Dollar General's (DG) CEO Rick Dreiling on Q3 2014 Results - Earnings Call Transcript

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Dollar General Corporation (NYSE:DG) Q3 2014 Earnings Conference Call December 4, 2014 10:00 AM ET

Executives

Mary Winn Pilkington - Vice President, Investor Relations and Public Relations

Rick Dreiling - Chairman and Chief Executive Officer

David Tehle - Chief Financial Officer

Analysts

Taylor LaBarr - Stifel

Michael Lasser - UBS

Scot Ciccarelli - RBC Capital Markets

Dan Wewer - Raymond James

Meredith Adler - Barclays

Matt Nemer - Wells Fargo Securities

John Heinbockel - Guggenheim

Edward Kelly - Credit Suisse

Paul Trussell - Deutsche Bank

Scott Mushkin - Wolfe Research

Dan Binder - Jefferies

Mark Montagna - Avondale Partners

Operator

Good morning. My name is Dorothy and I will be your conference operator today. At this time, I would like to welcome everyone to the Dollar General Third Quarter 2014 Earnings Call. Today is Thursday, December 4, 2014. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] This call is being recorded. A replay of the call will be available later today. Instructions for listening to the replay are available in the company’s earnings press release issued this morning.

Now, I would like to turn the conference over to Ms. Mary Winn Pilkington, Vice President of Investor Relations and Public Relations. Ms. Pilkington, you may begin your conference.

Mary Winn Pilkington

Thank you, Dorothy, and good morning everyone. On the call today are Rick Dreiling, our Chairman and CEO; and David Tehle, our CFO. We will first go through our prepared remarks and then we will open the up call for questions. Our earnings release issued today can be found on our website at dollargeneral.com under Investor Information, Press Releases.

Let me caution you that today’s comments will include forward-looking statements about our expectations, plans, predictions, and other non-historical matters, such as our 2014 forecasted financial results and capital expenditures, our planned fiscal 2014 and 2015 operating, merchandising and store growth initiatives, our beliefs regarding future consumer economic trends and various matters relating to our proposal to acquire Family Dollar. Important factors that could cause actual results or events to differ materially from those reflected in or implied by our forward-looking statements are included in our earnings release issued this morning; our 2013 Form 10-K which was filed on March 20, 2014; and in the comments that are made on this call. We encourage you to read these documents.

You should not unduly rely on forward-looking statements, which speak only as of today’s date. Dollar General disclaims any obligation to update or revise any information discussed in this call. We will also reference certain financial measures not derived in accordance with GAAP. Where available, reconciliations to the most comparable GAAP measures are included in this morning’s earnings release, which I have mentioned is posted on dollargeneral.com.

The purpose of today’s call is to discuss Dollar General’s performance for the fiscal third quarter and outlook for the fiscal year. At the end of our prepared remarks, we will open the call up to your questions on those subjects. During today’s Q&A, we will not discuss our proposed acquisition of Family Dollar or related matters. Please limit your questions to one and one follow-up question, if necessary.

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

Rick Dreiling

Thank you, Mary Winn. Good morning, everyone. This morning we announced the results for the third quarter of fiscal 2014. David and I will discuss the highlights of the quarter. Then I will address our current initiatives and provide an update on where we are with the Family Dollar transaction.

For the third quarter, net sales grew 7.8% to $4.72 billion. Comp store sales increased 2.8% as compared to the 2013 third quarter with increases in both traffic and average ticket. Extending that trend to 27 consecutive quarters, our comp sales trajectory improved as we move through the quarter and we have seen that trend accelerate into the fourth quarter. We had a good back-to-school season, along with strong sell-through for Halloween. And importantly, we are seeing a significant step up in comp sales as we start the fourth quarter. Momentum has built as we lapped the SNAP benefit cuts in the fourth quarter of 2013 and we expect to achieve a comp sales growth of approximately 5% for the fourth quarter.

Perishables and tobacco continue to be the largest contributors to same-store sales growth. Tobacco has continued to show very strong comp growth beyond its first full year anniversary. Our non-consumables were positive for the quarter marking the third consecutive quarter of improvement. We are extremely pleased with sales growth in our home and apparel categories this year. I believe our efforts on current trends and affordability in these areas have already begun to take hold with our customer.

Our gross profit rate of 30.1% of sales was 18 basis points less than last year’s third quarter. While this was below our expectations due to higher promotional markdowns across consumable categories and end-of-season inventory clearance, this represented a significant improvement over our recent quarterly trend. Finally, adjusted earnings per share for the third quarter increased 10% to $0.79 per share.

We have updated our guidance to reflect performance through the third quarter and our outlook for the fourth quarter for both sales and earnings. We continue to have a strong outlook for the fourth quarter. On the comp sales front, our initiatives coupled with our commitment to everyday low price continue to resonate with our customers. We kicked off the holiday season with a 3-day ad the week prior to Thanksgiving and continue to emphasize our savings over an 8-day period centered on Thanksgiving Day. We offered exclusive holiday savings across gifts, toys, electronics, clothing, décor, baking and additional categories for every holiday need. We are pleased with our customer’s response to these promotional events. As we lap some of the retail challenges from the fourth quarter of 2013, we are seeing broad-based momentum build in our business.

I will talk more about our operating initiatives in a moment, but now I would like to turn the call over to David.

