達樂 (DG) 2006 Q2 法說會逐字稿

This is the Dollar General Corporation second-quarter 2006 earnings conference call on Thursday, August 31, 2006, at 9 AM Central Time.

Good morning, ladies and gentlemen, and thank you for participating.

This call is being recorded by Conference America and shareholder.com.

Under federal law, no other recording or rebroadcast of the session is allowed without the Company's permission.

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

Before the presentation begins, the Company has asked that you listen to the following statement regarding forward-looking information.

In addition to historical information, the Company's comments during this call will contain forward-looking information such as statements regarding the Company's 2006 financial outlook, the expected annual effective tax rate, store growth targets, capital [expiditures], and other key plans and initiatives.

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

While the Company believes the assumptions underlying these statements are reasonable, any of these assumptions can be inaccurate and, therefore, actual results may differ materially from results projected or implied by the forward-looking statements.

The factors that may cause actual results to differ from the forward-looking information include, but are not limited to, those outlined in the Company's most recent Form 10-K and Form 10-Q and in the earnings press release issued today, as well as factors discussed in today's call.

The Company cautions you to not [underlay] results on these forward-looking statements, which speak only as of today's date.

Expect (sic) as may be required by law, the Company disclaims any obligation to publicly update or revise any forward-looking statements to reflect events or circumstances occurring after this call, or to reflect the occurrence of unanticipated events.

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

Beginning today's call is Mr. David Tehle, Executive President (sic -- see press release) and Chief Financial Officer.

Sir, you may begin.

Thank you, operator, and good morning, everyone.

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

This morning we reported a very disappointing quarter.

Net income for the second quarter was $45.5 million or $0.15 per share; and that's compared to net income of $75.6 million or $0.23 per share in the second quarter of last year.

Sales for the second quarter of '06 were $2.25 billion versus $2.07 billion in the prior year, an increase of 9%.

By category, sales of highly consumables were up 11%; seasonal sales were up 12%; but basic clothing was down 1% and home products were virtually flat.

Same store sales in the quarter increased by 3.2%.

As a reminder, that is over a strong comp store sale increase of 4.2% last year.

If you will remember we had strong comps in the first half of last year that started to soften in the back-to-school time frame.

That softening continued through March of this year.

As most of you are aware, we have distributed several advertising circulars since that time and we have also made some significant planogram changes.

The sales results are encouraging, although still not where we would like for them to be.

We believe we are attracting new customers, as well as giving our existing customers more reasons to shop Dollar General.

Increasing our comps has been and is still a key factor in our plan for '06.

Further evidence of this sales success occurred in August, as we announced a 4.8% comp this morning for the month of August.

To date, the ads and new merchandise have not improved the gross profit line as we would have hoped.

Our gross profit rate to sales for the current year quarter was 27.2%, down from last year's second-quarter gross profit rate of 28.6%.

The decrease in the gross profit rate is due to a number of factors, including lower sales as a percentage of total sales in the Company's home products and basic clothing categories, which generally have higher average markups; increased markdown activity primarily resulting from enhanced promotional activities; lower average markups on inventory at the beginning of the quarter; an increase in the inventory shrink rate; a decrease in the markups on purchases during the period, primarily attributable to increases in the sales of highly consumable products, including nationally branded products, which generally have lower average markups; and as you might guess, higher transportation expenses driven by higher fuel rates.

Selling, general, and administrative expenses were 23.6% of sales for the second quarter of '06 versus 22.8% of sales in fiscal '05.

Contributing to the increase in SG&A were advertising, utilities, store occupancy cost, and administrative salaries resulting from additions to the leadership team and the reorganization of our merchandising and real estate functions, as well as the expensing of stock options, of course.

These increases to SG&A were partially offset by a decrease in the accrual for incentive bonuses.

As a reminder also, last year in fiscal '05 we had a $2.6 million reduction in SG&A related to employee benefits expense; and that resulted due to an actuarial adjustment for healthcare claims.

That did not reoccur in '06.

Interest expense net of interest income for the quarter increased $2.2 million over the prior-year quarter, due to higher net borrowings primarily resulting from increased inventory balances.

I will talk more about our inventory in a minute.

Our effective income tax rate for the second quarter of '06 was 37.9% compared to 34.8% in the comparable prior-year period.

The tax rate in the quarter was higher than our anticipated 37.3% primarily due to a 2006 state tax law change that reduced previously recorded deferred tax assets related to the Company's operations in the state of Texas.

For the 26-week period year-to-date, net income was $93.1 million or $0.30 per share in fiscal '06, compared to $140.5 million or $0.43 per share in the comparable fiscal '05 period.

Year-to-date net sales increased 8.9% including a same store sales increase of 2.4%.

The Company's gross profit rate to sales decreased to 27.2% in the '06 year-to-date period from 28.6% in the '05 year-to-date period.

This decrease in the gross profit rate is due to a number of factors including lower markups on purchases in the period, primarily attributable to increased sales of highly consumable products; increased markdown activity, again primarily resulting from enhanced promotional activity; lower sales as a percentage of total sales in the home products and the basic clothing categories; higher transportation expenses, again driven by the higher fuel rates; and an increase in our inventory shrink rate to 3.30% in '06 compared to 3.12% in '05.

We believe, with regards to shrink, that in our efforts to improve top-line growth over the past two years, we have added more SKUs with higher shrink rates.

We are now focusing more on an item shrink impact as we rationalize our merchandise assortment.

These decreases in gross margin were partially offset by higher average markups on beginning inventory in the fiscal '06 period.

