well as the impact of our strong sales performance. Favorable results and benefits cost and workers compensation and general liability expenses, in addition to various other cost reduction efforts also contributed to the improvement. Cost of increase at our rate higher than our increase in sales include fees associated with the increased use of debit cards and higher advertising costs.

We're pleased with our ability to effectively balance sales, gross margin and SG&A to drive a 11% increase in operating profit. For the quarter, operating profit excluding secondary operating expenses were $388 million or 9.8% of sales. Interest expense was down $25 million from the prior year to $36 million. We made tremendous strides in reducing our debt over the past few years and further reduced our high interest rate debt in the second quarter. On July 15th, we redeemed the entire $450.7 million outstanding principal amount of our 11 7/8% senior subordinated notes funding the redemption with proceeds from the issuance of new 4 1/8% senior note. The redemption resulted in a pre-tax non-operating loss of $29 million.

Our effective income tax rate was 34.1% in the 2012 quarter compared to 36.8% in the 2011 quarter. This year's effective tax rate was lower due to a $14.5 million adjustment or approximately $0.04 per share resulting from the favorable cash settlement of income tax audits partially offset by the exploration of the work opportunity tax credit and the favorable impact of the higher credits in 2011.

Finally, our second quarter adjusted net income increased 27% to $231 million and adjusted earnings per share increased 33% to $0.69 per share including the $0.04 impact of the tax settlement. The reconciliation of adjusted net income and earnings per share to GAAP can be found in the morning's press release.

Our strong operating performance resulted in cash flow from operating activities of $373 million year-to-date. Capital expenditures through the second quarter were $304 million with a focus on store growth, relocations and remodels. As of August 3, total inventories across were $2.15 up from the prior year by 9% in total and 3% on a per store basis.

Our inventory growth rate was lower than recent trends primarily due to a shift of receipt into the third quarter. Inventory turns were 5.2 times. Total outstanding debt at the end of the quarter was $2.89 billion. Net of cash, our ratio of long term obligations, adjusted EBITDA was 1.4 times at the end of the 2012 second quarter compared to 1.6 times a year ago.

Finally before I go over our guidance for the rest of the year, today we announced the new $500 million share repurchase authorization. This authorization is on top of the $500 million authorization approved in December of 2011. That's a total of $1 billion of what is authorized in the a year. We executed $485 million of the original authorization for the purchase of 11.7 million shares so we currently have $515 million authorized for additional purchases.

We believe share buybacks continue to be the best way for us to return cash to our shareholders and further strengthen our capital structure. For modeling purposes, our guidance does not assume any additional buybacks in the current year. We are updating our full year guidance to reflect our first half performance and our outlook for the remainder of the year. As a remainder, last year was a 53 week year with 14 weeks in the fourth quarter. This year's fourth quarter only includes 13 weeks and as a result, will affect our ability to leverage fixed costs to the same extent as in the prior year. Specifically, in the fourth quarter, we estimate that SG&A excluding expenses resulting from the secondary offering in the prior year will increase approximately 4% over last year's quarter which will result in a notable deleverage of SG&A due to the 53rd week comparison in 2011. Excluding this impact, my expectation is that the underlying fourth quarter SG&A trend would be in line with the prior quarters of 2012.

We are raising our earnings per share guidance. We currently expected adjusted diluted earnings per share for the 52 week fiscal year to be in the range of $2.77 to $2.85 including the $0.04 benefit from the favorable tax audit settlement in the second quarter. Our previous adjusted earnings per share guidance was $2.68 to $2.78 which did not include the second quarter tax settlement. We are assuming approximately $330 million weighted average diluted shares and a full year effective tax rate in the range of 37 to 38% including the tax settlement.

We currently expect total sales to increase between 8% and 9% over the 53 week 2011 fiscal year or between 10 and 11% on a comparable 52 week basis. (Inaudible) sales, based on the comparable 52 week period are expected to increase 4 to 5%. We continue to expect gross margin expansion in the second half of the year from modest improvement for the full year. Operating profit excluding this year's secondary operating expenses is now expected to be in the range of $1.64 billion to $1.66 billion compared to previous guidance of $1.62 billion to $1.66 billion. Interest expense is expected to be in the range of $130 million to $140 million, a decrease of $15 million from our previous guidance due to our effective refinancing.

Capital expenditures are expected to be in the range of 600 million to $650 million. For the year, we plan to open approximately 625 new stores and to remodel or relocate a total of approximately 575 stores which is an increase from our earlier remodel and relocate plans of 550 stores.

The new store openings and relocations, we expect to have approximately 110 Dollar General Market stores and a 125 Dollar General plus by the end of the fiscal year.

With that, I'll turn the call back over to Rick.

Rick Dreiling

Thanks David. We had a strong quarter and we have an exciting second half of the year planned to build upon the momentum. We are pleased with the strong to the third quarter including a very solid back to school performance. Through the second quarter, we opened 295 new stores including 21 Dollar general markets and 18 Dollar General plus stores, our new larger format is expanded coolers and water aisles. We also remodeled or relocated 416 stores in the first half of the year including 25 Dollar General markets and 46 stores converted to our Dollar General plus format. These formats could be a test for us and while it is still early in the process, we are evolving the concepts and getting more experience in order to improve sales productivity and profitability. I like the top line results we are seeing and I remain excited about the potential role that these formats have in our store growth opportunities.