David Tehle

Thank you, Rick and good morning everyone. First, let me walk you through our gross margin performance. Gross profit increased by 7.2% as a percentage of sales and decreased by 18 basis points to 30.1% in the 2014 third quarter compared to the 2013 third quarter. Our product category with the lowest gross profit rate is consumables and this category continues to comprise a larger portion of our net sales primarily as a result of increased sales of lower margin tobacco and perishable products. The gross profit rate decrease was also impacted by an increase in markdowns due to increased promotional and end of season inventory clearance activities. These factors were partially offset by higher initial markups on inventory purchases and improved inventory shrink.

We recorded a LIFO provision of $2.2 million in the 2014 period compared to a LIFO benefit of $3.7 million in 2013 period. This equates to 13 basis points of negative pressure on gross margin percentage. As compared to our forecast for gross profit, we successfully mitigated the impacts of the West Coast ports slowdown and driver shortages on gross margin due in part to stem miles from the successful opening of our Bethel, Pennsylvania distribution center earlier this year.

SG&A expense was 21.8% of sales in the 2014 period compared to 21.4% in the 2013 period. For the third quarter 2014 SG&A expense includes expenses of $8 million or 17 basis points related to our proposed acquisition of Family Dollar. The remaining 21 basis points of SG&A rate increase are attributable to increases in rent, utilities and incentive compensation expenses. Offsetting these items were convenience fees charged to customers for cash back and debit card transactions and retail labor expense which increased at a rate lower than our increase in sales. The third quarter tax rate was 36.5% compared to last year’s effective tax rate of 35.6%. Both years included benefits from the reduction of reserves that were established in 2009. These amounted to $4.7 million in the 2014 quarter and $6 million in 2013 quarter. Excluding these adjustments, the increase in our tax rate relates to the expiration of various federal job tax credit programs and the impact of certain non-deductible expenses related to the proposed acquisition of Family Dollar.

Year-to-date, we generated cash from operations of $841 million, that’s up $80 million from last year’s 39 week period. Total capital expenditures were $289 million including $104 million for improvements, upgrades, remodels and relocations of existing stores. $86 million related to new leased stores primarily for leasehold improvements, fixtures and equipment. $36 million for distribution and transportation related capital expenditures. $29 million for stores built by the company and $28 million for information systems upgrades and technology related projects. Our share repurchase program is on hold as we await the outcome of our proposed transaction with Family Dollar.

Turning now to guidance, top line sales for the full year 2014 are expected to increase approximately 8% at the low end of our previous guidance range and same store sales are now expected to increase at or slightly below the low end of our previous range of 3.0% to 3.5%. With same store sales growth of approximately 5% forecast for the fourth quarter. We expect adjusted diluted earnings per share for the year to be in the middle of our previous full year adjusted earnings per share range of $3.45 to $3.55. This excludes any costs related to the potential FDO transaction.

In addition it assumes no additional share repurchases in the fourth quarter. It does assume the reinstatement of the work opportunity tax credit back to the beginning of the year which has always been included in our guidance for our effective tax rate for the year. The impact of the tax credit is approximately $0.04 per share. For the year we are on track to open approximately 700 new stores and capital expenditures are expected to be approximately $400 million which is down from our earlier expectations due primarily to the timing of the build out of our new San Antonio, Texas distribution center and lower overall costs for new stores.

With that I will turn the call back over to Rick.

Rick Dreiling

Thank you, David. As we have said for many quarters driving unit sales growth is key to our long-term strategy. And I am pleased to report that we continue to make progress in this area. Once again in Nielsen syndicated data, we have grown both units and dollars share in the mid to high-single digits in the most recent 4-week and 12-week periods on top of our long track record of share growth. I believe this is attributable to our commitment to affordability. With our focus on affordability, we are offering customers to trade down on purchase price for infants in key categories such as food, paper, home cleaning, and pet, unit growth is significantly ahead of sales growth in the most recent 12-week period. There is no doubt we may have sacrificed some sales as we look to drive units. Given the importance of unit growth and transaction growth as leading indicators of relevancy with our customers and of our future success, we believe this is the right trade-off for us.

Another factor impacting our comp sales growth worth mentioning is that we have had essentially no inflation. The foundation of everything we do at Dollar General is grounded in serving our customers. We remain committed as ever to providing our customers with everyday low prices they can count on. We want to make sure that our customers know that they can find nearly all of their everyday items in our small box convenient stores. Our customers are the first place we start as we build our merchandising plans for the coming year.

While on paper, it appears that the economy is improving, the low to middle income consumer who is our core customer continues to look for ways to manage her budget as she works to prioritize her spending and she trusts that we are on her side to help her stretch her budget. Keep in mind, she had a tough fourth quarter last year with the number of headwinds that are starting to moderate year-over-year, including SNAP benefit reductions, challenging weather, higher energy costs, reduction in unemployment benefits and the lingering effects on consumer spending from the 2% payroll tax increase in 2013.

As I reflect on our trends for the year, I believe that we underestimated the impact of these cumulative headwinds on our customer. As a result, there is no doubt that affordability is and will continue to be a focus of our core customer. Our renewed focus on $1 to $5 items continues to gain traction. We had more than 75% of our SKUs or 78% of our sales for the third quarter, that were items priced at $5 or less. This is important as we know we trade more customers with the $1 fixed price retail concept than any other small box retailers. Beyond that, we are continuing to add items with approximately 80 SKUs under our smart and simple brand at entry level price points across 26 merchandise categories.