SG&A expenses for the year-to-date period increased as a percentage of sales to 23.5% in '06 from 22.9% in '05.

We continue to look for opportunities to reduce our SG&A cost.

The effective income tax rate for the 2006 26-week period was 37.8% compared to 36% in the '05 period.

The increase in the effective income tax rate is a result of the December 31, 2005, expiration of the federal laws which allowed the Company to claim certain federal job credits for newly hired employees.

Also, this 2006 tax law change I mentioned earlier reduced previously recorded deferred tax assets in the state of Texas.

We had reduced state tax credits principally related to our new distribution centers and the nonreoccurrence in '06 of benefits we realized in '05 related to a internal tax restructuring.

We anticipate an annualized effective income tax rate excluding nonrecurring items of approximately 37.2% if the federal jobs credit programs are not reenacted retroactively, and approximately 36.7% if the reenactment is approved.

Inventories at the end of the quarter were up 18.8% over last year and above planned levels.

There were several factors that impacted inventories.

First, our new advertising campaigns prompted additional purchases of inventory to ensure adequate quantities in the stores.

Although the advertising circulars clearly aided sales, the sellthrough of the promotional inventory was below expectation.

The good news here is that the majority of this excess is highly consumable inventory, and it is expected to be sold off in the normal course of business.

Second, major planogram changes that occurred in the quarter added national brands such as Heinz, FRENCH’S, and Jif to the merchandise offering.

We believe most of these new items generally help broaden the appeal of our stores.

As appropriate, we will refine our product assortment and reduce certain lower-performing SKUs in the planograms in the second half of the year.

Finally, seasonal inventory purchases, including automotive, grills, and accessories, and back-to-school merchandise, increased in the quarter.

Sales of these items increased; however, sales of back-to-school merchandise in July were below our expectation.

Our current inventory levels are not acceptable, and we are implementing plans to reduce current inventory levels and to better align inventory growth with sales increases by the end of the fiscal year.

As of August 4, 2006, we operated 8,178 neighborhood stores, including 50 Dollar General Market stores.

Year to date, we opened 294 new stores; relocated 37 stores; and closed 45 stores.

For the year, we expect to meet our target 1of 800 new traditional stores, although total new store weeks are expected to be below our plan for the remainder of fiscal '06 due to slower store openings in the first half of the year.

We are however very pleased with the initial results of the changes we have made in our site selection and store opening processes, which so far have produced higher average sales per new store.

Cash capital expenditures through the second quarter of '06 were $156.3 million, primarily related to new stores and relocations; the completion of the Marion, Indiana, distribution center, which began shipping on August 21; and the further rollout of EZstore.

We currently expect capital expenditures for 2006, the fiscal year, to be in the range of $300 million to $350 million, lower than our original guidance, with decreases coming mainly in the DCs and various discretionary corporate and IT projects.

As you know, we had completed the purchase of shares under our existing repurchase authorization in the first quarter, and we did not repurchase any shares in the second quarter.

Now, with that I will turn it over to David Perdue for some additional comments on the business.

Thank you, David, and good morning, everyone.

Certainly the second quarter's financial results were more than disappointing to all of us here at Dollar General.

I assure you, no one in the leadership team or our Board of Directors at Dollar General take these results lightly.

We knew the quarter would be challenging going in.

We were facing tough comparisons from last year.

We have a very new management team in merchandising in particular.

In fact, some key positions were still open as late as the beginning of the quarter.

We have not yet had time to implement our strategies to improve our home and apparel business.

But that is coming, and I will have more to say about that later.

Our commitment to improving our comp sales through increased advertising put pressure on our margins in the quarter, as David just mentioned.

There are several positives, however.

First, while the circulars are not yet as productive as we had hoped, we can see some very encouraging results from our efforts to increase traffic and our same store sales.

Comps are up, a direct result of new SKUS, planogram changes, and our advertising efforts.

In fact, on a two-year basis, the last five months' comps are very encouraging.

Comps in many of our newer markets have surpassed the chain average.

Remember, except for relatively insignificant grand opening efforts, we had never really sought to tell our story or establish our brand in these new markets.

Frankly, this is a long-term proposition, but one we believe is likely to merit the investment.

Overall, fresh new planogram items added to date this year are being well received.

We are responding quickly to the ones that are not performing well.

Comps in our seasonal category have improved in response to some of our initiatives, although we still have to fine-tune the margin in that area.

Our new stores are performing well, better than last year's new stores.

As a matter of fact, they are comping up about twice the level of what our traditional stores are comping up so far this year.

We are also encouraged by the initial results of our new stores with the new layout.

So far these stores are averaging higher sales per week than the rest of our new store openings with a higher average basket.

We now have our leadership team in place, having added significant strength in the merchandising and real estate areas.

A couple of key areas in particular are getting a completely fresh look. -- Home products and apparel, to mention just two.

These are historically high-margin categories that have been underperforming for several years, partly due to external pressures on the discretionary spending of our lower-income customers.

We are analyzing the productivity of every square foot in these departments and working on new ways to serve our customers better in these areas.

Our improved sourcing capabilities that we have been working hard on these last two years should help us get these departments moving again.

Next, we have been talking for some time about the benefits of building strength in our private-label programs.

We now have resources dedicated to building this in our Company.

It's too early to speculate on the impact; but I believe a vibrant private-label program alongside a strong national brand program can dramatically improve our margins and better serve our customers.

While we would have preferred to have had home and apparel fixed and our private-label program further along to help buoy margins before we introduced increased marketing expenses and introduced more national brands, we felt, however, coming into this year we had to address our same store sales.

