達樂 (DG) 2003 Q2 法說會逐字稿

… Ladies and gentlemen, and thank you for participating in today's conference call with Dollar General Corporation.

This call is being recorded by Conference America and CCBN.

Federal law dictates that no other individual or entity will be allowed to record or rebroadcast this session without permission from the Company.

After a prepared statement by the Company, we will open the conference call for questions from the audience.

Before the presentation begins, the Company has requested that you listen to the following statement regarding forward-looking information and non-GAAP disclosures.

In addition to historical information, the Company's comments during this conference call will contain forward-looking information, such as statements regarding growth targets, key initiatives, and the anticipated results of those initiatives and annual sales earnings and other guidance.

The words believe, anticipate, project, plan, expect, estimate, objective, forecast, goal, intend, will likely result, or will continue, and similar expressions generally identify forward-looking statements.

The Company believes the assumptions underlying these forward-looking statements are reasonable.

However, any of the assumptions could be inaccurate and, therefore, actual results may differ materially from those projected in or implied by the forward-looking statements.

A number of factors may result in actual results differing from such forward-looking information, including, but not limited to, those set forth of the Company's most recent Annual Report on Form 10-K and in the press release issued today.

The Company cautions you not to place undue reliance on these forward-looking statements, which speak only as of today's date and by their nature reflect only the Company's good faith estimate of future results.

The Company disclaims any obligation to publicly update or revise any forward-looking statements to reflect events or circumstances occurring after the date of this conference call or to reflect the occurrence of unanticipated events.

The Company will be referring to certain financial information not derived in accordance with Generally Accepted Accounting Principles, or GAAP, in order to indicate more clearly for investors the Company's comparative year-to-year operating results.

This information should not be considered a substitute for any measure derived in accordance with GAAP.

The Company has included a reconciliation of this information to the most comparable GAAP measures in our news release issued earlier today, which can be accessed at www.DollarGeneral.com by clicking on the home page Spotlight item.

Beginning today's meeting is Mr. Jim Hagan, Executive Vice President and Chief Financial Officer.

Sir, you may begin.

Thank you, Operator, and good morning, everyone.

With me this morning are David Perdue, our Chief Executive Officer, and Emma Jo Kauffman, our Senior Director of Investor Relations.

I'm going to take you through our second quarter results, and then David will comment on our fiscal 2003 initiatives.

This morning, we reported that net income for the second quarter of 2003 was $59.9m, or 18 cents per share, as compared against net income in the prior year of $42.4m, or 13 cents per share, an increase of 41.5 percent.

The 2002 results include $5.2m in pretax restatement-related items that actually served to increase our reported results.

Excluding restatement-related items from the prior year's results, net income increased by 53.4 percent, as compared against net income and earnings per share of $39.1m and 12 cents in 2002.

Sales during the second quarter of 2003 were $1.65b, versus $1.45b in the prior year, an increase of 13.6 percent.

Same-store sales increased by 4.7 percent.

The gross profit rate during the quarter was 28.64 percent, versus 26.65 percent in the prior year, an increase of 199 basis points.

There were three principal factors contributing to the strong improvement in our gross margin rate, and I'll address them in order of magnitude.

The most significant factor is that we experienced over a 200-basis-point increase in the mark-up on our second quarter inventory receipts, as compared against the mark-up on inventory receipts in last year's second quarter.

All four of our major categories -- highly consumables, seasonable, home products, and basic clothing -- recorded at least a 100-basis-point increase in their purchase mark-up over the prior year.

In terms of some specific color, we benefited from increased activity in relatively higher mark-up items, including candy, snacks, pet, cough and cold, stationary supplies, and gift-wrap.

The mark-up was also helped by an increase in import activities, particularly in our home products category.

Our import receipts in the second quarter were up 111 percent versus the prior [inaudible].

The mark-up in all four categories also benefited from an increase in vendor monies.

I know vendor monies are a sensitive topic right now for retailers, so let me just assure you that compared to some other forms of retailing, we don't receive a lot of vendor monies, and the funds we do receive for the most part are given to us after we've earned them, based on our having met some sort of performance requirement.

The two other significant factors contributing to the improvement in gross margin were a reduction in damaged product markdowns and a reduction in our shrink provision calculated at retail from 3.61 percent last year to 3.05 percent this year.

I should mention that we are disappointed with the 3.05 percent shrink rate, which was higher than our internal plan.

SG&A expenses in the second quarter of 2003 were $371m, or 22.47 percent of sales, versus $313.7m, or 21.58 percent of sales in the prior year, an increase of 18.3 percent.

This year's SG&A expense as a percent of sales is higher than last year's by 89 basis points due principally to increases in worker's compensation and general liability costs, costs related to the departures of our President and our Senior Vice President of Development and Planning, increases in store occupancy and utility costs, and an increase in the 2003 performance-based bonus accrual as a result of our strong first-half performance.

Net interest expense in the second quarter of 2003 was $7.9m, versus $11.3m in the prior year.

The lower interest expense in the current year was principally due to the fact that we had less debt outstanding in the current-year quarter.

The Company's effective tax rate was 36.2 percent this year, versus 36.7 percent last year.

On a year-to-date basis, net income during the current year was $120.3m, or 36 cents per share, as compared against net income in the prior year of $88.3m, or 26 cents per share.

Excluding minimal net restatement-related items from both years, net income and earnings per share would've been $120.5m and 36 cents per share in the current year, versus $88.4m, or 26 cents per share in the prior year, an increase of 36.4 percent.

Year-to-date sales in 2003 were $3.22b, versus $2.84b in the prior year, an increase of 13.3 percent.

Same-stores sales increased by 4.5 percent.