In addition to the smart and simple brand, we continue to strategically introduce new $1 price point items on the shelf in key consumable categories, such as food, home cleaning and paper products that are focused on affordability. All-in, SKU counts in our dollar section of the store have increased more than 50% as compared to the end of 2013. New items include a combination of national brands and our private brands. In addition, we have expanded our dollar section offering to an additional 845 stores, with 96% of our stores having anywhere from 12 to 40 feet of dollar products across multiple categories with an emphasis on health, beauty, paper, home cleaning and food. These dollar category expansions are a great way for customers to have increased purchasing power in our stores. Given that our average basket is around $11 our expanded offerings can have a positive halo effect on our customer satisfaction as they leave our store with an additional item or two.

We continue to be very pleased with the performance of our $5 or less price point assortment on our non-consumable categories, which represent about 60% of our merchandise offering. This clear focus on expandable consumption items at affordable price points has contributed to solid growth in our home and apparel sales this year. As a result of these merchandise changes, we are seeing improvements in category sell-through rates.

Non-consumables are important to our sales mix as we strive to enhance our gross profit rate. In the coming year, our plans have been developed to advance expandable consumption items in multiple categories, including storage, candles and domestics. In addition, we are in the midst of repackaging our private brands across both select consumable and non-consumable categories. The goal of the repackaging is to enhance our customer’s perception of our private brand quality and value for the price. We had a test launch of the new packaging in select products with very encouraging results. And the majority of new repackaged items will be on the shelf in 2015. We continue to grow our private brand with SKU count up 6% and penetration of over 24%. We continue to look at ways to leverage technology and engage consumers. We completed the initial rollout of our digital coupon capabilities in August and began to aggressively launch that program at the end of September and throughout October with our fast way to say promotion.

To-date sign-ups had significantly exceeded our expectations and we have already hit our target for the year end. With nearly 18 million digital coupons downloaded already activations and redemptions are having a strong impact on sales of coupon specific items. In 2015 we will be able to use the data captured from this program like a loyalty card, but without incremental cost. For instance insights from a customer shopping trip can be used to customize individual promotions to drive trips and baskets. This is an exciting opportunity that we should be able to capitalize on in 2015.

I am pleased to report that we had favorable results and improving our inventory shrink performance in the third quarter. Over time shrink improvement continues to be an opportunity as we remain steadfastly committed to reducing our shrink levels on a store by store basis. The store format and layout SKU rationalization of high-shrink items, defensive merchandising and exception based reporting all play a role as we look for shrink improvement going forward. Driving productivity at the store level is important as ever, as our overarching goal was to create time savings that we can reinvest to better manage our stores and service our customers.

In order to enable productivity gains we are elevating our category management processes to optimize all areas of the store be on the planograms to include all shelf and end cap displays. Over the last several years we have made significant strides in the productivity of our planograms through SKU selection and ongoing refinement. We feel we have established a strong foundation on our planograms that we can refine periodically. We are concentrating on simplifying work at a store level by reducing the complexity of planogram resets.

At Dollar General real estate is the core strength. Our real estate model is disciplined and focused on financial returns. Year-to-date we have opened up 617 new stores and relocated or remodeled 874 stores including approximately 380 lifecycle remodels. The lifecycle remodels are focused on our legacy smaller footprint stores and allow us to improve adjacencies and planogram layouts. These stores are getting closer to the same sales lift as we get in our full remodel with a much lower investment resulting in returns on the lifecycle remodels that are over 200 basis points higher than our full remodel.

Given the strong returns, we plan to significantly expand our lifecycle remodel program in 2015. In addition, in the first quarter of 2015, we will be utilizing our merchandising predictive technology capabilities in over 250 of our lifecycle remodels to optimize our space and SKU productivity. So we expect these remodels to drive even higher sales.

In 2015 we plan to open approximately 730 new stores and to relocate or remodel 875 stores with the priority on lifecycle remodel. In total square footage growth is expected to be about 6%. We will expand our footprint into three new states in 2015 Maine, Rhode Island and Oregon as we use our real estate model to identify winning sites for our traditional Dollar General format. We are right where we want to be as we enter the New Year. Our real estate pipeline is 100% committed and we are already working on 2016. Our new store productivity continues to be about 85% of our comp base and we are looking forward to successful store openings in 2015. Also in 2015, we will open our 13th distribution center as we continue to invest in our infrastructure to support our growth. Site work has started on the new distribution center in San Antonio, Texas and we plan to begin shipping from that distribution center in late 2015. We have exciting plans for 2015 and have lots of opportunities ahead of us.

Now, turning briefly to our proposal to acquire Family Dollar, we are as committed as ever to this acquisition and believe that the synergies we expect to achieve through the combination of these two companies would benefit Dollar General shareholders and importantly the consumer for many years to come. We are working hard to be in a position to complete this transaction and begin the process of combining our two companies. To that end, as we have stated, we are actively engaging with the SEC and believe that we are making good progress on that front.

We filed our HSR notification with the SEC in mid-September. Since the filing, we have provided the SEC with tens of thousands of documents and have had a number of very valuable and productive discussions. Family Dollar shareholders are currently scheduled to vote on the Dollar Tree transaction at a special meeting on December 23. We are very aware of the calendar and we look forward to sharing more information with sufficient time for Family Dollar shareholders to make and inform voting decision at the December 23 shareholder meeting.

Our 75th anniversary has been a time to reflect on our company’s rich heritage and our mission of serving others. It’s also an exciting time to look to the future and envision what the next 75 years will bring for Dollar General. My sincere thanks and appreciation go out to the 106,400 Dollar General employees as we are in the midst of the busiest season of retail. Over the years, Dollar General employees have built this business through hard work and dedication to our mission and we owe them a great deal of gratitude. Thank you for an amazing 75 years.