We're still comfortable that the steps we took to bolster our comps and traffic trends were the right things to do.

I don't want to overlook some of our other achievements in the quarter.

We completed the construction of our Marion, Indiana, DC and began shipping August 21.

This new distribution center allows us to redistribute some of our stores and takes some of the pressure off several of our other DCs as we make changes in our merchandising and store operations.

We remain on track with EZstore in 6,800 stores at the end of the quarter.

EZstore continues to meet our expectations, and we're pleased with the impact it is having on our store operations.

In our real estate operations, we have made several very positive changes in our site selection and store opening processes, which have resulted in improved sales per rooftop in our fiscal 2006 store openings.

We are on track in terms of new stores for the year, but they are coming online more slowly than planned.

We do have the stores in our pipeline to meet our goal of 800 new Dollar General stores by year-end; but as I just said, we have been bringing them on a little slower, making sure that the quality is what we want.

We also continue to make progress in assessing our lease renewal and relocation processes, as we have mentioned before.

We have also begun a mystery shopper program to help us monitor our customer service.

This program is providing some great learnings, as we have reintroduced circulars.

We continue to enhance the tools available to our district managers and store managers to better manage the business.

As you have already seen in our press release today, we recently held our annual strategic planning session with our Board of Directors.

At that meeting we discussed alternatives that may be available to improve our operations.

We discussed the Company's historic inventory management and pack-away strategies; changes in recent years to these practices; and the potential impact on future profitability if we accelerate our transition away from some of these practices.

As most of you know, under our traditional inventory disposition strategy, the Company would have carried any remaining prior season inventory forward and would have attempted to adjust future inventory purchases to account for the carryover product.

Beginning in about the fourth quarter of 2003, principally at the conclusion of the holiday selling season, we began taking more end-of-season markdowns to accelerate the disposition of certain holiday-related and other items, as well as certain other seasonal, home, and basic clothing items that had not sold as expected.

Although these increased end-of-season markdowns resulted in less pack-away inventory, there is still a pack-away component of the Company's merchandising practices; and a significant amount of merchandise from prior seasons remains in many stores.

As part of our effort to increase newer product offerings in the stores, we are looking at the potential impact if we were to seek to more aggressively sell through existing prior-seasons inventory and at the same time institute programs to minimize the carryover or pack-away practice in future periods.

We have talked about the improvements we have made to the policies, procedures, and controls relating to our real estate practices.

At the strategic planning meeting we decided to take a fresh look at existing store locations in light of this new real estate practice.

As a result, we may consider whether in the future to refine how we identify stores as possible candidates for relocations, remodels, and closings.

If we change this, the number of store closings, relocations or remodels may increase materially from our historic levels.

We expect to be in a position to update you on the status of these alternatives before the end of the fiscal year.

Until that time, we do not anticipate commenting further.

In light of the possible impact of these operational alternatives and the variables surrounding our merchandising initiatives and promotional activities in the second half of year, we are not at this time providing earnings guidance for the fiscal third quarter; and we are withdrawing our previous annual earnings guidance for the year.

We continue to anticipate improved same store sales results over prior year levels; and we expect to be better prepared for the upcoming holiday season.

However, we see no dramatic improvement in our customers' ability to increase overall discretionary spending; and we expect the aggressive competitive environment to continue.

As a reminder, our 2005 fiscal year included a 53rd week, which we think accounted for approximately $162.9 million in the fourth quarter.

In conclusion, we believe we're making the right improvements to build this Company for the long term.

Some of these changes have caused problems with our short-term performance; specifically, comp sales late last year and profitability in the first half of this year, as we addressed this comp sale issue.

We're pleased with our current comp sales trend and are focused on our margins as we go into the back half of the year.

We're extremely disappointed with our results, as we both have said, in Q2.

But I can assure you that our management teams, Board of Directors, and I are committed to improving this recent performance.

We're focused on delivering quality merchandise and customer service in our stores every day.

I believe we have the team in place now to accomplish our operational and financial goals long-term.

With that, operator, we will take a few questions this morning.

Thank you very much.

(OPERATOR INSTRUCTIONS) Scott Mushkin from Banc of America Securities.

I just want to touch on labor turnover.

I know it's an issue that you guys highlighted at the investor day.

We have actually come across other information that it's not just at the store level, but there also some issues above that in the regional management.

Could you touch on that and what you are doing to improve that?

Well, I don't know what information you have come upon that is above the store manager; but our numbers show that we're moving in the right direction, particularly in our district manager turnover.

Our store manager turnover is not where we want it to be.

We have made significant progress back in '04 and early '05; and then we have had a tick-up here in over the last six to 12 months in our store manager turnover.

We take this very seriously, because we know there is a high correlation between our good stores and store managers that have been with us for at least five years.

We have a new Executive Vice President of HR, Challis Lowe, who is bringing some significant changes to our policies and what we are doing here.

We have had an outside study taken with regard to our policies and practices regarding compensation, regarding promotions, etc., etc., with regards to this issue.

We have also gone through a very major transition over the last 18 months that called EZstore.

While we know the workload in the store is less now, we can measure that, it is a transition.

Some of the store managers who were very comfortable working our procedures within the earlier manner were maybe uncomfortable with the revised requirement for being a store manager.

We know that voluntary turnover is -- we now measure voluntary and involuntary turnover.

So we know that we have two issues -- one where someone voluntarily leaves; the second where we may have hired or promoted someone improperly and therefore have discharged them.

However, over the last 18 months, I will tell you that our involuntary turnover has probably been unduly high regarding that, because we have taken the stance that we wanted to make sure we had the right people in the stores that could run the stores the way we want them run under the new practices.