At the end of the second quarter, we had a total of 10,203 stores in 40 states including 90 Dollar General markets and 70 plus stores. Our 27 stores in California at the end of the quarter are off to a great start. Our entry into California so far consists of four traditional stores, 14 Dollar General plus stores and 9 Dollar General markets. These stores are turning in strong sales performance consistent with our projections. We are on track for a total of 50 stores by the end of the year in California. Our new distribution centers, investment in Alabama and Lebec California are ramping up and in June we announced plans to build the 12th distribution center in Pennsylvania to support our store growth in the northeast. We expect this new DC to be completed in the fourth quarter of 2013.

We're making great progress on implementing phase five, our initiative aimed at optimizing shelf space to reflect demand in the stores based on geography, demographics and actual store experience. We believe this initiative will have a meaningful impact on our square foot productivity over the next two to three years. Year-to-date, we have touched approximately 570 stores or about 6,500 different set to ensure that they have the right planograms that fit their demographic profile. Results have been very favorable in this stores we've impacted. As you know, we've increased our emphasis on the $1 price point over the past year or so. We now have our $1 value in over 8000 stores and the nice thing about these offerings is that they are completely different from what's already in store and sales from this section are incremental to the basket. We will continue to add new merchandise and new categories for this section of our store to keep our customer engaged.

During this second quarter, we had strong performance in many of our non-consumable departments such as hardware, stationery home décor and domestic. There were several positives in apparel as well including accessories and everyday basic apparel such as men's work wear and lady sleep wear and undergarments. While ladies hanging apparel was disappointing, we do see some bright spots and we are optimistic that our fresh approach to apparel merchandising and pricing will gain further traction in the second half of the year.

We continue to make progress and improving our in stock levels. Out of stock for the second quarter were down 25% from a year ago and 45% from 2009. This improvement is contributing to positive results in our customer service scores as we believe that our focus in this area can continue to drive additional sales growth.

We are also moving forward with the implementation of our new supply chain system which we expect to complete over a multi-year time frame with a goal of reducing cost and increasing efficiency. As we are in the process of installing the new modules of our supply chain solution, we are running both the new and legacy systems in parallel to help prevent inventory disruptions or service level disruptions. This investment in our supply chain will enhance our ability to ensure that we have the right product at the right time in the right quantity and at the right cost to meet our customers' need.

So to wrap it up, we're very pleased with our second quarter and the first half of 2012 and we believe that we are well positioned for the second half of the year. at Dollar General, we remain focused on controlling what we can control and delivering strong financial results for our shareholders. I am confident that we have significant opportunities for sustainable growth at the heart of which is our commitment through convenient and our everyday low price strategy which continues to resonate strongly with our customers.

Before I close, I would like to give my sincere thanks to over 90,000 Dollar General employees who are responsible for serving our customers and delivered yet another great quarter. So with that Mary Winn, I will turn it over to you for questions.

Mary Winn Gordon

Okay, Lindsay we can go ahead and get started with the questions please.

Question-and-Answer Session

Operator

Thank you. At this time, we will open the floor for questions. (Operator Instructions). our first question comes from John Heinbockel with Guggenheim Securities.

John Heinbockel - Guggenheim Securities

I wanted to start with pricing. So, how stable do you think the environment is right now? And then as you look out to '13 and inflation coming, how do you think that's going to play out? Do you think that will be a rerun of 1Q'11 in terms of how quickly it gets passed through?

Rick Dreiling

Yes, let`s address pricing first. I think as I look at the price jacks in the ad activity, I think pricing is relatively stable much like the second quarter. I do think John you're seeing people value proposition more in print and more in radio and more on television. So I think while pricing is relatively stable, people are really touting their message much harder in the various types of media that are out there to do that. In regards to inflation, I would look at you and say, I anticipate we'll probably be very much the same thing you say in the first quarter. If that happened, but at Dollar General, once again we're committed to unit growth. And we're going to do everything we can to protect unit growth which ultimately is share growth.

John Heinbockel - Guggenheim Securities

Because you know, if you look back to 1Q11, you guys made a conscious effort to delay, postpone some of those price increases which served you well in the long-term. So I assumed that would be the MO again and I don't think we're going to see as much inflation as we did in '11 but that would be the approach you would take, correct?

Rick Dreiling

Yes, we believe the story at Dollar General, John, is unit and we have merchandising organization that's committed to that as I am. And we believe we drive units, everything else will take care of itself eventually.

John Heinbockel - Guggenheim Securities

If someone accuses you of saying to advertise market, their price differential as opposed to lowering price, so how do you combat that? For a lot of guys, I guess it wouldn’t make sense to lower price. I guess you'd fight fire with fire and do your own marketing but how do you attack that versus actual price cuts by somebody?

