Good morning. My name is Brandy and I will be your conference operator today. At this time, I would like to welcome everyone to the Dollar General Second Quarter 2014 Earnings Call. Today is Thursday, August 28, 2014. This call is being recorded.

Instructions for listening to the replay of the call are available in the company's earnings press release issued this morning. .

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

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

Let me caution you that today's comments will include forward-looking statements about our expectations, plans, predictions and other nonhistorical matters, such as our 2014 forecasted financial results and capital expenditures; our planned fiscal 2014 operating, merchandising and store growth initiatives; our share repurchase expectations; our beliefs regarding future consumer economic trends and various matters relating to our proposal to acquire Family Dollar.

Important factors that could cause actual results or events to differ materially from those reflected in or implied by our forward-looking statements are included in our earnings release issued this morning, our 2013 Form 10-K, which was filed on March 20, 2014 and in the comments that are made on this call. We encourage you to read these documents. .

You should not unduly rely on forward-looking statements, which speak only as of today's date. Dollar General disclaims any obligation to update or revise any information discussed in this call. .

We will also reference certain financial measures not derived in accordance with GAAP. Where available, reconciliations to the most comparable GAAP measures are included in this morning's earnings release, which, I have mentioned, is posted on dollargeneral.com. .

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

Thank you, Mary Winn. Good morning, everyone. This morning, we announced the results for the second quarter of fiscal 2014. David and I will discuss the highlights of the quarter, when I -- then I will briefly address the Family Dollar proposal. .

For the second quarter, total sales grew 7.5% to $4.72 billion. Comp sales increased 2.1% with increases in both traffic and average ticket, extending that trend to 26 consecutive quarters. Our second quarter same-store sales began very strong, with a year-over-year increase in May of more than 3.5%.

However, this growth moderated as we moved through June and July, given the competitive environment and the consumer who all -- who, although resilient in the face of economic uncertainty, remains cautious with their spending..

Tobacco and perishables continue to show the strongest sales gain and sales of candy and snacks, especially carbonated beverages, was also strong. Tobacco was continuing to comp positive even as we anniversary the rollout.

We're very pleased with the comp sales growth in our home and apparel categories as we continue to focus on making these departments more relevant to our customers. Our gross profit rate of 30.8% of sales was 53 basis points less than last year's second quarter..

As has been the case in the last few quarters, the competitive environment continued to be elevated during the second quarter. In response, we increased our promotional activities while maintaining our commitment to EDLP in the second quarter, resulting in higher promotional markdowns.

In addition, the higher mix of tobacco and perishables impacted our year-over-year gross margin compression..

Earnings per share increased 11% to $0.83 per share. On an adjusted basis, which excludes a legal settlement in 2013, earnings per share increased 8%. We remain on track to meet the full year adjusted earnings expectations we shared with you last quarter. .

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

Thank you, Rick, and good morning, everyone. In light of the competitive environment during much of the second quarter, we managed our gross margin well and we are especially pleased with our ability to control expenses in the quarter. Our gross profit increased 6% for the quarter.

As a percentage of sales, gross profit decreased by 53 basis points to 30.8%. As Rick mentioned, promotional markdowns were the most significant factor contributing to gross margin compression, in addition to the higher mix of lower-margin consumables, primarily tobacco and perishables. These factors were partially offset by higher initial markups..

The change in our year-over-year shrink rate and the LIFO adjustment were insignificant in the quarter. This is noteworthy as stabilizing our shrink performance is the first step towards ultimately improving the shrink results. .

SG&A expense was 21.7% of sales in the 2014 period compared to 21.9% in the 2013 period or 21.8%, excluding the $8.5 million legal settlement. Excluding the legal settlement from last year's SG&A, our SG&A rate improved slightly as a result of improved leverage on retail labor expense and a decrease in benefit costs.

Rent and advertising expenses increased at a higher rate than our increasing sales. Interest expense was up $2 million from the 2013 second quarter. We had higher borrowings related to our increased share repurchases.

The second quarter tax rate was 38.1% compared to last year's effective tax rate of 37.4%, with the increase relating to the expiration of various federal jobs tax credit program..

On a reported basis, our net income increased 2.4% to $251 million or $0.83 per share in the 2014 quarter from $245 million or $0.75 per share in the 2013 quarter. Excluding the $8.5 million legal settlement in the 2013 second quarter, adjusted income was up slightly. Earnings per share increased 11% on a GAAP basis and 8% on an adjusted basis..

Year-to-date, we generated cash from operations of $487 million.

Total capital expenditures were $191 million, including $66 million for improvements, upgrades, remodels and relocations of existing stores; $58 million related to new leased stores, primarily for leasehold improvements, fixtures and equipment; $27 million for distribution, transportation-related capital expenditures; $21 million for information system upgrades and technology-related projects; and $16 million for stores sold by the company..