Mary Winn, I will now open the call up for questions.

Mary Winn Pilkington

Yes. Dor, as previously mentioned we will not discuss our proposed acquisition of Family Dollar or related matters. Please limit your questions to one line and one follow-up question, if necessary. We will now open up the call for questions. Dorothy?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Taylor LaBarr with Stifel.

Taylor LaBarr-Stifel

Good morning, Taylor. Again, thanks for taking my question. Just wondering if you could comment a little bit on the seasonal category trends throughout the quarter? How they performed relative to expectations whether it was the same comp cadence of improvement? And then also expectations going into the fourth quarter, it looks over the past few years seasonal has been relatively weaker in the fourth quarter relative to other categories. So, should we – as you look at your plans and trends today, is that a structural trend we should expect to continue or is that more of a multi-year easy comparison that we should think about?

Rick Dreiling

Yes, great questions. We had a very good Halloween and good back-to-school really pleased with that. I will tell you the bigger season had slowed down a bit, summer and spring, and of course, we experienced a little bit of slow traffic last year on Christmas. I will tell you we had an offering this year on the Christmas side that is much different than last year and it’s focused on affordability. Many, many items below $5 and again this idea that the $1 price point is incredibly important to our customer, a lot of items focused on $1. And we – I don’t see a structural change yet. We are looking for good things with seasonal in the fourth quarter. We will see how it plays out.

Taylor LaBarr-Stifel

Great, thanks.

Rick Dreiling

Thanks, Taylor.

Operator

Our next question comes from the line of Michael Lasser with UBS.

Rick Dreiling

Good morning, Michael.

Michael Lasser-UBS

Good morning, Rick. Thanks a lot for taking my question. Obviously, a lot of focus on gas prices, but also on the competitive environment, in the third quarter we saw some improvement from some other discounters at least a sequential improvement from the second to the third quarter. So, my question is what do you think the possibility is that as gas prices decline that you will start to see some customers shift out of the discount convenience channel into other areas, especially after you have seen such a massive customer migration into your channel over the last several years?

Rick Dreiling

Yes. I think that the way I look at the gas prices, number one you are not going to see it takes a while for the consumer to really believe they got extra change in their pockets. It’s going to take a series of trips to the gas station to realize there is a little more money there. I think the other thing to take into account would be that it makes the customer more malleable. They obviously have the wherewithal to search for more deals across more channels. But at the end of the day we are on our 27th year of same store sales growth. We have had good times, we have had bad times, good economies, high gas prices, low gas prices and our customer always seems to search us out. So I think the work we have done on affordability, I think we have hit that one out of the park. The unit growth that we are seeing is great. And again I think as long as we stay focused on affordability the customer is going to always be searching for us.

Michael Lasser-UBS

That’s helpful. Thank you. My follow-up question is now that you have focused on affordability and building units, how do you build the basket or get them to trade back off after you have introduced the customer to all these new products, was that – is that not the focus?

Rick Dreiling

Yes. I would tell you the focus is on transactions and it’s focused on units. I – my personal feeling on this Michael is I never want to be in a position where I would tell my traffic is down and my basket is up. And I think that is – that’s when you start to get yourself into a bind. Our basket has been around $11 every year I have been here and what we are seeing is our customers coming back more often to us.

Michael Lasser-UBS

Okay. Thanks and good luck with the holiday.

Rick Dreiling

Thank you, Michael.

Operator

Your next question comes from the line of Scot Ciccarelli from RBC Capital Markets.

Rick Dreiling

Good morning Scot.

Scot Ciccarelli-RBC Capital Markets

Good morning. Hi guys. Obviously, you have had the lower gas prices and you have also seen a little bit of recovery in some of the labor metrics for let’s call it non-college educated consumers let’s call blue collar kind of people, Rick when you think about kind of all the gives and takes on the consumer side, I mean how are guys kind of thinking about and how do you think it rolls through 2015?

Rick Dreiling

Yes. I think the middle income, low income customer, I do think there is still – I still think they have got some issues. I don’t believe they have them to the magnitude they had them last year. I do feel better about the consumer, but I am still little more cautious. I am cautiously optimistic. And I think it’s interesting when we – you can almost go back last year and look at when the staff cuts hit and what would happen. This year you can see when we have lapped those staff cuts you can see the change in consumer behavior. So again I am cautiously optimistic. And I think it will flow through to the retail sales line as we move through ’15.

Scot Ciccarelli-RBC Capital Markets

And when you consider kind of incremental changes for ’15, I know it’s becoming a bigger topic for a bunch of our retailers just in terms of some of the changes being implemented with healthcare, affordable care, etcetera, have you guys thought about the potential impact that could potentially have on some of your consumer buying patterns?

Rick Dreiling

Yes. And again that’s why we are so committed to the affordability piece, that’s why we are working so hard, getting items into the store that price $5 or less or even centered around the $1 price point. The whole idea here is I believe affordability is going to be with us for a period of time yet.

Scot Ciccarelli-RBC Capital Markets

Got it. Thanks a lot guys.

Rick Dreiling

Yes. And our customer is always looking for a bargain.

Scot Ciccarelli-RBC Capital Markets

Understood, thanks a lot.

Rick Dreiling

Alright. Thanks Scot.

Operator

Your next question comes from the line of Dan Wewer from Raymond James.

Rick Dreiling

Good morning Dan.