Rick Dreiling

Yes, I could take a basket of items and give you a great comparison against anybody any day. What I will tell you is, we do a very good job of tracking where the big box operators are. We're very, very comfortable where we are. So it's kind of one of the things you can say what you want to say. We're very comfortable where we are and I'm very pleased that we continue to maintain a very large GAAP with drug and grocery.

John Heinbockel - Guggenheim Securities

All right and then finally, just thinking about California. So where is Lebec now in terms of how many stores are coming out of the facility and generally speaking, as you build these new facilities and supply chain economics improve over time, do you think those pricing generally come down in those new areas over time as your economics improve or was it more your pricing is where you want it to be when your margins get better?

Rick Dreiling

Yes, couple of questions there. First of all, approximately 120 stores are coming out of Lebec right now. Remember we'll have 50 stores in California at the end of the year. we're servicing New Mexico, Phoenix and Arizona out of there. In regards to pricing, obviously the advantage on the margin comes from reduced distribution and transportation costs and that obviously puts us in a position to be more competitive if need be or translate into higher margin improvement.

Operator

Thank you. Our next question comes from Matt boss with JPMorgan.

Matt boss - JPMorgan

So your gross margin forecast assumes modest improvement for the year which implies improvement in the second half. How should we think about some of the embedded components such as LIFO, mix, markdowns, any color there would be great.

Rick Dreiling

Yes, I think as we look at the back half of the year, we definitely see a positive win back from LIFO. If you remember last year in both the third quarter and the fourth quarter, we had fairly sizable LIFO hits in the third quarter at around $11 million and in the first quarter, it was $22 million and right now, for the full year, our best guestimate on LIFO for the full year is it will be around $2 million. We also see some potential favorability out of our transportation and distribution and stem mile reductions and some efficiencies in cartons per load. Although we do watch diesel prices pretty carefully, diesel has been increasing over the last six to eight weeks and it's actually above where it was a year ago at this time. We'll see what happens now that Labor Day is behind us. And then on the DC side, we do see some efficiencies coming out of those new DCs as we get over the learning curve for those two DC. So that's really how it plays out.

Matt boss - JPMorgan

Okay, great. And your topline performance, more on the discretionary side was really encouraging. Can you speak to some of the in store initiatives under way to keep this momentum going and also was this performance maintained in August as well on the discretionary side of that?

Rick Dreiling

Yes Matt, I have to tell you, I think the merchant over the last year have done a wonderful job of improving the quality of the product and maintaining the retail price and the cost for that matter. And I think what's happening is that people are recognizing that we are offering up values now that are pretty consistent on a day in and day out basis. I will tell you how it's translating into August. I mean our back to school was at high single digits and we're very pleased with what we're seeing and the interesting thing as you recall and as I talked to you about back to school last year, I talked about it being more needs based. People were buying pencils and papers and notebooks. This year, they are breaking down and buying the backpack and they are buying the things that kids hang on the backpack. And again, I attribute that to, I think we've done a much better job on being more relevant.

Operator

Next question comes from Meredith Adler with Barclays Capital.

Meredith Adler - Barclays Capital

I thought, on the phase five that you're working on, the targeted assortment of the source, is really very interesting. Can you talk a little bit about and how you're going about it and what you're observing as you roll it, as you test it in some places, what are the learning's from it.

Rick Dreiling

The obvious thing is, what we're doing is, we're looking at categories that should be good, that are less productive in some stores. And naturally what led us to the fact and it's not a very good example, but I like to use it all the time is, the diapers versus the incontinence product. We're doing well in diapers. So the question is why are these 1,500 stores aren't don't which leads you to go to those stores, take a look at that stores and go, oh my god, they are built in an area where the customer base is a little more mature. And that is the process that the merchants are applying across the organization. Why does beer do better here than wine. And that's the process that's taking place. Some of its driven obviously by demographics. Some of its driven by the economic environment that the store's in. I don't know if that's helpful or not Meredith.

Meredith Adler - Barclays Capital

Well you had mentioned like 570 stores but a much larger number of set. Is that the 6,500 set I think you mentioned, that means for specific parts of the store?

Rick Dreiling

That's correct. I mean eventually you'll touch every store in the chain, but in some stores you might touch two or three sets, in some stores you might touch nine or ten. And that's why we are trying to equate this, not to just doing the stores, we're trying to equate to the number of categories that we'll touch long term. And Meredith, that's why we're so bullish like phase one, two, three, four that this has runway because it's going to get take us time to get through it.

Meredith Adler - Barclays Capital

And are there downsides to this? I don't know whether it changes you're buying or makes it more complicated for the distribution centers or is that, those costs just not meaningful?

Rick Dreiling

Now that's a very good question and when we talk about doing this, we're not talking about adding a bunch of incremental SKUs. What we're talking about is adjusting the phasings that guarantee an in stock position. So this is an invisible transition to the distribution center.

Meredith Adler - Barclays Capital

And just my final question would be about the plus stores you see sort of have enough of them to have a judgment. What sells differently? What works differently in the plus stores and a regular store?

