達樂 (DG) 2010 Q2 法說會逐字稿

Ladies and gentlemen, this is the Dollar General Corporation second quarter 2010 conference call on Tuesday, August 31st, 2010 at 9 Central Time.

Good morning and thank you for participating in today's call.

This call is being recorded by conference America.

No other recordings or rebroadcast of this session are allowed without the Company's permission.

It is now my pleasure to turn the call over to Ms.

Mary Winn Gordon, Dollar General's Vice President of Investor Relations and Public Relations.

Ms.

Gordon, you may begin.

Thank you, Brandon.

Good morning everyone.

On the call today are Rick Dreiling, our Chairman and Chief Executive Officer, and David Tehle, our Chief Financial Officer.

We will go first through our prepared remarks, and then we'll open up the call for questions.

Before we begin, I will provide some cautionary comments regarding our forward-looking statements and non-GAAP disclosures.

Today's comments will include forward-looking statements such as those about our expectations, plans, strategies, objectives and anticipated financial and operating results including, but not limited to, our comments regarding our forecasted 2010 financial performance, planned operating initiatives, store growth and capital expenditures as well as our expectations with regards to consumer trends, anticipated private brand expansion, and foreign sourcing opportunities.

You can identify forward-looking statements because they do not pertain solely to historical matters, or they contain words such as believe, anticipate, project, plan, expect, forecast, intend, will likely result, or will continue, and similar statements.

Because such statements are subject to significant risk and uncertainties, we cannot assure you that they will prove to be correct or that any trends will continue.

Important factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in our 2009 10-K filed on March 31st, 2010, and our second quarter earnings release issued this morning, and in the comments that will be made on this call.

We caution against undue reliance on these statements which speak only as of today's date.

Dollar General disclaims any obligation to update or revise any information discussed in this call.

In addition, we will reference certain financial measures not derived in accordance with GAAP.

Reconciliations of these measures to the most comparable GAAP measures are included in this morning's earnings press release which can be found on our website at DollarGeneral.com, under investor information press releases.

You should not consider any of this information as a substitute for the most comparable GAAP measure.

Because not all companies use identical calculations, these presentations may not be comparable to other similarly titled measures of other companies.

It is now my pleasure to turn the call over to Rick.

Thank you, Mary Winn, and good morning and thank you all for joining us today.

I must say, we are very pleased with our second quarter and year-to-date results.

We had yet another great quarter of superior operating results, generating strong same store sales growth, gross margin expansion, SG&A leverage, and profitability.

This strong performance comes during a time when the macroeconomic environment remained very uncertain.

Consumers continued to experience significant challenges and the value messages from all retailers were highly promotional.

This has been one of the toughest competitive environments I can remember.

Dollar General remains very well-positioned to deliver value for our customers and they continue to recognize and reward our efforts.

In the quarter, we were responsive to the ever-changing competitive environment, while remaining true to our EDLP discipline.

We avoided sweeping reactionary moves, and instead only made changes that were strategic and sensible.

That approach paid off for us in the form of productive sales without unnecessary margin sacrifice.

I believe we are well-positioned to continue executing in this manner as we enter the second half of the year.

As a result, we have raised our full year financial outlook to reflect adjusted earnings per share growth of 28% to 33%.

David will provide more details on our financial results in a moment.

But I wanted to share a few highlights of the second quarter with you.

Our total sales increased 10.8%.

Same store sales increased 5.1% on top of an 8.6% increase in 2009's second quarter.

We actually saw same store sales accelerate during the last month of the quarter, and we are encouraged by the third quarter sales to date.

Gross margin expanded by 101 basis points to 32.2% of sales.

We leveraged SG&A by 32 basis points.

Our operating profit increased by 29% to $301 million, or 9.4% of sales, and adjusted net income increased by 55% to $145 million or $0.42 per share.

In line with our accelerated growth strategy, we opened 160 stores in the quarter, for a total of 315 new stores year-to-date.

This brings our store count to 9,113, with nearly 1,000 stores now in our new customer-centric format.

Our store count is up 6.2%, and our square footage is up 7.4% from a year ago.

Additionally, while the overall economic situation continues to pressure consumers, once again, we saw increases in both customer traffic and average ticket in the quarter, reflecting our customers' recognition of the superior value and convenience our stores offer.

As you can see, by any measure, we had an excellent second quarter.

During the quarter, our strong sales results were driven primarily by consumables, although several of our seasonal categories including spring and summer merchandise and toys continued the strength we saw in the first quarter.

