Dollar Tree's (DLTR) CEO Bob Sasser on Q2 2014 Results - Earnings Call Transcript

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Dollar Tree, Inc. (NASDAQ:DLTR) Q2 2014 Earnings Conference Call August 21, 2014 9:00 AM ET

Executives

Randy Guiler - IR

Bob Sasser - CEO

Kevin Wampler - CFO

Analysts

Paul Trussell - Deutsche Bank

Scot Ciccarelli – RBC

Vincent Sinisi - Morgan Stanley

Dan Wewer - Raymond James

Matt Nemer - Wells Fargo Securities

Joan Storms - Wedbush Securities

Meredith Adler - Barclays

Operator

Good day and welcome to the Dollar Tree Second Quarter Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Randy Guiler. Please go ahead.

Randy Guiler

Thank you, Marquita. Good morning and welcome to our conference call to discuss Dollar Tree’s performance for the second quarter of fiscal 2014. Our call today will be led by our Chief Executive Officer, Bob Sasser, who will share insights on our second quarter performance and an update on our business initiatives. Kevin Wampler, our Chief Financial Officer, will then provide a more detailed review of the second quarter financial performance and details related to our outlook for the remainder of 2014.

Before we begin, I would like to remind everyone that various remarks that will be make about future expectations, plans and prospects for the company constitute forward-looking statements for the purposes of the Safe Harbor Provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors included in our most recent press release, most recent current report on Form 8-K, quarterly report on Form 10-Q, and Annual Report on Form 10-K, which are on file with the SEC. We have no obligation to update our forward-looking statements and you should not expect us to do so.

On July 28, 2014 Dollar Tree announced it had entered into a definitive merger agreement to acquire Family Dollar Stores. The transaction is expected to close by early 2015. In the second quarter 2014 Dollar Tree incurred approximately $7.5 million in acquisition related cost. Unless otherwise noted all margin net income and earnings comparisons presented today exclude the impact of the Family Dollar acquisition related cost for the second quarter and year-to-date.

The purpose of this call today is to discuss Dollar Tree’s earnings for its second fiscal quarter. As mentioned Dollar Tree and Family Dollar have a definitive merger agreement. We are continuing to work on the proposed transaction. You have likely seen Dollar General's public letter from yesterday and Family Dollar’s response this morning. Bob will have a very brief statement on that but we want to focus on Dollar Tree’s earnings this morning and we do not intend to make any further comment at this time, neither in the Q&A session following our prepared remarks nor in follow up calls. Thank you in advance for respecting our position. I ask that you please limit your questions to one and one follow up question if necessary.

Now, I will turn the call over to Bob Sasser, Dollar Tree’s Chief Executive Officer.

Bob Sasser

Thanks, Randy, and good morning everyone. This morning we announced Dollar Tree’s results for the second quarter 2014. Comp store sales on a constant currency basis increased 4.5% in the quarter, driven by both increases in traffic and average ticket. Adjusted for the impact of Canadian currency fluctuations, the comparable store sales increase was 4.4%. This was on top of 3.7% comp in the second quarter last year and a 4.5% comp the year before.

Total sales grew 9.5% to just over $2.03 billion. Operating income increased by $11.2 million or 5.6% and operating margin for the quarter was 10.5%. Net income excluding acquisition costs increased to $126.1 million and adjusted earnings per share increased 8.9% to $0.61, compared with second quarter 2013 earnings of $0.56 per share.

For the first half of 2014 compared to the prior year total sales were $4.03 billion, an increase of 8.4% compared to the first half of 2013 and comp store sales increased 3.1% for the half. Earnings per share were $1.28, an increase of 11.3% compared with $1.15 per share in the first half last year.

Operating income increased by $26.6 million to $212.5 million. Operating margin was 11.0% and net income rose $6.1 million to $264.3 million. I’m very pleased with second quarter performance. With customers under continued pressure, our plan at Dollar Tree is to be a part of the solution to help them balance their budgets by offering higher values on more of the things they need every day and higher values on things they want.

We intend to serve our existing customers better while taking every opportunity to claim new customers and gain market share as we demonstrate that Dollar Tree is a convenient and fun place to shop. At Dollar Tree, yes you can afford it. Our merchants continue to deliver products that exceed customer’s expectations. Our values are higher than ever and our price is always $1 in every Dollar Tree store every day.

Our sales initiatives are producing results. Sales growth in the second quarter was a result of strong performance across the store in both our basic consumable and discretionary products. Top performing categories included pet supplies, hardware, household products, food, electronics and party. Sales strengthened throughout the quarter with our strongest comps in period six, July and the momentum continues. We’re pleased with the initial sales trends we’ve seen in the third quarter.

Performance in the second quarter was relatively consistent across the country and all zones achieved positive comp store sales. The highest comps were in our southern zones.

Looking forward, we’re positioned for continued relevance to the customer, sustained growth and increased profitability. We have room to grow and the ability to grow in many different ways.

We plan to continue growth by opening more stores, by increasing the productivity of all stores and by developing new formats, new markets and new channels as growth vehicles. During the second quarter we opened 90 new stores and we relocated and expanded 20 existing stores for a total of 110 projects. Total square footage increased 6.8%. We ended the quarter with 5,166 stores. While our opening cadence is a bit later this year, we’re on track to achieve our opening plan for the full year which included 375 new stores and 75 relocations and expansions for a total of 450 projects across the U.S. and Canada. As a reminder, square footage for the full year is planned to increase 7% over fiscal 2013.