The year-to-date gross profit rate in 2003 was 28.72 percent, versus 27 percent in the prior year.

Generally speaking, the explanation for the year-to-date improvement in the gross margin rate is similar to what I described for the second quarter -- a higher purchase mark-up than last year, a reduction in damaged product markdowns, and a reduction in the shrink provision.

SG&A expenses were $719.9m in the current year, versus $611m in the prior year, an increase of 17.8 percent.

Excluding restatement-related items from both years, SG&A expenses were $719.6m, or 22.35 percent of sales in the current year, versus $606.3m, or 21.33 percent of sales in the prior year, an increase of 18.7 percent.

The 102-basis-point increase in year-to-date expenses, excluding restatement-related items, was due principally to increases in worker's compensation and general liability costs and increases in store labor, store occupancy, and store utility costs.

Net interest expense in the current year was $17.3m, versus $21.8m last year, and, again, the reduction in interest expense was due principally to lower average debt outstanding, as compared against the same time last year.

The Company's year-to-date effective tax rate was 35.9 percent in the current year, versus 36.7 percent in the prior year.

The Company received an $840,000 benefit in this year's first quarter from a change in a state tax law.

On a year-to-date basis, the Company has opened 400 stores and closed 34 stores.

Our store count at the end of the quarter was 6,479.

Let me shift gears now and spend some time on the balance sheet.

We concluded the quarter on August 1 with $289.4m in total balance sheet debt, which is a reduction of $57.2m from January 31, 2003 and a reduction of $232.5m, as compared against the debt position at the end of last year's second quarter on August 2, 2002.

In this year's second quarter, we completed a transaction whereby we purchased an approximately $50m debt instrument from an institutional investor, which supported our South Boston, Virginia distribution center.

This had the effect of reducing our balance sheet debt by approximately $50m.

Our cash balance and our inventories stood at $102.3m and $1.18b, respectively at August 1, 2003.

Our rolling 12-month inventory turn was 3.9 times at August 1, 2003, compared with 3.7 times at August 2, 2002.

For the first 26 weeks of fiscal 2003, we spent 65.9m on capital expenditures.

Our current forecast indicates that our capital spending will pick up in the second half of the year, and our current plans still call for us to spend approximately $165m for the full year.

I'd like to conclude with some comments on earnings guidance and the status of our SEC investigation.

You may recall that at the beginning of the year we established a growth target of 11 to 15 percent for net income, excluding restatement-related items.

Due to the strength of the first half of the year, we are raising that guidance to a range of 15 percent to 20 percent.

Given that our net income, excluding restatement-related items, for the first half of this year increased by 36.4 percent, our new guidance implies that we are expecting a lower-percentage increase in net income in the second half of this year.

Let me explain why that's the case.

Our current estimates indicate that this year's fourth quarter gross margin rate may fall short of last year's fourth quarter margin rate of 30.01 percent.

There are three primary reasons why we think this may be the case, and I'll take you through them in order of magnitude.

First, our current estimates indicate that our purchase mark-up in the fourth quarter will be lower than last year.

In particular, we're forecasting a much lower purchase mark-up in the fourth quarter of this year in our seasonal and basic clothing departments.

In the seasonal area, we expect to bring in less high mark-up toys and trim-a-tree product as compared to last year.

Also in the seasonal area, in the fourth quarter of 2002, we received some high mark-up spring merchandise that this year is planned to arrive closer to the selling season in the first quarter of 2004.

In the basic clothing department, our mark-up is also being impacted by the timing of import receipts.

We are currently planning to receive higher margin spring items in our men's and ladies' department in the first quarter of 2004, as opposed to the fourth quarter of 2003.

In 2002, this type of merchandise was received during the fourth quarter.

The second primary reason for the potentially difficult comparison with last year's fourth quarter gross margin rate is that in last year's fourth quarter, we recorded an $8.9m pre-tax favorable LIFO adjustment.

We do not expect to record a significant, positive LIFO adjustment in the current year.

The third primary reason is that our current plans call for us to take more promotional markdowns in this year's fourth quarter, as compared to last year's fourth quarter, primarily to clear out Christmas seasonal merchandise.

In terms of some other comments on our annual guidance, we expect total sales to increase by 13 to 15 percent, same-store sales to increase by 4 to 6 percent, and we expect our full-year gross margin rate and full-year expense rate to sales to both be higher than they were last year.

On the SEC front, there is nothing new to report.

We have not had any significant recent contact with the SEC, but the investigation remains open, and we can't predict when it might conclude or what the outcome might be.

I'll now turn the call over to David for the operational review.

Thanks, Jim, and good morning, everyone.

First, I'm very pleased with the overall results of the quarter.

As you know, I'm still relatively new here, and I'm still learning the business, but I believe this is a great model, and we have some exciting initiatives underway in nearly every area of the Company.

To begin with, we announced today that Lawrence Jackson will be joining us as President and Chief Operating Officer on September 22.

Lawrence will be responsible for all our business operations of the Company, including store operations, merchandising, new business development, and supply chain functions.

Lawrence comes to Dollar General from Safeway, where he was Senior Vice President of Supply Operations since 1997.

Before joining Safeway, he spent 17 years in operations, sales, distribution, and technical positions at Pepsi.

He was named one of Fortune Magazine's "50 Most Powerful Black Executives," in 2002 and is on the board of directors of Radio Shack, Allied Waste, and Parsons Corporation.

Lawrence has a broad range of retail and distribution experience, and I am confident that he is the right person for this job.

I think he will be a great fit for the Company, and I'm really looking forward to working with him.

I'm also pleased to announce the reorganization of our Executive Management Team to allow a greater focus on specific areas critical to the Company's growth opportunities.