With regard to district managers, we have got a number of people -- I think last year it was something like order of magnitude 160-plus people that we promoted into that district manager function.

So we've had a lot of new people in there.

Turnover this quarter I believe is down just a bit; but it is still in that 25% to 30% range, I think.

Probably a little higher than we want long-term.

Our big focus is really on the store manager turnover, though, and it's a great call-out.

We're spending a little more money on it.

We have done a lot of analysis.

We are not happy with our current level at about 50%, so we are working hard on that.

On a rolling average, regional manager turnover is up 1% and district manager turnover is down 2%.

I was handed that statistic.

So I don't think we've got a major problem above that.

We do have a problem at the store level, though, because that is where our fight is enjoined right now.

Scott, thanks for the question.

Perfect.

Can I do one follow-up?

Sure.

Gross margin dollars, of the switch to the branded, do I take it it's a gross margin dollar loser?

How do you look at it when you decide to make a change like this as far as from an ROI prospective?

Yes, that is a great question, Scott.

In the first half, honestly, we made it -- it's very easy to add some branded, lower-margin items to your mix.

Because you pick up the phone, you call a vendor, and you can have it delivered the next week.

The balance to that is that within our private-label and our home and apparel, some of those changes we were not able to accomplish as quickly to buoy that balance.

So in the first half, I will be very candid with you, we basically lost our balance on the gross margin line.

I will tell you that some of the tools that we have put in place over the last, say, 90 days give us much more visibility to the overall impact -- not just within a department, but the entire firm -- with regard to a specific change.

The second piece of that is with the history now have this year on our open-to-buy policies and the new people that have come in, in our planning department, we now have tighter controls on what we are going to be buying behind either an ad or a promotional period like holiday.

So I think we're getting a little smarter about this.

This was a major change in the first half to try to drive comp sales.

I would not read anything long-term into it at all.

We're committed to have a branded piece in our business.

I don't see any reason that should decline.

What we are missing, Scott, is that we are anemic, frankly, on the private-label side.

We know that we are underleveraged on our private-label side and our sourcing percentages.

So those are two areas that are getting primary focus as we move over and start focusing on our merchandising area.

Great.

Maybe I will just turn it over.

I have one more, but I will just turn it over.

Mark Husson, HSBC.

(technical difficulty) and your procedure whereby you're trying to judge whether you should turn them over more often or remodel them.

I know you don't want to really talk about that in any detail and put numbers around it.

But can you just say, what is it about the merchandising changes that you have made here, or the way you see what the ideal store is, that has made you even question whether the big long tail of stores you have got is in the right shape?

Well, Mark, I can't really comment about what we're going to do in the future.

I will repeat a little bit of flavor;

I will give you a little flavor of what we have said in the past.

That is, we have over 8,000 stores.

A lot of these stores were built during different times over the last few decades, honestly, and under different real estate strategies and so forth.

Communities change.

There are several places that we can think of where either a community has -- the population has changed, the demographics have changed, competition set has changed.

So we are now putting in procedures where we will evaluate these existing stores a little more intensely regarding their profit contribution, their return on capital, etc., etc..

So I can't really say anything about what the outcome of this will be, except to say that we are in deep analysis right now.

As soon as we get comfortable that we have the right numbers, we will come back to you guys with a lot more detail.

When you sort of plug in DG Markets, for instance, into that kind of analysis, is it still looking like a promising use of capital?

Or is the jury out?

You know, Mark, we are very encouraged.

I think we have got new leadership there.

Wayne Gibson has been here about a year.

We have made several big changes there.

One of the learnings is that while we are getting profitability, we're moving profitability in the direction we need, the upfront capital quite candidly is a little bit more than we want.

So we are looking at revisions there.

We have changed the layout a little bit.

Certainly the product mix is evolving to be such that we can get the capital balance in line and the margin to what we want.

Frankly, the 50 stores that are up and operating right now I am very pleased with.

We're not ready to make a major statement to anybody yet.

But we continue to evolve that.

Remember, it took a long time for some of our competitors to develop their new models, their bigger models.

The other thing I will tell you, I think the square footage of this, we are evaluating that as part of the capital evaluation.

You may see some smaller footprints come out of this as a part of this effort.

But we're still heavily committed to make that happen.

Yes.

Finally, I guess I know you have said capital expenditures are coming down a little bit.

So.

And it sounded like you had canceled a couple of sort of central projects.

But underlying CapEx on new store openings, still as heavy as it has been.

Given that you still have got to go through this process of trying to work out what really works as kind of best-store, wouldn't it be prudent to cut back some of the new store opening CapEx here?

Well, that is part of what we're looking at, honestly, Mark.

That very thing.

I am not ready to respond to that.

I can't make any further comment.

But I will say that I think last quarter we made that comment as well.

It all ties in to the relocation, remodeling, and new green-grass stores.

That is the analysis that we are undertaking right now.

That CapEx could well come down.

We could redirect it into remodeling or relocations.

But we just are not ready to comment on that at this point.

Okay, that's helpful.

Thank you.

Meredith Adler, Lehman Brothers.

I have a question about what you talked about on the inventory write-downs.

I know you are not going to give us any sense of quantification.

I'm trying to understand how the process would work.

Would you actually go into the back room and take Easter baskets out in October, and put them out on the selling floor, and try to sell them?

Would you take them out and throw them away?

I am not sure.

I am just trying to understand how you would actually clear out this inventory.

You say be more aggressive.

Also does that involve both markdowns and labor?