Dan Wewer-Raymond James

Thanks. Your focus on growing transactions and market share makes a tremendous amount of sense, but the one problem is that Dollar General’s generally has now dropped for four consecutive years and inventory is about 50% of your tangible assets. So the focus on growing share is coming at the expense of lower returns, looking let’s say into 2015 or 2016 are there any initiatives that could enable you to achieve both a better market share as well as a higher inventory productivity?

David Tehle

A couple of comments on that, first of all you have take into account tobacco when you look at the margin. And we made a strategic decision to add tobacco knowing what that would do overall. I think as we look forward, there are initiatives going on in foreign sourcing in our private label as well as shrink. And as Rick mentioned in his comments, we saw some positives in shrink this quarter. So, we still have the capability to add to that gross margin in that gross margin percent. Having said that, again I go back to what Rick said as you kicked this off driving unit sales growth and transaction growth will continue to be high priorities for us. And what we are going to be focused on, because we think ultimately that’s what our long-term shareholders want to see, but yes, there is room in margin and there are things where we continue to work on, but again the unit growth and the transaction growth will always be at the top of the list.

Dan Wewer-Raymond James

And David, just a follow-up, you had in your prepared comments you noted that in the fourth quarter, you will get a $0.04 contribution from tax credits. So, I guess tax rate is going to be about 35.5%, 36%. Did you have a similar tax credit in the fourth quarter of last year?

David Tehle

So, what this is the, WOTC, the Work Opportunity Tax Credit. And the way this works is these benefits expired December of last year and we have been waiting all year for the federal government to take action on this. Last night, the House passed a bill of tax extenders by a vote of 378 to 46. That bill was now sent to the Senate and the Senate is waiting for – we are waiting for the Senate to take action on it. We obviously can’t predict what the Senate will do, but if past history is any indication more than likely a 1 year extension will be provided. This is what we saw back in 2012 when this happened also and then it will be retroactively applied back. So, we will get the full year credit in the fourth quarter. As we have done our guidance for the full year, we always had this in our guidance. This isn’t anything new. We felt like WOTC would come back and we felt like it would probably be the fourth quarter, simply because that’s how it happened in the past. So, again it’s been in there and that’s our thought process in terms of what hopefully will take place, but of course, we can’t predict what the federal government will do.

Dan Wewer-Raymond James

Exactly. And you are always saying it was included in last year’s fourth quarter earnings?

David Tehle

It was included all year, last year. Yes. If you go back to 2012, but it’s the fourth quarter in 2012, because we had this situation where we have got reinstated.

Dan Wewer-Raymond James

Okay, right. So, we are just trying to get an apples-to-apples number for the fourth quarter so? And so you are saying that it was worth $0.04 a year ago in the fourth quarter?

Mary Winn Pilkington

No, Dan, it’s Mary Winn. It was even because that have been adopted at the end of 2012, it was retroactive for 2012 and we took that all in the fourth quarter 2012. And at that point in time, we have provided the breakout of what that was on each quarter. And as it ended in 2013, it was effective all year in all four quarters.

Dan Wewer-Raymond James

Okay, I think I understand. Okay, thanks.

Mary Winn Pilkington

Beginning of 2014.

Dan Wewer-Raymond James

Here you go. Got it. Okay, great. Thank you.

David Tehle

Yes. It expired in December 2013.

Mary Winn Pilkington

That’s right.

Dan Wewer-Raymond James

Okay, thanks.

Mary Winn Pilkington

You are quite welcome. Dorothy, we will move to the next question.

Operator

Your next question comes from the line of Meredith Adler with Barclays.

Rick Dreiling

Good morning, Meredith.

Meredith Adler-Barclays

Good morning. Thanks for taking my question. I was wondering if you could just go into a little bit more detail about how you use the data from your coupon program. I understand you see it as being similar to loyalty program, but less expensive, but could you just walk us through kind of how it works what you get and then what you do with the information?

Rick Dreiling

Yes. I mean, it’s very similar to a loyalty card. The advantage is we don’t have to massage the data, the company that we are working with does. And what you do is you offer them a coupon to see if you can change their behavior and the example would be Meredith, I offer you a $1 off Charmin toilet tissue and you don’t respond to that coupon, right. And so then what would happen is that would mean you are buying your tissue somewhere else and I can turn around and make the offer more rich and then it allows me – and what happens is I have a slate of coupons and you opt into them. And again, the coupons you choose not to opt into would indicate you are probably buying your products somewhere else. And I can enrich in those – I can enrich those offers to drive your behavior.

Meredith Adler-Barclays

And do you get to in some way keep track of each individual’s purchases over time?

Rick Dreiling

Absolutely, remember everybody enters their phone number and its how they register.

Meredith Adler-Barclays

Right, got it. And then I guess wanted to talking – you were talking about your – I don’t want call them lifestyle remodels, but you know that’s not what I mean, of lifecycle remodels and…?

Rick Dreiling

Yes. Sure.

Meredith Adler-Barclays

And you talked about I think 250 stores where you are actually going to be changing the offering and I think probably matching it to the local community better, could you just talk about that initiative?

Rick Dreiling

Yes, absolutely. So what we are going to do is we are going to take a store that’s a store historically smaller that would go into a relocation been Meredith and we are going to fresh in these stores up and remodel them. And the idea here is they are going to have we will go into the store and analyze it and do category management. I will use an example. This particular store in this particular market might sell more powder detergent than liquid detergent. And what we will do is adjust the set to reflect more powder detergent, right. And there are markets believe it or not where power is still the biggest item. We have some markets where and I will used the example of diapers. We have a diaper set that’s exactly the same in every store across the chain. And now we will be able to contract diapers and maybe expand on incontinence items in areas where we are closer to – where the client is older. So we are really excited about this and it’s the heat mapping concept that the guys have taken and spread out where we can really understand what’s selling and what’s not on an individual store basis now.