Stonie O'Briant has been named Executive Vice President of Merchandising, Marketing, and Strategic Planning, and Tom Hartshorn has been named Executive Vice President of New Business Development.

Stonie and Tom, along with Jeff Sims, Vice President of Distribution, and Tony Davis, Vice President of Transportation, will report to Lawrence Jackson.

We will begin a search for a new Store Operations executive, including both internal and external candidates.

Tony is currently responsible for Store Operations at Dollar General and has been instrumental in developing and implementing all of the Company's recent store operation initiatives.

Tony has 30 years of retail experience in merchandising, store operations, distribution, marketing, transportation, and has contributed greatly to Dollar General's success.

Tom Hartshorn has overseen the addition of more than 1,600 new stores in the current -- in his current role at Dollar General, as well as managing the implementation of new planning systems and merchandising strategies that have supported the Company's same-store sales performance.

In his new role, Tom will be responsible for new store development, as well as the introduction of new company platforms and concepts.

Tom has over 35 years of retail experience, 11 of them spent in management at Dollar General.

He will be well positioned to help the Company realize its future growth opportunities.

Now, for an update on the quarter.

Though I'm certainly pleased with our recent performance, I would like to see a little more stability in the year-over-year timing of our merchandise receipts.

I think that this year there are some legitimate reasons for certain product coming in at a different time than it has in the past.

First, we've increased our import business dramatically.

Second, we've got a better handle on our in-stock position now that we've got item-level perpetual inventory data.

And, third, we're utilizing new systems for merchandise planning and merchandise allocations, which permit more precise planning.

With that said, in the planning process next year, we hope to bring more consistency to our merchandise flows, which should make the business easier to manage and easier to follow-up.

Our highest priorities are to have the products our customers need in stock and on the shelf and to provide our customers a consistent and friendly shopping experience.

We continue to focus on implementing more rigorous performance standards in our stores to improve consistency and productivity.

While this is difficult to measure, we believe we're making good progress.

All 35 of our training centers are now operating, and to date, about 1,600 new store managers have completed the four-week program.

This program covers the mission and culture of Dollar General, as well as the fundamentals of operating a Dollar General store.

It is still too early to draw conclusions about the long-term impact of this training, but we're excited about the results we're seeing so far.

Of course, part of the new manager training curriculum focuses on our efforts to control shrink.

As Jim said, we're not pleased with our inventory shrinkage results so far this year.

Since last quarter, in addition to our ongoing shrink initiatives, we have mobilized our efforts in our high-shrink stores.

We are tackling shrink from every angle in these stores with a coordinated effort among our operations people, loss prevention people, and human resources organization.

It is too early to predict the results of these efforts, but we have learned a lot in this [progress][sic], and we will continue to concentrate on these stores until the problems are resolved.

Just as a reminder, we do have very acceptable shrink in well over 2,000 of our stores, so we know it can be done.

From a merchandising standpoint, the summer season started a little slow, which means we have a little more spring and summer inventory right now than we would like.

Some of our new systems initiatives, like the [Arthur Planning System], our allocation system, and the store perpetual inventory system, have been instrumental in helping us control our inventory quantities at the store level, however.

We have implemented our automatic replenishment system for all our core SKUs in about 1,400 stores, and we're on target to roll out the program to as many as 2,500 stores by the end of the year.

So far, we have been very pleased with the system's results.

For non-core SKUs, we have significantly improved our merchandise allocation system and have prepared what we believe will be a very orderly plan for shipping fall and holiday season merchandise to the stores.

Seasonal [merchandise] shipped in smaller quantities, and unlike prior years, the stores should know in advance what they will be receiving each week.

The stores and the distribution centers, in particular, are very excited about this new process.

Year to date, we have opened 400 new stores, as Jim said, and remain on track to open our planned 650 new stores this year.

There is also a possibility we will open a few additional stores.

We now have a total of 2,149 stores with coolers.

These stores, on average, continue to show increased traffic and higher sales than the non-cooler stores.

We expect to have coolers in about 2,300 stores by the end of the fiscal year.

As we discussed in our last call, we began testing the impact of credit and debit cards in about 250 stores in May, mainly in Indiana.

We now have two full months' of data and are continuing our evaluation but are pleased so far.

Many of you have read or heard about a concept store we call the Dollar General Market that we are testing in the greater Nashville area.

First, I want to remind you that this is a test and is only one store.

This store had its grand opening on June 28 this year, so it is still very new.

Basically, the store is an extension of our current Dollar General concept of small-store convenience and meeting the needs of the underserved customer.

The concept is focused on providing the high traffic items our customers need at the right prices.

It is still very much a work in progress, and it is much too early to comment on the level of the success.

The last item I want to update you on is a search for a new distribution center site.

We plan to open a new DC in 2005.

At this time, we are attempting to look beyond 2005 and are actually focused on two different areas of the country for future sites.

In the meantime, we anticipate making some changes to several of our current facilities to improve merchandising throughput.

In summary, we have concluded a very strong first half of the year, and we're working on numerous initiatives that I think can have a very positive impact on the way we run the Company.

Long-term, I'm excited about the organization changes we announced today, and I look forward to reporting on the balance of the year and keeping you updated on our progress.

Jim, that's all I have for now.

At this time, we'll take your questions.

Thank you.

Thank you. [Caller instructions.]

Our first question comes from Daniel Barry at Merrill Lynch.

Good morning.

Congratulations on a good quarter.

Thank you.

I wonder if you'd elaborate a little bit more on your fourth quarter gross announcements?

You mentioned three reasons.

The first reason -- are you actually raising prices, or is all this change in gross in the second quarter and fourth quarter due to shift?

You also mentioned that your LIFO wouldn't be favorable.