Rick Dreiling

Yes, I would tell your number one, the perishable side of the business is much better because of the incremental cooler space, but I think what we're seeing at this stage of the game is the wider aisle is increasing the shopability in the store and the additional square footage is helping us with the in-stock. So you're seeing a nice lift basically overall and I can’t safe enough the incremental footage gives us more seasonal presence which helps us with the margin in the store.

Mary Winn Gordon

Lincy can we take the next question please?

Operator

Your next question comes from Colin McGranahan with Bernstein.

Colin McGranahan - Bernstein

Two quick ones for you, just looking at the non-consumables categories, the home category especially any apparel categories, you know the growth there was solid but a little bit deceleration from the first quarter. Was that the pull forward effect and then how do you get positive comps in apparel when total category growth is 4.2% relative to square foot growth around 7 and store growth of 5.8%, it's just that new stores don’t do much apparel business.

Mary Winn Gordon

Yes that’s a really good question and you hit the number right on the head of back off. It takes a while for that presence to ramp up and people get comfortable with the quality of the products you have got. When I look at the non-consumables and particularly apparel you know accessories, I think that merchants have done a great job of lining us with Foster Grant, how Foster Grant, Sun Glasses and readers which is by the name recognition again, great for the trade down customer because we have got a great price on those and they relate to that quality. We saw improvement in men particularly in work wear. We had a great quarter in underwear, when I look at ladies undergarments we did very well there and even to be Frank, while we had some drag in women’s hanging apparel there still was improvement there the drag wasn’t as bad as it has been and as I look at, I don’t want to forget about kids excuse me, the work that we have done on positioning kids and creating a center, what we are trying to do very hard Colin on the non-consumable side is what we have done on the consumable side.

We are trying to lift all the boats and we start to see that more even lift and while I am no way trying to imply that we have crossed the finish line but I feel for once we can see it from here.

Colin McGranahan - Bernstein

Okay that’s very helpful. Thank you, and then just second question. New store productivity is as we calculated it came in about 75% which is a little lower than where it's been and what thought about it might be higher given the impact of DG Plus and DG Markets in a mix, is there anything going on in that number?

Rick Dreiling

Yes that’s another excellent question, to be honest with you, we got behind on the number of new stores, we opened in the quarter and we didn’t get as many store weeks as we have historically seen in the quarter.

Colin McGranahan - Bernstein

Yes opened a little late in the quarter.

Rick Dreiling

Exactly rather than a store getting 7 or 8 weeks in the quarter, it got 2 or 3.

Mary Winn Gordon

All right Lincy we will take the next question please.

Operator

Thank you. Our next question comes from Scot Ciccarelli with RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets

First question is, can you size the incremental expense impact from running the dual supply chain system as well as the incremental cost associated with the move, or really the growth in California, more expense to market to obviously kind of make headway in.

Rick Dreiling

Yes and regards to the running the two platforms simultaneously, I would look at you and say very little incremental cost. I mean I would say it's negligible. We are doing that mainly as a safety valve Scot, what you don’t want to do is commit to a new program until you are a 100% convinced that’s going to be fully functional. While we are making a lot of great progress there we are been very cautious because what we don’t want a supply chain disruption and regards to California you know obviously it's going to be a little more expensive to operate. However, we are going in there with much higher volumes than we historically see in traditional markets. So in terms of the overall profitability of those, long term we think we are going to be just as solid in California as Alabama, Mississippi or Georgia.

David Tehle

Well that was the reason of course for opening the distribution center in Lubbock was to cut down the stem miles so we didn’t have to make those shipments out of our Ardmore facility in Oklahoma.

Scot Ciccarelli - RBC Capital Markets

Got it and that’s helpful and then you talked about with the reset, some stores down the road might have two or three touch, some will have nine or 10. How many store sets are there and how many sets are there in a storage so we know that what kind of what percentage.

David Tehle

Yes you know off the top of my head if I was guessing, anywhere from maybe 310 to 343 somewhere in there depending on the size of the store.

Mary Winn Gordon

All right, Lincy we will move on to the next question please.

Operator

Our next question comes from Dan Wewer with Raymond James.

Dan Wewer - Raymond James

The follow-up on your comments about pricing and the growing divergence between your everyday low pricing and everyday value pricing that some of your competitors are using. Are you finding that your customers will actually cherry pick between the two formats and perhaps go to one store and they have a hotter price on carbonated beverage for that weekend and shop dollar general for the other items?

David Tehle

Yes we have there is no doubt and I think every competitor will tell you have a subset of your customer that will always cherry pick right and we have that in our space as well the interesting stat for us and is that we tend to trade more customers with the dollar, the pure dollar segment than we do with people that would be more traditional for us and hence that we put the focus on the value valley over the last year and half. I know I would also like to throw out you too you know when you think about this you know I was actually talking to someone about this the other day, Dan there is a lot of white space out there, this really isn’t about that the deep small box discount channel which is just 5% of all of consumable retailing out there. We are trading customers across an over $800 billion world out there and that’s the exciting thing that we have discovered at Dollar General over the last 4.5 years is we can effectively compete not only with our light competitors but with drug and grocery and mass as well.