Meredith Adler-Barclays

And do you believe that that drives sales or margin or both?

Rick Dreiling

Actually, I would say both because what we end up doing is having the items the customer wants and hopefully they will buy more of them and then consequently it drives more transactions. And again I equate that Meredith down to more units and more transactions. We are focused on units and transactions.

Meredith Adler-Barclays

Great. Thank you.

Rick Dreiling

Thank you.

Mary Winn Pilkington

Right, Dorothy we will move to the next question.

Operator

Your next question comes from the line of Matt Nemer with Wells Fargo Securities.

Rick Dreiling

Good morning Matt.

Matt Nemer-Wells Fargo Securities

So I wanted to talk about promotional activity, it was very heavy early in Q2 and then it had moderated, but it sounds from your comments like it may pick back up again in Q3 given the higher consumables markdowns in the end of season inventory clearance, can you just give us some color around the cadence of the promotional activity?

Rick Dreiling

Yes, I think it is I would say it’s certainly a little higher than quarter two, but I would not call it irrational or nearly as competitive as last year. Again our goal has always been to come to the market with the right items. And I would look at you and say it’s primarily the promotional activity right now Matt around CST. And again, I think I brought up in the second quarter or first quarter that we were going to be in line on CST pricing and that’s where you will find the bulk of the incremental markdown for us.

Matt Nemer-Wells Fargo Securities

Okay, that’s helpful. And then just a quick follow-up, could you just talk to the interplay between the port issues and the driver shortages versus potential relief on freight from lower diesel prices?

Rick Dreiling

Yes, I will tell you that that we do have some merchandise that’s hung up on West Coast. We have worked very hard and absorbed incremental transportation costs to try and get in move that product around. I also know that we found out yesterday some of the shippers are refusing now to go in to the West Coast docks and which is going to create more pressure. We estimate that between the dock shortage, the higher cost to get merchandise moved that it’s about 6 to 9 basis points. We offset that by the way with vessel where we were able to get our stem miles down. I do think that it’s going to be a problem as we move through the fourth quarter and it will be a problem for everybody. We are working hard on trying to divert products to the East Coast. There has been no indication that they are going to support their brothers on the West Coast. So we are going to had stay tuned on that one.

Matt Nemer-Wells Fargo Securities

But is there anything as you see kind of gas prices down and diesel prices down is that big enough to potentially offset some of that how quickly does reset in your negotiations with the truckers?

Rick Dreiling

Yes, I think the down diesel prices will help, but I don’t know that it’s going to help depending on the magnitude of what we encounter. I think you guys all know the West Coast. The President has said he is not going to interfere with that. He is going to let it take its own course. So, I think the gas price, the lower diesel costs will help, but it’s not going to cover at all.

Matt Nemer-Wells Fargo Securities

Got it. Okay, very helpful. Have a great holiday.

Rick Dreiling

You too. Thank you.

Operator

Our next question comes from the line of John Heinbockel with Guggenheim.

Rick Dreiling

Good morning, John.

John Heinbockel-Guggenheim

Hey, Rick. So, let me ask you $5 items and under, where do you think that ultimately goes as a percent of sales, right? So, how do you think that goes in a reasonable period of time here? And then secondly as part of that if the number of items per basket are going up, ASP is going down, does that create some pressure managing retail labor, right, because you are trying to get throughput on more items with the same, kind of the same basket size?

Rick Dreiling

Yes. The first part of your question, we will let the customer decide, right. Why we are adding more $1 and more items under $5? We still have a broad selection of products, right. So, we are still very much in the game of letting the customer make the decision of what they want and part of the way we have – part of the way, part of our success over the last year has been our ability to broaden our appeal. And some of that is not only the affordability angle, but also having some more stuff in there.

The second part of your question, we are working on getting case packs down, which will make it easier for the retail team to absorb the incremental items. I also think that having been a retailer, having been on that side of the ledger, when sales are moving in the right direction, we have always somehow managed to conquer anything that’s associated with it. And Greg and his team have done a marvelous job this year so far of working their way through that. We also John have – which we rolled out this year, a very serious stocking initiative and we are doing a much better job, not only in how we ship the product to the stores, but we are doing a much better job of measuring stocking productivity.

John Heinbockel-Guggenheim

Alright. And then just secondly, I know you don’t – you never quantify where you sit with shrink, but where do you think that opportunity sits either relative to where it might have been when you first came in or relative to however you want to measure it is there is still a fairly large opportunity there?

Rick Dreiling

Yes, it is certainly not at the level it was when I came in. It’s better than that. But I see it as a significant improvement to come yet.

John Heinbockel-Guggenheim

Okay, thank you.

Rick Dreiling

Back even John, where we were, we need to be better than where we were if that helps.

John Heinbockel-Guggenheim

Okay, thanks a lot.

Rick Dreiling

You bet.

Operator

Your next question comes from the line of Edward Kelly with Credit Suisse.

Rick Dreiling

Good morning, Ed.

Edward Kelly-Credit Suisse

Hey, guys. How are you?

Rick Dreiling

Good.

