達樂 (DG) 2004 Q2 法說會逐字稿

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  • Operator

  • Good morning, 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 of plans and objectives for future operations, growth and initiatives in the Company's effective income tax rate.

  • The words believe, anticipate, project, plan, scheduled, accept, 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 the 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 statement.

  • The factors that may result in actual results differing from such forward-looking information include, but are not limited to, those set forth in the Company's most recent annual report on Form 10-K and in their second quarter earnings press release issued today.

  • The Company cautions you not to place undo reliance on these forward-looking statements which speak only as of today's date.

  • Except as may be required by law, the Company disclaims any obligation to publicly update or release any forward-looking statements to reflect events or circumstances occurring after the date of this conference call or to reflect the occurrence of an unanticipated event.

  • You are advised, however, to consult any further disclosures the Company may take on related subjects in its public disclosures or documents filed with the SEC.

  • The Company also discusses net income, earnings per share and effective income tax rates excluding certain adjustments.

  • These are non-GAAP financial measures which the Company believes more clearly reflect the Company's actual performance on a comparable and ongoing basis.

  • None of this information should be considered a substitute for any measures derived in accordance with GAAP.

  • Beginning today's meeting is Mr. David Tehle, Executive Vice President and Chief Financial Officer.

  • Sir, you may begin.

  • - CFO, EVP

  • Thank you, operator.

  • Good morning, everyone.

  • Today I'm going to go over the financial results for our quarter and our year-to-date update and then David Perdue, our Chairman, will give some more information on business developments in the quarter.

  • Net income for the second quarter of 2004 was 71.3 million or 22 cents per diluted share.

  • A 19% increase over last year's second quarter net income of 59.9 million or 18 cents per diluted share.

  • During the quarter the Company recorded a net reduction in certain income tax related liabilities and related interest accruals which increased net income by 7.4 million.

  • Excluding these adjustments, net income for the second quarter of 2004 would have been 63.9 million or 19 cents per share.

  • I will discuss these adjustments further later in this call.

  • Net sales during the quarter were 1.84 billion versus 1.65 billion in the prior year.

  • An increase of 11.2%.

  • Same store sales increased by 3.2% with increased traffic accounting for approximately 2.8% of the same store sale -- of the same store increase.

  • Our total net sales increases by major category were as follows: Housing consumable, 13.6%; seasonal 10.4%; home products, 0.2%; and basic clothing 11.7%.

  • Food, including our perishable cooler items, represented the highest increase in highly consumable sales.

  • Basic apparel sales were positively impacted by our increased emphasis on socks and underwear.

  • While home sales overall have been weak, core items in that category continue to perform well.

  • The gross profit rate during the quarter was 29.2% versus 28.6% in the prior year.

  • An improvement of 60 basis points.

  • This improvement was primarily due to a higher average markup on the Company's beginning inventory in 2004 as compared to 2003.

  • You may also remember that gross margin in the second quarter of last year was negatively impacted by a $4.7 million adjustment to value inventories at the lower of cost or market.

  • SG&A expenses in the quarter were 428.9 million or 23.4% of sales versus 371 million or 22.5% of sales in the prior year.

  • An increase of 15.6%.

  • This year's SG&A expense as a percent to sales is higher than last year's due to a number of factors including increases in the following expense categories that were in excess of the 11.2% increase in sales.

  • These include, increased rental expenses on the Company's leased facilities, increased costs of counting physical inventories in the stores, increased labor during the quarter related to the execution of changes in store layout and new planagrams for apparel and health and beauty, fees associated with the exception of debit cards, which we are now accepting in most of our stores as of the end of the quarter, an increased professional fees associated with the Company's 2004 store work-flow project.

  • The effective income tax rate for the second quarter was 31.5% in 2004 compared to 36.2% in 2003.

  • During the current year period, the Company recorded a net reduction in certain contingent income tax related liabilities and the related interest accruals due to a change in its probability assessment as described in SFAS No. 5 accounting for contingency, that the likelihood of certain potential income tax related exposure items would translate into actual future liability.

  • The probability assessment change in the second quarter as a result of 2 recent state income tax examinations pertaining to certain prior-year income tax returns.

  • These adjustments resulted in a favorable impact of approximately $6.2 million to the current period income tax provision net of the federal income tax affect.

  • Excluding this adjustment, the Company's effective tax rate during the current year period would have been 37.5%.

  • This rate is higher than the prior year due in part to the expiration of certain federal jobs and tax credits for employees hired after December 31, 2003.

  • The Company estimates the expiration of these federal credit programs increased the 2004 effective tax rate by about 0.5%.

  • Currently there is legislation pending in Congress that will reinstate these credits on a retroactive basis.

  • Although this legislation has not been enacted as of July 30th.

  • While the enactment of this legislation is expected, its passage is not certain.

  • Also, the effective tax rate in the prior year, which favorably impacted by a reduction of estimated tax return liabilities for years prior to 2003.

  • Related to the tax adjustment, we adjusted our interest accrual by approximately $2 million.

  • This adjustment and approximately $900,000 of interest capitalized primarily on our distribution center construction, account for most of the decrease in interest expense.

  • From $7.9 million in second quarter '03 to $4 million this year.

  • Now I'm going to talk about the 26 weeks ended July 30th.

  • On a year-to-date basis, net income in 2004 was $139.2 million or 42 cents per diluted share.

  • A 17% increase over last year's year-to-date net income of 120.3 million or 36 cents per diluted share.

  • Excluding the affect of the income tax related adjustments described above, net income for the 26-week period would have been 131.7 million or 39 cents per diluted share.

  • Total year-to-date sales increased 11.3% to 3.58 billion in 2004 versus 3.22 billion in 2003 including a same store sales increase of 3.1%.

  • The year-to-date gross profit rate was 29.3% versus 28.7% in the prior year, an improvement 55 basis points with about 30 basis points attributable to a higher average markup on the Company's beginning inventory in '04 as compared to '03 and about 20 basis points attributable to the valuation of inventories at the lower of cost or market.