In addition to opening more stores, we continue to execute our strategy to increase productivity in all stores. As discussed in prior quarters, our sales and productivity initiatives include category expansions. Our customers are finding more value as we continue to rationalize and expand assortments in pet supplies, hardware, health, beauty and eyewear as well as home and household products.

Across the chain customers are seeing more powerful seasonal and party presentation that create excitement and a fun shopping experience. Our seasonal assortments are creating merchandise energy with our store fronts changing with the seasons. We want to own the seasons at the $1 price point. Store associates are working to provide more effective customer engagement throughout the store and especially at the front end to drive impulse and related item sales through cross merchandising and suggestive selling. Our stores are keenly focused on providing value and a shopping experience that exceeds the expectations of every customer in every store every day.

Merchants and stores continue to focus on being first of the month ready with an increased emphasis on not just full but chunky displays of basic consumable core items at the first of the month when more customers are shopping for their basic needs. We’ve reintroduced our See What $20 Buys along with our Stretch Your Dollar campaigns through in-store promotions, signing and digital media and we’re pleased with the consumer response. It's right for the times. And to satisfy basic needs and to drive increased shopping frequency, we continue to expand our frozen and refrigerated category.

In the second quarter we installed freezers and coolers in 141 additional stores. We now offer frozen and refrigerated product in 3,410 stores with plans to continue growing. While this category is lower margin, the product serves the needs of our customer, it’s fast returning, more frequently purchased and the increase in shopping frequency provides the opportunity to drive sales across all categories, including higher margin discretionary product.

In addition to our Dollar Tree stores, a key component of our growth strategy is the continued expansion of our portfolio brands including Deal$ and Dollar Tree Canada. Our Deal$ brand extends our ability to serve more customers with more categories and increases our overall unit growth potential. Deal$ stores deliver low prices on every day essentials, party goods, seasonal and home product.

The stores operate using a multiple price point strategy. They offer a higher consumable mix than our Dollar Tree stores and they produce a higher average ticket. By lifting the restriction of the $1 price point at Deal$, we’re able to serve more customers with more products at value prices every day. We ended the second quarter with a total of 216 Deal$ stores. Our Dollar Tree Canada brand expansion continues. We opened 7 new Dollar Tree Canada stores, ending the quarter with 196 Canadian stores and we’re on pace to meet our expansion plans for the year.

Leveraging the buying power of Dollar Tree, our merchants are sourcing higher value product and our Canadian customers are finding broader more exciting assortments and better values in the stores. We continue to see enormous potential for growth in Canada. As we grow and improve, we believe the Canadian market will support up to 1,000 stores. This is in addition to the 7,000 store potential for Dollar Tree in the United States plus additional growth in our Deal$ brand. Our goal is to be recognized by customers as the leading retailer in Canada at the single price point of $1.25 just as we are in the U.S. at $1 price point.

In addition to Dollar Tree Deal$ and Dollar Tree Canada, our online business of Dollar Tree Direct is growing in size and performance. Dollar Tree Direct provides an opportunity to broaden our customer base, drive incremental sales, expand brand awareness and attract more customers into our stores.

In the second quarter, we launched a newly created section on our Web site called Extreme Values and New Arrivals. This provides online customers the opportunity to efficiently shop for amazing bonus buys, fantastic deals on manufacturers close outs and exciting new arrivals.

We continue to see growth in customer outreach for social media. A few examples include our Loyalty club, the Value Seekers club which have around 120% over the past 12 months. Our email database has grown more than 130% over the past year to more than 1.3 million subscribers and we now have more than 1.2 million followers on Facebook. Social media provides a tremendous opportunity to communicate with our customers about exiting events and great products both in our stores and online.

Lastly, as always our practice has been to build infrastructure to support growth ahead of the need. Earlier this year, we broke ground on a 250,000 square foot expansion of our Joliet Distribution Center. The expansion will bring the total size of the facility to 1,450,000 square feet, and will include a second sorter to the exiting material handling system to enhance capacity and efficiency. The project is on schedule for completion by yearend.

Before turning the call over to Kevin, who will give you more detail on our financial metrics and provide guidance, I will comment very briefly on Family Dollar. As you know, we have a definitive agreement with Family Dollar and we are committed to the transaction. We believe that we are offering Family Dollar shareholders compelling, immediate, and certain value for their investment and the opportunity to participate in the upside potential of the merger. We will off course be watching these new developments closely. We look forward to completing our transaction as soon as possible.

With that, I will turn the call over to Kevin.

Kevin Wampler

Thanks Bob. As Bob mentioned, our adjusted earnings per diluted share increased 8.9% in the second quarter to $0.61 per share. We are very pleased with our comp sales performance, which accelerated throughout the quarter. Starting with gross profit, our gross profit margin was 34.2% during the second quarter, compared with 35% in the prior year second quarter, a change of 80 basis points. The majority of the decrease was a combination of increased freight and merchandize mix.

Freight expense increased by nearly 40 basis points, reflecting higher trucking rates related to driver shortages. Merchandize mix negatively impacted margin which declined by approximately 30 basis points. As Bob mentioned, we have made strategic decisions to expand assortments focused on providing greater value for our customers.

Distribution expenses increased nearly 10 basis points, primarily driven by the expense associated with our new distribution center in Windsor, Connecticut. This facility opened in June of last year. We should annualize the year-on-year expense impact of this additional facility in the second half.