Edward Kelly-Credit Suisse

I would like to just ask you a question about the gross margin here. On a FIFO basis, you are actually almost flat, which is the first time in probably a couple of years, but you have seen that. And what I was looking into is maybe get some additional color on the puts and takes here, because the question is around affordability, for instance and the work you are doing there? What impact on the gross margin does that have? You have mentioned no inflation in the business, but I think we have seen inflation, for instance, in consumables. So, are you holding the line there? Is that having a negative impact, right? And then how are you offsetting all that?

David Tehle

Yes. I’d say let me take a shot at some of this and then certainly Rick will comment too. You have to remember in our business, we are not as based on meat and produce and things of that nature, where there has been lot more impact of inflation. Now, we have had a little bit of inflation in our candy and some of our other perishables, a little bit in tobacco. And particularly as compared to last year, where it was actually going the other way and that’s why we have this LIFO that I spelled out earlier on the call, but I think as you look at it, again I go back to the three basic items that help us on gross margin in terms of offsetting negatives and that is the foreign sourcing, the private label and the shrink and we continue to push all three of those in terms of trying to drive a little bit more on the gross margin and the gross margin percentage.

Edward Kelly-Credit Suisse

The work around affordability and particularly you think about like the $1 price point for instance, what impact does that have on margin? And then what impact does that have on gross profit dollars?

Rick Dreiling

Yes, the margin on the affordability items is actually accretive. They tend to – the $1 items tend to carry a little bit higher margin rate. As do and kind of that margin rate will – Ed not as great when to the $5 items, but the lower priced items believe it or not carry more and it should help our rate.

Edward Kelly-Credit Suisse

Alright, so do you think you are at the point where we should begin to see stability in the gross margin going forward or maybe even opportunity now?

Rick Dreiling

I – that is kind of where I am at right now to be honest with you. The work we have done on the margin, we all have to remember we got cigarettes in there which is a 17 basis points drag. Albeit we have cycled that, but we anticipate we have margin expansion opportunities going forward now.

Edward Kelly-Credit Suisse

Okay, great. Thank you.

Operator

Your next question comes from the line of Paul Trussell from Deutsche Bank.

Rick Dreiling

Good morning Paul.

Paul Trussell-Deutsche Bank

Good morning Rick. Just to continue the conversation there on margins, just if you can hold our hand a little bit more on how you are thinking then about the fourth quarter, you have mentioned in the prepared remarks that you were a little bit disappointed in gross margins or is a little bit below I should say your initial expectations. Do you see sequential improvement ahead given some of the comments you just made around some of these initiatives on private label. And also if you can just remind us David on how we should be thinking about the impact of the incentive comp swing within SG&A?

David Tehle

Yes. So I think as we look at the fourth quarter right now we are calling margins to be relatively flat overall in terms of basis points. And then we do have a significant delevering of SG&A and you hit it right on the biggest piece of that, it has to do with the incentive comp. If you go back to our script from fourth quarter last year, you will see that we spelled out that incentive comp was a 45 basis point negative – excuse me a 45 basis point positive last year to it because in essence we had a fairly sizable reserve reversal in the fourth quarter since we did not pay any incentive comp. So that’s the magnitude of what we are up against this fourth quarter.

Paul Trussell-Deutsche Bank

Got it, that’s very helpful. And then just to go back and kind of clarify the fourth quarter comp outlook is certainly encouraging to hear that there has been an improvement in trends recently and we certainly acknowledge that you have an easier compare as we move through the quarter, but still a 5% comp would be a pretty meaningful lift and acceleration on a one year basis maybe give us a little bit more color on what provides that level of confidence, how you think the discretionary categories will perform and to what extent if at all are you – do you believe that there will be incremental buying activity due to lower gas prices?

Rick Dreiling

Yes. Really good question and I will break it into a couple of different buckets here. This week last year was the first major snow event of the year in which we took a pretty sizable – we had sizable difficulty managing the weather this Saturday, this coming Saturday, Sunday, Monday and Tuesday and next week. If you look at January Paul of last year and I think we called it out on the conference call for the fourth quarter. We came to work and had a thousand stores shutdown in several locations, right. And we dealt with a very, very, very weak January last year. January historically is one of our better months, better periods of the year.

So I feel very comfortable in that there was – and remember I am getting a little ahead of myself here is I think as I recall there was a major snow event the week before Christmas last year. And unless you read the farmers almanac, I am very positive on weather for the quarter. But I think that with – we have got that in our favor. And then I think the quality of our merchandise offering for Christmas is much better than it was last year, much better focused on affordability. This is obviously the big trick-or-treat weekend. This is the first weekend where we see a lot of the Christmas trees being bought and all the decorations. And I am still a little bit of a merchant and we have reviewed all of our merchandising plans for December and January with the team and we look pretty good.

Paul Trussell-Deutsche Bank

Best of luck.

Rick Dreiling

Thank you.

Operator

Your next question comes from the line of Scott Mushkin with Wolfe Research.

Rick Dreiling

Good morning, Scott.

Scott Mushkin-Wolfe Research

Hey, good morning guys. Thanks for taking my questions. I wanted to kind of step back and maybe just review, I know we have suspended the share repurchase, but maybe we can just remind everybody kind of how you look at your balance sheet just generally in share repurchase notwithstanding obviously the activity, but just kind of a review of how you guys think about things?

Rick Dreiling

Sure. Obviously, our number one priority is investing in the business. We are a growth company. It’s important to us to be opening up stores. So making sure that we have the capital to open new stores to do remodels, to do relocations and that we have the infrastructure in the back end of the business to support those stores whether that be in the transportation and distribution area, in IT that we have systems that will help make sure that we are supporting the stores, it’s all about the stores obviously. And then with the cash we have left over, our priority is share buyback. And again buying back as much stock as we can with what we have left after we have invested in the business and because of the pending efforts on Family Dollar, we have suspended that share buyback on a temporary basis.