Dan Wewer - Raymond James

That was my follow-up question when you look at the market share capture between drug and supermarket which one is proving to be the most vulnerable to Dollar General.

David Tehle

Our share gains are coming from drugs first, grocery second and mass third.

Dan Wewer - Raymond James

Okay and then just a final, real quick question on page five, are you able to implement that in all of your new stores or do you need to have some operating history for new store before you have the data to start customizing inventory for that location.

David Tehle

Yes that’s another outstanding question, we have enough in all age, when we go into a market area, the store kit is set properly when we go in.

Dan Wewer - Raymond James

So all these stores have Phase IV.

David Tehle

That’s correct.

Mary Winn Gordon

Lincy we will move to the next question.

Operator

Our next question comes from Deborah Weinswig with Citi.

Deborah Weinswig – Citi

So in terms of a the apparel if I go the last quarter you talked about been much more promotional in terms of the approached to pricing, how key do you think that was in the success in the quarter.

David Tehle

I think quite frankly it was very successful, I think Deb I told everybody we arrived at the conclusion that the consumers is more used to seeing apparel promoted rather than everyday low price they are used to seeing it 20% off or 50% or buy one get one free and we really believe that we are moving in the right direction with that and what we will see more in the back half of the year.

Deborah Weinswig – Citi

And I thought there was something really interesting, you gave your prepared remarks where you talked about I think it was back in LA that there are 23% of your people said that it was not for me and its quality in the percent goes down to 7% or 8%, can you talk about how does that change where you put your stores in terms of locations and how that changes you know your product. I mean how does that just change to potential future success of Dollar General.

Rick Dreiling

I think quite frankly Deb it opens up the potential for Dollar General in a lot of markets or even trade areas that we would probably been afraid to go into the past. I mean there has been a radical change in the mix of products inside our stores over the last 4.5 years. I had to say we signed Foster Grant. I mean think about Foster Grant, that’s a name you all know and we have a fabulous retail on it. I mean very excited, we designed a dryers, ice-cream contract where we will dryers or Eddy's ice cream. Yes, you know through Nestle and those that brand recognition is making us relevant and it puts us in a position where we can demand maybe a little higher initials opening store sales when we build a new store which gives us the ability to go into a little more upscale market than we have dealt within the past.

Deborah Weinswig – Citi

Okay and then final one in terms of looking at the SG&A improvement in the quarter, how do we think about what inning we are in with regards workforce management and is how much more opportunity is there going forward?

Rick Dreiling

I think if you look at the quarter Deb, we definitely had favorable from workforce management that came forward in retail salaries and I think we probably have a couple more quarters in terms of favorability, they are obviously it's been going on for a while now and at some point it will start to diminish. We also had favorability in the quarter from our lower benefit cost as well as lower workers compensation cost. If we look at our mining targets over this year and next year, I mean there are a lot of things on our agenda in addition workforce management which has been a tremendous opportunity for us. We have opportunities other ways in labor to reduce cost. We have damages that we are looking at, supplies, rent, maintenance in the stores and then all kinds of things going on in transportation and efficient SKU movement. So again I want to stress how important our mining per cost reduction effort is at Dollar General and it's definitely has a lot of legs yet in terms of the future.

Mary Winn Gordon

Great Lincy we will move on to the next question.

Operator

Next question comes from Charles Grom with Deutsche Bank.

Charles Grom - Deutsche Bank

I will point to you a thing that discretionary could begin help you guys on the margin front and with regards to your second half gross profit margin outlook for a mass improvement, if (inaudible) over the years is going to be 2 million and that alone is going to give you about 30 to 40 bips in the second quarter per quarter, I am just wondering what are the head wins you guys are going to face because that guidance for a modest improvement looks pretty conservative.

Rick Dreiling

Yes I will take the first half, because the back half is a little harder, I will leave that for Tehle. In terms of I think that I am short getting very bullish on the non-consumable side, however it's too early yet and I think it will play out as we move through the second half. I think our strategy you know in terms of how we are pricing the product, we have done a much better job of buying the product and there is a little more margin there. So as I looked down the road I think as we moved through the back half of the year we are going to see some improvement.

David Tehle

Yes I think as we look at the pieces of the margin, definitely you know there is some mix issues continuing to go on, we watched that very carefully particularly to get into the fourth quarter as we get into the holiday season that’s a little called in terms of what the holiday is going to look like. We also believe we are going to have marks up than we had last year. You know some of that is an offset from LIFO obviously, the best something that we track carefully and then we are watching the diesel cost I mentioned earlier in terms of the impact they will have on transportation cost and right now diesel cost are above where they were last year. So you know we put it all together and that’s where we came out on it Chuck.

Charles Grom - Deutsche Bank

Okay and then you know just a follow-up on Matt’s question early, was the high single digit strength in just to back to school categories.

Rick Dreiling

We are pleased with what are we are seeing in non-consumables.

Charles Grom - Deutsche Bank

Okay so just across but it's not a (inaudible) side.