Excluding acquisition related costs, SG&A expenses were 23.7% of sales for the quarter, compared with 24.1% in the second quarter last year. Payroll related expenses drove the majority of the improvement representing 30 basis points as we have lower expenses as a percent of sales for insurance benefits, payroll, incentive compensation, and payroll taxes. Adjusted operating income increased $11.2 million compared to the second quarter last year and adjusted operating margin decreased 40 basis points to 10.5% when compared to the second quarter last year.

The tax rate for the second quarter was 38.2%, compared to 37.9% in the second quarter last year. The increase in the tax rate is due to lower workers opportunities tax credits in the current year resulting from the expiration of certain tax provisions.

Looking at the balance sheet and the statement of cash flows, cash and investments at quarter end totaled $467.7 million, compared with $413.7 million at the end of the second quarter of 2013. As you may recall, on September 2013, our Board authorized a $2 billion share repurchase program. Under this authorization, the Company invested $1 billion for share repurchases through an accelerated share repurchase program that was launched on September 17.

The ASR was funded by $250 million of available cash and $750 million from the private placement of senior notes completed in September. During the second quarter on May 15th, the Company received 1.2 million shares completing the ASR. Altogether the Company received a total 18.1 million shares under the $1 billion accelerated share repurchase program. The Company has $1 billion remaining on its share repurchase authorization.

The Company did not repurchase shares during the second quarter and the diluted weighted average shares outstanding for the second quarter were 206.6 million.

Our consolidated inventory at quarter end was 6.5% greater than at the same time last year, while selling square footage increased 6.8%. Consolidated inventory per selling square foot decreased 0.3%. Our inventory turns increased in the second quarter and we expect continued improvement in inventory turns for the full year. We believe that current inventory levels are appropriate to support scheduled new store openings and our sales initiatives for the third quarter.

Capital expenditures were $88.3 million in the second quarter of 2014 versus $96.4 million in the second quarter last year. For the full year 2014, we are planning consolidated capital expenditures to be in the range of $360 million to $370 million.

Capital expenditures are focused on new stores and remodels, including additional fee development stores, the addition of frozen and refrigerated capability to approximately 460 stores, which has then increased from our previous estimate of 320 stores, IT system enhancements, the expansion of our Joliet, Illinois distribution center and the initial phases of work on our 11th DC.

Depreciation and amortization in the second quarter totaled $49.9 million versus $46.6 million in the second quarter last year, an improvement of approximately 5 basis points as a percent of sales. We continue to expect depreciation expense to be in the range of $200 million to $210 million for the year.

Our guidance for 2014 takes into account the actual performance in the first half and except for small refinement to the share count and tax rate, our outlook is unchanged for the second half of 2014 from that which we issued on February 26. Our guidance includes the following assumptions. We anticipate that freight cost will continue to be a meaningful headwind to gross margin primarily as a result of driver shortages and related wage increases.

Product margin will remain under pressure based on strategic decisions to invest in certain product categories and drive increased market share. We cannot predict future currency fluctuations so we have not adjusted our guidance for changes in currency rates. And as we look ahead to the fourth quarter this year there is one additional selling day between Thanksgiving and Christmas, which returns us to a more normal pattern than last year. Our guidance also assumes a tax rate of 37.2% for the third quarter and 37.9% for the full year. Weighted average diluted share counts are assumed to be $206.6 million for the third quarter and 206.9 million shares for the full year. Additionally we have not included any acquisition related cost in our second half guidance as we cannot currently forecast the timing of when these costs will be incurred. With this in mind, for the third quarter of 2014 we are forecasting sales in the range of $2.02 billion to $2.07 billion based on a low to mid-single digit comparable store sales increase and 7.2% square footage growth.

We anticipate that gross profit margin will continue to be challenged by year-over-year freight increases as well as our commitment to provide greater value to our consumers in this challenging macro environment. Diluted earnings per share is expected to be in range of $0.61 to $0.66, which represent a 5.2% to 13.8% increase compared to third quarter 2013 earnings of $0.58 per diluted share. For the full fiscal year 2014 we are forecasting sales in the range of $8.44 billion to $8.55 billion based on low to low mid-single digit increases in comparable store sales and 7% square footage growth. Diluted earnings per share is expected to be in the range of $2.94 to $3.06. This represents an increase of 8.1% to 12.5% over 2013 earnings per share of $2.72.

With that I’ll now turn the call back over to Bob.

Bob Sasser

Thanks Kevin. Our initiative is to drive comp store sales or finding enthusiastic acceptance with the customer by all accounts continues to be under pressure to balance their household budgets. Our in-stock home basics is the best ever. Customers are finding more of the things they need and want on each trip. Stores are first of the month ready with chunky displays of basic products. When the customer has money in their pocket and they’re ready to shop, we want to be ready with the product they want. We think of the first of the month as 12 additional holidays and we prepare for them as such.

The expansion of Wow items are providing customers with bigger sizes, bonus buys and bigger savings across the store. Our category expansions in pet supplies, hardware, household supplies, food, electronics and party are producing company leading results and comp sales increases. We continue to roll out frozen and refrigerated product to more stores. Our customers like this product. They shop us first and frequently to get the values they need.