The quest for value is extending beyond basic consumable needs to more discretionary purchases, and we believe our value proposition, which has been enhanced by our improved merchandise selection, quality, packaging and store level execution is appealing to customers in nearly all economic levels.

In addition to seasonal items and toys, we have also started to see an uptick in other non-consumables as we roll out new merchandise and improve our offerings.

Recent results in domestics, housewares and stationery have been strong as well as our back-to-school performance.

We continue to focus on four key operating priorities, including driving productive sales growth, increasing gross margin, leveraging process improvements and information technology to reduce costs and finally, strengthening and expanding Dollar General's culture of serving others.

Our first priority is driving productive sales growth and we're making great progress in this area.

Sales per square foot reached $199, an increase of about 6% over the prior year.

Over the past two years, we have been improving the utilization of our store space by raising our shelf heights.

Phase three of four began to roll out in the first quarter of this year and focuses on health, beauty, apparel and home.

In addition, we have made the decision to accelerate phase four, which includes the conversion of our seasonal merchandise into 78 inch profile.

We have already begun this transition.

As part of the phase three 78 inch profile expansion, we are adding shelf space to further expand the Rexall brand, bringing upon our successful launch of Rexall vitamins last year and leveraging the equity of this well-known brand which was first introduced in 1903.

In September, we'll be launching about 60 new Rexall products in key categories including cold, cough, medicine and first aid.

In the fourth quarter, more than 100 additional products will be converting to the Rexall brand, including the 60 Rexall vitamin SKUs already up and running, there should be about 220 Rexall products available in your Dollar General store by the end of 2010.

And we plan to further leverage the brand in 2011 as we introduce more new Rexall products that will include additional items in cough and cold, and first aid, with planned expansion into foot care, skincare, and dental.

Across our non-consumable categories, we made great progress in transforming our product offering.

We've expanded our new True Living brand across home decor including kitchen and bath, as well as our True Living Outdoors brand and True Living Kids, our outdoor toy line.

We have also relaunched our exclusive Bobbie Brooks apparel for women in time for the fall season.

Bobbie Brooks is a brand that has loyalty and credibility with our target audience.

This relaunch is a revival of the brand's cache and repositioning of Dollar General's outlook on style, proving that basic apparel can be current and fashionable.

All pieces in the line are under $16, allowing women to create an entire fall wardrobe from work to weekend on a budget.

The styles are classic, easy to mix and match, and are on-trend.

As part of the line, the signature piece is a five pocket stretch denim jean, which starts at only $12.

We believe the trend-right styling, value and quality offering of this line will appeal widely to our female customers.

In order to engage our employees and connect with our customers we conducted a model search among our employees for the faces of Bobbie Brooks.

From more than 600 applications, we chose winners based on their portrayal of the brand message.

We wanted women who were confident, and also had inspiring life stories like many of our employees and customers.

Our employee models are featured in the look book that we have released for the fall.

All very exciting, and a first for the dollar store segment.

You can see more about Bobbie Brooks on our website.

In addition to same store sales growth, we've accelerated new store growth as planned, opening 315 new stores year-to-date, and relocating or remodeling an additional 301 stores, using our new customer-centric format.

We've been very pleased with the sales and performance of these stores.

Our second priority is to increase our gross margins.

We expect a gross margin benefit for the year from the ongoing transformation of our private brand products as well as additional efficiencies in sourcing.

We continued to expand and port receipts in key areas such as toys, domestics, home decor, housewares, stationery and pet supplies.

As I noted, we also continued to benefit from the upgraded quality, value, pricing and redesigned packaging of our private brand.

Our third priority is to leverage process improvement and information technology to reduce cost.

We remain focused on mining the organization for cost reductions that are transparent to our customers.

A few examples of our cost saving initiatives include continuing the expansion of energy management systems to control energy usage in the stores.

Increasing preventative maintenance, driving efficiencies in our stores through increased leverage of the back office computers we have installed over the last two years, and improving our processes to facilitate easier and more efficient stocking in our stores.

We are seeing efficiencies across the board as we drive our bottom line growth.

Our final priority is our commitment to strengthening and expanding our culture of serving others, including our employees and the communities we serve.

We recently initiated a talent development center for our store managers to develop and cultivate internal candidates for our district manager positions.

We will soon be expanding this program through the district managers, as a source of talent for promotion to our regional directors.

I'm very excited about the long-term impact of this program in strengthening the Dollar General team from within the organization.

In summary, we've made great progress in the first half of 2010, and I believe we are well-positioned as we enter the second half of the year.

Our customers are shopping with us more often and spending more with each trip.

