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Executives

Pat Watson - Corporate Communications.

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

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

Bruce A. Efird - President

Rick A. Chambers - Executive Vice President - Pharmacy Operations

Dennis (Keith) Curtis - Executive Vice President, General Merchandise Manager

Analysts

Patrick Mckeever - Mkm Partners Llc

Mark Miller - William Blair & Company, L.L.C

Gary Giblen - Goldsmith & Harris

John Lawrence - Morgan, Keegan & Company, Inc.

Jillian Caruthers - Johnson Rice & Company

Paul Trussell - J.P. Morgan

David Magee - Suntrust Robinson Humphrey

Joan Storms - Wedbush Morgan Securities Inc.

William Keller - Ftn Midwest Securities Corp.

Fred’s Inc. (FRED) F2Q08 Earnings Call August 28, 2008 10:00 AM ET

Operator

Welcome to the Fred’s Inc Conference Call. (Operator Instructions). At this time for opening remarks I would like to turn the call over to Pat Watson.

Pat Watson

Thank you for joining Fred’s to review the company’s financial and operating results for the second quarter and first half of fiscal year 2008, periods that ended on August 2, 2008.

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

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

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

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

Jerry Shore

Good morning to all of you and thanks for joining us this morning for our discussion of second quarter results for second quarter 2008.

With me this morning and available for questions are Michael J. Hayes, Chief Executive Officer; Bruce Efird, President; Rick Chambers, Executive Vice President of Pharmacy Operations; and Keith Curtis, Executive Vice President and General Merchandise Manager.

As the company reported in its press release this morning, total sales for the second quarter rose 5% to $447.1 million compared with $424.6 million last year. On a comparable store basis sales increased 4.9% for the quarter versus 0.8% in the same period last year. The sales results reflect the company’s previously announced program to close 75 under performing stores and 22 under performing pharmacies in 2008. Excluding these store closures total sales from ongoing stores increased 7% in the second quarter.

The sales mix for the second quarter was 25.5% household goods, 15.3% food and tobacco, 7.9% health and beauty aid, 9.3% paper and chemical, 9.1% apparel and linen, 30.7% pharmacy and 2.2% franchise. This compares with the following mix in the same quarter last year: 23.9% household goods, 14.1% food and tobacco, 8.2% health and beauty aids, 9.2% paper and chemical, 10% apparel and linens, 32.6% pharmacy, and 2.1% franchise.

For the quarter comparable store customer traffic increased 3.4% over last year, while the average customer ticket increased 1.5% to $18.89.

For the first six months of 2008 total sales reached $911.4 million compared with $866.9 million in the year earlier period reflecting a 5% increase in total sales and a 3.5% increase in comparable store sales versus an increase of 1.3% in the prior year period.

The sales mix for the year to date period was 24.9% household goods, 15.4% food and tobacco, 8.1% health and beauty aids, 9.2% paper and chemical, 8.9% apparel, 31.3% pharmacy and 2.2% franchise. This compares with the following mix in the same period last year: 23.4% household goods, 14.2% food an tobacco, 8.2% health and beauty aids, 9% paper and chemical, 10.2% apparel and soft line, 32.9% pharmacy and 2.1% franchise.

On a year-to-date basis comparable store customer traffic increased 2.3% over last year, while the average customer ticket increased approximately 1.2% to $18.88.

For the second quarter of 2008 Fred’s had net income of $1.0 million or $0.03 per diluted share compared with net income of $3.1 million or $0.08 per diluted share in the second quarter of 2007. Included in these second quarter results are costs associated with the closing of 50 stores and one pharmacy during the quarter as part of the company’s previously announced strategic plan, which included the closing of 75 under performing stores, and 22 under performing pharmacies in 2008.

The net cost associated with these stores and pharmacy closings in the second quarter totaled $4.7 million on a pre-tax basis and also included non-cash expenses totaling $6.7 million on a pre-tax basis for the remaining lease related liability. Excluding these net costs associated with the store restructuring program, net income was $4.2 million or $0.10 per diluted share, which is an increase of 25% over the second quarter earnings per diluted share of $0.08 last year.

I will point out that the cost of store and pharmacy closings in the prior year are not adjusted, as they were part of the company’s normal and ongoing process for closing unprofitable stores. The adjusted comparisons are made to quantify the financial impact of the company’s announced 2008 restructuring program.