Seasonal product adds excitement and merchandise energy to the shopping experience with an ever changing assortment of fun and colorful product right at the front entrance. Our stores are full, fun and friendly with more customer engagement as we strive for the same great experience for every customer and every store, every day. As you’ve likely heard from many retailers the consumer continues to be under pressure. Our sales initiatives are aimed responding to those customers' needs by being a part of the solution in their efforts to balance a household budget. We are investing in our customers, they are responding enthusiastically and you can see it in our results. Our second quarter comp store sales increase of 4.5% was our best quarterly comp performance in two years. We’re expanding market share. Sales came as result of increases in both traffic and average ticket with the largest increase coming from traffic. Sales growth came from across the store with comp increases in basics and variety fairly evenly divided.

Sales strengthened throughout the quarter with our highest comp sales in July and sales momentum has continued into August. Total sales grew 9.5% and we exceeded $2 billion in second quarter sales for the first time in Company history. We achieved 10.5% operating margin, down from our record high in second quarter last year and still the highest performance in the discount retail sector.

And earnings per share grew 8.9% to $0.61 per diluted share in the middle of our range of guidance. We have multiple platforms for growth. In second quarter we opened 90 new stores, expanded and relocated 20 stores and we ended the quarter with 5,166 stores and square footage growth of 6.8%.

The Dollar Tree brand is a benchmark of value for our customers and is a great opportunity to grow and expand the Dollar Tree brand in the United States through more stores and more productive stores. The Deal$ brand is serving customers with increased value on even more categories.

Dollar Tree Direct continues to broaden its reach to customers throughout North America and Dollar Tree Canada is growing in size and customer acceptance. As I look to the future, I see exciting opportunity. Our balance sheet strong, the Dollar Tree business model is powerful, flexible and more relevant than ever, providing extreme value to customers while recording record levels of earnings.

It’s been tested by time and validated by history. We remain committed to a concept that customers love and we’re positioned to continue growing profitably for many years ahead. We have a vision of where we want to go and the ability to get there with infrastructure, capital and most importantly a talented management team that has a long history of retail success. It’s a great time to be Dollar Tree. Our inventories are clean and fresh, the shells are full of terrific merchandise, our stock rooms are in great shape and our values have never been higher.

We will now address your questions about our second quarter. So that we can accommodate as many callers as time permits, we ask that you limit your questions to two.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Paul Trussell with Deutsche Bank.

Paul Trussell - Deutsche Bank

Congratulations on a very impressive second quarter comp. You highlight that pet supplies, hardware, household, food, electronics, party goods were the categories that were leading the comp growth but if you can just kind of clarify for us that when you say you invested in expanded assortments of high value product, exactly what categories did that reference and how do we think about IMU and mix pressure going forward because of those investments?

Bob Sasser

Paul, we’ve always said we’re in control of our merchandise markup and we still are and this was a very conscious decision to -- in the time when the customers were under pressure and traffic was stubborn and everyone was complaining about really starting back last year during fourth quarter. We responded by being the solution to their problems and not part of the problem.

So we have invested in product. We have expanded some categories. There's really two parts to your question. The highest comping departments, the ones you listed, pet supplies and hardware and household products, food, electronics, party are amongst the highest percentage comp departments. A couple of those are our highest volume departments, party and food.

So we’ve had increases by increasing and driving the business in these key departments for our customer across the board. Our variety has grown as well as our consumer products has grown, our home is specially was very powerful in second quarter.

Some of the items or some of the categories is licensed party goods. We’ve added license, the Disney license and Marvel license to our mix. We added rubber made food storage into our housewares, branded pet food for an example and you see pet supplies as popping up as one of the leading comp departments.

We're offering the king size candy bars. It's not the small candy bars anymore. We’ve expanded on our dish and our home -- our dish detergent and our home area with some of the cleaning supplies with brands like Dawn and Palmolive. In HBC, we’ve driven the business on our branded toothpaste, Crest toothpaste. We have in our food and snacks business Stax potato chips in our home area again, in our home supplies, household supplies, national brand toilet paper, national brand paper towel. So, throughout the store, we’ve expanded in more space and more inventory and more of the things that our customers are looking for in a tough time, driving the business in those categories and we’ve also been looking at special opportunity buys, Wow items, multipacks, larger sizes for the same prices and really delivering as much value for our customer every day. When they go into stores they're seeing more value than they've ever seen.

And as I said, the proof is in the numbers. Our traffic was up. Our average ticket was up, which has always been stubborn. As you know it’s everything is a $1. So the average ticket you’ve got to sell some more. So more people are shopping as more frequently, our traffic is up, they’re staying longer and they’re buying more, our average ticket is up.

Paul Trussell - Deutsche Bank

And just as a follow-up, just to kind of shift gears, Bob, obviously in seeking to do the acquisition of Family Dollar, there were some questions from investors looking in on how confident you guys are, and your ability to run multi-price point stores and so perhaps if you can just give us some additional color on Deal$, the current quarter’s performance but also if you can just take us back a little bit about how the productivity and the operating margins have improved over the timeframe of your ownership? What have you learned and how you can benefit from those learnings in your upcoming endeavor?

Bob Sasser

Paul, I'm going to answer your question in a little different way. I'm not going to comment on the Family Dollar acquisition. As I said, we just can’t comment on that. I am not going to comment on this. If your question is about our Deal$ format, I'm very proud of Deal$ and we are seeing a lot of expansion, and a lot of traction on our Deal$. I’ll give you a little color on our Deal$ business. We ended the quarter with 216 Deal$ stores. Our comps were single digit positive in our Deal$ stores. The merchandize mix in our Deal$ stores is little different than what you find at Dollar Tree. In addition to lifting the restriction of the price point, we have a little more consumable mix in our Deal$ stores. Consumable mix for the quarter was about 62% versus 38% for the non-consumable.