  • Year-to-date SG&A expenses were 826.6 million or 23.1% of sales versus 719.9 million or 22.4% of sales in the prior year, with the year-to-date explanations being essentially the same as those for the second quarter, with the exception of store labor relating to store resets which was primarily a timing difference with Q1.

  • Interest expense year-to-date was $10.5 million.

  • This is a decrease of $6.8 million or 39% from last year.

  • This is due to the $2 million tax related interest accrual adjustment mentioned earlier, $1.4 million of interest capitalized primarily related to our distribution center construction, a $1.4 million reduction in debt amortization relating to the termination of a credit facility in '03, and a reduction of $1.2 million resulting from the purchase of promissory notes in mid '03 related to our South Boston distribution center.

  • The Company's year-to-date effective tax rate was 34.4% in 2004 versus 35.9% in 2003.

  • Remember that last year's rate includes an $800,000 reduction in taxes due to a change in state tax evaluation reserves.

  • Regarding this year, excluding the net $6.2 million adjustment I discussed earlier, the Company's year-to-date effective tax rate would have been 37.3%.

  • We are currently assuming a 37.3% tax rate for the remainder of the year.

  • Again, we believe our effective tax rate has been negatively impacted by 50 basis points as a result of the jobs tax credit expiration.

  • Year to date, the Company opened 420 stores including 2 Dollar General Markets and closed 41 stores ending the quarter with 7,079 total stores, including 4 Dollar General Markets.

  • Year-to-date we spent $124.8 million of cash on capital expenditures.

  • Total inventories at July 30th were 1.38 billion compared to 1.18 billion August 1 of 2003.

  • An increase of 16%.

  • The largest portion of this increase is in highly consumables, which we believe reflects both our goals for a better in-stock position in our stores and the fact that we just completed the rollout of our new HBA Planagram at the end of the second quarter.

  • Inventory shrinkage on a year-to-date basis calculated at the retail value of inventory as a percent of net sales was approximately 3.18% year-to-date in 2004, compared to 3.07% for the same period in 2003.

  • Although the Company performs physical inventories in all of its stores annually, the same stores are not necessarily counted in the same reporting periods as they were in the previous year.

  • Therefore, the comparability of this year's shrink percentage versus last year's percentage could be impacted since many different stores may be in each sample.

  • As as we approach year-end the comparability of results will improve.

  • Year-to-date shrink results at the stores have improved when compared to those same stores from last year.

  • With regard to our share repurchase program, we have approximately 1.5 million shares remaining under our 12 million share repurchase authorization.

  • Now I would like to turn the call over to David Perdue, our Chairman, for his comments on the business.

  • - Chairman, CEO

  • Good morning, everyone.

  • Thank you, David.

  • At the outset, let me say that I'm pleased with the progress we have made on executing new initiatives this year.

  • I continue to be concerned, however, about the external environment, particularly as it impacts our core low income consumer.

  • We recognize that we still have a lot of work to do this year.

  • Internally, we are executing well on the initiatives we've talked about over the last year.

  • In fact, as you know, our same store sales are at the top of our sector currently.

  • I believe this reflects the progress we have made so far this year, and I would like to discuss our progress on a few of those initiatives.

  • At the end of the quarter we had coolers in nearly 5,600 stores.

  • Over 1,900 of these stores were accepting EBT at the end of the quarter.

  • And nearly 3,500 are accepting EBT today.

  • That's quite good progress.

  • Substantially all of our stores are now accepting check cards and pin-based debit, as well as Discover Card, which we announced recently.

  • The rollout of our auto replenishment system was completed as of the end of the first quarter and resulted in significantly higher in-stock levels in our stores.

  • All of our planagram work has been completed and is beginning to show a positive impact as we speak.

  • While our total inventory levels are up year-over-year, much of that increase, as David just mentioned, is in highly consumable core replenishable products.

  • This increase is largely due to the increase in our stores' in-stock position currently.

  • Apparel inventories that should be noted are down from last year, even with the addition of our new sock and underwear SKU program.

  • Our goal in margin, that is our purchase markup is up as a result of specific initiatives.

  • We now have a fully-integrated recruiting and hiring function in the field and it is making a big impact.

  • For the year, we have 99 new district managers.

  • With 54 of those being internal promotions.

  • I am very pleased that both our store manager and district manager turnover rates have also declined so far this year.

  • During the quarter we had a field leadership sales meeting here in Nashville that accentuated our plans and execution requirements for the second half of the year.

  • This meeting was the first meeting of this type since 1998, and I think it was a huge success.

  • We've completed the development phase of our Easy Store project and have begun the rollout of Easy Store initiatives to the entire chain.

  • Starting in the Southwest, we expect to complete the rollout over an 18 to 24 month time frame.

  • As we have said, this project examined almost every aspect of operating our stores, including material handling, labor, and staffing, as well as basic operating procedures.

  • Through the end of the quarter we had opened 420 stores, including our 7,000th store in Clovis, New Mexico.

  • We are on track to open at least 695 stores this year.

  • Although we may defer a few of the Dollar General Markets planed to open late this year into the first quarter of next year.

  • Construction of our new DC in South Carolina is on schedule and is expected to open in mid to late 2005.

  • The upgrades to our South Boston and Ardmore expansions are also on schedule, with South Boston expected to come on-line in September and Ardmore in February.

  • All this being said, the retail environment remains difficult and our core customers continue to be under a lot of financial pressure.

  • Gas prices remain high.

  • The war is still ongoing, which creates uncertainty among consumers and may have a particularly big impact on those stores in towns with large military populations.

  • We are facing the typical uncertainties of an election year and the unemployment in low income -- in our low income segment remains high.

  • While we can not control these external factors, we remain focused on our core strategy of serving the underserved customer.

  • In conclusion, the external environment continues to be somewhat troubling.

  • Although we are pleased with our internal execution of our strategies, remember that it is still very early in the implementation of many of our initiatives.

  • We have our team in place and our new people are already contributing.

  • The team's number one priority remains our stores where we can make the greatest impact for our customers, and therefore, for our Company and our shareholders.

  • We are keeping our focus on growing our business while achieving solid financial results.