For the six months ended August 2, 2008 net income totaled $8.3 million or $0.21 per diluted share compared with net income of $10.5 million or $0.26 per diluted share for the first half of 2007. Excluding the costs associated with the store restructuring program for the year-to-date period, net income was $11.5 million or $0.29 per diluted share, an increase of 10% over the first half of 2007.

Operating income was $1.9 million or 0.4% of sales in the second quarter compared with $5.7 million or 1.3% of sales in the year earlier period. Again excluding costs associated with the store restructuring program operating income was $6.7 million or 1.5% of sales, a 17% increase over the second quarter of last year. For the first half of 2008 operating income was $13.7 million or 1.5% of sales compared with $16.9 million or 1.9% of sales in the first half of 2007. Adjusting for the costs associated with the store restructuring program operating income was $18.5 million or 2% of sales which is a 10% improvement over the first two quarters of 2007.

Gross profit for the second quarter increased 2% to $123.9 million compared with $121.5 million in the same period last year. Gross profit for the first half of 2008 increased 3% to $256.43 million over the $248.5 million in the same period of 2007.

Gross margin for the quarter decreased to 27.7% of sales from 28.6% of sales in the prior period. The 90 basis point reduction results primarily from the continued product mix shift for basic and consumable products, but also increased costs of inbound freight affected the margin negatively by 20 basis points and the inflationary affect on pharmacy LIFO inventory adversely affected gross margin by 10 basis points.

Gross margin for the year-to-date period was 28.1% versus 28.7% last year, with the increase attributed to the same factors of [inaudible] for the second quarter and the inbound and LIFO impact were 20 basis points and 10 basis points respectively affect on gross margin.

SG&A expenses for the second quarter of 2008, including depreciation and amortization, were 27.3% of sales, the same result as in the year earlier period. Excluding the cost associated with the store restructuring program, expenses were 26.4% of sales and also included in the SG&A expenses are the $6.7 million of non-cash costs of expected lease related liabilities.

The expense leverage of 90 basis points comes primarily from managing costs in our stores while accomplishing the increase in comparable store sales volumes. Labor leveraged by 40 basis points overall, advertising 20 basis points, occupancy costs 15 basis points and distribution expenses leveraged 5 basis points in the quarter despite significant increases in fuel costs.

For the first half of 2008 SG&A expenses were 26.6% of sales compared with 26.8% in the prior period and again adjusting for the costs associated with the restructuring program expenses were 26.1% of sales versus the 26.8% in the first six months of last year.

Depreciation and amortization totaled $6.8 million in the second quarter and $13.9 million for the year-to-date period. For the second quarter of 2008 net interest expense was $78,000.00 versus $237,000.00 in the second quarter of 2007. The improvement in the quarter results primarily from the improved cash flows from the store closing, the inventory improvements in existing stores and the operating expense leverage and on a year-to-date basis net interest expense totaled $251,000 compared with $141,000 in the two quarters of last year.

The income tax rate in the second quarter was 44.7% of pre-tax income compared with 44% in the same period last year and for the year-to-date period the tax rate is 38.3% and we anticipate the tax rate for the remaining two quarters of 2008 to be in the range of 35% to 37%.

Now moving to the balance sheet, total inventory decreased 4% to $335.3 million at the end of the quarter compared with $347.6 million in the second quarter of 2007. The decrease in inventory is attributed to 5% fewer stores at the end of the quarter as compared to the same period last year, somewhat offset by our initiatives to improve in stock performance and add surprise as a light item. Inventory turns remained at 3.8 during the quarter and we anticipate that improving to 3.9 by the end of the year.

Capital expenditures for the second quarter totaled $3.8 million compared with $8.9 million in the second quarter of 2007 and on a year-to-date basis capital expenditures totaled $9.3 million compared with $14.8 million for the first half of 2007.

The break down of year-to-date capital expenditures included $4.4 million for new stores and pharmacies, $3 million for existing and remodeled stores, $600,000 for DC equipment, and $1.3 million for corporate and technology upgrades. Additionally there was $1.4 million related to acquisitions of pharmacies as compared to $400,000 in the second quarter of last year.

Year-to-date expenditures for acquisitions of pharmacies were $1.5 million compared with $0.7 million last year.

Total debt at the end of the quarter was $5.5 million compared with $34 million last year. At the end of the quarter there were no borrowings under our revolving line of credit, compared to $32.9 million last year. Additionally cash and equivalents were $9.6 million at the end of the quarter this year compared with $2.3 million at the same period last year.