Are you saying it will be flat or down, and can you give us a number?

And, thirdly, you talked about more promotional markdowns to clear Christmas.

Is that a strategic change in the Company, that you're taking markdowns quicker?

I'd start with the last item first.

And I'd say the answer to that is yes, and we have better information now to react more quickly, and I think that this is really a process that probably started here 12 months or so ago.

It was really kicked off by the process we went through in the restatement, where we identified aged inventory and took markdowns there.

But I think that started a shift in culture to taking seasonal markdowns at the conclusion of a season.

I don't think we're ever going to be quite like the department stores, but this is a cultural shift here.

The second item was LIFO, and with respect to LIFO, I think that all we can say is that we're fairly comfortable that there's not going to be a repeat of the $8-9m sort of positive adjustment we had last year.

Our LIFO reserve is now down to the point where it's about, in round numbers, $5m, and the categories that still make up the $5m, that, therefore, could still have a reduction producing income, are not categories that we think are likely to see significant deflation.

So, you know, I don't want to get more specific on the guidance than that, but LIFO will not be, we don't think, a big positive adjustment this year.

Oh, you're implying it might be a little positive, not negative?

Wouldn't be a charge?

I just would avoid that entirely.

We just know it's not going to be a big positive.

Okay.

And then I think on your first point, you know, the vast majority of this purchased mark-up adjustment does not have to do with price increases.

There have been some selected price increases.

One area that comes to mind is some of the health and beauty aid areas.

And we have not seen any change in sales as a result, but I would tell you that if you lined up the various components of our purchase mark-up improvement, which is what I attempted to do on my portion of the call, you'll notice that price increases was not one of them, and that was because it was -- from a magnitude standpoint, it wasn't.

But there have been some selective price increases.

Daniel, I'll add to that only that we are very sensitive to our market price -- market basket pricing competitiveness, so we continue to monitor that, and I would second Jim's response on that that any price increases were only a minor part of what we're seeing year to date.

This may be a silly question, but I assume that where you instituted selective price increases, you feel that you're so much below your competitors that you can get away with the increase?

Is that the idea?

Well, we're continually evaluating that, and in certain instances, yes.

We mark to market, but, also, it reflects some changes in merchandise packaging and things like that, too.

So it's hard to measure it in a [indiscernible] manner.

Thank you very much.

Thanks, Daniel.

Thank you.

Our next question comes from Gary Balter, UBS.

Thank you.

I'll make this into three parts.

On the expenses, of the 89 basis points, is it possible to give us some degree of how much of that was one-time in terms of departure management and how much was bonuses?

Could you break it down to a bit more detail?

Yes.

Let me -- I'm not so sure I'm going to give you precise basis points, but give me a second here, and I'll see if I can't give you some sort of flavor for it.

I would tell you that the basis point change and, you know, let's talk about on a year-to-date basis where we're up 100 basis points --

Okay.

-- year over year.

The worker's compensation and general liability costs, from a basis-point-change standpoint, is the highest, and it's the highest, you know, by, in round numbers, about 10 basis points, so it sort of sticks out.

Um-hmm.

You know, we had rent, we had utilities, and I think that the actual component of employee costs on a year-to-date basis was fairly light.

It was more pronounced in the second quarter in terms of the basis point change over last year.

Is that departure of management, is that -- are we talking like five or 10?

Is that a really small amount?

Because that's really one time in nature.

Yeah, it is one time, and I'll even give you a round number on it.

The round number is somewhere in the neighborhood of $2.2m --

Okay, great.

-- for the second quarter.

Question number two is nobody's talking about the impact of gas prices.

I don't know if you're seeing anything from that, or your thoughts on with gas pricing moving up so quickly what it could do to your business?

Well, you know, this is similar to the tax refund question last quarter.

So far, we don't see any impact of that, but we are very sensitive to the impact of rising gas prices on our customers' budgets.

Remember that we have a relatively low share of wallet with our customers.

Therefore, we feel like that the commodity basics that we're merchandising will probably not be impacted to a large degree.

And then the last is following up on Dan's question on the gross margin.

The number -- the first reason you gave is actually essentially telling us gross margin will move from fourth quarter to first quarter.

Is that the right way to read it, so we shouldn't be more bullish on mixture?

I didn't say that; you did.

Okay, okay.

Thank you very much.

Thank you, Gary.

Thank you.

Our next question comes from [John Harlow][ph] with [Barrow Hints][ph].

Thank you.

My question was answered.

Thank you, sir.

Our next question comes from Kelly Chase, Thomas Weisel.

Hi, gentlemen.

I wanted to get a little bit more detail.

You did say that shrink, although it improved dramatically year over year, was not as strong as you had anticipated.

Could you give us a little bit more detail on what you think is happening there and what we could look for maybe for the back half of the year?

Well, this is an insidious problem, Kelly, and it's one that as you remember from last quarter I, personally, am focusing the Company on.

This is a major strategic initiative for us.

We have focused on our high-shrink stores, and there are several hundred of these that we are focusing on.

We mobilized our asset protection team, as well as our internal audit team, as well as our human resource team, and we have a number of prosecutions in that effort, as well as some great learning about where some of this shrink is coming from.

What we're finding is very material to how we're going to get it fixed.

I think the reason that we're not very pleased with second quarter is, honestly, we just started this effort in second quarter and across the broad network of 6,500 stores, the particular inventories that we're taking in second quarter just didn't show much improvement over last year, not as much as had been budgeted for the year or planned for the year.

So while it’s too early to give you any optimism, I will tell you that we’re going to stay committed to this thing.

And we will continue to talk about it in these calls with you.

But I am convinced that we’ve started enough high level focus on this, and we’ve got the resources behind it, that we’re going to move the dial on this, back half this year or early next year.