  • In our third quarter conference call, which is scheduled for December 1 this year, we plan to share with you some of our plans and expectations for our fiscal 2005.

  • Now we will be happy to take your questions.

  • Thank you.

  • Operator

  • At this time we will open the floor for questions.

  • If you would like to ask a question, please press the star key followed by the 1 key on your touchtone phone now.

  • Questions will be taken in the order in which they are received.

  • If at any time you would like to remove yourself from the questioning queue, please press star 2.

  • Our first question comes from Christine Augustine with Bear Stearns.

  • - Analyst

  • Thank you.

  • Could you provide us with an update on your guidance for '04 which was $1.1 to $1.05?

  • - Chairman, CEO

  • Christine, thank you.

  • This is David Perdue, I'm -- we have 2 Davids here.

  • - Analyst

  • Oh, sorry.

  • - Chairman, CEO

  • So I'll call him Tehle and me Perdue, sorry.

  • It is our practice really not to update our guidance through the year.

  • It is what it is.

  • I'm sorry.

  • - Analyst

  • How about how we should be thinking about the inventory going forward?

  • How much of this increase was in the highly consumables, and is this the sort of trend line that you expect to see for the rest of the year?

  • - Chairman, CEO

  • Well, as you might know we have just finished our planagram changes for the year, and a large part of what we are seeing at the end of the second quarter, Christine, is an increase in inventory partly due to that planagram change, and this happens seasonally every year.

  • The second part that, obviously is the increase in our in-stock percentages.

  • While we don't quote that publicly, we can say that they are up significantly.

  • And if you have been in our stores anecdotally you can see that as well in a broad based way.

  • So we think that our current inventory position with regard to what's in the stores is adequate, it is what we want and we are working now overall to continue to reduce our increase that is, our turns and be much more efficient as we work on our supply chain integration.

  • - Analyst

  • And then finally, about how many of your customers do you think will use the Discover Card?

  • - Chairman, CEO

  • Wow, Christine, that's the $64,000 question.

  • We debate that, we have seen statistics.

  • We are not sure.

  • What we're trying to do is make sure that we make every available avenue available to our customers in terms of paying for their merchandise.

  • You know, as you know, we have 3 states that are testing Master Card and Visa as well, but we have a great relationship with those companies, as well as Discover.

  • So we are going look at that over the next year or so and really try to evaluate it.

  • - Analyst

  • Thank you.

  • - Chairman, CEO

  • Thank you, Christine.

  • Operator

  • Our next question comes from Ralph Dean with Wachovia Securities.

  • - Analyst

  • Great.

  • Thank you.

  • Just on the cooler program, could you tell us when that will be completed and then also talk a little about the sales boost that you're seeing in those stores that have had it for, you know, an extended period of time?

  • - Chairman, CEO

  • Ralph, thank you, this is Perdue again.

  • Yeah, we are excited about the rollout of the coolers, thank you.

  • We are ahead of schedule, actually.

  • We had quoted at the end of last quarter that by the end of the year we would have some 80% of the chain.

  • We'll be beyond that.

  • It won't be 100%.

  • There are some stores -- a few stores that will never probably -- they will never get coolers because of contractual limitations with our landlords.

  • So we're very rapidly rolling that out, but it will be beyond the 80%.

  • But it won't be 100%.

  • With regard to the sales uptick.

  • Obviously, we have had good experience over the last year or so as we evaluated the cooler program, when we brought Lawrence Jackson in as our new President and COO, we took a very hard look at evaluating the economics and we decided that in most stores instead of rolling out 8 cooler doors, we really thought the better use of capital was 5, and as we have quoted before, the average transaction goes up to about $13.5 per transaction from about an $8.5 average.

  • And that continues to be reasonably representative.

  • We're anxious to see the impact of EBT on the additional coolers as well.

  • So it's too early to really call out what we think that expectation is going to be.

  • We just don't know at this point.

  • But we know it will have some impact.

  • - Analyst

  • Okay, great.

  • And then just one follow-up.

  • You mentioned that the home sector is weak, but core items are doing well.

  • Are the core items like household chemicals and are the weaker categories the more discretionary items?

  • - Chairman, CEO

  • That's an interesting point, Ralph.

  • We can only speculate, but what we see this year, and I think it has to do with the environment, is that our customers are going to the essentials and some of the other items are not performing as well.

  • However, I must call out seasonal in the second quarter did very well.

  • So it is not universal.

  • - Analyst

  • Thank you.

  • - Chairman, CEO

  • Thank you, Ralph.

  • Operator

  • Our next question comes from David Cumberland with Robert W. Baird.

  • - Analyst

  • Good morning.

  • - Chairman, CEO

  • Good morning, David.

  • - Analyst

  • On the Easy Store program, will you complete the rollout in the Southwest before moving on to other regions, and then while you are in the rollout phase or initially in the rollout phase now, will you continue to have professional fees?

  • - President, COO

  • David, this is Lawrence Jackson.

  • Let me answer that question.

  • The first part of the question is, yes, we will rollout in the Southwest first before we rollout everywhere else.

  • We anticipate having that done approximately at the end of this calendar year.

  • As we go forward, we will have some support in execution of the rollout.

  • And it is a massive rollout across 7,000 stores and it is a very promising result.

  • Thus, we don't want to stumble because at the end of the day we get a little slim about how we roll it out.

  • We'll have some support, but no where near the levels of fee support that we had earlier in the year in building the process.

  • - Analyst

  • Thank you.

  • And, Lawrence, to clarify, you said the rollout in the Southwest would be complete by the end of this calendar year?

  • - President, COO

  • End of this year.

  • - Analyst

  • And so, David Perdue, your reference to an 18 to 24 month rollout, was that across all regions?

  • - Chairman, CEO

  • That's correct, David.

  • - Analyst

  • Great.

  • Thank you very much.

  • - Chairman, CEO

  • Thanks, David.

  • Operator

  • Our next question comes from Mark Miller with William Blair.

  • - Analyst

  • Hi, good morning.

  • I was hoping you could give a little more color on the improvement you've seen in shrink across similar stores.