Good morning, Meredith.

This is Perdue.

I can't comment going forward;

I can tell you what we have been doing the last couple of years.

We have been more aggressive.

No, we don't take seasonal merchandise out and try to push it off-season.

There may be one or two exceptions where we have sold Christmas or holiday wrapping paper in July.

On occasion around July 4th we have done that.

But for the most part, we try to take care of this in the appropriate season.

But we have been much more aggressive, particularly in '04 and '05, regarding this issue.

We are evaluating right now not only the quantification of it but the methodology, as you refer, to how we would address that.

That is one of the things that is being evaluated and one reason why it takes a little time to get all of this to where we can bring it back to you.

There is a lot more analysis we're doing on that.

We would not want to reach any premature conclusions here.

That is why we will make a comment at a later date on it.

Okay, I do have a question about the process of marking down inventory.

When you pack stuff away, do you take any markdown at all?

Or is it just in the books at whatever its original value was? [That's saying] what you have done in the past.

It varies depending upon the products.

Some product will be marked down and some won't.

It is evaluated on an individual basis.

But historically, Meredith, it was minimal.

We had a lower cost to market methodology at the end of every quarter.

It's an accounting process.

It's very detailed, it's very rigorous.

We are all very comfortable that that has been very effective in the last several years.

But it does vary.

Okay.

Then I just had a question about expenses.

You did -- your sales have clearly picked up; but expenses seem to be rising faster than sales.

Can you talk about -- I mean, some of these things are hard to control.

But is there anything you can do about utilities?

You have got a lot of corporate expenses going up.

When does that level off?

Meredith, good points.

You know, we have got the top-line items are obviously store labor and occupancy costs.

Labor is going down as a rate; and occupancy costs have been going up.

Hence the intense scrutiny around our real estate practices and so forth.

We think that we can be more efficient there, although the environment is getting more expensive, as I think I have said before.

We are working to be much more efficient in terms of what we put in the ground and then how we operate it.

With regard to administrative, we've got obviously some advertising expense this year.

We have added a short-term salary -- some salary increases in the real estate and the merchandising area in particular.

But we believe that those will be absorbed shortly.

As you remember, up until this quarter, we basically have been telling you guys that we have leveraged our salary expenses, which we have over the last few years.

We want to continue that.

We're focused on those expense lines now in the administrative side that are potentially giving us -- you know, some of the workers comps issues and so forth.

We believe we have put some things in place.

One of the reasons we did EZstore was to address that.

While that really hasn't started hitting us yet, we do believe the indicators are moving in the right direction, that as that accrual tail starts to wear down we will begin to see some benefits there.

So we're focused on it intensely right now.

This is not a comfortable area where we are right now, where we see our overall expenses not being leveraged to the degree that we should.

David?

Meredith, just one other comment on utilities.

We did make a capital investment this year in our stores on programmable thermostats and some ways to help control both the heating and the cooling within the stores, as well as some of the lighting issues in the stores.

We believe that will have a payback in terms of helping us control the utilities on a go-forward basis.

We are in the process of getting that installed in our stores as we speak.

It's an effort throughout this fiscal year.

So that should help us attack utilities.

Obviously there is not much we can do about rate changes on utilities; but we can certainly try to impact the consumption of it on our end.

Meredith, let me add one other piece to this.

I think it's important to add that we are spending a lot of time.

As we spent a lot of time over the last few years focusing on our stores, and I think we are making some big improvements there.

Although we have still got a lot of work to do, we're focused on cleanliness and things like that.

We have some mystery shopper programs out now to help us, give us objective independent opinions about that.

Now we're beginning to move in the merchandising.

I really believe that as we get into some of these new areas, some of these new states where rent is higher, we're going to have to look at zone pricing possibilities and so forth.

We have been moving constantly on that.

We have not backed away from that.

We're going to be very careful about it, because we don't want to go in and raise prices in an area that customers can't handle it.

But within the available market, we will be looking at zone pricing as we look at these new states.

Great, thank you very much.

Mark Miller, William Blair.

First of all, I want to say I am glad that you are making efforts to get closer to the customer with the mystery shopper program.

You said you have had some great learnings; but you didn't really expand on that.

I'm supposing some positive, some not.

What do think your customer is seeing in the stores right now?

Well, it's a mixed bag, Mark, and that is our frustration.

I think the big learning is -- I don't know that it was a learning; it was a confirmation.

We have an idea of how many stores out there are being well run.

We can look at many indicators, and there are some consistencies between a well-run store from a profit standpoint and how it looks to the customer.

Although there are exceptions.

We have many older, small stores that are less than 5,000 square feet that are being allocated a full 7,000-foot allocation for the most part.

Those stores look very messy and crowded.

We have some stores that are still making the transition to EZstore; and we don't have all of the stocking discipline and the box integrity on the floor that we want.

Floor cleanliness, updated maintenance, it's a mixed bag.

Some of the learning has been very positive.

Some of the learning has been very negative and sobering.

But that is why we are doing it.

We spent a good bit of time talking to people in the fast-food industry about how they maintain their standards.

We believe we've got an acceptable standard, and we've got many stores that are meeting that today.

We also have many stores that don't.

So if you go out and look anecdotally, you can come away with a very mixed impression of who Dollar General is; and I'm not satisfied with that.

This to me as one of the key ingredients to our long-term success, is to build more consistency of presentation at the store to our customers.

Frankly, it is one of the driving forces behind this real estate analysis that is underway right now.

I appreciate that candor.

In the prepared remarks you talked about six negatives in the second quarter on gross margin.