Year-to-date, we have opened 426 new stores and relocated or remodeled 585 stores, including over 250 of the approximately 400 planned life cycle remodels. We continue to be pleased with the performance of our newly relocated and remodeled stores..

We did not repurchase shares in the second quarter. We have approximately $223 million remaining in the existing authorization. Since the inception of the share repurchase program in December 2011, we've repurchased approximately $2.3 billion or 44.5 million shares of our common stock.

Our share repurchase program is currently on hold as we await the outcome of our proposed transaction with Family Dollar. Looking at the balance sheet, as of August 1, total inventory were $2.79 billion, up about 4% on a per-store basis..

Turning now to guidance. Looking forward, we expect -- we continue to expect top line sales for 2014 to increase 8% to 9%. Same-store sales are now expected to increase 3.0% to 3.5%, given our trends we saw in the first half of the year.

Overall, square footage is expected to grow approximately 6% to 7% and we continue to expect adjusted diluted earnings per share for the year of $3.45 to $3.55, excluding any cost changes to our share repurchase estimates related to the potential FDO transaction..

As you model your earnings for the third and fourth quarter, please keep in mind that we expect stronger earnings per share growth in the fourth quarter as compared to the third quarter due to the easing of the comparison.

For the year, we plan to open approximately 700 new stores and capital expenditures are expected to be in the range of $450 million to $500 million..

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

Thanks, David. As we have said for many quarters, driving unit sales growth is key to our strategy and we remain committed as ever to providing our customers with everyday low prices they can count on.

We want to make sure that customers who walk or drive by our stores every day know that they can find nearly all of their everyday items in our small-box convenience stores.

So while we would have liked stronger comp sales growth in the second quarter, we are pleased with the nice step-up in customer traffic in our stores and the way the team managed expenses..

We have seen our key initiatives, such as an increased focus on affordability, expansion of health and beauty offerings and life cycle remodels, gain traction, albeit somewhat slower than we had anticipated. In non-consumables, we have exciting work underway for the second half of the year.

In the fast-growing tech area, we have expanded our cellphone offerings and accessories. For the home, our domestic department has been reset, refreshed with new product assortment, new colors, dedicated end caps and a new bath towel offering with a very attractive price point of just $2..

In addition, we are in the midst of repackaging our private brands across both select consumable and non-consumable categories. The goal of the repackaging is to enhance our customers' perception of our private brand quality and most importantly, the value for the price.

We had a soft launch of certain key items in August, with very encouraging results from our consumer research. All in, we expect our sales improvement to continue as we move through the year and quarterly comparisons continue to ease. Keep in mind, our merchandising strategy is based on disciplined category management process. .

For the vast majority of consumable items, we sell our national brands that shoppers can find across multiple formats and channels. The vast majority of the items we sell can be found in every large-box discounter, the front end of every drugstore and grocery store and even smaller, more localized retailers.

What has allowed us to be successful is our ability to pare a vast number of SKUs down to the optimal items, with only the brands, the sizes and the price points that appeal to and meet the immediate or what we refer to as fill-in needs of our customers. .

We are able to execute the strategy with the support of our disciplined category management process, coupled with significant distribution synergies and strong buying power, resulting from purchasing significant quantities of limited SKUs.

This foundation of limited assortment and distribution efficiencies allows us to successfully compete with much larger retailers and provide our customers with everyday low prices that they can trust. .

Let's turn to the customer for a minute. You've heard other retailers say this, low and middle-end consumers are continuing to struggle. They have changed their buying habits. Data now suggests that, out of necessity, many folks have reduced their overall consumption and absolute unit growth across Nielsen-measured channel data supports this.

While our customer always finds a way to work through difficult times, she is struggling to overcome the sustained nature of the headwind she is facing.

As we move through the second half of the year, we will begin to lap headwinds that have weighed on our core customer, including concern over the government shutdown in October, uncertainties for unemployment benefits and reduced SNAP benefits..

There is no doubt that affordability remains a key focus of our core customer. We talked about our affordability initiatives in our first quarter call, so I'd like to give you a quick update. First and foremost, we are as committed as ever to our philosophy of everyday low price to drive traffic and units.

We are continuing to add items under our Smart & Simple brand at entry-level price points and we continue to strategically introduce new $1 price point items in key consumable categories, such as food, home cleaning and paper products, that are focused on affordability. New items include a combination of national brands and our private brands.

We currently have approximately 2,500 core $1 items in our stores, which is up 5.5% from last year. Sales of core $1 SKUs increased over 13% in the second quarter, with over 44% of customer transactions including a core $1 item..

We're very pleased with our customers' response to our $1 to $5 price point assortment in our non-consumable category. These sharp price points, coupled with appealing merchandise, are enhancing the relevance of our non-consumable as evidenced by solid improvement in our home and apparel sales in the second quarter.