The company operates 664 discount general merchandise stores including 24 Fred’s franchise stores. During the second quarter the company opened seven stores and two new pharmacies. On a year-to-date basis the company has opened 15 stores and three new pharmacies.

Continuing with our current strategy of closing under performing stores we have closed 67 stores and 22 pharmacies through the second quarter. With these closings the company’s total selling square footage has decreased this year to $9.4 million square feet. Compared to the same period last year total selling square footage has decreased by approximately 6%. The company anticipates that it will open 16 to 18 stores and 5 to 10 pharmacies and the selling space will decrease 9% for the year.

Financial guidance for the remainder of the year is as follows:

In the third quarter the company expects total sales to be flat with last year reflecting the closing of the 75 stores and 22 pharmacies in line with our restructuring program. Comparable store sales in the third quarter are expected to be in the range of 1% to 3%. We anticipate August sales to be at the lower end of the range for the quarter. The August retail calendar has an unfavorable effect of no first of the month where sales are typically higher. Also, the comparable store sales comparison in August is tougher as we experienced stronger sales last year than in the remaining months of the quarter.

Earnings per share are forecasted to be in the range of $0.16 to $0.18 per diluted share in the third quarter, increasing 33% to 50% over the same period last year and looking ahead the company continues to expect total earnings per diluted share for 2008 to be in the range of $0.54 to $0.58 including the costs related to the announced store closings. Excluding the costs associated with the store restructuring program in 2008 earnings per diluted shared are expected to be in the range of $0.72 to $0.76.

This concludes our financial summary and we will be happy to answer any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Patrick Mckeever - Mkm Partners Llc.

Patrick Mckeever - Mkm Partners Llc

On the gross margin decline in the quarter, how did that compare to your internal expectations?

Jerry Shore

I will answer that first and then Bruce can comment. We did not anticipate the 90 basis points. It was more to be in the range that we experienced in the first quarter, but then the opposite to that was the favorable operating expenses that we were able to leverage with the higher sales.

Bruce Efird

Just to add a little additional comment, obviously the impact came from the inbound freight additional charges, the increase in LIFO, but predominantly in the mix shift and we continue to see the mix in our sales shift from higher margin apparel and some home categories into our lower margin consumables.

We are also experiencing the impact of accelerated cost increases as a result of higher commodity prices and as with other retailers we are seeing these price increases from major manufacturers in the range of 7 to 33%.

Some of the things that we are doing to mitigate that are we have accelerated our price checks to ensure that we are leveraging opportunities to move when the market allows us, as well as continuing to work with the manufacturer and make sure our merchants are being diligent on challenging any cost increase. Another point that I would make is that our team is delivering on our plan to better manage the inventory which will improve the margins as a result of less clearance markdowns and we anticipate that to continue.

We will continue to put emphasis on our own brands, which the penetration has significantly improved through the first half; we anticipate that to continue as the owned brand or private label carries a higher margin. Those are some of the initiatives that we have in place to improve our margins.

Patrick Mckeever - Mkm Partners Llc

It sounds like there has been sort of a negative delta on the gross margin line and sales are a little soft going into, I know there are some issues with the first of the month and the comparison, but a little soft going into the third quarter, so I’m just wondering on the guidance, I mean basically you are reaffirming your back half of the year ETS outlook. Are some of the cost savings associated with the store closings coming in favorable to your original plan?

Jerry Shore

They are at least on where we though they were, but we are also getting the better leverage this year with programs that we’re putting in through the stores and distribution costs have been better, so I would say we are on plan with the costs related to the stores and [inaudible] pushing forward [inaudible].

Patrick Mckeever - Mkm Partners Llc

Do you feel like you are seeing benefits from incremental sales at stores that were not too far from some of the stores that have closed now, is that starting to materialize? I know you were looking to shift as much of the sales as you could from the underperforming store to the store that wasn’t too far away. Have you been monitoring those stores, are you seeing any incremental growth there?

Jerry Shore

Yes we have been monitoring. We have our list of what we call the referral stores and we are seeing a benefit in the stores. It is likely ahead of what we anticipated to pick up, but overall it’s a relatively minimal impact to the total sales. We are monitoring it and we are seeing the benefits exceeding the plan.