  • What is the magnitude of that?

  • Is it as favorable as what you seem to be seeing in the first quarter, and I guess if that continues, then what type of opportunity is there for favorable shrink revision later in the year?

  • Thanks.

  • - Chairman, CEO

  • Mark, thank you.

  • This is Perdue again.

  • We really don't quote that number publicly, but it's significant.

  • I think it is very important to say that it is still early in our initiatives that we started last year in attacking shrink.

  • We still think that that 2.5 number long-term, and this is a post-accrual release number that is reported.

  • We think that's a reasonable target and we are not walking away from that.

  • We see significant improvement when you compare like stores that have had their inventories taken and these are several thousand stores year-to-date, we see significant decreases.

  • As the year goes forward, as we close toward the end of the year, as David said in his remarks, we will see the reported number and our internal like-store numbers approaching each other.

  • - Analyst

  • Thank you.

  • And then the next question is the -- trying to get a sense of the magnitude of the store manager turnover improvement, you said you are seeing some improvement, is that turning more quickly now or some -- a look on I guess, basically, where you see that going.

  • And where is it now versus when you joined the Company?

  • Thanks.

  • - Chairman, CEO

  • Thank you.

  • It is substantially lower than where it was when I joined the Company for sure and even when Lawrence joined.

  • We don't quote a precise number on that, but I will say that it is below the 50% mark.

  • We called out last year that it was higher than 50, it has moved below 50 and we think that looking at the numbers that the gradient of decline is fairly consistent and we think the programs of the way we're hiring now, the integration of HR in the field, the training of these people and then the support we're giving them, we have changed the way we integrate new store managers into the field.

  • We don't just throw them into a store any longer.

  • We put them in the store first and then we send them to training and then we bring them back to the stores and this integration is really beginning to have an impact.

  • The recent district manager meeting that we called out earlier was largely intended to address this issue.

  • We think it is a profound part of our model that we have to get turnover down.

  • We think it contributes to productivity issues, as well as shrink issues.

  • So I appreciate you calling that out, Mark.

  • But it is continuing to improve as we speak.

  • - Analyst

  • Great, thank you very much.

  • - Chairman, CEO

  • Thanks, Mark.

  • Operator

  • Our next question comes from Shari Ebert with J.P. Morgan.

  • - Analyst

  • Good morning, everyone.

  • - Chairman, CEO

  • Good morning, Shari.

  • - Analyst

  • And congratulations on the progress so far this year.

  • - Chairman, CEO

  • Thank you.

  • - Analyst

  • I just wanted to follow-up on the SG&A run rate.

  • Obviously, expenses are a little bit higher year-over-year than they were in Q1.

  • It looked like there were a number of one-time items, I just want to get a sense of what we should be looking for in terms of the SG&A growth going forward.

  • - Chairman, CEO

  • Shari, I'll let Tehle handle that.

  • This is Perdue, but let me just put a parenthetical comment on that.

  • When we closed last year and then gave guidance for this year, I called out out that 2004 would be an investment year.

  • We saw the need to invest in our stores, we needed help to do that.

  • We also increase -- we saw the need to increase our inventory coverage and so forth.

  • So we have spent some money this year in some areas that we think are one-time expenses, but having said that, I am very pleased with what we're seeing from those investments.

  • I'll let David talk about the specific increases and maybe how we look going forward.

  • - CFO, EVP

  • Yeah, Shari, if you look at the 4 or 5 items that caused the increases, we did have some higher rental expenses on our facility, increased cost to accounting physical inventories.

  • Those items will probably continue on as we look to the future.

  • The increased labor during the quarter related to the execution of changes in store layouts and new planagrams.

  • Obviously, that was an event that took place in the quarter in terms of changing the planagram.

  • The debit card fees will continue, the fees associated with accepting debit cards.

  • We had that in most of our stores at the end of the quarter.

  • And then as we mentioned the professional fees for the workflow project will continue to some extent as we move forward with that project, as Lawrence mentioned.

  • Not quite to the level as we have seen in the past, but we will still have some expenses related to that.

  • - Analyst

  • But by in large it sounds like things will be increasing at a lower rate going forward?

  • - CFO, EVP

  • Well, again, we don't give specific guidance on line items, but I think that's all we're prepared to say.

  • - Analyst

  • Okay.

  • My second question is just on EBT.

  • Just wondering your plans and any response you've had to those plans so far, in terms of alerting the customer to your acceptance.

  • - President, COO

  • Shari, this is Lawrence Jackson.

  • You know, we have a plan to have a solid marketing communication program to all of our customers once we are fully rolled out in leveraged.

  • Like anything else, across a large number of stores and we hope to by the end of the year have a significant number of stores, somewhere between 4,000 and 5,000 stores on the EBT program.

  • It is a tough qualification process you have to go through.

  • First of all, we have to have coolers in place and the various perishable products.

  • Second, we have to have specialized training and certification that is done and it is basically a state by state, region by region basis with the Department of Agriculture.

  • So once we have all of those things in place and we are sure that the customer can perceive the same experience at every store they go to, we'll have sort of a national marketing program around EBT.

  • Today, as the store comes up on EBT it is pretty much a localized, at the store level notification to the customers as they come through the door with static clings, et cetera.

  • And some -- there are plenty of places we are seeing great results on the EBT.

  • - Analyst

  • Okay, great.

  • And my last question is just a housekeeping item in terms of modeling the interest expense going forward, will it be sort of at this 4 million rate per quarter or how should we be thinking about this adjustment?

  • - CFO, EVP

  • Well, Shari, I think all I can -- this is David Tehle, all I can say on that is you'll have to read our queue in detail.

  • We try to be very transparent in terms of all the items that occurred and the comparisons to last year and what we believe to be one-off items.

  • And again, because that specific line item guidance I really can't say anything more than that.

  • However, I do think we are pretty transparent in terms of how we explain interest expense.

  • - Analyst

  • Okay.

  • Thanks.

  • - Chairman, CEO

  • Thanks, Shari.

  • Operator

  • Our next question comes from Dan Wewer at CIBC.