And as you compare that to our Dollar Tree stores, at Dollar Tree we’re about 50/50. And for the quarter it was consumable 50.4% and 49.6% in the non-consumable at Dollar Tree. So you can see that the Deal$ mix is a little more consumable. The basket, a little bit about the basket, our average ticket at Deal$, it was $9.51 for the quarter. at Dollar Tree we’re about we’re always around $8, a little less, $7.80, I think for Q2. We have lifted the restrictions of the price point at our Deal$. So the average ticket with items that are greater than a dollar was $14.23. Almost 54% of all transactions had items greater than a dollar also.

So our customers in the Deal$ stores are responding positively to the merchandizes that we sell, that’s not a dollar. Our average unit retail for anything that’s over a dollar that we sell is $3.15, that’s been pretty much where it’s been for the past year. We like to see that grow and working on ways to make that grow. I think that's is a big opportunity. Greater than a dollar items represented 48.5% of Deal$ total sales. So as we’ve lifted the restriction of the dollar price point, we’re seeing exciting growth in Deal$. Again at Deal$, we can serve more customers with more categories and more ways.

Operator

We’ll take our next question from Scot Ciccarelli with RBC.

Scot Ciccarelli – RBC

Gross margin related question as well. I know you guys really tried to provide value to consumers and for the last several years you have kind of pointed to improving merchandize margin. It sounds like that was not the case this quarter. So I guess the question is, does this signal a potential, just philosophical change going forward regarding how we’re viewing merchandize -- the merchandize sales versus margin mix?

Bob Sasser

It’s a fair question and I'm happy say, no. It’s not really the change in our direction, it’s more a response to the times. We are always as retailers, it is incumbent upon us to remain relevant to our customers and as the customer pressures change we have to react to other retailers, you might see lowering prices. Our price is $1. Instead of lowering prices and you’ve heard me say this before, we will invest in more value in tougher times and we started seeing pressure on traffic and we started hearing from customers back late last year and our comps weren’t as robust as they had been. And as a result, as we always do as good retailers, we chose to drive for traffic and market share. We can sit back and bemoan back, the customers are under pressure and remain stubbornly under pressure or we can do something about it. We have done that and we’ve done what’s very core to what we do at Dollar Tree and that is to exceed the customers’ expectations for what $1 buys.

And in this day and time, as customers are really looking for a way to help balance their budget, we have become a solution to their problem. They look for us to help them out. And if you look at the results, the traffic was up. It drove most the comp sales but our average ticket was up also. So as I said earlier, they’re coming more often and when they’re there, they are staying longer and they’re buying more. They’re seeing more product. These values are across the store too. We speak of things as if it's really just that simple, as consumer versus discretionary. It’s never really just that simple. We have those two big buckets but if you looked at that at a little more granular level, you would see that our home business was really driving and carrying a big load in the second quarter and our home business is made up of things that really are either both discretionary and consumable. They are things you need, there are things you want. There is food containers, you need them, you want them. They are high margin, they are not as high margin as our seasonal business but they are higher margin than our basic consumable business.

So we were driving traffic throughout our store. We’re looking to gain market share and frankly the big issue that hit second quarter and probably is going to continue to hit us in rest of the year was the freight. As I've always said when we see an issue we’re always able to respond accordingly and if we see cost pressures in one area, if we see it coming and we can make plans for it, we can always make allowances and find other ways to save and we can do the same thing with our freight cost. But this freight driver shortage issue came upon everyone pretty suddenly, we’ve been expecting something but we weren’t really seeing it until recently.

So along with investing in our customer which I will do again, and driving more sales, at a likely lesser gross margin rate, that was about 30 basis points. In addition to that in the second quarter we had 40 basis point pressure on freight, which is also in our gross margin. So that's something we’ll deal with as we go forward. This management team is really good at figuring out how to swallow some of these cost pressures and take advantage of other ways of delivering the gross profit. But in the meantime we're responding by giving our customers more value. That’s who we are, that’s what we do.

Operator

We’ll take our next question from Vincent Sinisi with Morgan Stanley.

Vincent Sinisi - Morgan Stanley

I wanted to first ask you about really the consumer behaviors that you're seeing. I know you said it remains constrained, though of course are responding to your initiatives and that's fairly increased from a comp perspective throughout the quarter. But can you give any color around stores that maybe in relatively higher income areas versus some that maybe on lower end and if you’re still seeing some differences between kind of the three buckets of income of your customers?

Bob Sasser

Frankly it’s across the board. We really don’t see anything that you can point to. There is a stark demarcation line between the higher income and the lower income. There is always markets we're in, some of the lower income markets and the urban markets, it’s always been more highly consumable. But across the board, if you start looking at the higher income versus Middle America suburban, everybody is looking for value and everybody likes shopping at Dollar Tree.