Rick Dreiling

Yes that’s exactly right, I wasn’t trying to send a message but that was the comp where we are at, I was just talking about the back to school.

Charles Grom - Deutsche Bank

Okay good and the other three formats you rolled down in California which are the three formats are you most happy with so far?

Rick Dreiling

That’s another really good question, I am a big proponent of the Dollar General, the traditional store. I think it's our bread and butter, it will always be our bread and butter and those stores are performing exceptionally well. I am very happy with what we are seeing in the Dollar General. We have entered the stock end market with three stores and with our Dollar General market Chuck and we are very pleased with what we are seeing there and the Dollar General plus, again the higher volume stores particularly in California with the density, we think it's going to be a good play too but again I want to reinforce, it's all about the Dollar General traditional store and that’s our bread and butter.

Mary Winn Gordon

Lincy, we will take the next question please.

Operator

Our next question comes from John Zolidis with Buckingham Research.

John Zolidis - Buckingham Research

Two quick questions, one on the SG&A growth in the quarter, it was a little bit lower on a percentage basis year-over-year than 1Q and you didn’t call out expenses related to the new distribution centers. So can you just talk about whether or to what extent those are adding incremental expenses and my second question is on transfer payments. I believe the latest data shows that the snap benefit payments have kind of flattened out relative to couple of years ago and certainly unemployment payments are down dramatically. Does that impact your business and your customer? Thanks

Rick Dreiling

Yes on the first part of the question, the we definitely had as the DCs came up that didn’t hit SG&A anymore in the second quarter but again when we prioritize the items and give what the biggest hitters were, the workers comp, the benefits and the retail salaries workforce management were larger than the impact of the DC, so that’s why it specifically didn’t get called out. On the San piece I will say a little bit and I will let Rick comment too, it stays pretty steady at 5% of our business and it's been that way for a while.

David Tehle

Yes that’s just basically, our customer tends to go somewhere else first and use us as a fill in.

Mary Winn Gordon

Lincy we will go on to the next question please.

Operator

Your next question comes from Joseph Parkhill with Morgan Stanley.

Joseph Parkhill - Morgan Stanley

A lot of my questions have been asked but I figured I would ask all about inventories, I think you mentioned something about some timing issues but if I look at a category perspective it looks like the biggest change in categories is home is up about 16%, so I was wondering if that’s just a timing difference or anything to do with some newer merchandize initiatives that you have.

Rick Dreiling

I mean our home business continues to do well as we mentioned, the timing difference we were talking about was we had, it was mainly payroll that we thought we were going to get in the quarter that didn’t come in the quarter and it was third quarter and that made that per store amount a little bit lower than we had been running traditionally. Again we are pretty happy with our turns that we have 5.2 turn versus a 5.1 that we had a year ago on the inventories, so we continued to be pleased and as always we try to balance our inventory turns we are in stock again the customer experience what we are trying to do for the customer in the stores.

Joseph Parkhill - Morgan Stanley

Okay and then just quickly, I mean wondering if you have any contingency plans in case there is a strike on the East-Coast port and if that were to happen how should we think about how that would impact your overall business.

David Tehle

Yes what we will do is we have a consolidation center on the East-Coast as well as the West and what we will do is move that product there and then ship it into the stores. So we feel pretty good that we got it covered.

Mary Winn Gordon

Lincy will we have the next question please.

Operator

Next question comes from David Mann with Johnson Rice.

David Mann - Johnson Rice

Going back to hanging apparel, given the struggle you have been there. Can you talk about in the back half and into ’13 some tactics that you might use to try and jump start that or should we continue to expect that to struggle.

Rick Dreiling

Like we are, like I said while we had some drag on hanging apparel in the second quarter. It was not as bad as we have seen the previous couple three quarters and we think two things are going to happen, number one our pricing strategy which we have seen some positive movement on across the apparel in general and now what’s happening is the fall and winter product is starting to finally come in and that’s our Lucinda Long, our Vice President, that’s our first real buy and I have to tell you we showed the Board the product at our Board meeting last week and they were encouraged in the quality of the product we are going to have out there.

So it's soon, it's very soon David, but I do think we are making, we are taking the right steps.

David Mann - Johnson Rice

Great and then an earlier comment I think David you made about mark-up perhaps been a little bit more modest in the second half, can you just clarify why that might be and they will soon update on what you are achieving on global sourcing. Thank you.

Rick Dreiling

On the mark-up comment a lot of that has to do with the LIFO and again I threw out some fairly large numbers last year that we took on LIFO in the third and fourth quarter and that had to do with cost increases that we were taking from vendors and as we have mentioned we selectively did have to take some prices up because of the cost increases that we got, so that really is why we had the mark-ups and the mark-up comment and with LIFO being lower obviously we don’t have as many of those mark-ups. On the foreign sourcing right now on a year-to-date basis, foreign sourcing is about 9.7% versus 8.5% last year. We have added new items in stationary back to school, home, domestics and toys. We now have a very small satellite offices and by satellite office I mean computer or phone and one or two people, so it's minimal capital investment but still doing us a lot of good. Satellite offices in Vietnam, Istanbul, Monterrey, Mexico and West Central, China.