Okay.

Great.

And then a follow-up question to the fourth quarter margin.

You had mentioned that you’re going to bring in less toys as well as I guess tree trimming items.

Can you talk a little bit about your rationale in doing that?

I can tell you that, from a toy standpoint, it’s an assessment of the inventory levels that we have there right now.

And from a trim-a-tree standpoint, we do have some carryover from last year.

And there will also be some trim-a-tree that’s going to come in, in the third quarter of this year, that otherwise last year came in, in the fourth quarter.

Okay.

So that should benefit.

And it sounds like that’s a higher margin category for you.

That might benefit a little bit the third quarter then?

I’m not – I guess we may have a little bit more trim-a-tree coming in, in the third quarter this year, as compared to last year, because of the dock worker strike.

But I would not take that and extrapolate out any sort of material benefit from it.

Okay.

Maybe I didn’t understand the whole thing, because it sounds like, based upon what you just said, that you’re not necessarily expecting to sell less of these products.

You’re just not going to bring in as much inventory, because you already have it in stock.

Is that correct?

David Perdue, Jr.: Yes Kelly.

I think that is correct.

Okay.

So then how does it necessarily impact margin?

It impacts margin, because whether you bring in high mark-up categories is one of the components that blends into the application of a gross margin rate against the sales that you do.

Okay.

So it’s just a carryover of the inventory pot.

Okay great.

Thank you.

David Perdue, Jr.: Thank you Kelly.

Thank you.

Our next question comes from Mark Miller, William Blair.

Hi.

Good morning.

David, I’m hoping you can outline a little bit further your merchandising strategy for Dollar General, because there are somewhat disparate initiatives, as I perceive it, in the coolers, in the Dollar General Market, and then at the same time your previously announced discussion around increasing apparel imports and seasonal.

So how would you reconcile those two seemingly disparate initiatives?

David Perdue, Jr.: Well that’s a very good observation Mark.

On the surface they do look very disparate.

When you look at the utilization levels that we have as a company, the relative sales per foot, while they’re increasing year over year, they’re still at a relatively low level compared to other forms of retailing.

And, when we look at that, we still think that we can improve our turns at point of sale.

So while we are looking at potentially increasing the contribution of apparel, certainly the turns and the profitability from that category, we’re also looking at how to better utilize the facings in the space we have in our highly consumable replenishable product as well.

When you look at our core strategy, it is to provide products that people need every day, and surround that with core products in seasonal and in apparel and in home fashion.

And we’re not changing that core strategy.

The cooler program is an attempt to meet needs of our customers that we got from research that we were not meeting, and to provide it in an atmosphere of convenience.

And that’s what we’re trying to do right now.

I don’t see anything in consistent about developing the cooler program, and even this Dollar General Market concept, with our core principal focus.

And that is for meeting the needs of the underserved customer as it relates to highly consumable basic products.

Thank you David.

A question on the gross margin Jim.

I might have missed it.

But how much did the timing differences here, in terms of purchases as compared to sell through on some of these high margin categories, how much of a lift did that provide in the margins?

Thanks.

I don’t think that we’ve quantified that down to a basis point in the margin.

And it’s a little bit more complicated than you might think to try and do that.

The way I have characterized it is identifying the increase in purchase mark-up.

And purchase mark-up is one component - it’s a significant one - of what ultimately goes into your blended gross margin rate.

Well if it’s complicated for you, it’s additionally complicated for us.

I mean can you give us some ballpark figure?

I mean is this 50 basis points in the gross margin?

Is it more?

Is it less?

No.

I’m reluctant to do that without doing some more specific work on it.

Okay.

And then with the cap ex, I think you’ve opened something like 60% of your goal for the year, only spent about 40% of your cap ex budget.

Does that imply that you might come in materially above that 650 store opening goal?

Or are there other cap ex investments that would be arising that we wouldn’t have foreseen?

Thanks.

David Perdue, Jr.: That’s a good catch Mark.

No, it doesn’t imply that we will open a fairly larger number of stores.

When we say we may open a few extra stores, it’s just that we have a pipeline, as you might imagine.

So the end of the calendar year doesn’t really impact us that much.

So I don’t think that’s the reason for the increase in potential cap ex in the balance of the year.

What is driving that is the timing of certain distribution center related investments.

Okay.

But on your point there about the pipeline for next year, does that imply that you might be able to build upon that number meaningfully for next year?

David Perdue, Jr.: Well I think it’s safe to assume that the level of growth that we have enjoyed the last couple of years – I see no reason to back up from that strategy at this point Mark.

Perfect.

Thank you.

David Perdue, Jr.: Thank you.

Thank you.

Our next question comes from David Cumberland with Robert Baird Company.

Good morning.

Within your SG&A, have you cycled the store labor ratio increases?

That was not called out as a factor in the higher ratio.

Yes.

We have.

And in the second quarter we actually achieved very modest leverage versus last year on a store labor line.

Great.

And also within the SG&A ratio, of the items that are not inherently one time, which factors are expected to persist through the second half?

And which may subside later in the year?

Well I would tell you that it’s likely that worker’s comp and general liability claims will continue to be an issue for us.

And utilities, it’s probably too early to say.

A lot depends upon the weather in December and January.

I’d say occupancy costs year over year are likely to probably be an issue of similar magnitude to what we’ve been experiencing the first half of the year.

I think those are the major line items.

Thank you.

Thank you.

Our next question comes from Dan Wewer, CIBC.

Good morning.

I may have missed this.

I was disconnected from the call.

But did you indicate the initial mark-ups improved 200 basis points in the quarter?

Yeah.

For the second quarter, that’s correct.