I know we don't have guidance going forward, but I would be interested in some color, if you could, on which of those factors you think you may have some relief on in the second half.

Thanks.

Well, one thing I can assure you is we're not going to overbuy inventories the way we did in the first half, or I won't be here.

That is one.

I think, in all seriousness, Mark, I think the balance of inventory planning, already, is much better than it was at the end of last year and the early part of this year.

We have brought some people in with great disciplines.

There is a new team on the home, seasonal, apparel side in terms of planning and so forth.

So I believe that will help.

I also believe a better balance on some of the other higher-margin SKUs that are were not available in the first half to us, are now coming online.

And we have a very exciting holiday plan right now.

We started work last year when we saw holiday coming in as badly as it did.

We started working then on our fourth quarter this year.

We have said before we have a circular plan.

But we've got many other things planned at the store level to have some energy this year in the back half to help us with our margin.

The other is that we've got some new people in home and apparel right now that are making some very, very smart moves toward item presentation, away from line building, and that sort of thing.

We know what has been doing very well.

Our children's apparel, our lady's activewear, and even our men's underwear has been doing very well.

However, one of the byproducts of some of these changes to some of these higher-margin items, even in the past, particularly last year, contributed to our shrink.

That has been a big learning to us in the first half.

So I think some of these high-shrink SKUs that also attacked our margin are being looked at very, very carefully about whether they're going to be in the line this fall.

So that is a quick overview, but I hope you get a sense of -- I think David has another --.

Yes, one more item there.

Our HBA planogram was just set.

That is just in the stores right now.

We think there's some opportunities there to -- it is a new, exciting planogram.

Again, we didn't have that in the first half; we will have that in the second half.

David mentioned there are some changes in apparel and home that are going in.

Again, we didn't have in the first half, that we think could add some excitement to the second half in the stores.

My final question is on the new stores.

You have commented that you are pleased with the sales.

I am wondering, with the higher occupancy you are seeing, which I presume is a function of the new sites, how much are you giving it back there on expenses?

So if you mix the two together, what kind of ROI are you looking on those new sites compared to the historical pro formas?

Well, if you go back far enough, when we were finding stuff at $2.50 a foot and that sort of thing, we're not finding a lot of that today.

So if you went back far enough, I am sure that that return on investment is not being matched today.

But I think overall, once you get through the occupancy cost -- and that is another reason why we are bringing these stores on a little slower this year, is that stores that might have come online last year or the year before with higher rent, we're being much more careful about our forecast of sales.

So we have been a little smarter about predicting what these stores would do coming off the blocks.

So if you look at last year, I would say right now that our ROI is much better, independent of what we're paying for rent.

Because I know what we're doing in sales.

We're up a little over 4.5% through the first half of the year, this year's new stores compared to last year's new stores.

For us, that is a big deal.

That is about twice our comp sale improvement this year, year to date.

I think we are about 2-4, 2 -3, somewhere like that year to date on our comp sales.

So we are very pleased with that new store performance.

We are also pleased with the margin contribution, to answer your question more directly.

This is not just about consumables on the front-end.

They're bringing in very, very good margin.

In fact some of our new stores with the new layout have moved much more strongly toward the home, seasonal, apparel area; and that gives us a very encouraging sign.

I think one of the things in the back half that I didn't mention, Mark, is that the profitability inside the consumable area -- our consumable area has been really strong.

Last year in one of the worst retail experiences that this Company has had in a long time, our consumables still comped up 5.5% for the year.

They're comping up very nicely this year.

The margin was hit in the first half because we added a lot of brand.

There is better balance coming in the back half on the margin front in that big category; and it's 65% of our business or thereabouts.

Just a clarification on the comps.

Our same store sales for the 30-week period we just released actually increased 2.5%.

A little better than what you said.

Okay, thank you, both.

Okay, thank you, both.

David Katz, Matrix.

I just wanted to track.

Obviously there has been a lot of margin pressure as sales have grown over the last two years.

Do you think that that is a permanent impairment in margins or it's a short-term phenomenon?

If you go back and look through the past few years, we moved from the 27% range back in probably 2000, 2001; we built it up in '04 and '05 to around the mid 29s, 29.3%.

I think one year it was 29.5%.

Last year build to 28.7% gross margin largely because of the poor holiday period that we had, negative comps in fourth quarter, and the lack of contribution from some of our higher-margin items, and the more aggressive sell-off of inventory, frankly, last year.

This year, we had what we described already as an imbalance in the first half to address our comp sales.

Certainly 27.2% is not a long-term comfort level for us on margin.

I think we can still deliver, and we are doing it today in many areas.

We are delivering great prices with very acceptable margins.

It was just that the mix got out of line in the first half.

So we're working hard not so much to raise prices -- I don't see that happening at all.

What I do see is getting the mix.

Although there might be some occasional opportunity to do that, particular when we look at zone pricing.

But the biggest opportunity here is get the balance back in our mix and get some of these higher-margin items or departments moving in the way that they did a few years ago, back in '04 and early '05.

The other thing, within our highly consumable area, we are also looking at the purchase markup in that area and trying to do the various things that will help us within that area.

Even though obviously as David said we are trying to change the mix more towards apparel and home products, we're doing everything we can to help the margin within the highly consumable area.

A piece of that is the private-label that David talked about earlier, as well as some global sourcing opportunities that we're working on as we speak.

That should help us there as we move forward.

The same thing would apply to net margins?

Yes, absolutely.

I think what we're focused on there is our EBIT contribution having deteriorated last year to mid 60s.

That is not acceptable to us.