  • - Analyst

  • Good morning.

  • - Chairman, CEO

  • Good morning, Dan.

  • - Analyst

  • The first question I had was trying to square the improving initial markups for the entire Company with the growth and consumables.

  • You would think those would be at odds with each other.

  • - Chairman, CEO

  • Great call out, Dan.

  • This is Perdue.

  • We are actually proud of that.

  • We like the fact that some of our initiatives -- we are sourcing now more directly.

  • We have a resources targeted directly at improving our opportunistic purchases.

  • We have initiatives inside our merchandising group, we don't miss calling out that we have 2 new general merchandise managers that have joined us.

  • One of those is heading up the consumable area.

  • And although it is early in his tenure he is already having a dramatic impact in that department.

  • So we feel like that there is opportunity in every single division we have in the merchandise group to work on our margin.

  • As you well know at the operating level while our SG&A, if you adjust for various vagaries of differences in accounting between competitors, our operating margin might be a little bit less than some of our close competitors and our SG&A is less, but our margin might also be a little less.

  • So we think we've have opportunities within the price constraints that we have to continue to improve our gross margin.

  • But go-in margin right now is improving at the same time that consumables also are growing.

  • - Analyst

  • Second question I had was regarding the cautious macro environment that you alluded to, and trying to square the -- your company's and the industry's mediocre sales results today compared to much better results during the recession of 2000 and, you know, besides differences in gasoline and home heating fuel, what else has changed?

  • - Chairman, CEO

  • Well, you know, when you go to 2000 it's tough to make a comparison to Dollar General because that was probably our worst year in the last decade.

  • I think our comp sales that year were close to zero.

  • With regard to the industry though, last year when we started looking forward into this year and when we gave our guidance to the year, I also cautioned about some of the things that we saw going on.

  • I think the biggest difference, frankly, is the nature of the new jobs that are being created.

  • This is all anecdotal, Dan, and it's very speculative on my part, but when we look around our network of customers, particularly in areas where we know intimately around our distribution centers, we see pockets of really high unemployment, double-digit unemployment and it has been chronic over a long period of time.

  • And that's not changing.

  • So we put all that together and I think that's probably the biggest impact.

  • But don't discount the impact of gasoline on the low income consumer.

  • - Analyst

  • Okay.

  • And just the last question real quickly on occupancy expenses rising, does that reflect a movement into better locations than the Company has in the past?

  • - Chairman, CEO

  • Yeah, Dan, thanks.

  • This is Perdue again.

  • It does to some degree, it also is a manifestation of our attempt to brand ourselves a little bit better at the store level.

  • We are, as you know, have more build to suits this year.

  • We called that out before as a percentage of total new stores.

  • But it is not a profound impact.

  • What you see is, will be, we think, as you move forward, we don't see a profound increase in that in terms of our planning with regard to new stores.

  • - Analyst

  • Okay, great.

  • Thanks and good luck.

  • - Chairman, CEO

  • Thanks.

  • Operator

  • Our next question comes from Meredith Adler at Lehman Brothers.

  • - Analyst

  • Yeah, first I just wanted to ask you a question about the planagrams.

  • You talk about that as being an expense.

  • Was there something that you did that was particularly unique this quarter or is this just what you do every year?

  • - Chairman, CEO

  • Meredith, this is Perdue.

  • I'll turn that over to Lawrence.

  • Good morning by the way.

  • - Analyst

  • Yes.

  • Good morning to you.

  • - Chairman, CEO

  • You know, we timed it a little bit differently this year and that's really only the only call out I will say.

  • The flow of merchandise in relation to the BSR program, the auto replenishment program was particularly critical this year.

  • But this is something we routinely do every year and I'll let Lawrence add some flavor to that.

  • - President, COO

  • Yeah, planagram changes is something that pretty much every retailer goes through.

  • This year we had a timing differential.

  • But a little bit unique to us this year is also that the physical movement of things within the store was a little broader than we normally do.

  • For example, in both the HBA area as well as in the sort of socks and underwear area, we made a significant change in the location in the store as well as the fixtures that would support those things within the store.

  • And on a year-to-year basis, that doesn't happen every year and that's a lot of work.

  • And you don't try to do them very frequently because it can be very disruptive inside the store when we try to do that.

  • - Analyst

  • Okay.

  • So it might be fair to say that when we look at the expenses for the second quarter there is a little bit of a hit from doing something that extensive?

  • - President, COO

  • Exactly.

  • - CFO, EVP

  • That's fair.

  • - Chairman, CEO

  • That's correct.

  • - Analyst

  • Okay.

  • I have maybe what seems like a kind of stupid question, but you use the expression when you talked about the gross margin, a decrease in lower cost or market inventory adjustment.

  • Is that the same as what people call markdowns?

  • - CFO, EVP

  • No, that's LCM.

  • That's kind of a technical accounting term, and it really occurred last year, the $4.7 million adjustment in this quarter last year where inventories were written down.

  • In general what that indicates is you are writing the inventory down to the market level which is below cost.

  • So it is a little different than a markdown.

  • - Analyst

  • Okay.

  • So if we were to think about markdowns, you said seasonal sales were pretty good.

  • You had some home and apparel that were a bit softer, but do you -- how do you feel about the inventories in those items where there may be some seasonality?

  • Are you feeling good about your inventories?

  • - Chairman, CEO

  • Meredith, this is Perdue.

  • Yeah, overall we feel pretty good.

  • Inventory is up, that's never a good thing.

  • But this is one time when I think it was part of our design and that is with our basic store replenishment program, we knew that these inventories would go up a little bit in the stores and that's a good thing.

  • We are certainly in stock and it is fairly balanced.

  • I mean, I think this inventory moves where you see consumables growing more readily than some of the more seasonal product.

  • That's what gives me comfort in our current inventory position.

  • - Analyst

  • So no markdowns that are waiting to be taken or anything?

  • - Chairman, CEO

  • Well, I can't comment on that, but I will just say that I feel good about the balance of our inventory today.

  • - Analyst

  • Okay.

  • I have one other question.