One of the things that we always pound the table about is it's not just shopping at Dollar Tree, because you’re looking for something you need. People do that and it’s only $1. It's great value. But our customers also shop us because they enjoy the shopping experience. It’s fun. You come in. You walk into a seasonal product, you walk into fun colorful product, an ever changing mix, as always something that you find didn’t expect to find as a customer. So we have discretionary business about 50%, consumer business about 50%. If you look at the mix, you're seeing it's pretty much the same. It's just 50-50. It might be one quarter. One is up a little and one the other, differently the next but still around 50-50.

So my answer is the customers are under pressure. Mostly middle income and lower income customers is anecdotal. Just from what we see, it continues to be burdened in concern. We’ve said that. We're not alone saying in that. They’re facing higher taxes, higher healthcare cost, stubbornly high unemployment, although it looks like it might be getting a little better on the unemployment side, higher cost of living really and no improvement in wages to speak off. They continue to face uncertainty and we are -- as I said we’re responding to them with offering expand assortments of basic, more Wow items, bigger size with bonus buys, overall values for the dollar and they’re responding to it. Again I’m really pleased -- several things this quarter but our sales growth came across a broad range of categories, not one or the other.

Our sales growth came from traffic largely, which is in the retail business you've got to have the traffic. So we didn’t give up our traffic. Tough times, we invested in keeping the traffic coming in the store but also during the quarter our average ticket was up. So when they were in the stores, they had only more traffic more, more footsteps but when they’re in the store they stayed longer and they bought more.

Our frozen and refrigerated product continues. We're rolling that out to more stores. Customers respond favorably to that through increased shopping frequency. And on the seasonal and party and toys, discretionary items, by the way yes, you can afford it, it feels good to walk into a Dollar Tree and you can still buy toys for the kid because they’re only $1 and you can still buy party gifts for the birthday. Everything is only $1. So that shopping experience in tough times is really worth something. We place value on them.

Vincent Sinisi - Morgan Stanley

And if I just could ask another question about the expanded high value items. Can you give a little bit of discussion around? Do you think that just having some new products into the store is really driving those sales or is it how you’re merchandising? Is it your See What $20 Buys, your Stretch Your Dollar campaign, just maybe a little more around with the advertising or if there's incremental advertising for those products specifically?

Bob Sasser

It’s not so much more advertising. As you know we’re really not an ad driven company and advertising price points. There is no price reductions. The price is $1 today, it was yesterday, it's a $1 march. So given that, urgency in our concept has never been something that we’ve invested a lot of funds in. But in-store is a different story and yes we’ve employed all of the above. We’re signing in the store, with printed material in the store, with merchandize in the store, really beefing up some of those displays and those in caps and those value items and showing them and signing them up and telling the story of what great value saving. By the way we don’t -- we make money on these items. It’s just that it’s a slightly less margin than maybe our highest margin seasonal department.

So, when you’re going to our home area and you start talking about food containers and storage bags and wraps and all the things that you need in the kitchen for your household supplies and mops and brooms and all of those kinds of things, we’re selling more and more of those products. It’s not loss leader. We make a lot of money on that but it’s not -- it's just not quite that highest margin that you get from some of those clearly discretionary products like the seasonal areas.

So you’re going to find Bounty in our stores, you’re going to find Angel Soft toilet paper, you’re going to find stacked potato chips, you’re going to find rubber made, you’re going to find some name brands, you’re going to find some non-name brands but you’re going to find bigger sizes. In other words, a 12 ounce item might be 18 ounce items and it’s a $1, still the same item as you love in the past at Dollar Tree and we've beefed up the sizes and we've beefed up the value and we’re offering that and they’re recognizing it because they’re buying it and our comps are up in tough times like we are in now. Our 4.5% comp is I think really going match up very favorably to what you see out there in retail.

Operator

We’ll take our next question from Dan Wewer with Raymond James.

Dan Wewer - Raymond James

So Dollar Tree's gross margin rate of 35.9%, you reach that every year from 2010 through 2012 and you’d have to go back to 2003 before you had a higher gross margin rate than that but then last year margins were down 30 bps, were down 60 bps in the first half of this year. Do you think that we have finally reached the point where it’s really difficult to protect margin rate for Dollar Tree with that single price point strategy. This has been a topic for the last decade but do you think that we finally reached that tipping point?

Bob Sasser

No, I don’t. It’s not -- I'd like to tell you that the pressure is not on the initial mark up of product, it’s on our choices. It’s still about what we choose to sell. It’s still about understanding the value that we need offer to the customer to drive their purchase decision. At $1 price point is not the issue at hand here, it’s really just long and stubborn and pressure on the middle income customers and specially the lowest income customers and it’s been several years now and there is somewhat not really -- it’s going to get better, I’m optimistic, but there's not much light at the end of the tunnel and customers continue to look for value.

I would remind you too that we still have sector leading operating margin, we pale only in comparison to our own previous operating margin. But it’s a matter of choice. We can drive higher margins but we have chosen to instead of sitting back and resting on whatever that 11% or whatever it was, operating margins are for the previous year, we’ve chosen to invest in the customer, we've chosen to invest in more value, more traffic, higher average ticket. We want our customers to think of us as money short, go to Dollar Tree. If you want to have a fun shopping experience, go to Dollar Tree, if you want party supplies, go to Dollar Tree, it’s all $1 and it’s all great value. So, this is a matter of choices, there is not pressure on the cost from an inflationary standpoint, we can still --we turn down more product than we sell.

Dan Wewer - Raymond James

A different topic, on the potential of the 7,000 Dollar Tree stores in the U.S., that’s primarily focused on your traditional suburban market real estate strategy. What precludes the Dollar Tree concept from working in smaller, not necessarily rural markets but smaller markets than you have historically focused?