Apparel comped positive for the first time in a year, driven by broad-based growth across ladies, men's and boys. Non-consumables are important to our sales mix as we strive to enhance our gross profit rate. .

We have completed the rollout of our DG digital coupon capabilities in all stores. Sign-ups for the program are going well even before our full launch planned for this quarter. We will be making a big splash with our customers in late September with the promotion entitled FAST WAY TO SAVE to drive awareness and enrollment.

Over time, we believe this exciting program will drive shopper engagement..

Turning to expense control. Technology and our EZ Store process are allowing us to further eliminate work in the stores that is non-value-added and to streamline our processes. Our goal is to create time savings that we can reinvest to better manage our stores and serve our customers.

Some of our most meaningful projects relate to our more efficient back-office procedures and simplification of our inventory management process. As we discussed before, continuous improvements to the distribution, center-of-store process make our EZ Store delivery system even more efficient. .

How are store standards? Are we in stock on the items they need? How is the checkout experience? These revamped metrics give us a much better view on what our customers want and the value in our stores. We expect this program to benefit our customers' shopping experience and help drive sales..

I am pleased to report that we had modestly favorable results, stabilizing our inventory shrink in the second quarter, an important first step in ultimately improving our shrink results. Shrink improvement continues to be an opportunity as we remain steadfastly committed to improving shrink and optimizing our shrink levels on a store-by-store basis. .

At the end of the second quarter, we had 11,535 stores with 85.2 million square feet of selling space in 40 states; of those, more than 1,800 are in our most current DG13 format, which is more convenient -- which has a more convenient layout, improved store signage and a refreshed yellow and black color scheme.

Last quarter, we talked about our life cycle remodel program, which focuses on our legacy smaller-footprint stores, allowing us to improve adjacency and planogram layout in a manner more consistent with our DG13 stores. .

Our total remodels to date this year includes over 250 life cycle remodels, which now are performing significantly ahead of the chain on a same-store sales basis. This program helps us build our brand positioning in the marketplace as there is an opportunity to maximize sales with significantly lower capital expenditure.

We remain very excited that there are approximately 14,000 untapped locations providing opportunities for organic new store growth with low risk and high returns. .

We opened our Bethel distribution center in the first quarter and has ramped up ahead of our expectations on all productivity metrics. This facility will continue to support our new store expansion in the Northeast. This gives us a great template to follow as we look to build our new distribution center in San Antonio, Texas.

With that being said, I want to extend my sincere thanks and appreciation to the 105,000 Dollar General employees as we celebrate our 75th anniversary of savings and service..

To wrap all of this up, I'd like to now turn to our proposal to acquire Family Dollar. We remain committed to what we view as a superior proposal for Family Dollar shareholders, who would receive a higher value for their shares and all-cash certainty.

For Dollar General shareholders, the proposed transaction is a significant strategic opportunity to create immediate and long-lasting shareholder value.

Importantly, this proposed combination would solidify Dollar General's position as the leading small-box discount retailer, allowing us to deliver convenience, greater selection and everyday low prices to customers through nearly 20,000 stores in 46 states, with sales exceeding $28 billion and over 160,000 employees..

Based on our strong track record of success in improving our own profitability since 2008, we believe we can manage the Family Dollar stores more efficiently and effectively.

Additionally, although we have highly complementary business models, we believe that further refinement of the combined product offerings will add value for our customers, providing them with convenience and everyday low prices on household basics and necessities, along with a compelling assortment of non-consumable merchandise..

The cost savings and synergies from the proposed transaction will enable us to share such savings with our customers. We've done extensive analysis of the potential synergies between the 2 companies across merchandising, store operations, supply chain and administrative function.

As a result of that work, we have a comprehensive and thoughtful action plan ready to put in place to capture the synergies available in this potential transaction.

We believe that this proposed combination would be very well positioned for long-term revenue and earnings growth, given the anticipated $550 million to $600 million of annual run rate synergies over 3 years..

We expect the proposed transaction would be immediately accretive to earnings in the low-double digits, excluding implementation and transaction costs. While we would expect to begin to receive benefits in the first year, the synergies would be expected to ramp up consistently across the 3 years.

Approximately 20% of the synergies are expected to come from improved category management and increased sales productivity across both consumables and non-consumable categories. 40% will come from gross margin expansion, from merchandise procurement and sourcing and the optimization across our supply chain to reduce stem miles.

The remaining 40% would be from SG&A cost reductions, including the implementation of our rolltainer delivery method to the stores. .

Our plans are specific, actionable across every work stream of the business. I look forward to oversee the successful integration of these 2 companies if the transaction is completed and I am prepared to remain as CEO through May of 2016 to do so..

While much has been said about the antitrust issues, we remain confident that these issues are very manageable. We have done extensive antitrust work over the last year. The up to 700-store divestiture number that we proposed was based on extensive antitrust work in order to take the issue off the table for the Family Dollar board.