Operator

Your next question comes from Mark Miller with William Blair & Company, L.L.C

Mark Miller - William Blair & Company, L.L.C

Could you give us some sense for what the losses were in the first half of the year for stores that were ultimately closed by the end of July? And if we look at the first half $0.29 EPS excluding costs from the store restructuring program versus $0.26 last year, what would that be if we also strip out the stores that are closed, if we take out the losses from both periods?

Jerry Shore

First of all on your question of the costs associated with the closing of this years stores, we received the benefit in the going out of business sales on the gross profit line of about $2.6 million and that was offset by total costs of liquidation of about $7.4 million, so that’s how we got to the number that we did; included in that $7.4 million are the expenses, the non-cash items for the reserves established for the lease liabilities.

Then talking about your, as I understood the expenses for and the $0.29 related to that, if I understood the question that you’re asking, what was the effect of the store closings on the year-to-date basis and it was about $0.09 of earnings.

Mark Miller - William Blair & Company, L.L.C

Actually what I’m asking is, you stripped out the costs associated with the store-restructuring program this year, now you’re at $0.29 with that effect, but what if we looked at really only the stores that are still in operation? So if we took out the money losing stores that have been closed, if we took it out of both periods, would the company have had earnings growth in the first half and roughly what was the change in bottom line performance from ongoing stores?

Jerry Shore

We commented that the ongoing stores year-over-year did a 17% improvement in operating profits. I think that would be the effect over last year of the stores.

Mark Miller - William Blair & Company, L.L.C

Okay I’ll follow up later for more detail. Then relative to the cost increases that you commented on, those are some pretty big jumps that Bruce referenced. What would be the approximate sort of cost increase you’re seeing across the store maybe excluding pharmacy and then how much of that is being passed through? I wasn’t quite clear in the gross margin decline how much of it was coming from you having to absorb some of that cost increase and how much of it was due to mix shift which reflects apparel and other higher margin categories being a smaller percent of sales?

Jerry Shore

We can’t quantify the overall cost increases that we’re getting across the board, but we have anticipated that about 50% of the margin erosion attributed to mix shift or 50% is cost increases, 50% is in the mix shift, but again we are doing all that we can to pass those along where we can and again, increasing the frequency of retail surveys and we’re much more diligent around our surveys than we’ve been in the past.

Mark Miller - William Blair & Company, L.L.C

On the cash flow in the quarter you had excellent leverage of payables quarter on quarter. Is there anything unusual about the timing there and if not how is the company able to accomplish the next step up?

Jerry Shore

It is an effort that we are working on to manage our payables and improve days wherever we can. The second quarter ended positively. I’m not ready to take credit for the whole difference and say that’s where we’re going to continue to be, but we have made some changes that have improved what we’re doing in terms of processing payments and making sure that we do manage the days appropriately.

Operator

Your next question comes from Gary Giblen with Goldsmith & Harris.

Gary Giblen - Goldsmith & Harris

In your assessment is the softening in August due more to the depletion of the tax rebate checks or the overall softening in the macro economy?

Jerry Shore

I will first say that I believe it’s more the effect of that first of the month, because if you look at the amount of sales that we typically do on a first of the month, if we drive that comp between 1% and 2% we do $100 and $30 million a month and the first of the month would have that much of an effect on us, especially with pharmacy. Pharmacies are largely affected by first of the month.

Gary Giblen - Goldsmith & Harris

Are you satisfied with flattish pharmacy comps or would you consider more fully emulating the $4.00 generic program that most chains have in effect now?

Rick Chambers

What we are seeing is our strip comps are continuing to perform strong versus plain.

We are, as you said, seeing the softening of our top line sales. Part of it has to do with our competitive nature with the $4.00 program that we’re matching our competition with and then the other part obviously has to do with the continuation of the generic shift that we continue to see.

Gary Giblen - Goldsmith & Harris

But I mean now you’re only doing the $4.00 generics to a limited extent and in a small number of stores, right?

Rick Chambers

We have in about 1/3 of our stores with an anticipated roll out to widen that. As we have said historically on other calls, we’ve been more protective of market share in those markets where we’ve had to come in and implement our programs, but we are looking for a wider scale roll out in the coming months.

Gary Giblen - Goldsmith & Harris

In your assessment and I realize nobody has a crystal ball but will Wal Mart or others dial up promotionally for the holidays and what is your underlying assumption about that kind of thing in your guidance for the second half?