  • You guys didn't mention at all anything about health care benefit costs or Workers' Comp.

  • And also I don't know if you can comment at all about laws of overtime for store managers, but I was just wondering whether you were seeing specifically big increases on the health care side of things.

  • - CFO, EVP

  • Meredith, this is Tehle, yes, to answer your question, we are both in health care and Workers' Comp, we didn't spell it out specifically here just because it didn't hit our threshold versus some of these other items, but absolutely.

  • I guess like most companies in America, we are definitely seeing issues in that area and aggressively trying to do things to offset that from a safety point of view, as well as trying to keep our employees more healthy to offset some of the health care expenses, but yes it is definitely an issue for us.

  • - Chairman, CEO

  • This is Perdue.

  • Just one thing, as we called out before and as we saw at the district manager sales meeting recently, a large part of our Workers' Comp is actually initiated around the movement of merchandise to our stores.

  • Typically on truck day.

  • A significant portion I might add.

  • And so we believe that the natural operating procedures that we are working on right now will dramatically impact that over time.

  • Now, as you know, there's a pay off, a large part of the increase this year is an increase in the actual experience that we're seeing from 2000, 2001 and back.

  • So it will take a while to bleed that one down.

  • - Analyst

  • Okay, great.

  • Thank you.

  • - Chairman, CEO

  • Thank you, Meredith.

  • - CFO, EVP

  • Thank you.

  • Operator

  • Our next question comes from John Harlow with Barrow, Hanley.

  • - Analyst

  • Thanks.

  • I don't understand the changes in interest expense because of the accrual in the state taxes and stuff.

  • That's just way over my head.

  • Can you help me with that?

  • - Chairman, CEO

  • Good morning, John.

  • Thanks.

  • I'll leave that to Tehle.

  • - CFO, EVP

  • Part of the process of our accrual was that there was both a tax fee to that and the interest related to that tax and the interest had been accrued as interest expense.

  • So when we reversed it it came out as a positive to interest expense.

  • It was 2 separate accruals.

  • One having to do with tax and the other having to do with the interest on potentially paying that tax.

  • - Analyst

  • You would have an accrual in your interest expense for taxes?

  • - CFO, EVP

  • You would have an accrual for potentially having to pay penalties on that -- on the tax.

  • Having to pay interest.

  • - Analyst

  • Okay.

  • Well the second accrual is actually in the tax paid line, is that correct?

  • - CFO, EVP

  • I'm sorry.

  • Say that again.

  • - Analyst

  • You said there are 2 accruals.

  • - CFO, EVP

  • Uh-huh.

  • - Analyst

  • The second explanation I understood, the first one I didn't.

  • I am looking at interest expense and I'm looking at 2 different numbers, actual and pro forma and 2 million bucks is $2 million and I don't get it.

  • So it is still over my head.

  • Try again.

  • - CFO, EVP

  • Well, again, when we reversed these tax liabilities a piece of it related to interest that we had accrued so when we reversed that interest that hit the interest expense line.

  • - Analyst

  • Okay.

  • And that's it?

  • - CFO, EVP

  • That's it.

  • - Analyst

  • What would be the run rate going forward?

  • - CFO, EVP

  • Well again, we don't give forward-looking guidance on that, but obviously this reversal was a one-time event.

  • - Analyst

  • Okay.

  • Have you all made any comment about increasing your share authorization.

  • I know you had a Board meeting.

  • Was it discussed or where are we going with that?

  • - Chairman, CEO

  • Yeah, John, this is Perdue.

  • We have a finance committee of the Board and they continue to look at this, that is under review.

  • We still have some outstanding authorization right now and that will be reviewed as that authorization is used up.

  • - Analyst

  • Okay.

  • When do you have any idea when all this investment spending is going to end?

  • - Chairman, CEO

  • Well, I hope not for a long time, frankly.

  • Let me classify investment spending.

  • The short-term investment spending as it relates to stores, you know, as Lawrence said, is a predominantly 2004 issue.

  • In 2005 we will spend a little bit outside in that area, but not nearly as much as we did this year.

  • So there are some one-time things that we are doing this year and early next year that probably don't have a continuum.

  • With regard to the capital expenses, with regard to our distribution and our store growth, you know, as long as we're favored with the growth opportunity that we have today, that's going to continue.

  • - Analyst

  • No, I understand the second part.

  • I think if you step back last year maybe at this time you would have thought the SG&A as a percent of sales was starting to moderate and actually fall into this year.

  • Now it is starting to accelerate again, and you wonder when the things that need to be done are done and then it starts to decline.

  • - Chairman, CEO

  • That's good -- that's a good point, a good call out, because SG&A is certainly on our radar screen.

  • As we said earlier, relative to some competitors we are a little low -- lower, but having said that, we still see opportunities once these one-time expenses are out of the way we continue to look at that line and work hard to have it tempered.

  • - Analyst

  • Well, the trouble with the disclosure in today's conference call in my opinion, is that the disclosure to try to understand what the true underlying rate is, nobody will answer the question.

  • A few have tried to get to it in a couple of ways, but we really don't know.

  • So I can't tell what the true underlying rate is, which is probably the question of the day.

  • You all want to help on that again or are we just staying pat where we are?

  • - CFO, EVP

  • I think for a couple different reasons, I just -- I don't want to get into details of that, John, sorry.

  • - Analyst

  • Okay.

  • Thank you.

  • Operator

  • Our next question comes from Ed Roche with the Banc of America Securities.

  • - Analyst

  • Good morning.

  • - Chairman, CEO

  • Morning, Ed.

  • - CFO, EVP

  • Good morning, Ed.

  • - Analyst

  • Thinking about the occupancy costs, just want to revisit that.

  • It seems to me that it would be factored into your returns for the store project, right?

  • And I'm just wondering, are we seeing a little bit of a compromise on those store level returns or does the increase in occupancy as a percentage of sales reflect that these new build to suits are early in their existence and will be ramping up to better returns once they are near maturity?

  • - Chairman, CEO

  • Ed, this is Perdue.

  • Yeah, let me separate the store improvement project from the rent line.