So if you take the 200 - the improvement on your IMU, and then you roll in the reduction in shrink and reduced damage product, why was the gross margin up 199 basis points, and not 399 basis points?

Because the math doesn’t quite work.

I understand what you attempted to do.

It made a lot of sense to do that.

The math doesn’t quite work that way.

And I think that’s part of the frustration – you know, Mark asked a similar sort of question.

And that is that the purchase mark-up for the current quarter is not the only component of the gross margin calculation, of the actual gross margin sale calculation.

And it rolls through over a period of time.

And you’re basically using more of an average purchase mark-up in any one given quarter that is more than just the purchase mark-up from the second quarter.

In other words, you’re using a blended average of the purchase mark-up that’s embedded in the inventory in effect for the last turn of inventory.

Do you -- From a systems perspective, do you have the ability to move from a retail inventory method to a specific cost, so that we don’t have this kind of –-

You interrupted exactly what I was going to tell you.

I was going to apologize to you for being on the retail method of accounting.

And that’s what makes this sometimes tough to follow quarter to quarter.

And cost-based accounting would certainly be easier.

But that’s a massive undertaking in terms of shifting from being on the retail accounting system.

And I think given what we have bitten off over the last couple years in new systems, especially given the fact that we’re getting ready to implement a retail stock ledger, which will improve upon our retail method of accounting, it’s probably unlikely we’ll be changing to the cost basis of accounting soon here.

But that’s what causes part of these quarter to quarter fluctuations in gross.

And at the beginning of the year, in your K, you had indicated that you may go from 11 to maybe it was 24 categories in your retail inventory method.

Yeah. 10 to 23.

10 to 23.

Has that happened yet?

No.

It’s likely to happen next fiscal year.

And theoretically it should have no margin implications.

But I guess practically it could.

I was kind of curious as to how you think it may impact next year’s margins when you make that change.

Well here’s what I can tell you.

And Ernst & Young has not come behind us to really beat these numbers up.

So you’ve got to be careful about using this too precisely.

But we have started to run parallel information here on a monthly basis, utilizing the 23 departments.

And, at least on an unaudited basis – and again, this will shake out more at year end, when E&Y really beats us up – on an unaudited basis the numbers are not materially different.

Great.

Well thanks a lot, and good luck.

Thanks Dan.

Thank you.

Our next question comes from Cris Blackman, Empirical Capital.

Yeah.

Thank you.

You mentioned – not to beat a dead horse.

But you mentioned you were disappointed with shrink at 3.05%.

Can you give us an idea on what your longer-term goals for shrink is?

David Perdue, Jr.: Well we really haven’t externally stated that.

But I think when you look at best practices, we believe that we first have got to get in the mid-twos.

I just think that we’ve got several divisions right now that are in that area or below.

So we know it can be done.

The question is, across 6,500 stores, what the average will be.

We know that some of our best stores are well under 2%.

So I think as a network average, Cris, it’s got to be in the low to mid-twos long term.

Okay.

Your square footage size going forward on your stores, can you give a little color on how you’d expect that square footage to be, say next year?

David Perdue, Jr.: I think if you look close in at next year Cris, I don’t see a materially change in relative square footage per store relative to this year.

I think longer term there, as we segment the store concepts and how we segment the merchandise that we put in those stores, there might be some reason to believe that we would have a slight increase over a three or four year planning horizon.

Are you using that as an average totally or individual stores?

Are you expecting pockets of individual stores to be larger?

David Perdue, Jr.: Yeah.

I think there could be pockets of stores that would be a little larger, which would of course bring the network up, as well as we are looking at some of our really smaller stores right now, and critically evaluating the labor and occupancy cost leverages of those smaller models.

So that’s why I think over time you would see us tend to have a little bit bigger footprint, even in the existing models.

Okay.

Jim, you mentioned on utility costs that the risk you see in utility costs is pretty much just weather in January and February.

With the addition to all of these coolers, you’re not seeing any significant increase in utility costs there?

It impacts utility costs.

But it’s not material to the overall results.

David Perdue, Jr.: Cris, it’s not really what grew the first half.

Gas prices and weather I think were the two larger contributors.

Okay.

Any comments on your plans for cash flow beyond the $165m in cap ex?

I don’t.

I think it’s been our practice to avoid giving forward-looking information on cash flows.

Okay.

Thank you.

Thank you.

Our next question comes from Craig Giventer, Oppenheimer Capital.

Hi.

Congratulations to all of you on a very solid quarter.

Thanks Craig.

I was wondering if you might be able to expand a little bit more on the hiring of Mr. Jackson, his experience, the Dollar General Market, and maybe frame for us where you think Dollar General fits in within the retail landscape on a long-term basis.

David Perdue, Jr.: Wow.

I’ll take a stab at the first one.

I am very excited about Lawrence’s background, coming out of consumer products, and with the retail background that he’s got.

His personality certainly fits our culture.

His values fit very well with our value system.

And more than anything else, Lawrence gets it.

He sees this model.

He is excited about it.

And this was not a new thing for him.

He has been familiar with our model for some time.

As it relates to where Dollar General fits in the marketplace, that’s a philosophical question Craig.

And I think we enjoy a very nice place right now, in that the flattening – what I term as the flattening of the retail landscape – is benefiting our sector, in that a lot of customers are coming to us that are relatively new customers.

And I think what’s happening is the pressure on prices that Wal-Mart created over the last 30 years is benefiting us.

And what we’re doing right now is focusing on our strategy of providing good prices in a convenient manner for the highly consumable basic products that consumers need on a repeated basis.

So we like our position right now.

A lot of things can happen in the future Craig, as you well know.

But right now we see plenty of opportunities to grow our model, in a lot of different ways.

Thank you.

Thank you.