We did in terms of the, if you look at the quarter the receipts were a little bit higher on foreign sourcing about a 11.4% versus 8.4% last year. We did have some early receipts in toys and stationary and again I think the year-to-date number is more representative of where we see the foreign sourcing. So again a lot of effort going on there and seeing impact in the current year because of it.

Mary Winn Gordon

All right Lincy, we will take the next question please.

Operator

Our next question comes from Mark Montagna with Avondale Partners.

Mark Montagna - Avondale Partners

Can you give us an update as to what percentage of consumable sales are now private brand?

Rick Dreiling

You know our penetration hit an all-time high, its 24.3 or 24.2?

David Tehle

Yes.

Mark Montagna - Avondale Partners

Okay and then what about the dollar items, where is that penetration now?

David Tehle

About 26%.

Mark Montagna - Avondale Partners

Okay and then higher mark-downs you had, was that all related to Apparel or were there higher mark-downs elsewhere.

Rick Dreiling

Some of that was in the consumable area, also some consumables and then the apparel too.

Mark Montagna - Avondale Partners

But what drove the higher mark-downs in the consumables area.

Rick Dreiling

It's a little more promotional in terms of what we are doing.

Mark Montagna - Avondale Partners

Okay and then are those promotions shared with vendors through some co-op advertising or is that.

Rick Dreiling

Well if you look at we always try to partner with our vendors appropriately on these types of things and sometimes we are success with that and sometimes we are not.

David Tehle

And Mark this falls back to our commitment to unit growth right, we are going to keep the units moving and we really believe that that’s foundation of our success last year and going into this year.

Mark Montagna - Avondale Partners

And then coming back to some of the questions where you had mentioned that drug and grocery customers that’s where you have seen a lot of market share gains, are you seeing anything specific were drugs for customers come in more looking for HBA and the grocery customers are more looking for the food items.

Rick Dreiling

You know here is what I would say, it's a really good question as I sit here and reflect on it what I would say is we were underpenetrated in HBA and we made a conscious decision a year ago to go in and expand those categories. So I can’t specifically say to you yes I am getting that from the drug customer or my consumable that’s coming from the grocery channel. But I think if you look at the power of what we have done with Rexall particularly on the HBA side, that brand recognition. I think we have just elevated the quality of the product at a great price and it's coming a little bit from everywhere Mark if that makes any sense.

Mark Montagna - Avondale Partners

Sure and just lastly, accessories within apparel did well, is that a new initiative that you expanded the assortment in that little category.

Rick Dreiling

Yes we have expanded the assortment and I also don’t want to sell short this commitment what we have with Foster Grant now. Again that’s what we don’t give then we brought tied in that’s a big deal.

Mary Winn Gordon

Lincy let’s take the next question please.

Operator

Our next question comes from Aram Rubinson with Nomura Securities.

Aram Rubinson - Nomura Securities

Can you tell us a little bit about the composition of the comp specifically about how much ticket was up roughly?

Rick Dreiling

You know we don’t break that out separately, they both contributed to the comp and transaction was higher than ticket but really they were both favorable and we are happy to see that.

Aram Rubinson - Nomura Securities

Okay and so maybe let me kind of try and just ask it more holistically, it seems that you have cited a lot of initiatives to drive your average ticket. You didn’t quantify a lot of them at your analyst date but there is still not a lot of movement I guess generically in the channel and in your business as well. Can you weigh in on how fixed you think the average ticket is in your channel overtime and even if you looked out five years, are we still in the $10 range or what do you think that involves too.

Rick Dreiling

Yes I think we can never lose focus of the site that we are the fill in shop or a bigger shop that takes some place else. And you know as I think about it. The importance of driving traffic I think is the number one thing for us right. Our customer goes and spends their money somewhere than they only have so much left and I think they will continue to spend more with us when there is less economic pressure on them. So as I think about the basket I think we will see modest growth through the years but we are committed to driving footsteps which we think ultimately will be the win for us and David do you have anything to add on that?

David Tehle

Yes the only thing I would add is that we do use the non-consumable driving basket as we said before and we are pretty happy with some of the new trends we are seeing in non-consumables.

Aram Rubinson - Nomura Securities

So you think five years from now, we are still on a $10 range?

Rick Dreiling

I don’t want to answer that one, I wish, I hope it's bigger than that but we will have to wait and see I think you are dealing with a channel that’s becoming more relevant and I think the one that we are demonstrating is we are broadening the appeal to a much different client base we have had in the past. Now I certainly could take you somewhere you could see some growth.

Mary Winn Gordon

Lincy we can cover another question.

Operator

Our next question comes from Anthony Chukumba with BB&T Capital Markets.

Anthony Chukumba - BB&T Capital Markets

Just had a quick question on California. I know it's early but it seems like you had a lot more the DG market, the DG Plus, your traditional stores then you also have more traditional stores and things like you know really kind of the ones that are performing the best. I mean how do you think about five years down the line, what is the break out of stores between the three formats in California.