Rick Chambers

I would say that we will see continued increased promotional activity as evidenced in back to school. Every time you think you’ve seen an all time promotional high there is another one out there, so we anticipate increased promotional activity and we have adjusted our plan accordingly.

Operator

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

John Lawrence - Morgan, Keegan & Company, Inc.

Would you talk just a little bit, Bruce maybe, about your battleship stores? Obviously they’ve been tracking a little bit ahead of the control group. What would the four wall profitability of those stores look like now and is it what you expected and does that make you feel more comfortable going to the second half and as you roll out to the other part of the chain?

Rick Chambers

We do have our top performing store program which we focused on our top 50 producing stores and we call that our battleship program and we are seeing overall improvement. Our comp sales were above the chain during the first half. We are lagging behind slightly to our plan on profit contribution due to some higher expenses we experienced in Q1; however those are coming in line in the later part of Q2 and we expect to be on plan at the balance of the year with our goals and budget we have given those stores to increase their contribution.

John Lawrence - Morgan, Keegan & Company, Inc

Bruce taking that one step further, remind us of the roll out of how you’re taking these plans across the chain as we move into the back half of ’08 and into ’09.

Bruce Efird

Well we are selectively identifying initiatives. One in particular, just to give you an example, is our surprise and delight or special buys that we initially started in the battleship stores, we are now expanding into other stores. My challenge to the team has been to ensure that we get it right in these top 50 and that we have a sustainable contribution in the 50 stores before we start moving all the initiatives into other stores.

The in stock initiatives started in the top stores, bright [ph] and delight started in the top stores and we’re rolling those out selectively, I guess is the best way to put it, in the balance of the chain. We also have the comparable program in our top 40 performing pharmacies or our flagship pharmacies and our goal is similar, to accelerate the profit contribution in those stores and our incremental profit contribution in these top performing pharmacies is on track with our plan.

John Lawrence - Morgan, Keegan & Company, Inc

What was the item, if you don’t mind Bruce, what was the item that caused the delta from closing the gap there at the end of the second quarter from a cost perspective?

Bruce Efird

Partially in labor and in supplies.

John Lawrence - Morgan, Keegan & Company, Inc

But certainly things that you can deal with and adjust accordingly?

Bruce Efird

Absolutely.

Operator

Your next question comes from Jillian Caruthers with Johnson Rice & Company.

Jillian Caruthers - Johnson Rice & Company

I have a follow up on a previous question about the hype in promotional activity for back to school. Do you think that has any impact to August falling at the low end of plan? I know you had pointed out the first of the month loss.

Rick Chambers

What we have really seen is more after back to school. We are seeing it now at the end of the month which really tells us about the paycheck cycle and that first of the month not coming until I believe it’s Monday, but that’s where we’ve seen it more so than back to school.

Dennis “Keith” Curtis

Even with the heightened activity advertising in marketing for back to school, we feel like we were well positioned in the market place this year. Although we are not completely finished with our analysis of the back to school period, we feel that we executed our plans very well at store level and we’re pleased with our marketing efforts there and achieved our plans and our inventory positions were very good in the back to school categories and very favorable. That will be a big positive going forward to us in the future too, in those categories.

Jillian Caruthers - Johnson Rice & Company

Kind of digging into the pharmacy side of the business, I know you had mentioned a couple calls back that a store that has a pharmacy potentially has a 9% to 10% higher sales level; if you could talk about how that trends been going. Then also focused in the 22 pharmacies that you closed, what was the reasoning of that when typically a pharmacy does create a more profitable front end store?

Rick Chambers

On the ones that we did close last year, as we look back over the last two or three years, then we kind of looked at the demographic or make up of those pharmacies that were closed, it was somewhat more slanted towards some of our younger pharmacies. There were a few older ones in there where maybe the neighborhood or the market around that had divested away from us, so we went ahead and made the decision to include those closings in our list.

But, it got into basically how we were opening those pharmacies and location real estate proximity to medical communities and so forth and other competition factors that went into that and we refocused our strategy on that going forward and it proved very successful in the last 12 to 18 months in the cold starts that we have been opening, we are seeing a positive change with those new stores going forward. That was more of what went into it and why they worked are some of the factors that I mentioned in terms of past decisions.

Jillian Caruthers - Johnson Rice & Company

Do you have any additional comments on the profitability or the increase sales bumps that a pharmacy adds to front end sales?