We are ready and willing to share this analysis with Family Dollar and its counsel and are confident that we would be able to quickly and efficiently resolve any potential antitrust issues.

We continue to carefully review our options regarding our proposal and we truly hope that Family Dollar will continue -- will come to the table to explore a tremendous opportunity for maximizing value for its shareholders. .

Mary Winn, I would now like to open it up for questions. .

Okay. Thank you, Rick. As a reminder, the purpose of this call is to discuss our second quarter earnings and we would appreciate if you would keep your questions limited to that topic. We will not be answering any questions regarding our proposal for Family Dollar. Thank you in advance for your cooperation. .

Brandy, we'll now open the lines up for questions. .

[Operator Instructions] Your first question comes from the line of Stephen Grambling of Goldman Sachs. .

I guess the first would just be on the guidance. You took down the comp range a little bit but have reiterated EPS even as you suggested gross margin pressures remain to a degree.

What are some of the key puts and takes in SG&A or elsewhere that are enabling you to reiterate the EPS range?.

Yes. And again, we -- I would say we kind of trimmed it a little bit in terms of when we went from a $3 to $4 to $3 to $3.50. Definitely, we're seeing a little bit better SG&A leverage in the back half of the year than what we previously had. We also tweaked the share count a little bit. The share count is a little bit lower.

And again, I don't view this as a major change, what we did on the comp side of it. .

Stephen, as I'm looking at the back half of the year, the thing that I like most about quarter 2 was an acceleration of transaction growth and acceleration of unit growth. And I have always been a believer, if those 2 are moving north, sooner or later, everything else catches up. .

Great. That's helpful. And then, I guess, to change gears a little bit. If you can comment a little bit on maybe what Plan B is if there is no deal and how you think about capital allocation.

Recognizing that the share buyback -- or the buyback program has been suspended, as we look further out, if there isn't a deal, is there any commentary you can give us on how you will be thinking about the leverage ratio and buybacks going forward?.

Stephen, very fair question. I'm not prepared to go there yet because I'm not so -- I don't want to give up on the deal yet. .

All right. And then maybe if I can squeeze one other one in there, would just be your -- the better traffic.

As you think about consumables and tobacco being lapped, are you still getting the same attachment rate? Or is there anything that's changing there relative to your initial expectations?.

Actually, great question. And again, the attachment rate on cigarettes is exactly like it has been. And we're lapping where we were last year and our cigarettes are comping positive. So we're very excited with that strategic change in our mix. .

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

So the first question is, in the 10-Q, you talked to the promotional environment in the quarter and then mentioned that activity has moderated recently. So I'm just wondering if you can give a little more color on where it upticked during the quarter and kind of why we saw the spike up and back down. .

Yes. I would say the competitive activity in May was pretty intense, centered around the Memorial Day holiday. We actually made the decision to hang with our Every Day Low Pricing but get into the promotional foray and that's why we had a little bit more margin pressure than we had actually anticipated.

Primarily, the driver of our margin pressure in quarter 2 was promotional markdowns, which was a conscious decision that we made. As we move through June, sales begin -- the competitive environment, I would say, begin to moderate. And then it got really hot around the 4th of July.

We also made a decision to play in the promotional battle around the 4th of July. As we move through July, kind of stayed kind of intense. And as we moved into August, I would say it started to slow back down and it's not nearly what it was in the Memorial Day and July 4 time frame. I would like to throw out back-to-school for us.

We're having a very good back-to-school right now. Our back-to-school category, we are up 4.5% right now. In fact, this week, which is the first of the 2 really intense weeks, we're actually up over 7% in the categories that are related to back to school.

And I relate that to the fact that the environment has cooled down and everyday low price has a lot more value right now. .

That's great to hear.

And then, secondly, the retail labor leverage that you achieved in the quarter, is that more related to the rolltainer initiative? Or is it more of a tactical decision around the promotional environment?.

I think it's driven primarily by the work that Greg and his team are doing on work elimination. We're doing a much better job on the EZ Store sort, which is allowing the sort to be even more relevant in relation to the proximity of the product on the rolltainer, where it is on the shelf.

But I think we're doing a good job of eliminating unnecessary work and our goal, Matt, long term, is to reinvest that labor back into more selling opportunities. .

Our next question comes from the line of Stacie Rabinowitz of Consumer Edge Research. .

As you're talking about -- I have 2 questions, which may be related. As you're talking about increased promotional activity, I was wondering which category is -- or within your categories, private label versus branded, where that activity might have been concentrated.

And then, secondly, I thought it was interesting that you guys were talking about candy, snacks and tobacco as being some of the headlines this quarter. Those seem a little bit more discretionary than some of the other categories.

And given you're talking about a pressured consumer, I was wondering if you were doing anything special for those categories that might have led to that growth. .

Yes. Great question. Let me do the first one. The increased promotional activity was primarily around soda pricing. I would say probably soda pricing, bread and milk will probably be the 3 key categories. And probably, in all honesty, more on the national brand side than the private brand side.