Scott Mushkin-Wolfe Research

And a follow-up as far as like the levels of leverage you are comfortable with on the balance sheet, can you refresh us on that one as well?

Rick Dreiling

Sure.

Scott Mushkin-Wolfe Research

Well, outside the M&A activity?

Rick Dreiling

Right. Yes, exactly and that’s very, very important. We became investment grade a while back and our thought process is that we want to stay investment grade in order to do that debt to EBITDA needs to be somewhere in that 3.0, maybe a little bit higher than that 3.1 somewhere in that range overall is where our targets are. Right now, we are at 3.1. We had a fairly sizable share buyback earlier in the year, $800 million that’s still with us that’s impacted that industry. That’s why it’s 3.1. We had been in 3.0 pretty solidly for many quarters on that.

Scott Mushkin-Wolfe Research

Alright, that’s perfect. And then I had another longer term strategic question really revolving around the merchandising, I know you guys have got the DG market out there and it’s still I think in test mode, but what is the kind of longer term think about how you are thinking about perishables in your business? Lot of our research shows at the lower end, you started to embrace a higher degree of wanting more fresh items and want to think is that something you think you can do by yourself? Will you need a partner? I mean, how are you thinking about fresh going forward?

Rick Dreiling

Yes. I think – as I think about this, one of the areas that we have struggled with the most on the DG market side is the produce and the meat side, the fresh side. And when you grow up like I did managing in a grocery store, managing in produce and meat, you realize that it’s basically, you treat it like a living thing. And when you don’t grow up with that, it’s very hard to get people to understand the importance of rotation and the importance of display techniques. So, it sounds easy to do, but it’s much more difficult than that. I think long-term, it’s possible that a Dollar General might have some subset of fresh merchandise like maybe some oranges and some apples and bananas and potatoes, but long-term right now at least and by the way you never say never, but right now I would say us getting into any kind of significant position in that kind of perishable merchandise is probably not on our radar screen right now. Now, frozen food we love and we have done a lot of great work on that. And by the way, we have done some good on easier to manage perishable items like cheese and butter and orange juice and some items like that, lunch maybe.

Scott Mushkin-Wolfe Research

Alright, perfect guys. That does it for me. Thank you.

Rick Dreiling

Thank you.

Operator

Your next question comes from the line of Dan Binder with Jefferies.

Rick Dreiling

Good morning, Dan.

Dan Binder-Jefferies

Hi, good morning. My question was around gross margin, you cited some promotional activity, I am just curious how much of the promotional activity is reactive versus more predatory from your perspective and if gross margin opportunities exist, do you think you can get more predatory in particular areas?

Rick Dreiling

Yes, I think I will answer that one. I would characterize it probably more reactionary than predatory. We are intently focused on everyday low price and – but part of that is you have to be careful that there are some items out there where the consumer might judge your everyday low price based on what they see in the end. So – and again, I will reiterate primarily the promotional activity that we had in the quarter was all on CFD. So, yes – and I would also say the more and more stable the promotional environment gets, it allows you to make investments in other areas of the business that you might want to like the non-consumable side.

Dan Binder-Jefferies

And my follow-up question was on home and apparel if I realize there has been a lot of mix change here and the price points you have talked about quite a bit, how much of the improvement in those businesses do you think is a function of the price points changing versus the quality of the product or the particular products that you are putting on the shelves?

Rick Dreiling

Yes, it’s actually a combination of both. We are doing a much better job of color, a much better job of getting the product into the stores at the right time, a much better job of clearing out the old product prior to the new product getting in. And then I have to tell you, we are promoting the product very similar to how a department store would.

Dan Binder-Jefferies

Great, thank you.

Mary Winn Pilkington

Dorothy, we probably have time for one more question.

Operator

Okay. Your final question comes from the line of Mark Montagna with Avondale Partners.

Rick Dreiling

Hey, Mark.

Mark Montagna-Avondale Partners

Hey, good morning. A question about IMU, wondering how many quarters in a row has it been at the IMU has been noticeably higher? And then does that coincide with the rise of the dollar items or is there something else that’s helping drive that?

Rick Dreiling

Off hand, I don’t know how many quarters in a row it has been up, but I can tell you it’s a combination of the dollar items and doing a better job of buying.

Mark Montagna-Avondale Partners

Okay. And then as a follow-up, David, on the guidance for the fiscal year, I think you said that it does not – it’s not impacted by the cost of the potential that you are spending on the FDO pursuit, but in the third quarter, you included $8 million into SG&A. I just want to make sure I heard that right in understanding what you are saying on that?

David Tehle

So, in the third quarter, we excluded the $8 million we spelled it out and we excluded it. As a matter of fact, if you go to the press release, there is a chart at the back that will show you what’s excluded from earnings per share and that is excluded. And again, any cost that we will have in the fourth quarter will be excluded also.

Mark Montagna-Avondale Partners

Okay, alright. Thank you.

Mary Winn Pilkington

Alright, operator, that concludes our call today. Emmett, Joe and I will be around if anybody has any questions. I know we lost a few people in the queue, but thank you very much for your time and attention and we look forward to speaking to you soon.

Operator

Ladies and gentlemen, that does conclude the call for today. We thank you for your participation and ask that you please disconnect your lines.

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