I think that when you look at expenses, we have got some things coming.

Obviously, the big line, labor, we have done some things; and as a percent of sales, that has been tempered.

Our occupancy costs as we have talked about have increased.

The biggest one, frankly, is up in margin; that is transportation costs have just hit us hard over the last 18 months as fuel prices went up.

But yes, we're working hard to leverage the expense line all the way up and down the administrative costs.

So this is not just about gross margin.

This is really all about EBIT.

In fact, if we were to change some of our model, I am not at all wedded to the current gross margin plan.

If in fact I could get in a situation where they had a lower margin and lower expenses, as long as my EBITDA was acceptable I would be quite happy with that.

We're looking at some of that when we look at some of these new models like a DG Market, where you might give up a little bit in margin but you would certainly leverage your expenses much more, and therefore have a very acceptable EBITDA contribution.

Thank you.

Christine Augustine, Bear Stearns.

You mentioned at the outset that you think you are seeing some new customers.

I would like to know how you have come to that conclusion.

Are you actually seeing an improvement in traffic trends?

Then my second question is, what specifically are some of the processes that you have put in place, or what do you intend to do, with regard to the receipts and the fact that the national brands come in at lower margins?

It was a little surprising, I guess, that that was a drag.

Because I would think you would have known what was on order coming into the quarter.

Thank you.

Great questions, Christine.

First, let me address the new customer.

You know, the fastest-growing demographic group at Dollar General are households above $50,000; and those are new customers.

We know that [the turn] customers are good.

Some customers in our base.

And we know we have a significant number of customers that are very loyal and very consistent.

But because this sector is not really very differentiated yet, it's not very branded, there is a great crossover of customers.

We also know that in our new states we are adding a lot of new customers as a percentage to our base.

We're getting a new learning there, because we're talking to some of those customers to get their impressions of Dollar General afresh.

These are people that don't know anything about us, and we are getting input from them.

Our traffic is improving, although it is nowhere near the levels of '02 and '03, frankly, in terms of growth.

In fact, it is still flat to negative just a bit.

But it certainly improved over the last six months.

With regard to the process in receipts, the inventory issue this spring was primarily around a forecast issue, as opposed to a receipt balance.

The forecast was behind the ads.

Remember it's the first time in eight or nine years we have put ads out.

That Easter ad was a big ad for us.

We were very aggressive when we planned that back in January.

It was also done spur of the moment, because we had already bought our home, seasonal, and apparel inventory for the first half.

So we had to look into our existing inventory and develop the ad.

So a large part of that ad performance came out of the consumable area, where we could get turnaround on new products very quickly.

That caused the imbalance.

We knew it was going to happen; but we just misforecast, frankly, the sales of the higher-margin home and apparel, particularly in the first half.

That is the real miss.

Now, I will say, to answer the question very candidly, when you look at the learnings that we have picked up through that period of time, we found some weaknesses, frankly, in our planning process.

We have weekly open-to-buy meetings that have added a lot more integrity to the close-in balance between SKUs and between departments.

That is going to help us long-term, although it is very early.

I think we also, getting to David's point on the sales front, we have put more teeth into our sales forecasting in terms of making sure that our sales forecast are realistic.

But going back to a point he made, when you have not done an ad in nine years it's very difficult to gauge what the impact of that advertising will be on your business.

We didn't want to err on the side of disappointing our customers and not having the product in the store.

Obviously we erred on the side of having too much inventory.

But again our strategy was to make sure the customer was taken care of.

The other question I would like to ask you is, would you be willing to comment at all on the appointment of a new Board member who has a very extensive financial background, but that there is really not anybody on the Board with a lot of retail experience?

I mean, in terms of outside directors.

So I was just sort of curious about that choice.

Well, this individual is a very experienced individual.

He has a relationship with the Board.

He knows some people on the Board.

He is an extremely capable individual.

We have been searching.

We had an outstanding search.

We evaluated people.

One of the problems you have in the retail community today is the conflict.

We sell a lot of product that other people sell; and our Board has taken a very conservative stance with regards to that -- and correctly so -- potential conflict of interest.

We're very pleased with his addition.

We are, though, always on the lookout for a director with retail background.

We think that that could be a help here at the Company.

Thank you very much.

Patrick McKeever, Avondale Partners.

I just have a question on guidance.

I guess I understand why you might choose to withdraw your guidance, given some of the issues that you talked about in the press release and that affected the second quarter, including the inventory issue.

But you already had not been providing as much guidance as some others out in retail.

You haven't been providing sales guidance, or you have not done that in some time.

There hasn't been a lot on the margin side in the way of concrete margin guidance and that kind of thing.

So my question is, how can we as analysts and investors, or how should we measure your progress as we move forward, especially as it relates to some of these issues that affected the quarter so significantly?

Patrick, this is Purdue.

I think when you consider the things that we are evaluating right now, we just don't feel comfortable commenting on any guidance really at this point in time regarding the second half, until we get a better handle on what the Board and we are going to do regarding these two issues that we have [vote].

So I know it's an uncomfortable period of time.

We're rushing as fast as we can to get this analysis done.

We will, as soon as we get a good number that we are comfortable with and an agreement with the Board on strategy, we will be right back to you.

I know it's an uncomfortable time right now.

I think in perspective, since '03 we have become more and more forthcoming in relative terms.

I understand that we may not do everything that some people do.

We do more than some others do.

But we are trying to become a little more transparent as we go forward and understand this business better and better.

I think also if you look at the history of the Company giving guidance -- and again this probably doesn't help your initial question,.