Tobacco is tobacco, but soda for us resides in candy and snacks. And that's why you would see that number rise because it's primarily driven by carbonated beverage. .

Your next question comes from the line of Mark Montagna of Avondale. .

Last year, in the second half, drugstore has gotten very deeply promotional.

Are you anticipating a repeat of that again? Or can we effectively anniversary that, that we're not going to have to worry so much?.

My -- I look at the ad every day with my team -- every Monday with my team. It does appear, Mark, that things are starting to moderate. You'll see a pretty aggressive soda price once in a while. But my view right now is, as we move into the back half, that it appears to finally be getting more in the traditional sense, competitive but not elevated. .

Okay. And then just as a follow-up.

When you were talking about competitor promotions, was that more heavily concentrated at discounters? Or was it grocery stores or drugstores or pretty evenly spread?.

Yes. Great question. I would say across the board. What happens is when one channel gets hot, every other channel has to respond. .

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

A lot of my questions have been asked. But I think you guys have talked a little bit about testing unique planograms for individual stores based on sort of local demographics and demand.

Is that something you've actually put in place and you're willing to talk about? Or is it too early?.

Yes. It's a little early, but the primary driver of that is the life cycle store and that's the idea of going at limited square feet. So we're going in and taking out categories that aren't performing as well, expanding on the ones that are, which gives us the opportunity to add more regional or local items.

The sales results on the life cycle stores, Meredith, are very good right now. We're very pleased, but a little too soon to lay it all on the table yet. .

And do you think, from what you're seeing there, that any of the things you've done in the life cycle remodels, whether it's the unique planograms or other things, have application to the -- maybe stores that aren't quite so small or quite so old?.

Yes, absolutely. What this has allowed us to do is to experiment with different SKUs without having to make a much larger commitment. So yes, the answer is yes. .

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

So Rick, I just want to get back to kind of the environment. I think you said you're off to a good start.

But if you had to kind of look at the numbers and say, how much is what we're doing versus how much is just the ebb and flow of the consumer? Because it seems like they come out for events, maybe they're coming out for back-to-school, although back-to-school is very early this year and then they go back into hibernation.

So I guess I'm trying to gauge -- you guys have a lot of balls in the air trying to drive your traffic and your comp.

How much of it is you and how much is just the ebb and flow of the consumer that's kind of manic-depressive?.

Yes. I think that's a very fair question. The first thing I would say is you have to remember, we've introduced a lot of what we're calling affordable SKUs. So some of the pressure we've put on the top sales line is the fact that we're selling an item at $1 that we probably would have sold for $1.50 or even $2 a year ago. So some of that is us.

And again, I always come back to, Scott, I believe this is a unit game and a transaction game and we've made a conscious decision to sell SKUs that we believe are affordable. And I think it's fair to say, too, that the customer is buying less. They are stretching that food dollar. I think they are coming out for events.

I think that our performance around -- I would look at you and tell you our performance around Memorial Day and July 4 was better than it's been in several years and we were there for the consumer with the right prices.

So right now, I would say, it's probably -- some of it is, maybe 50%, a change in tactic for us, where we're trying to sell lower-value SKUs and get them into that basket. And probably a good 50% is a retreat on the consumer side. .

Great, that's perfect. I appreciate the color. Then I had just one more. I think you guys flagged health care as helping on the expense growth side and I was wondering how sustainable is that as we get into '15 with some more changes coming in the health care law and other things.

I mean, is that something that we think we can continue to get leverage on? Or is that something that's going to fade?.

Well, where we're at right now, our benefit savings -- the team here is taking a really interesting tack, in that we are really wellness focused. Even myself, I have to talk to a wellness coach once a quarter that talks to me about how much I'm exercising, what I'm eating, how I'm doing with my weight.

And that program is actually going through the chain. And I think, as silly as that sounds, I think that it has actually helped us. We have seen lower enrollment. So I think those are all positive signs. It's a little soon for me to forecast 2015, but I think we've laid a lot of really good pipe here that's helping us on that line. .

Your next question comes from the line of John Heinbockel of Guggenheim. .

So let me ask you -- start with the comp chronology. Do you think that -- the drop-off in June and July, do you think that was largely competitive driven? And I asked that because some of the categories you mentioned, seasonal looked a little disappointing, given how good your stores looked.

What's your take on that? And do you think that's -- what happened there? And do you think in August, have we now kind of bounced back to where we were in May?.

Yes. I think as I look at the summer seasonal number, that -- yes, actually, the seasonal -- the summer seasonal was up 3.3%, 3.7%, right in that window. There are other categories in there with seasonal that dragged the total number down. So I'm actually quite pleased with what our offering was and again, a major commitment to more affordable items.