Jerry Shore

We’ve seen the similar performance as in the past, we’ve not seen significant changes in that, but we do continue to believe that we would prefer at all times to have a pharmacy with that store and make it work that way, because it does drive the general merchandise traffic.

Bruce Efird

We do remain committed to allocating additional capital to take advantage of any available file buys within our markets.

Jillian Caruthers - Johnson Rice & Company

Are you still targeting kind of the long-term goal of 50% of the store base with pharmacies?

Jerry Shore

The only change that we’d probably agree to for sure is in 2009 all of our build to suits will be open with a pharmacy, which is a new commitment that we’ve made as a result of the success of Rick’s program on cold starts and the change in their marketing and penetration capabilities.

Operator

Your next question comes from Paul Trussell with J.P. Morgan.

Paul Trussell - J.P. Morgan

Just digging into the full year guidance a little bit more, if you could just kind of update us on the comp that is embedded for the full year guidance as well as what your inventory levels are expected to be at year-end ex the store closings.

I am also just wondering if your assumption is that we will continue to see roughly 300 basis point shifts in the food, tobacco, and household goods category over the balance of the year.

Jerry Shore

I don’t want to get too much into the details of modeling on this conference call, because that’s difficult to do. We are expecting to continue the inventory turn improvement, as I said and we have managed our inventories and expect to. We go them where they need to be and we will continue to work on improving that, so I think to reach the 3.9 inventory turn for the year that we talked about that we will continue to see the improvements in inventory.

We do expect comps to continue in that one to three range and we do expect the margins of product mix to continue, but we also have the initiatives and Keith and Bruce may want to talk about that, but we’re not ignoring the fact that it’s going to be competitive and there is going to be the margin impact and the freight and LIFO as we’ve talked about.

Operator

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

David Magee - Suntrust Robinson Humphrey

If you hit your numbers for the current year for your guidance, that is going to mean a nice increase in your EBIT margin for the year, which is obviously due to a number of company specific initiatives you guys have put in place. I am thinking about next year, in your opinion do you have further tools, further opportunities to see improvements or do you need a better economic environment in 2009 to move the ball further on the margin side?

Rick Chambers

I think everybody is going to move gingerly through the second half of this year. Bruce has substantially new initiatives that he has designed for 2009 and his team that should show operating improvement throughout the course of the year. However, none of us are going to be able to do it if there is a tidal wave of an economic recession that we’re not aware of or planning for now.

David Magee - Suntrust Robinson Humphrey

As you contemplate next year in terms of store openings and what not, what is your current thinking about the environment for next year? Do you think it’s more of the same?

Rick Chambers

Well we have taken two very strong steps for 2009. One of which is by putting our balance sheet into what we would call a very powerful position. The real estate market being in flux out there, we think of the quite a few opportunities; however we are and we therefore believe we will be in a position to take advantage of it.

The second one is the one that we talked about a moment ago, where we made a definitive decision that all of our build to suits would now carry a pharmacy in it. Jerry has brought forth a whole new team I the real estate area and a formal process that I think will substantially upgrade the ability of the company to pick and secure a much better site in 2009 and thereafter. So what we have done from a capital budget, Bruce brought forth a budget that he looked for, for between 20 and 30 stores next year and we’re sticking to that with a balance sheet that will allow us to take advantage of any opportunities that come up.

Operator

Your next question comes from Joan Storms with Wedbush Morgan Securities Inc.

Joan Storms - Wedbush Morgan Securities Inc

I want to get an update on some of the initiatives as far as for example, I think Bruce had talked a little bit earlier about private label and where the penetration rate is now and where you think it might be say by year end or into ’09. Then also how is the kids’ apparel test going.

Bruce Efird

Going back to some of the previous updates, I will give you a little more color on the initiatives, but as you know in our transformation plan that we outlined in February, one of our key strategic initiatives for this year I was really focused on improving some basic fundamentals within our business and one of those basic fundamentals was our service level or in stock performance. Keith and his team have executed extremely well on improving our service level and we implemented a number of supply chain merchandising distribution and store specific procedures to improve this and on our top selling items the 750 items that are our best sellers, we are consistently beating our goal and our overall service level has improved over 400 basis points year-over-year during the first half.

We mentioned another initiative that we outlined was around improvement and inventory productivity and our overall health of inventory position going into the second half is good. We put in place more disciplined approaches to managing our inventory flow specifically and allocating product to the store and our inventory turns are above last year and our average inventory per store is below last year.