But the previous CFO would give yearly net income guidance only; and then we started going to quarterly guidance, quarterly earnings per share guidance.

So the Company, as David said, in the past probably gave even less guidance than we have been giving currently.

Sure, sure.

Fair enough.

Then my other question is just, David Perdue, on the general comments that you made about the consumer, the health of your consumer, really, and how you had not seen a material change in spending habits.

My question is, we have actually seen, it seems anyway, some acceleration in sales really across the deep discount store space, across the dollar store space, over the past few months.

So there I guess what you are saying is it's more on the mix side, that (multiple speakers).

Patrick, I would take issue with that.

I think if you look at the deep discount side, in the United States anyway, over the last few months, you really have to go back and look at a two-year basis to make that decision.

We have got the graphs.

I have got the charts.

I don't think that I see a material improvement, although in our business we certainly have rebounded from the back half of last year.

Some of our competitors have some great initiatives out there that are driving comp sales a little more than normal, such as coolers and so forth that we did a few years ago.

So I know they're getting some benefit there short-term.

However, I am not sure I can interpret that either on their side or my side relative to comp store performance or discretionary spending.

The other is when I look at the performance of departments that are basically discretionary, in our business and from what I can see outside there is a very mixed bag.

It is not consistent.

While I do think there is some rationalization that is going on vis-a-vis higher fuel prices, and there has actually in the last few days been a little bit of a reprieve it seems, in my mind it is just a little early to say that that is going to mean anything.

Now on the other hand, there probably is some pent-up demand building in the lower-income sector, frankly.

Any kind of relief, either new jobs, which are improving a little bit, or fuel prices, which are improving close in, if those two trends were to continue then we might see some positive movements in this lower-income sector.

But right now, the performance in the lower-income sector over the last six months frankly is a mixed bag in the entire sector.

You have to look at where people were last year when you talk about the improvement this year.

I am just trying to put a little flavor on that, Patrick.

Sure.

I mean I understand that some companies have some particularly easy comparisons.

Companies within the space have some particularly easy comparisons with last year.

But it just seems that there has been more broad-based maybe improvement.

I think I see it even looking at things on a two-year basis, but --.

Yes, I think I wouldn't disagree with that.

I just want to be very careful.

As we go into a holiday season looking at our business and so forth, this discretionary income issue and the traffic issue --.

If our traffic pattern and others had come back, and people were talking about traffic as now more akin to where it was in '03, before we saw the beginning of this fuel price spiral that we are in, I would be a little more bullish.

But I will say, I think there is -- obviously when we see our comp sales moving a little bit now, we are encouraged -- let me just say that -- that we are reconnecting in a way that is being positively received, even in a tough environment.

So I think I see some of the same things you're seeing.

Maybe we would differ in degree, that's all.

Okay, thanks, David.

I was just going to say, operator, we will take one more question.

We are actually past our close time.

But we will take one last question.

Deborah Weinswig with Citigroup.

Two questions.

One David, you had talked about what you are doing with the private-label programs, that there will be more resources dedicated to building that.

Can you go into a little bit more detail on what specifically you're doing there?

Yes, we have hired people from bigger box backgrounds that have specific private-label backgrounds and experience.

We have built our sourcing capability in Asia now to where we can do that.

We have talked to a couple of outside people about how they can help us integrate this.

What I want to do is brand the space.

Nobody has really done that in this sector.

Market research confirms that and so forth.

We think private-label is one way, along with a good communication, coordinated communication plan, that we can do that.

This sector has really been loath to do that all the years, because frankly various companies approached a little differently.

The profit model was a little different.

But that day has come.

I think that differentiation is going to be required in this space.

Private-label in coordination with that kind of communication is a great way to drive that home.

There's some good people out there to learn from.

I really like what Trader Joe's does in their high-end private-label.

We can't do that.

But there are places where -- if you consider about 17% of our offering is private-label, that is really low for somebody in the deep discount sector.

So we know we have got an upside potential there.

Also, our branded space is only 33% roughly last year.

We think that that has some room for improvement, although we want to be very careful from a margin point of view.

But that balance can be brought in line, and that is what we're working towards.

Specifically, we're looking now at prioritizing the specific departments that we want to go after first.

We're looking at labeling alternatives to coordinate that across the store.

Frankly, we are putting timetables together on that.

So you will hear more and more about that as we evolve this.

But this is part of the merchandising strategy change that is coming, that we're beginning to work on now under Beryl Buley's leadership and some of the other people that we have brought in.

That is the next big area that, as we mentioned three years ago on our strategic planning process, that we hope to focus on.

So private-label will be a very, very big part of that.

Okay.

Then probably a good way to end the call, it sounds like there are a lot of initiatives that you're focused on right now.

Where do you think that Dollar General has the biggest opportunity?

I think a couple things.

One, the balance of our mix, if we get home, seasonal, apparel moving in the right way.

And by the way, seasonal is very encouraging.

It is double-digit comps year-to-date.

Although its margin is down a little bit, that is primarily in one department.

We know that pet, hardware, automotive, those departments have big potential for us, we believe.

We also believe that there is a need for apparel in our model; we just need to do it better.

The second thing is, I really believe this private-label issue from a margin point of view is the second big idea.

Then thirdly, frankly, is our sourcing.

We are very underleveraged in those two areas.

So those are the three big callouts that I would give you right now.

By the way, if you look at those, those are all margin related.

Great.

Thank you so much, and best of luck.

Thanks, guys.

Good morning.

Thank you, everybody.

Thank you, ladies and gentlemen, the call has now concluded.

You may now disconnect.