We are definitely feeling very good about where we are quarter-to-date. And the most important thing -- I'm sorry, John, the most important thing is we're continuing to grow our share and we're continuing to grow our units. .

Okay. And then just as a follow-up to that, what are you seeing early on with states that have raised minimum wage, right? California did that July 1 and then some other states.

Are you yet seeing that flow through into better consumer behavior? And when do you think that will happen?.

Yes. I think it's a little soon yet. But I will tell you this. I mean it make sense to me that if you put more money in people's pockets, it's going to translate into more sales to us. So yes, I mean, I said it's a little soon yet and we don't have enough store representation in California to get a really big read on that yet. .

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

Rick, in your prepared comments, you noted that your core consumer is just cutting back on purchases, given their financial situation. And that certainly seems to be evident when you look at sales trends for the industry.

So with that in mind, if you're successful in improving the sales productivity in the Family Dollar stores, let's say, $40 or $50 a square foot, getting close to Dollar General standards, what kind of cannibalization would you expect to take place in that Dollar General store that may be only one shopping center away?.

Dan, I really can't talk about that right now. But I will tell you, that's all been taken into our analysis. And again, we feel pretty strong about what we're bringing into the table on the deal. So I need to pass on that one for now. .

But I think -- I wasn't really asking about the deal.

I was just trying to -- I mean, if the industry is not growing, there -- would you think that there would be some cannibalization?.

Again, I want to kind of stay away from that because it's kind of tied to the Family Dollar deal. And again, I apologize. I just don't think I should answer that right now. .

Okay. Well, this may be a question you may not want to answer either.

But in terms of your retirement plans and then you indicated during your prepared comments, you'd be willing to stay until May of 2016, is there a search going on right now just as a contingency if the Family Dollar situation doesn't play out the way you hope that it does?.

Yes. Right now -- I think that's a very fair question. But right now, I'm very optimistic of where all this is going to go.

So again, we'll get back to you on that later on, right?.

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

A couple of questions for you, Rick. First one is related to urban stores versus rural stores. And it is just a question about really the model of both of them.

And what I was hoping you could do is try to help us understand the differences between an urban store and a rural store in terms of how does productivity look, how does -- how do margins look, how do returns look.

And is there really a large structural difference between the 2 models, let's talk about you, right, for you, as we think about an urban versus a rural store?.

Yes. I think that's a really fair question. Our rural stores tend to do very well. They operate at a lower volume rate than the urban stores and they tend to have a lower expense structure than the urban stores. Both stores tend to carry about the same margin, in all honestly -- honesty.

So net-net, the overall performance of the 2 stores tends to be about the same. I would say the only difference between the 2 formats would be -- well, actually a couple of things.

Number one, shrink will be higher in an urban environment than a suburban environment and you deal with more competitive pressure in the urban environment because there tends to be more choices. But overall, at the end of the day, our performance has been typically pretty even across the board. .

And Rick, do you think an urban store -- whether it's inner city versus maybe like outer ring of the city, for instance, does that create a difference?.

Yes. I tend to look at -- we call the ones on the outer ring satellite city. That's more of suburbia versus urban. And again, we look at that a little bit different than the urban environment and suburbia would be right in between the 2 extremes. .

Okay. And then second question for you is on the gross margin. Obviously, traffic is important, right? And it's your focus.

If we think about the current environment as maybe a little bit of a new normal, tougher consumer, this sort of trend, warfare on how do you get that extra dollar amongst the competitors, how do we think about your gross margin over the next few years, for instance, if this is what it is, right? I mean, if this is -- is it sustainable at the current level? Or do you think that we'd be looking at sort of ongoing investment and pricing promotion?.

Yes. I think as you look at it, you have to look at the pluses and the minuses. We still have a lot of confidence in our initiatives that we've been talking about for the past few years, our private label and the things we're doing, some of the exciting things, the new items that we're adding in private label and the growth that we're seeing there.

Foreign sourcing continues to be strong. It continues to be growing in terms of our focus there. We're focusing a little more on consumables and trying to be less China-centric in terms of where we're bringing items in from.

And then we've mentioned shrink on this call earlier, that we're starting to see some progress there through what we're doing with technology and process and incentives. So I mean, those are all positives. Obviously, we're going to stay true to EDLP and making sure that we're driving more units through the box.

And we've said this before, ultimately, that's the most important thing for us, staying true to who we are in EDLP and keeping -- growing our market share and growing the units that we're selling through the individual stores. So that will override everything else.

So we have initiatives in place that we believe can help us grow margin, but ultimately, it's going to depend on staying true to EDLP and making sure we continue to grow our share. And we will sacrifice gross margin to do that. .

Your next question comes from Vincent Sinisi of Morgan Stanley. .

I wanted to ask you a bit more on the continued introduction of the $1 items.

Can you give us a sense for what percentage of those are replacing some items that are already on the shelves? Or is it strictly being additionally added?.