  • The store improvement project should actually help our rate over a long period of time if we can get productivity up.

  • Having said that, the build to suits do have a short-term impact as they get started.

  • But we are also upgrading our locations.

  • This is not just a build to suit issue.

  • And I will say that the environment is a little more competitive in certain markets today.

  • So I think it is a combination of trying to upgrade in a minor way some of our locations, the competitive nature of certain markets and then I think the build to suit issue is the third impact on that.

  • - Analyst

  • Okay.

  • That's really helpful.

  • Thanks.

  • And then I want to venture into an area I don't know anything about, so maybe you can help me on the debit and the credit acceptance here.

  • What kind of benefits are you expecting from each of those?

  • And then when you think about an $8.50 transaction, you usually feel that the cost per transaction can get a little bit prohibitive, but can you give us some color on what kind of arrangements you have negotiated for that?

  • - Chairman, CEO

  • Well, let me just say we have looked at this -- we continue to look at it very closely as we test in 3 states various payment methods.

  • We have announced a relationship with Discover.

  • We think the economics work even in our environment, maybe especially in our environment.

  • And certainly as we add coolers we think that the dynamics will change from our historical averages.

  • So that when we look at some of our modeling that we have done around this, we are very hopeful that this is going to be creative.

  • And that it will actually encourage our customers to spend a little more of their money in our stores and so these are dollars that they spend anyways.

  • So what we're trying to do in this effort is to increase our share of wallet more than anything else, Ed.

  • - Analyst

  • Perfect.

  • Thank you.

  • - Chairman, CEO

  • Thank you.

  • Operator

  • Our next question comes from Patrick McKeever of SunTrust.

  • - Analyst

  • Hey, guys this obviously isn't Patrick. [Laughter].

  • I'm Carrie in for Patrick today.

  • I had a question back on fuel prices, but more on the expense side.

  • Are you seeing a big expense strain on increased rates?

  • - Chairman, CEO

  • Carrie, thank you.

  • This is Perdue.

  • Yes, we do see an impact on that year-to-date.

  • There is no question.

  • You know, we have very competitive distribution costs and transportation costs.

  • But we see 2 issues on the transportation side.

  • One is obviously the fuel costs.

  • But secondly is the -- and this is going to be totally counter intuitive.

  • We have a third-party vendor that does all of our trucking and the availability of drivers is becoming much more competitive today and those are two issues that are affecting our transportation situation.

  • - Analyst

  • Okay.

  • And then also back to the impact that it has on your core customer, can you give us any color as to whether it has been a bigger impact or if it has gone on longer than you had originally thought?

  • - Chairman, CEO

  • Well, Carrie what happens with our low-end consumer is they adjust their spending when gasoline goes up as much as it has on a weekly cash budget, discretionary items get pushed off and that's what we are seeing.

  • Our consumable business remains very steady.

  • You know, I'm not an international economist so I can't relate to the long-term nature of high gas prices.

  • I can just give you our observation of how it impacts our customers and it has been profound over a significant period of time.

  • But it is tracked very constantly through the last 6 to 9 months.

  • - Analyst

  • Okay.

  • And then one final question, with the new overtime laws that have come out recently, do you all have any idea if that's going to have a big impact on your labor costs?

  • - Chairman, CEO

  • Carrie, this is Perdue.

  • I don't think it will.

  • I mean, we just don't see a profound impact at all there.

  • - Analyst

  • Okay, great.

  • Thanks.

  • Operator

  • Our next question comes from Ronald Bookbinder with Sterne, Agee.

  • - Analyst

  • Good morning.

  • - Chairman, CEO

  • Good morning.

  • - Analyst

  • Just wanted to dig into this inventory again.

  • You mentioned that the consumables was part of the greatest part of the increase, but given that the consumables sales growth is the highest, that would be expected.

  • Are there any sectors of the inventory that are growing faster than sales, such as the home or seasonal categories?

  • - Chairman, CEO

  • Not really.

  • You know, home is up but not a lot, and in line with sales.

  • You know, seasonal merchandise is always a concern as you roll into each season.

  • But right now we are well positioned in that as well and I called out apparel earlier as actually being down even though their sales are up.

  • So I think most of the story is in the consumable area, Ron.

  • - Analyst

  • Okay.

  • Given that you all use the retail inventory method, wouldn't expansion or greater purchases of consumable inventory, wouldn't that pressure your gross margin a bit?

  • - Chairman, CEO

  • Well, that was your earlier question, Ron --

  • - Analyst

  • Yeah, I know you are doing better buying, but.

  • - Chairman, CEO

  • Historically it would.

  • But we've been working hard over the last year on our margins up and down our merchandise chain, and, you know, I think what you're seeing is a result of some of that work.

  • We obviously have a tender tension between our gross margin, our go-in margin, if you will.

  • And our pricing competitiveness at the market basket level.

  • So we continue to look at that very closely.

  • But what you're seeing is the result of a lot of hard work over the last year and a half.

  • - Analyst

  • With the margin expansion, under the retail inventory method, wouldn't that also put some pressure on the shrink causing it to be a little bit greater than you might actually be experiencing?

  • - CFO, EVP

  • Not necessarily.

  • I think you really have to look at the year-over-year impact when you look at shrink and what the accruals were last year versus this year, and so, no, I don't think necessarily it would result in that.

  • And again, we're very pleased on an operating basis, what we have been seeing on a like store basis year-over-year on our shrink.

  • So we're happy to see the improvement store versus store.

  • - Analyst

  • Okay, great.

  • Thank you very much.

  • - Chairman, CEO

  • Thank you.

  • Operator

  • Our next question comes with Mark Mandel with Fulcrum Global Partners.

  • - Analyst

  • Thanks, good morning, everyone.

  • - Chairman, CEO

  • Good morning.

  • - Analyst

  • Regarding the 2 components of the gross margin improvement, can you give us the relative magnitude of those items.

  • - Chairman, CEO

  • Do you want to take that, David?

  • - CFO, EVP

  • Yeah, what we had said was -- one second here.