Our initiatives are paying off.

At the same time, we recognize that uncertainties remain in the market.

The economy in particular, the combined rate of unemployment and underemployment, which stands at about 18%, still has our customers carefully spending their dollars.

The competitive environment was extremely focused on the value message to the customer during the second quarter, and the market remains highly competitive as it always is in tough economies.

We will closely monitor how our customers respond over the coming months, to both the economic and competitive climates, as we continue to focus on our four operating priorities and controlling what we can control.

I am convinced that Dollar General has the right model and we have the right plans in place to serve our customers and to be successful in this environment.

Finally, I'm extremely pleased with the execution of the entire Dollar General team during the quarter.

Now, David will walk you through the details of our financial results, and provide additional information on our outlook for the rest of the year.

Thank you, Rick, and good morning everyone.

I am pleased to say we developed a strong operating plan at the beginning of the year, and we have executed that plan well through the first half of the year.

As Rick said, we had a very strong second quarter.

Our management team, merchants, and field operations team deserve a great deal of credit for recognizing and acting upon the needs of our customers as they continue to face difficult and uncertain economic times.

Turning to the results for the quarter.

Sales for the second quarter were $3.21 billion, up $312 million, or 10.8% from the second quarter of last year.

Same store sales increased 5.1% on top of an 8.6% increase in the 2009 period.

Both customer traffic and average ticket continued to increase, and as Rick said, we saw same store sales accelerate in July.

Our gross profit rate was 32.2%, an increase of 101 basis points over the 2009 second quarter, mainly due to higher average markups.

Higher markups are primarily the result of our success in reducing overall product costs including benefits derived from increased volume as well as the outcome of our significantly improved category management processes.

An increase in our private brand assortment continues to contribute to our ability to achieve higher markups.

Improved markups were partially offset by increased markdowns and some extent elevated transportation cost, primarily caused by higher diesel fuel costs.

Diesel averaged $2.99 per gallon in the 2010 quarter versus $2.45 in the 2009 quarter.

That's a 22% increase.

SG&A as a percentage of sales was 22.9%, a decrease of 32 basis points from 23.2% in the 2009 second quarter, due primarily to our strong sales performance.

In addition to expense leverage, both the estimate in the quarter for incentive compensation and our adjustment for asset impairments were down from last year, and we continue to realize savings from our recycling efforts.

Fees related to increased usage of debit cards, partially offset these SG&A reductions.

Operating profit was $301 million, up $68 million, or 29% from the 2009 second quarter.

As a percentage of sales, our operating margin rate was 9.4%, up from 8% last year.

Given the challenging economic environment, and the strong performance we're up against from last year, we're very pleased with this improvement, and our ability to drive both gross margin and expense leverage, even as we accelerate our investment in new store development.

Interest expense was $69 million for the quarter, a reduction of $21 million from last year's second quarter, primarily due to our debt repurchases.

Total debt at the end of Q2 was down $785 million or 19% from a year ago.

During the second quarter, we repurchased $50 million of our senior notes with excess cash on hand resulting in a charge of $6.5 million primarily related to the premium paid to repurchase the notes.

This charge is included in other nonoperating income.

Net of tax, the impact of the buyback reduced earnings per share by about a $0.01.

Net income for the quarter was $141 million or $0.41 per share, excluding the loss on debt repurchases, net income was $145 million, an increase of 55% from the 2009 second quarter.

Adjusted per share of $0.42 reflects an increase of 45% over last year.

You can find more details of our year-to-date performance in our press release, but I'll review a few of the highlights.

For the 26 week year-to-date period, net sales were $6.33 billion, up $644 million, or 11.3% from last year, including a same store sales increase of 5.9%.

Year-to-date gross profit grew by 16% to $2.04 billion or 32.2% of sales, an increase of 118 basis points over the 2009 year-to-date period.

This was primarily due to our ability to deliver higher average markups.

Operating profit was $591 million, up $133 million or 29%.

Excluding $15 million of expenses in the first quarter, related to our secondary offering, operating profit increased 32% to $607 million, or 9.6% of sales compared to 8.1% of sales in 2009.

Interest expense was $141 million for the year-to-date period, a reduction of $38 million from last year.

Our effective tax rate was 37.5% for the 26 week period, compared to 36.9% in the 2009 period.

The increase in the tax rate is due principally to a smaller adjustment in 2010 of a differed tax valuation allowance, associated with state income taxes compared to the 2009 period.

Turning to our cash flow.

Year-to-date we generated $275 million of cash from operating activities, up $31 million even after investing more heavily in merchandise inventories to support our new stores, strategic initiatives, and higher sales levels.