Yes. Vince, those are all incremental SKUs. We have a category management process, where we step back -- and I shouldn't say they're incremental. Something else probably came off in another category that wasn't moving and turning as fast. But for example, in the soap set we -- or the chemical set, we would have added SKUs, taking it from somewhere else.

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Okay, okay.

And then just on your $1 to $5 non-consumables -- and this is maybe a good kind of combo question with that, as well as the $1 items -- kind of what inning do you think we're in with that? Where can it go? And particularly on the $1 to $5 non-consumables, do you guys foresee any kind of change down the road in terms of mix of consumables versus non-consumables?.

Yes. I would -- Vince, I would like to see the non-consumable mix start to increase. Obviously, that's where the margin is in our business and the introduction of these $1 SKUs, $5 SKUs -- I think we're going to have more $1 SKUs for Christmas this year than we have ever had.

And they carry more margin, albeit you sacrifice on the top line, but you give the customer what they want. So we are working very hard to get the non-consumable mix as a percentage of sales up. .

Do you have any sense, Rick, for where ultimately that could go?.

I wish I could look at you and give you a definitive number. I'd just like to see it move north of last year for a quarter. I want to start there first. .

Your next question comes from the line of Peter Keith of Piper Jaffray. .

I know it's not up there but nice growth on the discretionary category. I had a question on SG&A. I was wondering, at the beginning of the year, you guys had quantified about $45 million to $50 million of fallback in incentive comp and Affordable Care Act.

I was wondering if that dynamic was still in place because your SG&A leverage is still coming in a little better than we expected. .

Yes. That dynamic is still in place. Again, if you look at this quarter that we're coming out of, we got some help from benefits, from health care, our claims being down. We talked a little bit about that. And then our workers' comp also gave us some help.

So still saying what we had said earlier in the year around the impact of that team share, affordable care and then that sale leaseback that we do have on SG&A. Certainly, there may be some factors offsetting that, but those items are still out there. .

Okay. And then, I guess, just thinking about that rolling forward. You've historically had seen 3% comp to get some leverage. It looks like that has come down even despite the headwinds.

Are you now at maybe a lower run rate on where you could begin to see leverage?.

No, no. We've said 3% to 3.5% and I think 3 to 5 -- 3.5% is probably still a good number. Again, we had some things in this quarter that definitely helped us, but I wouldn't come too far off of that 3.5% that we talked about traditionally. .

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

It's good to see the 2-year comp accelerate even as you lap the cigarette introduction last year. I'm curious if you can quantify what that contributed to comps this quarter as we've lapped that initiative. .

Yes. I would tell you, probably, we haven't really let that out. But the contribution to the comp is de-accelerating at a significant rate and the important thing is the comp -- that cigarettes are still comping positive. .

Right, okay. You mentioned earlier that the summer seasonal was strong but maybe some other areas were soft. I don't know if you had any more color around those other areas and what the opportunity might be to improve on that. .

Yes. It was primarily sundries, household type items that, as we said, we're working a little bit hard on to get those going. I was pleased with apparel. I am -- I'd like to reinforce that. We had men's and ladies and children's, boys particularly, were all solid.

And one of the other things, too, Dan, in -- believe it or not, in the seasonal category is magazines. And the whole magazine world is going through a significant restructuring now and we're not as in stock on that particular category of magazines and books as we have in the past.

So the seasonal number is just more than just good old-fashioned summer seasonal stuff. .

Okay. And I don't know if you'll be willing to answer this because it is a little bit related to Family Dollar.

But I was just curious, given all the work you've done on real estate, how many sort of 2-player markets would you say are out there today where you don't have another major competitor besides a Dollar store?.

Yes. And again, I apologize, it's a little soon for me to be talking about those things. So all I would say is we're continuing to work and explore our options. .

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

So I guess my question is also on the promotional environment. I mean, clearly, it's intense. It seems to be increasingly volatile, changing on what sounded like a week-by-week basis, given your comments about that.

So I guess my question is what expectations have you kind of built in regarding the broader competitive environment into your guidance for the holiday season, where we know it's always a more promotional time frame?.

Yes. I think that as we move through the back half of the year, I think the competitive environment will be heightened, but I don't think it's going to be irrational. I think, it appears to me, people -- or someone else actually brought it up on the call. I think the activity in the consumer is more focused around certain specific events.

And I think Labor Day -- and we're prepared for the intense Labor Day, but then we think, things will probably settle down for a period of time. We're ready to go for Black Friday. We've got a Christmas plan in place and I see no deviation from what we have laid out. .

But if the environment is always more heightened around the holidays and you brought up Black Friday and obviously, Christmas after that, I mean isn't that where it's most likely to get irrational?.

Yes. But I think, right now, we have a plan in place that's a little -- we've gone through 2 quarters of this. We have a plan in place now that should be able to anticipate that if it's going to happen. That's why we're pretty confident that the back half margin is going to be pretty flat to last year. .