On the private label growth, our timing really couldn’t have been better on really launching a major focus on our own brand or private label, because our customers continue to seek more value. Historically our private label penetration in consumables is roughly half the penetration of best in class drug and tier one super markets, so there is a lot of upside potential. Our penetration so far this year within consumables has increased 130 basis points through the first half and we will continue the increased promotional activity. Our label and package redesigns as well as launching and adding additional items.

We are on track with one of our key initiatives that we had mentioned, but on the surprise in the later treasure hunt type items, Keith and his team established Fred’s back into the close out market and we are seeing a number of opportunities and we are pleased with the result that we’ve seen thus far that we’re won back into that business in a very selective fashion with the items that we choose and the number of stores that we add these items to.

Then I guess I’ll touch on one of the last initiatives, which is around leveraging pharmacy as a competitive advantage. As Rick mentioned we have seen healthy script comps during the first half and our plan is to continue to expand the prescription plus card as well as remain committed to allocating capital to take advantage of file buys.

Keith do you want to talk about the children’s reintroduction test?

Dennis “Keith” Curtis

Our test back into children’s reintroduction we are excited and really cautiously optimistic about the reentry. We feel that we are going to have a much more updated offering there and our inventory is going to be obviously very clean and we are going to offer something that our customers will appreciate and I am pleased to announce that all of our shipments are en route and complete and our plan is on target for the successful roll out at the end of September. We are focusing on lower price points and quality of goods and we are looking forward to that being a good addition test, a good addition in those 100 stores.

Joan Storms - Wedbush Morgan Securities Inc

Are we expecting any more, what should we be looking for maybe in the third quarter and are there any additional store closing costs?

Jerry Shore

Yes we will finish the remaining eight stores or seven of the eight stores in the third quarter. One I believe is going to be later on, but we will finish most of those. There will be a smaller amount in the third quarter related to the cost of closing them, but they are in our forecast that we put out there.

Dennis “Keith” Curtis

There are a couple things that I am going to add to that. One of the things that we did accomplish in the last quarter and Bruce maybe you can bring the group up to it, is that we solidified our union contract and we have resigned for three years and the contract was very favorable to both sides we think, staying well within the guidelines of the 2 ½% inflations that we projected out over the next three years.

Operator

Your next question comes from Gary Giblen with Goldsmith & Harris.

Gary Giblen - Goldsmith & Harris

Given that you have that 11% fewer stores this year than last year, your SG&A performance was impressive in this quarter, but can you get a little more granular on how you can keep the SG&A ratio healthy as it has been given total scale that has been decreased by the store closures?

Michael Hayes

I am not going to get into a lot of detail and granular, but what I will say is this is the first quarter that they were closing so I certainly would anticipate that as we go forward we will continue to see that, especially over the next three quarters, but a lot of the initiatives were, as you heard Bruce talk about, were not related to the restructuring, that was really one of the initiatives was to restructure the 75 stores. Others are in place and will continue to accumulate as we go forward.

Gary Giblen - Goldsmith & Harris

What is the very latest update on the status of the Merrill Lynch exploration of strategic alternatives? Can you bring us up to date on that?

Michael Hayes

We commented on that in one of our last press releases that really there is nothing going on with that in terms of any outside activity. The comment was the update would be the same thing that we commented; I believe it was in our June sales release.

Gary Giblen - Goldsmith & Harris

One point of clarification though, is Merrill Lynch still engaged in looking at alternatives or has that process been suspended?

Michael Hayes

Yes they are.

Gary Giblen - Goldsmith & Harris

Okay so they are still working, but nothing is happening at the moment?

Michael Hayes

There is nothing that has been received that the board felt was appropriate.

Gary Giblen - Goldsmith & Harris

Is there any time frame in which you would end the process if nothing attractive comes up?

Michael Hayes

Well we have several processes going on and as we said in the initiatives it’s goats in three or four directions. It doesn’t go in just one singular direction, it was very helpful in the strategic realignment of the stores and they’re helping us establish a strategy to pull the balance sheet back to what we consider a very powerful balance sheet, which we’ve accomplished a great deal of.

The second part is there are opportunities out there that are showing up at different locations and the market continues to be in the pharmacy world quite interesting, so we expect to see them continue to work with the board on where ever the opportunity unfolds.