Bob Sasser

Nothing and by the way, we’ve been saying 7,000 stores for a long, long time. I can’t tell you how many years. It’s been that long and the world has changed and our business has changed and our stores have gotten larger and our mix of product has gotten more to the consumer products need, 50% things you need, 50% discretionary. So we do very well in small markets, we do very well in urban markets, we do very well in rural markets. Our strength is in the suburban markets and Middle America but there is nothing that precludes us from continuing past the 7,000 mark. I’m not announcing a new number out there but certainly we haven’t done the math on that for quite some time. You can’t find a place where we don’t do well frankly and I know that sounds like it’s bragging but our stores -- 99 point some percent of our stores are profitable and as you know we have stores in the boroughs, in the northeast of Brooklyn and the Bronx, and we have stores in Idaho.

Dan Wewer - Raymond James

But you're thinking that if real estate opportunities were to become available and markets say have 50,000 in population that could work for Dollar Tree?

Bob Sasser

We're always looking for great real estate at prices that fit our model.

Operator

We’ll take our next question from Matt Nemer with Wells Fargo Securities.

Matt Nemer - Wells Fargo Securities

First question is a follow-up on gross margin and I just wanted to understand the timing around the IMU decision. Is it fair that that’s the kind of decision you make sort of six to 12 months earlier? And then should we think of this as a four-quarter investment cycle that you kind of have four quarters of that hit and then it goes away? Thanks.

Bob Sasser

Well if it goes away or not depends on the customer, but certainly at some point you start anniversarying some of these things. But the important goods are a little longer, a little longer buying cycle. If you remember we started talking back in fourth quarter about initiatives to drive sales and it’s not new to hear us talk about more Wow in our stores and those kinds of things. I think first quarter, if you went back and looked at our -- I know I spoke about the same kinds of things and first quarter we had the terrible weather early on, but then it got better as the quarter went on, as the weather went away. So we started getting some traction on some of the strategies that we were talking about then.

And of course that carried on into second quarter and I think at the end of the first quarter, I said by the way momentum continues in the second quarter and it did. And it got better throughout the second quarter. Period four -- period five was better than four, period six was best of all in the quarter. So we have again ramping up on initiatives that were began some time ago. Now looking forward I will tell you that we think about this as flying an airplane. It’s a little stick a little rudder. We’re flexible. We have a flexible model and when times are tough and we need more traffic, we'll move towards the consumer products and when times are little better or costs are going down, sometimes we may invest in more customers or we may invest in margin. So it really is all about the current environment and how you feel about the future environment. I think it’s going to remain tough for the rest of this year. We’re not planning on any second half, any macro news that says the things are going to be a whole lot better. So we’re planning on continue pressure and we’re planning also on continued pressure on gross margin from freight.

It’s in our guidance. So it’s baked in there and of course we’re always working to offset that in other ways. But I think it’s -- but we’re in control of it. I guess the point that I’d like to leave you with is we’re not victims who run in the business, we’ve always done it. We've been doing it now for 28, 29 years. And our gross margin, we have ups and downs and it’s all relevant to the customer and what’s going on in the world.

Matt Nemer - Wells Fargo Securities

And then just as a follow-up on freight, what are -- could you talk to some of areas that would look to mitigate the impact of that? And with diesel, I know the diesel is down I think $0.15 to $0.20 from its peak, is that one area that we can see as a potential benefit or is that actually reset relatively frequently?

Bob Sasser

Diesel, as we look at it so far this year, it’s really tracking and fairly close to last year. So not a big difference one way or the other compared to last year. So there's not a lot of positive or negative there. And it’s kind of been in that range for the last almost three years realistically. So whether we could get some -- listen, we'd love for diesel price to continue to fall and be able to take advantage of that, but there is no guarantee of that at the end of the day.

I think as we look at freight going forward, it’s no different than any other item. It’s about process. It’s about looking at new ways to potentially deal with it. But I think -- as we’ve said within -- in giving our guidance, we expect it to be a headwind as we got through this year. And it’s really the effect in the second quarter was just a little bit more than what we’ve talked about in Q1. Q1 I think we said it was about 30 basis point negative effect on our gross profit. In Q2 it was little closer to 40. But the biggest thing we can do to help ourselves at the end of day is continue to drive sales, keep market share, take market share and keep people coming into the stores and good sales help in a lot of ways and I think that's the way we think about it.

Operator

Due to time restraints we only time for a few more questions. And we’ll go next to Joan Storms with Wedbush Securities.

Joan Storms - Wedbush Securities

I was very impressed with the discussion about the ticket, because ticket has been flat for a really long time and if you could delve into that a little bit, it seems like you’re investing in the high value products and the increased traffic and then that's leading to the ticket. So I was wondering if you could get go and sell.

Bob Sasser

Yes, it’s more traffic largely as comp driven by more traffic in the quarter but also our ticket and that seems to be a trend. It's coming from -- they're coming more frequently to the stores, they’re staying longer, they’re buying more. We’re challenging them to buy more products. We’ve taken -- it's not just the low margin fast turning consumer products that we have ensured that we’re going to be in stock in, the things they expect to get when they come in our store, but it’s also the surprising value when they come in the store and some of the stuff is not low margin. It's just a little less margin than we would normally sell it for.