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

Just wanted to follow up on the top line. As you did reiterate -- or you provided adjusted full year guidance for same-store sales up 3% to 3.5% after comping, I believe, a 1.8% in the first half. And with the tobacco comp still positive but decelerating, if you can just maybe help us understand which categories you expect to see the acceleration.

Just maybe provide a little bit more color on the initiatives in consumables or how we should think about maybe discretionary side of the store with apparel and home just so we are more confident and comfortable with the back half. .

Yes. As I'm looking at this, Paul, I expect the acceleration to be broad-based. I am particularly looking for food, chemical and paper, particularly, to begin to accelerate as we move through the back half of the year.

I think that we will see comps accelerate as we move across the 2 quarters, taking into account we're up against a very soft fourth quarter last year. What is encouraging me right now is the increase in traffic and the increase in units and particularly, the increase in unit share.

And why we have sacrificed some sales in order to sell more SKUs that are more affordable, we believe that the traffic is going to overcome that as we move through the quarter. The attachment rate on cigarettes continues to be at or above what we thought it was going to be. And I think we're very well positioned.

I'm very excited about what we're going to do from November to January 1, in particular. And by the way, I forgot about we had the coupon program rolling out, too, which is going to allow our customer to be able to extract savings out of the newspaper without having to click coupon.

And it'd be downloaded to their phone and they can use as many as they want when they get to the store. .

That's very helpful. Just in terms of gross margin, we have now had a few quarters in a row of contraction in the 50- to 60-basis-point range.

Could you just help clarify what is embedded in the guidance in the second half? I know you're lapping tobacco so that just certainly helped, along with the private label and shrink initiatives that you spoke to.

But just clarify, to what extent gross margins are expected to decline or actually turn flat to positive as we move forward to the balance of the year?.

Yes. I'll take a shot and then certainly, Rick may want to say more. We're not giving a specific number on gross margin. We do see considerable improvement from what we saw from the first half of the year and you're right, one of the big factors is lapping tobacco.

We also see the back half of the year being less promotional than what we saw in the front half of the year. So that has an impact also on it. So we are anticipating significant improvement on a basis-point basis from what we saw in the first half of the year. .

And I would say, too, Paul, that when I look at the margin in the second quarter particularly, a lot of that was self-inflicted by our decision to get a little more promotional, particularly on CSD, but not give up on our everyday low prices. And we did not off -- we didn't raise any prices to offset that promotional activity.

And I'm actually thinking, based on what we saw with customer traffic and units, it was a wise decision. .

Could you at all quantify the self-infliction versus the tobacco drag to 2Q gross margins?.

Yes. I would rather not do that and I apologize. .

We have ranked them and we've reported it in the press release as well. .

Promotional activity was certainly on the top. .

Right, the highest, yes. .

Your next question comes from the line of David Mann of Johnson Rice. .

I'm curious, when you talked about some of the affordable initiatives that you're doing, can you just clarify the margin impact of those items as you accelerate that, are they at the same IMU? Or is there some degradation there?.

Yes. Good question. They actually tend to carry more margin at the end of the day. Now you've sacrificed the sales, you have to look at it a little like private brands, right? When the consumer buys a private brand, you give up some sales but you make more margin. The $1 SKUs that we've been adding are actually carrying more margin. .

Okay. That's great clarification.

And then on the legacy remodel program, any more commentary you can give on the kind of lift you're seeing there and the opportunity to perhaps accelerate that into '15? I mean, how much can you ramp that up?.

Yes. I think I would -- rather than getting into a specific, I would say the lift is significantly above the average that we are running in the chain right now. And our goal is -- we think we have up to 1,500 stores that we could do. We have 250 done.

So as we move through '15, I think as this continues to play out, you'll probably, probably hear us talking about accelerating that. .

And then one last question. The inventory growth coming out of the quarter, I mean, it seems like you're expecting a similar kind of comp increase to that growth, so I just want to make sure.

Any additional clearance carryover versus last year that we need to think about?.

Our turns right now, the way we calculate them, are 4.8. It's the same as it's been the past 3 quarters. Total inventory increased a little over 10% on a 7.5% sales increase. We like to see that inventory increase about the same as sales. On a store basis, we were up 3.7%, 4%, somewhere in that range.

Clearly, new SKUs, tobacco presentation levels, a variety of reasons. The bulk of it is core inventory. So that's kind of where we stand on inventory right now. .

The other thing I'd like to throw out there, as I'm sure you guys are aware, there's an import strike scare out there and we made a conscious decision to bring some of our holiday merchandise in a little sooner. .

Brandy, I have it at top of the hour, so unfortunately, we're going to cut the call off now. But everyone, thank you very much for joining us. If you have any questions, Emma Jo and I are around, so please feel free to give us a call. And thank you for your time and attention today. .

That does conclude today's conference. You may now disconnect..