Rick Dreiling

I think Anthony as you look at it, it has to do right now with the availability of real estate when we rolled into that market and it was slated more toward a bigger footprint and we made a conscious decision since we had that bigger footprint to put in DG Plus and the DG markets, long term in California like the rest of the chain our commitment to the Dollar General, the traditional store and we do believe like other areas of the countries there will be opportunities surgically to drop a plus store or a Dollar General market. But long term our commitment in California is to the DG traditional store.

Mary Winn Gordon

Then Lincy, there is time for another question.

Operator

Our next question comes from Denise Chai - Bank of America Merrill Lynch.

Denise Chai - Bank of America Merrill Lynch

You seem to be increasing the number of DG Plus stores that you are going to be opening this year. So if you could just comment a bit on the early performance that you are seeing on these plus stores in terms of maybe sales per square foot, basket size, basket components on this kind of thing compared to traditional DG or a DG market that will be really helpful.

Rick Dreiling

Yes on regards to the number of them opening, we said about almost a year ago we would have a 100 open by the end of year and I believe we got approximately 70 open now. In fact I actually might have said 100 to 125 somewhere in there. Right now it's a little soon for me to be talking about you know basket size and all of that but I will tell you Denise the preliminary indications are, we feel good. It's a bigger box it's going to require a little more effort in regards to mix, the cost of the facility and we are working on all those issues now and what I have said is after we get them open and then we have a little run-way with them and then we will give you some updates on where we are at.

Unidentified Analyst

And just one thing I want to clarify on August Back to School, do you say that you comp up by high single digits?

Rick Dreiling

That is correct and I was just talking about Back to School I am not talking about the entire quarter, just Back to School, we are really pleased with what we are seeing.

Mary Winn Gordon

Lincy I see two more people in the queue so let’s try to get through both of those and then we will get off given time constraint.

Operator

Our next question comes from Patrick McKeever with MKM Partners.

Patrick McKeever - MKM Partners

Question on e-commerce, I think you have had your e-commerce business before up and running for about a year now. What does the I mean I guess maybe if you can just give us some broad idea as to how big a business it is, what does the mix of sales look like, are you doing, are you selling more individual items or you are selling a fair amount of bulk merchandize and then I guess is this an incremental customer to you?

Rick Dreiling

Yes I think I kind of started the back rather than the front, what’s been best thing about the e-commerce site it's a customer that’s coming from states, we are not even in which we find fascinating and I think what’s going on here is Patrick that people are trying us out through the e-commerce site. What it has done by the way we are selling more unit items and bulk items, it's used more towards our electronic promotions, more towards HBA those sorts of things and I think what it has done is its forced us to do a much better job of upgrading the site.

We now a store locator program on there that I think it's very robust and again maybe even items like baby diapers, bulk items right, it's in terms of the amount of business it's going to do long term for us. I don’t want you to think it's going to be a $200 million business because it's never going to be that but it's an opportunity for us to expose ourselves, continue to refine it and hopefully use it as a communication vehicle to the customer.

Patrick McKeever - MKM Partners

And just a quick one on the Back to School merchandize or Back to School categories, I mean what percent of your business let’s say in August would you consider to be Back to School related?

Rick Dreiling

Patrick I don’t have that kind of granular information in front of me other than to say that we were very pleased with it, very pleased.

Mary Winn Gordon

Lincy I think we have got time for the last person in the queue please.

Operator

Our final question will come from Joe Feldman with Telsey Advisory Group.

Joe Feldman - Telsey Advisory Group

The one thing just more forward thinking that I did wanted to ask you about was, have you guys given any thought to what the impact of the different outcomes of the presidential election might mean on your customer. If the Republican win versus the Democrats and how that might impact social funding and I know you said Snap still only 5% but what does that do to your core customer, you know just in general if anything at all.

Rick Dreiling

Yes I think as I reflect on it here. When I think about our core customer, I think no matter who wins the Presidential election in the course of the next 60 days. I think there is going to be continued pressure on that customer for a very long period of time, whether it be you know these programs are going to come, what programs come, how much they are. I think at the end of the day, regardless of who is President people still need jobs and we all know that the pressure on the economy is going to keep that front center for everybody for a long period of time.

So what I will tell you Joe is, we started this journey as a team here by focusing on what we can control and while I can’t control the political environment I certainly can control what we sell, how much we sell it for and when we sell it for and that’s why we will stay focused and hopefully that will pay the same fruits 4.5 years from now like it's last.

David Tehle

One final comment Rick that I want to make it was pointed out in my opening comments so I might have said the wrong number on the weighted average diluted shares and the right numbers in the press release, our revised guidance is based on approximately 337 million weighted average diluted shares, just to avoid any confusion there.

Mary Winn Gordon

With that concludes our call, I am around all day and if anybody has any questions please don’t hesitate to call me and thank you for your interest in Dollar General.

Operator

Thank you ladies and gentlemen, this concludes today’s teleconference call. You may now disconnect.

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Source: Dollar General CEO Discusses Q2 2012 Results - Earnings Call Transcript
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