Capital expenditures totaled $163 million for the 2010 period, compared to $107 million in the 2009 period, with the increase primarily relating to the higher number of new stores, remodels and relocations.

Moving to the balance sheet.

As of July 30th, total inventories at cost were $1.74 billion, up 12% in total, or 5% on a per store basis.

We have increased our inventory levels to support store growth, new merchandising initiatives, and our increased overall sales volumes.

Inventory turns improved to 5.2 times from 5.1 times a year ago.

Total outstanding debt at the end of the quarter was $3.35 billion.

As I mentioned, we have repurchased a significant amount of debt over the past year, resulting in a year-over-year decrease of $785 million.

Net of cash, our ratio of long-term obligation to adjusted EBITDA was 2.2 times at the end of the second quarter, compared to 3.3 times a year ago.

Adjusted EBITDA for the last 12 months increased by 28% from the comparable year-ago period to $1.42 billion.

In summary, we've had a great first half of the year, exceeding our expectations.

So far we've done remarkably well at anticipating and fulfilling our customers' demands and successfully introducing new, appealing items.

Given our successes to date, we are updating our full year guidance to reflect our first half performance.

While we remain cautiously optimistic about the remainder of the year.

We believe that consumers will remain cautious with their discretionary dollars even if the economy begins to improve, and sadly, we're not optimistic about a near term recovery.

That being said, we now expect to deliver adjusted earnings per share growth of 28 to 33%, or adjusted diluted earnings per share of $1.68 to $1.74.

This compares to our previous expectation for adjusted diluted earnings per share growth of 24 to 29%, or adjusted diluted earnings per share amounts of $1.62 to $1.69.

Both estimates assume about 345 million weighted average diluted shares outstanding for the year.

We expect total sales for 2010 to increase 8.5% to 10.5% over last year, which is also an increase from previous guidance.

This includes a 4% to 6% increase in same store sales for the year.

Adjusted operating profit growth is forecasted to increase 20 to 23%, and we expect our full year tax rate to be approximately 38%.

For the year, we continue to expect to open 600 new stores and to remodel or relocate a total of approximately 500 stores.

We now expect capital expenditures for the year to be approximately $350 million.

We expect the economy to continue to be challenging for consumers as we move forward, but at the same time we are confident in our ability to execute our plan for the rest of the year.

In closing, we have had a great first half of the year.

We delivered strong financial performance in a volatile environment.

We have an excellent retail management team in place that has made strategic decisions that are driving productive sales growth, and finally, Dollar General is well-positioned for future growth.

With that, I'd like to go ahead and open the call for questions.

(Operator Instructions).

Our first question will come from Joseph Parkhill of Morgan Stanley.

Please go ahead.

Hi, good morning.

I was wondering if you could give us a little bit more color behind accelerating the time line on phase four, when you expect that to hit stores and your decision behind accelerating that phase.

Great question, Joe.

The reason we accelerated it, we're so bullish on the holiday offering that we have, we wanted to put ourselves in a position where we could expose the maximum amount of that product to the customer, and the easiest way of doing that was accelerating the roll-out of the 78-inch profile.

We'll have it done as we enter into the fourth quarter and again, the idea is we'll be able to put more of our quality product out on display.

And did that impact the inventory levels for the end of 2Q?

Yes.

I mean, our inventory levels are due to a couple things.

Number one, we have the roll-out now of our Bobbie Brooks line and our other non-consumable merchandise which has a higher average retail ticket.

You know, I'm sure you're well aware of the pressure that was on ocean freight and we elected to get some merchandise in here early to avoid being short on the product and then of course now you're starting to see the seasonal merchandise start to roll in also.

Okay.

Great.

Just quickly, on the second quarter comp.

Can you talk a little bit more about what drove the variability throughout the quarter, was it more ticket or traffic?

Also, if you could just talk a little bit more about competitive pressures.

Was that consistent throughout or did you see a change there at all?

Yes, I think as I look back on the second quarter, there's no doubt that around the Memorial Day holiday through the course of June, there was a tremendous amount of competitive pressure from all different channels, all different retailers.

And Joe, the interesting thing about extremely competitive pricing is it usually doesn't last very long and we stayed true to our EDLP plan, our strategy, and we only made price changes that we thought were really necessary.

So I think if I was you, thinking in terms of the quarter and the three periods, I think in terms of a horseshoe.

However, we never really got out of our guidance range.

Okay.

Great.

Thank you.

Operator, we'll take the next question.

Thank you.