Our next question comes from Dan Kurz, D.K. Equities.

Yes.

Good morning.

Congratulations from me as well on a fine quarter.

I wonder if you could tell me, imports as a percent of cost of goods sold in Q2, I don’t think you stated that.

Would you mind telling us what it was, and where you believe it might go say a year from now?

David Perdue, Jr.: Dan, while Jim’s looking up the specific number for the quarter, I think last year’s number for the full year was somewhere around 13%.

And I’ll answer the general question about where we’re going.

We’re increasing our import penetration.

We are under-leveraged in that area relative to some of our key competitors.

But we’re doing it in a very judicious manner, with our key vendors, as well as our own merchandising group.

So I think you will see that number trend up over time.

On a year to date basis, for the first 26 weeks, this year imports were 16.8%.

And same time last year they were 11.5%.

Thank you both.

And the magnitude of that increase, do you think that will be reachieved over the next year?

Second half, it is likely to not be mirrored.

The sort of increase that we saw in the first half of the year, and for the whole first – for the first 26 weeks, it was about a 79% increase.

That’s not going to be repeated in the second half of the year.

And if I can shift to maybe a basis point way of saying it, is there a chance that we might, for the foreseeable future, see a three, four, five hundred basis point increase in imports as a percent of cost of good sales?

As a percent of cost of goods sold.

I’m sorry.

David Perdue, Jr.: I’m not sure.

I haven’t – Dan, this is David.

I have not looked at it that way.

Okay.

David Perdue, Jr.: I’m just trying to do the math here.

I think that what – when you look at the rate increase that we had first half of this year, and if you balance that with a reduced rate in the back half, you’re going to come up with a blended rate that’s probably greater than we had – well certainly greater than we had last year.

And I would tend to think that that rate of growth in imports over the next two to three years is not outside the realm of possibility.

In fact, I would further.

I would say that we probably have a – we have a plan inside to drive in that direction.

But, putting it in terms of basis point growth and cost of goods, we’d need to put a pencil to paper on that.

Okay.

Would it be fair to say that whatever the amount is, the increase that – well suffice it to say that the margins or the gross margin associated with imported procurement is typically going to be substantially higher than domestically?

David Perdue, Jr.: That’s correct.

Okay.

May I shift gears?

An earlier caller asked about the high gasoline prices.

May I just briefly revisit that?

And perhaps I missed something.

David Perdue, Jr.: Sure.

Specifically, once tax refunds wear off and aren’t necessarily repeated year after year, won’t we, as Dollar General shareholders, and assuming gas prices stay elevated, won’t we be faced with a Dollar General customer whose limited resources might cause them to simply have to pay more for gas, because there isn’t any other form of transportation, and thus spend commensuratively less in Dollar General Stores, or at the least have a headwind concerning same store sales growth?

David Perdue, Jr.: I’m sorry.

Dan, in general – this is David – I would agree with that, with this caveat.

And that is that the two points I made earlier – one is that we have a relatively low share of wallet.

And two is that the vast majority of purchases are on highly consumable, basic products that people have to have – give me some confidence that the impact would be less on us than it will be on some other forms of discretionary retail purchases.

Okay.

Thank you.

And one last thing, if I may.

How will – more of a big picture question – with all of the great progress you’re making this year, how will you primarily seek to drive further bottom line growth going forward into next year and the years beyond?

I say that with this in mind.

Not too long ago, you were focused on driving principally higher volumes, especially on lower margin consumables, and had built a massive distribution network to do it with.

And hopefully obviously also achieve higher returns and higher ROI.

And moreover, that you would take a slight erosion in gross margin percentage, and more than offset it with the greater volume.

And that leverage would be more or less achieved at the SG&A level if anywhere.

It just seems to me – and I may be missing something – that on balance things have flipped, that the leverage now appears to be at the gross margin level, and the negative impact at the SG&A line.

Could you perhaps tell me what I’m missing, or how things might develop in outlying years?

It is going to be more of this year?

Are we going to be more or less past some of the earlier game plans?

David Perdue, Jr.: Dan, that’s a fantastic question.

I wish we had more time to discuss it.

Let me give you my best shot at that.

First of all, I think this year, with regard to the strategy that you laid out in the first part of your question, this year is certainly an anomaly.

We are not getting leverage on our SG&A expenses.

We certainly plan to do that going forward.

The second thing is that I think the margin growth that you are seeing this year is really more a function of those issues that Jim outlined earlier, and are probably not indicative of the strategy going forward with regard to the balance of growing revenue.

Now, having said that, we are continually looking at the merchandising mix to manage margins, to manage the market basket pricing competitiveness, and also substantially support our ability to grow.

I will remind you that when you look at our opportunity for growth, we are still interesting in growing revenue.

But I think what I’m trying to do is to get the return on invested capital back to where it was a few years ago, and a little more competitive with some of our other competitors.

And I think if you look in the last year or two, it is improving.

And I think when we close this year, that return on invested capital will be more in line with what we want it to be.

And certainly going forward, that’s a key variable that we’re measuring ourselves by internally.

But this longer term strategy is one that we continually are looking at.

But we think we’ve got an opportunity to grow this existing model that we have right now, the existing footprint, by increasing productivity in the existing stores.

We think we can grow existing stores and existing space.

We think we can grow the number of existing stores, our existing model in new states.

And so we think we’ve got several parallel paths to support the growth at the same time of becoming better merchants with regard to the mix of our product from a profitability point of view.

So it’s a long-winded answer to a very difficult question.

But I appreciate your thought on that.

Thank you gentlemen, for your detailed response and for the excellent results.

Thank you.

Our next question comes from Andrew Wolf, BB&T Capital.

Hi.

Thank you.

