This discussion and analysis is based on, should be read with, and is qualified in its entirety by, the accompanying unaudited condensed consolidated financial statements and related notes, as well as our consolidated financial statements and the related Management's Discussion and Analysis of Financial Condition and Results of Operations as contained in our Annual Report on Form 10-K for the year ended
January 31, 2014. It also should be read in conjunction with the disclosure under "Cautionary Disclosure Regarding Forward-Looking Statements" in this report. Merger Proposal On August 18, 2014, we announced we had submitted a proposal to the Board of Directors of Family Dollar Stores, Inc. ("Family Dollar") to acquire all of the outstanding shares of Family Dollar common stock for $78.50per share in cash. On August 21, 2014, this proposal was rejected by the Board of Directors of Family Dollar. There can be no assurance that a transaction will be completed on the terms proposed or at all. Executive Overview We are the largest discount retailer in the United Statesby number of stores, with 11,535 stores located in 40 states as of August 1, 2014, primarily in the southern, southwestern, midwestern and eastern United States. We offer a broad selection of merchandise, including consumable products such as food, paper and cleaning products, health and beauty products, pet supplies and tobacco products, and non-consumable products such as seasonal merchandise, home decor and domestics, and basic apparel. Our merchandise includes high quality national brands from leading manufacturers, as well as comparable quality private brand selections with prices at substantial discounts to national brands. We offer our customers these national brand and private brand products at everyday low prices (typically $10or less) in our convenient small-box (small store) locations. The core customers we serve are value-conscious, many with low or fixed incomes, and we have always been intensely focused on helping them make the most of their spending dollars. Like other companies, we have been operating for several years in an environment with ongoing macroeconomic challenges and uncertainties, and the timetable and strength of economic recovery for our core customers remains uncertain. The longer our customers have to manage under such negative conditions, the more difficult it is for them to stretch their spending dollars, not only for discretionary purchases (as has been the case in recent years) but also for non-discretionary purchases. During this period of extended economic weakness, we have achieved significant success by responding to our customers' needs for value and convenience, in part, by increasing our offerings of basic consumables. In recent years, other retailers, including many of those in the dollar, discount and drug sectors, have expanded their consumables offerings. In addition, these retailers, as well as others, such as those in the mass merchandising and grocery sectors, have increased their promotional activities. The promotional environment remained quite competitive early in our second quarter and has continued to be more challenging than in the relatively recent past, although we believe competitive promotional activities have moderated recently. 22
We remain focused on executing our four operating priorities, which are: 1) drive productive sales growth, 2) increase, or enhance, our gross profit margins, 3) leverage process improvements and information technology to reduce costs, and 4) strengthen and expand our culture of serving others.
We seek to drive productive sales growth through increasing customer traffic, unit sales and average transaction amount in our same-stores and by adding new stores, as well as remodeling and relocating stores. We opened 426 new stores in the first half of 2014 and plan to open 700 stores for the full year. In the first quarter of 2013, we made a strategic decision to add tobacco products in our stores with the primary goal of increasing customer traffic. The rollout of tobacco products was substantially executed between March and June of 2013. In addition, in the first half of 2013, we expanded the number of coolers for refrigerated and frozen foods and beverages in over 1,600 existing stores. Tobacco products and perishables were the most significant drivers of same-store sales growth in 2013 and continued to increase at a faster rate than overall same-store sales through the 2014 second quarter. As expected, the addition of tobacco products and the increased proportion of sales of perishables have posed challenges to our second priority of enhancing our gross profit rate because these products generally have lower profit margins. Ongoing initiatives to enhance our gross profit rate include merchandise category management, utilization of private brands, inventory shrink reduction initiatives, efforts to improve distribution and transportation efficiencies, and strategic focus on pricing and markdowns, while remaining committed to our everyday low price strategy. We remain committed to our seasonal, home, and apparel categories, which generally have higher gross profit rates. While we are encouraged by improvement in our sales of home products and apparel in the first half of 2014, we expect the growth of consumables to continue to outpace the growth of non-consumables throughout the remainder of 2014. Commodities cost inflation was minimal in the first half of 2014 and throughout 2013 and, in some instances, we experienced a decrease in such costs. Accordingly, overall price increases passed through to our customers have been minimal. We remain committed to reducing costs, particularly selling, general and administrative expenses ("SG&A") that do not affect the customer experience. In 2012 and 2013, we successfully reduced our retail labor costs as a percentage of sales, in part, by optimizing our workforce management system and simplifying or eliminating various tasks performed in the stores and we are continuing these efforts in 2014. In addition, we believe we have additional opportunities to reduce costs through our focused procurement efforts. However, we expect overall SG&A to be a higher percentage of sales in 2014 than in 2013, due to several factors, including the year-over-year impact of a significant reduction in incentive compensation in 2013, and an increase in 2014 store occupancy costs resulting from a sale-leaseback transaction completed at the end of 2013. During the first half of 2014, we continued our mission of serving others by striving to give our customers clean, well-stocked stores with quality products at low prices, our employees 23
an environment that attracts and retains talented personnel, and supporting our store communities through our charitable and other efforts.