Our next question will come from Scot Ciccarelli of RBC Capital Markets.

Please go ahead.

Good morning, Scot.

Good morning.

This is actually Austin sitting in for Scott today.

With respect to your gross margins, you called out your improved sourcing capabilities as one of the factors that drove that this quarter.

Could you also talk about any effect of your private label initiative on margins during the quarter?

Yes, I'll take that.

This is David.

If we look at the private brand, private brand came in at 21.7% of sales versus 20.9% when we look at the consumable sales.

That's a 17% increase over last year for a comparable quarter.

We've added 140 new items here year-to-date and we continue to be very proud of our private brand program and the improvement that we've had and again, just to refresh your memory, it has a much higher margin than the branded product and it continues to, again, contribute to the overall gross margin percentage.

Great.

Thanks very much.

Operator, next question?

Thank you.

Our next question will come from Meredith Adler of Barclays Capital.

Please go ahead.

Good morning, Meredith.

Good morning.

Thanks very much.

I guess a couple of questions.

I'd like to start by just talking a little bit about what you're doing with the more discretionary items.

Obviously, Bobbie Brooks is going to get a very healthy merchandising push.

But do you have any concern that because the economy is still so weak, that maybe you need to pull back a little bit on some of your discretionary plans?

That's a great question, Meredith.

This strategy has been in the making for about a year and-a-half.

And I guess my answer to you would be it's too late to pull back.

You already have the product.

The product's on the water or it's here.

That's number one.

Number two, though, I would characterize what we've done as very thoughtful.

When you think about particularly the Bobbie Brooks line, while it's trend relevant, it's still very much basic stuff.

It's items that we believe the customer has to come and get on a day in and day out basis.

We also believe it's very important as we reposition the Company that we're able to make a statement on that side of the aisle.

The exciting thing for me, and while I'm comfortable doing this is the quality of the inventory that's in the chain is so strong, we feel that we have enough room here to navigate our way through this if that's what it takes.

So you're not particularly worried about excessive markdowns?

I am not.

Okay.

And then I had another question, maybe, you talked a little bit about the competitive environment in the second quarter.

Can you comment at all about what you're seeing right now?

I mean, we were just listening to a supermarket talk about it still being extremely competitive in their world but -- and their geography, but maybe you could talk about what you're seeing.

I would look at you and say the environment is still exceptionally competitive.

However, it's not at the level it was in the Memorial Day, June time frame.

It's interesting, when you go out there and look across the different channels how -- I was actually commenting to the merchants the other day, it's almost like even a gas station has a price on toilet tissue now, right.

There's a lot of cannibalization going on in a lot of fronts as people are trying to drive sales.

And then my final question would be about square footage growth.

It looks like you have achieved more in the past 12 months.

I think we were thinking about more like 5 to 6 and you were over 7.

Should we anticipate that you will stay at the higher pace?

I know there's a lot of real estate opportunities out there for you.

Or was that just timing?

It's more timing, Meredith.

I think for the year it will be that 6%-plus we talked about previously.

The 7 -- 7% was more of a timing issue for this time for this quarter.

Okay.

And sorry, squeeze in one more question.

You talk about the private label having a much higher gross margin percent.

Are you also getting higher penny profit on the private label items?

Significantly higher, yes.

Great.

Thank you very much.

Operator, next question.

Thank you.

Our next question will come from Charles Grom of JPMorgan.

Please go ahead.

Good morning, Chuck.

Good morning.

Just a question, a couple questions on, first is on sales.

If you look at the year-over-year growth in some of the categories that are more discretionary, still good on a one year basis, a little bit of a slowdown on a two-year basis.

Just wondering if you could talk about the cadence of those categories during the quarter.

Did they still have that -- the trend that you spoke to earlier?

Yes, we actually -- the non-consumables followed the consumables in that we saw some acceleration toward the back half of the quarter and we attribute that, Chuck, to the new products finally starting to get into the stores.

Okay.

And then David, maybe you could kind of walk through or quantify, get a little bit more granular with us in terms of the benefits from the net markups and how much of a drag the markdowns were in the higher transportation costs.

As a follow-up to that, if you could give us a little bit of visibility into the back half in terms of your guidance for operating margin growth of 20 to 23, can you speak to the split between GPM and SG&A?

Yes, let me tell you what I can tell you there, Chuck, in terms of -- we'll start with the current quarter and what drove the gross margin percentage.

As we mentioned it was the higher markups more than anything else and that means the reduced overall product costs we had from the partnership that we had with all of our key vendors who had been increasing their volume with us, so we've had the volume increases.