I just wanted to revisit I think your first question, which was on pricing in relation to the initial markup.

I think you said you didn’t raise pricing – that was not a factor.

Or did you raise pricing sort of in line with your competitors?

We said that pricing was a very minimal component of the improvement in purchase mark-up.

I identified the health and beauty aids area as an area where we took some selected price increases, and haven’t seen any reduction in sales as a result.

But it was not one of the items I identified when I went through the gross margin highlights.

Okay.

So could you reconcile that 200 basis point between either better buying on your existing products, or bringing in new merchandise with a richer mix?

I would think that would be pretty much the list.

I couldn’t do it as I sit here right now.

I think probably someone in our merchandising area could probably take a stab at that.

But that wouldn’t be all that easy to do either to tell you the truth.

Well how about in terms of order of magnitude?

I think people want to look to see how sustainable this is.

And obviously you’re bringing in more imports.

I’m sure it’s fair to assume that the initial mark-up there is higher.

That’s correct.

I guess a simple question is was more of the 200 basis point increase from better buying with existing vendors on existing product, or from bringing in new product?

I’d say it’s a blend of both.

But if you were going to weigh it one versus the other, it’d be existing product.

And is that systems driven?

I really – I haven’t studied your company that closely for long.

And I realize the whole industry has systems issues.

But have you gotten to a point where your systems are capable of aggregating debt in such a way that you are able to leverage vendors more effectively?

David Perdue, Jr.: Well leverage vendors effectively – I think the company has been partnering with vendors for a long time.

And I think that continues to be one of the core competencies here, along with our ability to open our new stores profitably.

I think when you look at the opportunity going forward from a pricing point of view, we feel like we’re continuing to really focus on the competitiveness of that market basket pricing, as I have said.

The systems allow us to do that in a much more precise way today internally.

The [Arthur] system, the new allocation system, and so forth, we think have brought us back – the investment over the last three years has brought us back to a point of competitiveness that we believe over the next year to 18 months, as Jim has said, as we become used to using these new systems, will be much more capable of managing these flows.

The anomaly that we’re talking about this year is the result of some of the transitions of those systems, as well as some of the timing of this merchandise flow that I addressed earlier.

But I think the systems – I’m very optimistic about the future impact over the next 18 months of some of these new systems that we’ve been working on.

Okay.

Thank you.

David Perdue, Jr.: Thank you.

We have time for one more question.

Thank you.

Thank you.

Our next question comes from David Mann, Johnson Rice.

Yes.

David, I believe you commented earlier that summer seasonal inventories that you’re carrying over is a little higher than last year.

Can you just elaborate on what caused that, given your strong sales, whether you’ve taken mark-downs on that merchandise captured in Q2, and how much inventory are we talking about?

David Perdue, Jr.: I’ll let Jim try to quantify that for you.

But I’ll answer the question generally.

Spring was a tough season for us.

Even though we had a great quarter, some of the seasonal product, because of the increase in imports, and because of the transition of some of the systems, the timing of receipt of some of the seasonal product came in heavily.

And, frankly, we just bought too much in some areas.

And we’re sitting with that inventory right now.

With regard to the mark-down strategy, we have adjusted our buying plan in the back half of some of this seasonal product that can carry over.

And we are impacting the seasonal buys for back half of the year, which Jim has alluded to, and its impact on our calculated margin.

I don’t have a specific number.

I’ll see if Jim can respond to that point.

Here’s some color I can give you on the department seasonal with respect to recent sales there.

And what we’ve seen strengthen in the seasonal area is actually all year around items that we classify as seasonal.

There are items like what we call electrical, which would be duct tape and screwdrivers.

Cameras have been strong in this area; flashlights.

Automotive has been strong.

So it’s – when we talk about seasonal, I think one of the things that’s a little confusing is that people think very much about summer merchandise specifically or winter merchandise specifically.

And we have other categories that also blend into that seasonal line item.

In terms of the mark-downs, were they already taken on the merchandise you look to clear?

Or is that going to be something that will hurt us or have some impact in the third quarter?

It will not have a significant impact in the third quarter.

I can tell you that.

Give me a second.

Let me look at something.

And while you’re looking, I guess the question I would ask on third quarter, can you just comment also maybe in a broader sense, directionally on the three factors that helped you in second quarter, and what directions you think they’ll be in magnitudes in the third quarter?

I’m sorry.

I was looking here.

We are taking some.

I would call it immaterial.

There are some plans to take some summer clearance.

But it’s not going to – you’re not going to really see an impact in the quarter as a result.

I’m sorry David.

What was the other question?

David Perdue, Jr.: I’m sorry.

The third quarter in terms of gross margin, can you just comment directionally and in some magnitude on the three factors that benefited you in the first and second quarters?

And obviously some other folks have asked, and highlighted that it’s somewhat confusing to try and gets our arms around which way some of these things are going to go.

Yeah.

No, we sympathize with you on that.

We specifically want to avoid getting into quarterly discussions or quarterly guidance.

We highlighted the fourth quarter here, only because it does have such an overall impact.

If we were to fall short of the gross margin rate from last year, like I indicated is a possibility, it will have an impact on the overall net income growth rate for the full year, to a magnitude that we thought we should call out for you.

But generally speaking, we want to avoid quarterly discussions on guidance.

Okay.

And then the last question on the tax rate.

You’ve kind of come in a little less than expected for the first quarters.

What happened in the second quarter?

And is that going to continue the rest of the year?

You can use – I will give you this.

I think in your models, probably for the back half of the year, use an effective rate of about 36.3.

That’s the run rate right now.

Okay.

Thank you.

Good job.

Thank you everyone for participating.

And we’ll be around during the course of the day if you have further questions.