Gary Giblen - Goldsmith & Harris

I guess I hadn’t fully understood that, but they’re just saying part of the strategic plan that was unveiled in February had some input, in other words the operational plans that you’re doing are kind of having some input from Merrill Lynch as well as [interposing]—

Michael Hayes

Yes they helped us model through the various cost associations and things of reducing the scaling down, rebuilding the balance sheet. So there has been help in a variety of directions and they continue to look for the best ways to maximize shareholder value for the board of directors.

Gary Giblen - Goldsmith & Harris

So it’s not just transactional focus. That helps a lot, thank you.

Operator

Your next question comes from William Keller with Ftn Midwest Securities Corp.

William Keller - Ftn Midwest Securities Corp.

On the kid apparel, just to make sure I understand, that is expected to hit stores in September and is that positioned to maybe hit the tail end of back to school shopping or is it more looking forward to fourth quarter?

Rick Chambers

It is more looking forward to the end of the fourth quarter. That is the day we have some marketing and some advertising that we’re doing for those 100 stores and actually was positioned to get us into the fourth quarter.

Bruce Efird

Yes we pushed and challenged ourselves to hit the back to school time frame; however the decision was made to ensure that we had a well thought out plan when we went into stores. We got one shot at it in these 100 stores to start the test and I’d rather get it right and at least get the fourth quarter.

Again, you will have going through the fourth quarter we won’t start to see good results and metrics to determine success on it until early part of next year.

Operator

Your last question comes from Mark Miller - William Blair & Company, L.L.C.

Mark Miller - William Blair & Company, L.L.C

Mike I wanted to probe on your comment that the market is interesting in pharmacy. So as we look at the abilities to use, as you describe it, the powerful balance sheet is that more so in file buys or are we talking about potentially outright store purchases? And if we look back, can you just give us some perspective what your ROI has been on file buys generally? I actually can’t recall the company being active from a store purchasing standpoint, but if I’m mistaken or if it goes even further back than my experience, what has been the historical experience with store purchases and how small would you go on a store that you could pick up?

Michael. Hayes

Rick what is your current ROI on those file buys?

Rick Chambers

Our internal hurl [ph] was 20% our ROI on our file buy and we’ve been trending on plan with that with the file buys we’ve done we’re on plan through half the year with anticipation of meeting our budget for the balance of the year in the back half.

In terms of our growth that Mike had talked to and you were referring to earlier with the balance sheet, I think it also help put us in a better position to be able to go out maybe with a more aggressive cold star program that we have historically, because obviously that’s more controllable from our perspective, as you very well know dealing with the independent file buy opportunity, those pretty much present themselves when they present themselves and it’s hard to structure a controlled growth around that. So our plan going forward is to look more to control growth through the successful cold star program that we’ve seen over the last 12 to 18 months.

Michael Hayes

One of the tools that Mike talked about what we’re doing differently in our real estate programs, but there’s a lot better interaction not only between the team members of that, but we’re utilizing the predictive modeling software that we’ve implemented this year and we’ve been working with pharmacy to find locations that would work well for both general merchandising and the pharmacy.

Mark Miller - William Blair & Company, L.L.C

So based on your answer it’s more file buys as opposed to any store purchases that we should expect in 2009 and I wouldn’t expect those to be huge dollars, if I’m correct in my understanding, so would the company then want to stay in the same sort of net cash position or would there be a scenario where you reengage on the share repurchase program which I think was suspended for a time?

Michael Hayes

Let’s put that in two quick answers. The first one is no opportunity, should it come our way, would not be reviewed. We’re not suggesting there is one out there now and didn’t mean to suggest that there’s one out there, but we want to be in the position to take advantage of it and it was one of the important issues that we felt we needed to get the balance sheet tightened down.

Secondly the commitment that the team has made to the board of directors is that as we accumulate cash, as you know Jerry and Bruce’s plan that was revealed earlier in the year called for the building up of $100 million in cash flow over the next five years and what we’ve assigned and agreed to the board of directors on is that if we cannot achieve a better ROI on new store openings and pharmacy acquisitions, then we will use that capital to do stock repurchases. So, from here on in the challenge will be to achieve the best shareholder value we can get to either through reacquisition of stock and/or through continuous expanded growth and acquisitions.

There is a formula that is laid down and it has to exceed, each on is being tested when capital is being drawn down from the executive committee.

Michael Hayes

Thank you all for joining us today and we look forward to talking with you on another successful quarter.

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Source: Fred’s Inc. F2Q08 (Qtr End 08/02/08) Earnings Call Transcript
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