Also due to category management, the things that Todd Vasos and his team are doing in the whole category management area within the store and then the private brand results that we talked about.

I already mentioned the growth figures that we've seen in private brand.

On the markdowns, I would categorize it more at tempered price promotions, in terms of what we saw.

As I mentioned, we tried to stay true to our EDLP philosophy.

Certainly we had some markdowns, but they were tempered in nature.

As we move forward, again, we're not giving specific guidance in terms of the breakout between the gross margin and the SG&A, but you know, in terms of our operating profit, we do see a 20 to 23% increase for the full year in the operating profit growth, and certainly, if you look at our initiatives that we've talked about, our private brand, our distribution, transportation and our sourcing, the benefit of those would hit the gross margin line.

Okay.

Then one follow-up, if I could.

Looks like you got about 30 bips of leverage on the five comp.

If we assume your hurdle rates about 2.5 to 3%, that's about 15 bips of leverage for every comp point above that hurdle.

Is that a good benchmark to use going forward for you guys?

I think what we talked about is that at about a 3 comp is where we see ourselves leveraging the expenses.

So I think you're in the ballpark there.

Okay.

Great.

And then sorry, one more, if I could.

On interest expense for the back half of the year, do you guys -- do you expect like a $69 million number for the third and fourth quarter?

Is that reasonable?

We're not giving specific guidance on interest expense, Chuck.

Okay.

Great.

Thanks.

Thanks, Chuck.

Operator, we'll move to the next question, please.

Sure.

Our next question will come from John Zolidis of Buckingham Research.

Please go ahead.

Good morning, John.

Good morning.

Three quick questions.

The first one is kind of a housekeeping on D&A.

I saw that it declined sequentially and year-over-year.

Was wondering if you could talk to why that's declining and what we should expect for the full year?

And the second question is about one of your competitors opening up their stores for longer hours.

Have you seen any impact on your business from that competitive action?

And then lastly, third question, on the Rexall brand, you mentioned you're adding a number of SKUs there.

Are you taking branded products out to put the Rexall in, or are you just adding SKUs overall to your mix?

Thank you.

Yes, the D&A is impacted by the purchase accounting that was done when we went private with KKR, and there's an amortization that gets smaller every year there so you're seeing an impact of that getting smaller this year.

John, I'll take the other two.

The extended hours,the competition goes and comes on hours regardless of who they are.

They extend them.

They shorten them.

I think the important things for us, when you look back on our program, we continue to comp on the hours that we have extended in the past.

In regards to the Rexall brand, the strategy on the Rexall brand is that it is kind of a hybrid between a national brand and a private brand and it will be positioned in the stores between private brands and national brands.

Okay.

So did you take any other items out to replace them with Rexall?

We did not wholesale discontinue any national brand items.

You also have to remember, we have the 78-inch profile that's allowing us to gain extra space in the store.

Great, thank you.

Good luck.

Thank you.

Operator, next question, please.

Next question will come from Bernard Sosnick of Gilford Securities.

Please go ahead.

Good morning.

Good morning.

With respect to the horseshoe effect that you mentioned, is one end of the horseshoe a little bit higher than the other?

It is.

Which end?

I would assume you could probably figure that out.

Okay.

Thank you very much.

You're welcome.

Operator, next question, please.

Thank you.

Our next question will come from Carla Casella of JPMorgan.

Good morning, Carla.

Hi.

One question about the bonds.

Which bonds did you repurchase in the quarter?

And then second question's on free cash flow.

What's your priority for free cash flow?

Yes, the $50 million purchase was the senior bonds.

In the quarter we bought them back I think at like 111.

Our focus on cash flow continues to be the same as it has been in the past.

Invest in the business, making sure that we have investment in inventory to drive our productive sales, investing in the capital expenditures of the business, again, as we build new stores, as we do our remodels, our relocations, as well as some other projects that have returns that we will do investments for in the business and then the secondary priority will be of course retiring debt, and as you know we retired over $700 million of debt from where we were last year at this time, and then in the current quarter of course we had the $50 million reduction from the buyback of the senior notes.

Okay.

Then one business question to follow up and that's it.

If you look at carbonated beverages, can you just talk about where you stand in terms of your positioning there, branded versus private label, and thoughts of whether that category should be branded or private?

We've reintroduced Clover Valley into our carbonated beverage set, and it's a national brand equivalent.

We had some quality problems with the product a couple years ago.

And our position on the carbonated beverage section is exactly like it is with the rest of the store.