  • No, I don't think we break that out separately here.

  • What we said on a year-to-date basis was that out of the 55-point improvement, 30 basis points were attributable to the markup on the beginning inventory, and 20 basis points were attributable to the LCM adjustment that had happened last year.

  • So I guess that's the answer on a year-to-date basis.

  • We really don't have the quarter broken out.

  • - Analyst

  • Okay.

  • Thanks so much.

  • The second question regarding the inventory increase.

  • I know you don't like to give guidance, but any color as to what we might expect the inventory situation to look like at the end of the year in terms of a percentage increase?

  • - Chairman, CEO

  • I guess I have to be the bearer of bad news, Mark, I'm sorry.

  • No, we really don't want to be specific about a forward-looking number like that.

  • I have said earlier in the call though, where we are in our inventory position today given that we had just gone through the planagram change and the auto replenishment implementation the first half of the year, I am pleased with the balance of our inventory.

  • - Analyst

  • Okay.

  • Fine.

  • And the final question I have, regarding the deferred openings on the Dollar General Market, what's the nature of that?

  • Should we read anything into that and what's your experience been so far on the markets?

  • - Chairman, CEO

  • Thank you, Mark, for calling that out.

  • I really appreciate that because this is still a very exciting part of our business.

  • We haven't said a lot about it over the last year purposely.

  • We have 4 stores up and running and they have far surpassed our expectations.

  • We are very pleased.

  • I would not read anything into that.

  • That is a timing thing between possibly January and February or early in the first quarter next year.

  • And it may not happen.

  • What we are seeing is that the negotiations in these properties given that they are a little bit larger, we want to be very careful with these first few that come out of the ground and make sure that we get exactly the right location.

  • We are testing a lot of things and so this is not the normal rollout of a proven model.

  • We want to make sure that each one of these has all of these variables tied down so we can measure them properly.

  • Good call though, thanks.

  • - Analyst

  • Okay.

  • Thanks a lot.

  • That's all I had.

  • - Chairman, CEO

  • Thanks, Mark.

  • Operator

  • Our next question comes from Michael Baker with Deutsche Bank.

  • - Analyst

  • Hi, thanks, guys.

  • Just one more try on the gross margin as it relates to the lower cost to market change.

  • You had said to a previous question that that was in relation to the inventory write down which I remember you took a few years ago, or -- I didn't quite understand that.

  • And is this something that we will continue to see in the coming quarters?

  • - CFO, EVP

  • No, actually what it is is it's a markdown that occurred this quarter last year.

  • So it's a -- it's an event that you have a comparability issue comparing the current quarter to the same quarter last year.

  • So it happened exactly 1 year ago this quarter and it was a $4.7 million LCM adjustment.

  • - Analyst

  • So it helped the gross margin last year and now you are comparing it against it?

  • Is that what you're saying.

  • - CFO, EVP

  • No, it hurt the gross margin last year.

  • It was an expense that was taken last year and by it not reoccuring this year --

  • - Analyst

  • Right, that's what I meant.

  • - CFO, EVP

  • It gets help this year from it.

  • - Analyst

  • Right.

  • That's what I meant.

  • So these are related to goods that are no longer -- so this is what happened last year, these goods are no longer in the store right now.

  • They are presumably sold?

  • - CFO, EVP

  • You know, I wouldn't know absolutely for sure, but, yes, that would be the assumption when you take a -- an LCM adjustment that you move the goods out.

  • - Analyst

  • Okay.

  • Can you remind me -- last question.

  • And I can go back and look it up, but did you take a similar adjustment in either the third or the fourth quarter of last year so we would cycle against that, or is it just in the second quarter.

  • - CFO, EVP

  • I don't think there was a similar adjustment in the other quarters.

  • Of course, LCM is something we look at every month.

  • It is just a regular part of doing your accounting.

  • So at any point you can have an LCM adjustment.

  • But I don't recall seeing a large adjustment those 2 quarters you asked about.

  • - Analyst

  • Great.

  • Thank you.

  • - Chairman, CEO

  • Operator, we have time I think for one more question.

  • Operator

  • Our next question comes from David Mann at Johnson Rice.

  • - Analyst

  • Hi, good morning.

  • - Chairman, CEO

  • Morning.

  • - Analyst

  • A couple questions.

  • I think on the last call you talked about your back to school merchandise flow.

  • You expected it to be more efficient and perhaps have some different signage.

  • Can you just estimate for us how well that went for SNU.

  • - President, COO

  • This is Lawrence Jackson and I think it has gone pretty well.

  • In most of our stores we have had signage in our back to school.

  • We used a lot of shipper, self-shipper cartons to be more efficient in display and get some bulk stack out.

  • Quite frankly, we have been pleased with the execution of back to school in the stores.

  • It looks real robust and it has called out to the customers more clearly than it has been in the past.

  • - Analyst

  • Okay, great.

  • And then going back to the SG&A cost components, I believe last quarter you actually quantified what the higher consulting costs were in the first quarter.

  • Would you be able to do that for us this quarter?

  • - CFO, EVP

  • Yeah.

  • We had $2.1 million of consulting costs related to the store project in this quarter.

  • - Analyst

  • And so that's down a little bit from last quarter.

  • Should we expect it around that level in Q3 or down or?

  • - Chairman, CEO

  • Well, David this is Perdue.

  • I think, what we have said in the last call is that we thought with regard to outside expenses the first half would be heavier.

  • - Analyst

  • Okay.

  • - Chairman, CEO

  • That's about all I can say today.

  • - Analyst

  • All right.

  • And then one last question, the gross margin increase, you are pointing towards the higher average markup on beginning inventories.

  • Can you give us a sense on how that markup on beginning inventories is starting the third quarter?

  • - CFO, EVP

  • I wish I could.

  • I just don't feel comfortable -- that's a forward-looking item.

  • I'm sorry.

  • - Analyst

  • Even though it is a number you probably already have?

  • - CFO, EVP

  • Yeah.

  • - Analyst

  • Okay, thank you very much.

  • - Chairman, CEO

  • Thank you, David.

  • Thank you, everyone.