The following highlights the results of the second quarter of 2014 over the comparable 2013 period in many of our key financial metrics. Basis points amounts referred to below are equal to 0.01% as a percentage of sales.
† Net sales increased 7.5% to
$4.72 billion. Sales in same-stores increased 2.1% driven by increases in customer traffic and average transaction amount. Average sales per square foot for all stores over the 52-week period ended August 1, 2014were $220. † Gross profit, as a percentage of sales, was 30.8% in the 2014 period compared to 31.3% in the 2013 period, a decline of 53 basis points. We experienced an increase in promotional markdowns as well as an increase in the proportion of overall sales from lower margin consumables categories, including tobacco products and perishables, partially offset by higher initial inventory markups.
† SG&A, as a percentage of sales, was 21.7% compared to 21.9% in the 2013 period, a decrease of 21 basis points including a 19 basis point legal settlement in 2013. Changes in SG&A, as a percentage of sales, were also impacted by increases in rent and advertising expenses, partially offset by store labor efficiencies and a reduction in benefits costs.
† Interest expense increased by
$2.0 millionto $22.6 millionin the 2014 period due in part to higher borrowings for share repurchases during the preceding 12 months. Total outstanding debt (including the current portion of long-term obligations) as of August 1, 2014was $2.98 billion. † Net income was $251.3 million, or $0.83per diluted share, compared to net income of $245.5 million, or $0.75per diluted share, in the 2013 period. Diluted shares outstanding decreased by 21.8 million shares, reflecting the impact of share repurchases. † Cash generated from operating activities was $486.9 millionon a year to date basis, compared to $484.1 millionin the comparable prior year period. At August 1, 2014, we had a cash balance of $172.5 million.
† Inventory turnover was 4.8 times on a rolling four-quarter basis. Inventories increased 4% on a per store basis over the 2013 period.
† During the first half of 2014, we opened 426 new stores, remodeled or relocated 585 stores and closed 23 stores, resulting in a store count of 11,535 as of
August 1, 2014. The above discussion is a summary only. Readers should refer to the detailed discussion of our operating results below for the full analysis of our financial performance in the current year period as compared with the prior year period. 24
Results of Operations Accounting Periods. We utilize a 52-53 week fiscal year convention that ends on the Friday nearest to
January 31. The following text contains references to years 2014 and 2013, which represent the 52-week fiscal years ending January 30, 2015and January 31, 2014, respectively. References to the second quarter accounting periods for 2014 and 2013 contained herein refer to the 13-week accounting periods ended August 1, 2014and August 2, 2013, respectively. Seasonality. The nature of our business is seasonal to a certain extent. Primarily because of sales of holiday-related merchandise, sales in our fourth quarter (November, December and January) have historically been higher than sales achieved in each of the first three quarters of the fiscal year. Expenses, and to a greater extent operating profit, vary by quarter. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods. 25 --------------------------------------------------------------------------------
The following table contains results of operations data for the most recent 13-week and 26-week periods of each of 2014 and 2013, and the dollar and percentage variances among those periods:
(dollars in millions, 13 Weeks Ended 2014 vs. 2013 26 Weeks Ended 2014 vs. 2013 except per share August 1, August 2, Amount % August 1, August 2, Amount % amounts) 2014 2013 change change 2014 2013 change change Net sales by category: Consumables
$ 3,576.2 $ 3,301.8 $ 274.48.3 % $ 7,021.7 $ 6,496.7 $ 524.98.1 % % of net sales 75.70% 75.13% 75.94%
Seasonal 593.6 575.9 17.7 3.1 1,135.0 1,105.2 29.9 2.7 % of net sales 12.57% 13.10% 12.28%