We proudly sell national brands and we proudly sell private brands, and we're going to let the customer make that decision, and what we are confident in is the quality of the product and the retail pricing that it has.

Operator, next question, please.

Thank you.

Our next question will come from Matt Nemer of Wells Fargo Securities.

Please go ahead.

Good morning, Matt.

Good morning everyone.

My first question is on the accelerated phase four shelf space expansion.

Could you talk about the incremental shelf space and gross margin dollar potential versus earlier phases.

Let me say it this way to you.

The gross margin obviously, we're dealing with seasonal merchandise.

There would be an argument that the margin per foot is going to be higher with this particular phase.

I don't know if that answers your question or not.

It does.

Thank you.

Then secondly, on the comp acceleration towards the end of the quarter and I guess into the current quarter, what was the trend last year?

Is that an acceleration on a two-year basis or is there anything that would cause it to soften up last year during that same period?

When you're thinking about comps right now, I have to say it's very volatile out there right now.

When I think about where we are right now and where we're going to be at the end of the year, I'm very, very comfortable that we have the right things in place.

We have a holiday strategy for the third consecutive year that's better than the year before.

All I would tell you is we're comfortable with what we're saying.

Then lastly, is it possible to provide a little bit of color on the impact to gross margin from the unplanned markdowns due to the competitive environment that you mentioned?

We're an EDLP operator.

We're staying true to that.

And there's always going to be a skirmish out there where you're going to have to invest.

So we're very comfortable with where the margin came out for the quarter.

Okay.

Great.

Thanks.

Thanks a lot.

Thank you.

Our next question will come from Anthony Chukumba of BB&T Capital.

Please go ahead.

Good morning.

Good morning.

Just had two quick questions.

One is on the roll-out of the customer-centric stores.

I'm assuming it's safe to assume they have higher sales per square foot than your older stores, but I was wondering if you could quantify that at all.

And I just wanted to get any update you could provide on rolling out alcohol to your stores in terms of number of stores, and any early read on that.

Thank you.

Yes, in terms of the customer-centric store, they are performing better than we have historically seen with our old remodels and relos, and I'd kind of like to leave it at that if I could.

In regards to alcohol, we currently have 618 stores that are done.

And this is something that's a very methodical roll-out for us.

We're pleased with the results.

We're pleased with what it's doing with the basket in particular.

And we'll roll through this in another year and we'll give you an update as we move through the rest of the year.

Operator, we'll take the next question, please.

Thank you.

Our next question will come from Colin McGranahan from Sanford Bernstein.

Please go ahead.

Good morning.

Hi, it's Avery filling in for Colin.

I was curious whether you could provide an update on new store productivity and any insight on the productivity of your new, more urban stores, versus your new rural locations?

Our new stores are operating at 90% of our average store volume, which quite frankly continues to please us to no end.

And in regards to the urban stores, again, we continue to be very pleased with what we're getting there.

We're very pleased in the urban stores with the initial size of the sales volume.

Wonderful.

And then on a separate note, the environment clearly is highly promotional.

There's also potential for continued benefit from tradedown.

Have you run any studies to see how much benefit you're gaining in that arena?

Yes, that's an excellent question.

We just completed our yearly market research and the environment, I'll give you two comments on it.

The environment number one is creating more of our basic customer.

There is more of that customer today than there was a year ago, and we're also continuing to see customers who are acknowledging that they're trading down and for the second year in a row, we're getting acknowledgement that they continue -- again, now this is what they're saying, but we're getting acknowledgement that they're recognizing the changes in Dollar General and they intend to stay even if the environment improves.

Great.

Thanks so much.

You're welcome.

Operator we'll take the next question.

Our next question will come from Alan Rifkin from Banc of America.

Please go ahead.

Good morning, Alan.

This is actually [Curtis] filling in for Alan.

How are you guys doing?

Good.

Great.

Just a couple quick housekeeping items and then more of a general question.

But first, I was just wondering if you guys are maintaining your guidance for 1500 new customer-centric stores for the year?

Yes, that's still good.

Okay.

Great.

Great.

And then in terms of your CapEx, you guys narrowed it to $350 million from $325 million to $350 million.

And I was just wondering what that's attributable to and are you guys still thinking I guess in terms of how you're going to split it, you know, with the same kind of guidance you gave from last quarter?

Yes, I think, again, we're -- it's at the high end of the range that we gave.

Last time we said $325 million to $350 million so it's basically just shoring it up a little bit, saying $350 million, and yes, it definitely is the same way as before with the bulk of it being the new stores and the remodels and the relocations in terms of where we're investing and then the investment in the existing stores would be the next highest item, particularly the 78-inch profile as well as other things we're doing in the stores, with fixturing, closed circuit TV, et cetera.