And what it's doing is it's tempting that customer to buy one more item, which they would buy, one more item, that would be a big comp but when they're in the store, we want them to come for what are the things they need. While they’re in there, we want to sell them on trend and on style and on fashion and on wow. Look at this! This is a great item. By the way I've use this before and is 20% more this time. So I’m going to buy some more on this trip. Or it might be a new item that they haven’t seen before that we’ve invested in and stacked up front. So it really is -- it’s our buyers creating more value and it’s our stores merchandising it in such a way to drive more sales. We've talked about customer engagement, we’ve talked about related sales. We talk about drive items at the front of our store with the cashier suggesting just one more item as they go of the door. We’re tempting our customers to buy more in every way and we saw good results from that in the second quarter.

Joan Storms - Wedbush Securities

Great. And then could you also comment, you talked a little bit about making sure you’re really ready for the first of the month and being in stock. Can you comment like on how you’ve in-stocked that much better for the first of the month. It really seems like you're making an effort to have that on time.

Bob Sasser

Well, first of the month there's a lot of payroll checks out there, a lot of people get paid at the first of the month, a lot of the government checks go out the first of the month. There's lot of things and a lot more spendable income around the first of the month and many of our customers, especially the lower income customers wait till the first of the month because they just really don’t have the ability other times.

When they come to the store we want then to have the best experience possible for the first of the month. So our stores and our replenishment people and our merchants are working ahead of the first of each month for the plans, what’s going on, which end cap, what’s the highest sales opportunities, where can we stack things up, where can we make a difference in the store. By the way on the basic things, the highest, the key items that we know they want on every trip, let's make sure that we're in stock in business, we refreshed our categories here in that period of time, we will stack out more here in that period of time, we’ll plan our end caps around first of the month ready. And as I said it’s sort of like having another season. It's when you set Easter and you first roll it out and you put it all on the sales floor and you build end caps and you put the signing in place, and the night before you're walking around and you're patting it down and looking to make sure, checking it out.

Our entire organization is focused on the first of the month sales, whether the it’s store and the store managers, the buyers, replenishment people, the logistics people, we all plan our business to a large degree around those first of the month, especially in the basic categories.

Operator

We will take our final question from Meredith Adler with Barclays.

Meredith Adler - Barclays

I’d like to talk first about just brands and you clearly are carrying more brands. Is there any change in your discussions with vendors? Are they more willing to make smaller packaging? Are they excited about the potential of having broader distribution of their products? Or are you just now deciding to carry those items?

Bob Sasser

It’s always a choice. On the first question our manufacturers like doing business with us. Obviously there is some things that they can’t do business with us on, but things like small appliances, you're never going to find George Foreman grills in a Dollar Tree store but there are -- the consumer products people really like our business. We’re a large retailer. We cut a large swath across 48 states in Canada. We engage with a lot of customers. You can get your brand in our stores and it gets noticed and people see it and constantly builds your brand equity at Dollar Tree.

At Dollar Tree it’s all about value though. So again its choices and brands may typically -- not always but typically come with a little lower margin, maybe a little higher sales rate but a little lower margin. So we’re always balancing the name brand offering with the private label name brand equivalent offering, which has a little higher margin and by the way our customer really responds to large sizes and bigger values, when given the choice between the brands, all things equal, they like the brands. When all things aren’t equal, they usually go for the bigger sizes and the bigger quantities. But from time to time, we’ve always introduced brands and we continue to look for that. Our brand vendors like us. I believe and we’ve always aspired to be good business people and good merchants and what I mean by that, our concept is simple. We’re looking for the best price and as consumer products people to come us we’re not looking for monies and add backs and market funds and co-op funds and key city funds and all the things that are added on. We ask for, give us the best cost, let us take possession of it as early on in the supply chain as possible. We'll get it to the right store at the right time but I need the lowest price and I'll buy it in a way that really works for you. I might buy it in your down production time but I need, main thing is we need value that worth more than $1. We’ll bring it to our stores. We'll get it in the right place and we want to pass those savings along to our customers.

So, that’s the way we work with everyone. That’s the way we work with the brands. When you see us talking about introducing more brands, it’s usually a decision that says we’re looking for really -- to add a little bit more sizzle, add a little more excitement. We know it's a little less margin but it’s an investment in the customers, investment in the traffic.

Meredith Adler - Barclays

Great, and I just have one other question about, you mentioned fee development and that was I guess including CapEx, but does that imply that you are building, starting to really focus on building more free standing stores but presumably you don’t have fee development if you’re going into a shopping center?

Bob Sasser

No, Meredith, a couple of years ago we did start looking at fee development and bringing a few projects out of the ground ourselves. Obviously, if you think back a couple of years ago, the developers were still capital constrained and many of them still are today. And so there are not as many new projects. And the other thing we found as we went through this process is, we really like the idea of having a store located where we want it, the right size, right shape, it has four walls instead of six or eight at end of the day and basically the linears layout better, the adjacencies for merchandising layout better and we can put our best foot forward and we’ve found that these locations have performed very well, the ones. Now it's a small subset of our overall openings in any given year but it’s something that we like and will continue to be part of our overall portfolio process.

Randy Guiler

Thank you for joining us on today’s call and thank you for your continued interest in Dollar Tree. Our next scheduled earnings conference call will be Thursday, November 20, 2014. Have a good day.

Operator

That does conclude today’s conference, we appreciate your participation. You may now disconnect.

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