Great.

And then just one last question.

I know it's not a huge portion of your sales but did you guys see any noticeable or material changes in terms of food stamp usage during the quarter?

Yes, our food stamp usage continues to grow at about the same rate as the national average.

So yes, it's pretty consistent with what's it's been previously.

Great.

Thanks a lot, guys.

You're quite welcome.

Operator, we'll take the next question, please.

Sure.

(Operator Instructions).

Our next question will come from Deborah Weinswig of Citigroup.

Please go ahead.

Good morning, Deb.

This is actually Tina Hwang on behalf of Deb.

Thanks for taking my call.

Just two questions.

First, I was wondering if you could talk about what you're seeing with respect to product and freight cost for the back half of this year and next year, if possible?

Yes, I think clearly we had some issues in the quarter having to do with ocean freight, the transit times, the timing of our receipts and it was really a capacity issue.

There was a shortage of shipping capacity.

John Flanigan and his team have been working very closely with the ocean carriers and we actually saw some improvement towards the end of the quarter and we're seeing a little bit of a freeing up of capacity right now, overall.

So we believe as we move forward into the back half of the year, the ocean freight will be less of an issue than it was in the second quarter, because the capacity will be, again, opened up a little bit and, again, we've had some good discussions and working very closely with our key carriers on this.

Okay.

And on the cost side for the product?

Yes, I mean, right now it's a little soon to forecast that but I will tell you there's no doubt there's inflation in there, cotton's higher than it's been in the past, petroleum based packaging and things are higher but we continue to work with the manufacturers to try and negotiate those incremental costs out.

Great.

And then also during the second quarter you called out transportation costs increases as a headwind for gross margins.

We've heard a lot of other retailers talking about doing things to mitigate the increases there.

So was wondering if you could tell us what Dollar General's doing on this front.

Yes, we'll talk about the distribution side of it on the distribution transportation because we actually leveraged our distribution costs as a percentage of sales in the quarter and again, John Flanigan and his team have done a great job of implementing the new engineered labor standard that we talked about when we were on the road show.

We now have five DCs that are ramping up on the labor standards, and we're starting to see some preliminary positive results from that.

We have voice pick in all of our DCs and again, that's helping us, and then we have a lot of controls on our expenses that are helping us.

In particular, we've got a big effort on maintenance expenses and maintenance is showing some improvement.

Ultimately, we continue to focus on the queue, on the trucks, in reducing stem miles and again, we still feel like we have a lot of room in distribution and that's helping us offset what we saw in the transportation side of the business.

Thanks so much.

Operator, next question, please.

Thank you.

Our next question will come from Bret Jordan of Avondale Partners.

Please go ahead.

Good morning, Bret.

Good morning.

This is Anand in for Bret.

I just have two quick questions.

If you were to carve out from the full year CapEx guidance what part of that is going towards the accelerated phase four implementation?

For competitive reasons we don't break that out specifically.

But it's within our overall capital budget of $350 million.

Okay.

Fair enough.

And then can you just share any performance based metrics on how cosmetics is doing after the implementation of the L'Oreal products into the line?

We continue to be pleased with our new cosmetics set.

Okay.

Thanks.

Operator, I think we have one more question in the queue and that's it.

Yes, ma'am.

Our next question comes from Meredith Adler of Barclays Capital.

Please go ahead.

Hey, Meredith.

Hey.

Just a quick follow-up.

There was commentary about incentive compensation in the press release.

I think that it would be lower.

I thought that's what it said.

But maybe I was misunderstanding that.

Could you talk about a little bit?

That's correct.

If you compare it year-over-year, at this time last year the incentive compensation was being accrued at a higher rate vis-a-vis where we were versus the budget versus where we are, where we are this year.

But for overall incentive comp for the year, are you expecting it to be higher or lower?

Well, you know, that's hard to tell.

We're only halfway through the year.

But at this point the accrual rate that we have for it is lower than the accrual rate that we had last year at this time.

As you look at it as a percentage of sales.

It wasn't any catch-up in the second quarter last year?

No, not really.

Not really.

Okay.

Thank you very much.

All right.

Operator, I don't think we have any more questions at this point?

No, ma'am, that was the last question.

Okay.

Turn the conference back to you.

Thank you everyone for joining us.

I'm around all day if anyone has any questions for follow-up.

Please feel free to give me a call.

Thank you.

This concludes today's teleconference.

You may now disconnect your line.