Home products 285.4 265.4 20.0 7.5 569.0
531.2 37.8 7.1 % of net sales 6.04% 6.04% 6.15%
Apparel 268.8 251.5 17.3 6.9 520.4 495.3 25.1 5.1 % of net sales 5.69% 5.72% 5.63%
$ 4,724.0 $ 4,394.7 $ 329.47.5 % $ 9,246.1 $ 8,628.4 $ 617.77.2 % Cost of goods sold 3,268.5 3,017.4 251.1 8.3 6,432.8 5,955.9 476.9 8.0 % of net sales 69.19% 68.66% 69.57%
Gross profit 1,455.6 1,377.3 78.3 5.7 2,813.3
2,672.4 140.9 5.3 % of net sales 30.81% 31.34% 30.43% 30.97% Selling, general and administrative expenses 1,027.0 964.5 62.6 6.5 2,005.1 1,864.6 140.5 7.5 % of net sales 21.74% 21.95% 21.69%
profit 428.5 412.8 15.7 3.8 808.2 807.8 0.4 0.1 % of net sales 9.07% 9.39% 8.74%
expense 22.6 20.6 2.0 9.5 44.9 45.1 (0.3 ) (0.6 ) % of net sales 0.48% 0.47% 0.49%
Other (income) expense - - - - - 18.9 (18.9 ) (100.0 ) % of net sales 0.00% 0.00% 0.00%
Income before income taxes 405.9 392.2 13.7 3.5 763.4 743.8 19.6 2.6 % of net sales 8.59% 8.92% 8.26%
Income taxes 154.7 146.7 8.0 5.4 289.7 278.2 11.5 4.1 % of net sales 3.27% 3.34% 3.13%
earnings per share
$ 0.83 $ 0.75 $ 0.0810.7 % $ 1.54 $ 1.42 $ 0.128.5 %
13 WEEKS ENDED
Net Sales. The net sales increase in the 2014 second quarter reflects a same-store sales increase of 2.1% compared to the 2013 quarter. Same-stores include stores that have been open for at least 13 months and remain open at the end of the reporting period. For the 2014 quarter, there were 10,685 same-stores which accounted for sales of
$4.4 billion. Increases in customer traffic and average transaction amount contributed to the increase in same-store sales. Consumables sales continued to increase at a higher rate than non-consumables in the 2014 quarter, with the most significant growth related to tobacco products and strong sales of perishables and candy and snacks. Same-store sales growth was solid in home products and apparel. The sales increase was also impacted by new stores, partially offset by sales from closed stores. 26 -------------------------------------------------------------------------------- Gross Profit. Gross profit increased by 5.7%, and as a percentage of sales, decreased by 53 basis points to 30.8% in the 2014 second quarter. The gross profit rate decrease in the 2014 period as compared to the 2013 period was driven by an increase in markdowns, primarily due to increased promotional activity. In addition, consumables comprised a larger portion of our net sales, primarily as a result of increased sales of lower margin consumables such as tobacco and perishable products. These factors were partially offset by higher initial markups on inventory purchases. SG&A Expense. SG&A expense was 21.7% as a percentage of sales in the 2014 period compared to 21.9% in the 2013 period, an improvement of 21 basis points. The 2013 results include expenses of $8.5 million, or 19 basis points as a percentage of sales, for a legal settlement of a previously decertified collective action. Retail labor expense increased at a rate lower than our increase in sales and our benefits costs declined, offset by increases in rent and advertising expenses. Interest Expense. The increase in interest expense in the 2014 period compared to the 2013 period is partially due to greater borrowings primarily resulting from our share repurchases during the last twelve months. Income Taxes. The effective income tax rate for the 2014 period was 38.1% compared to a rate of 37.4% for the 2013 period which represents a net increase of 0.7 percentage points. The effective tax rate increase was due to the expiration of various federal job credit programs (primarily the Work Opportunity Tax Credit) for eligible employees hired after December 31, 2013. When these credit programs have expired in the past, most recently impacting our 2012 fiscal year, Congresshas re-instated them on a retroactive basis. It is uncertain as to whether or when this will occur on this occasion.
26 WEEKS ENDED
Net Sales. The net sales increase in the 2014 period reflects a same-store sales increase of 1.8% compared to the 2013 period. In the 2014 period, our 10,685 same-stores accounted for sales of
$8.7 billion. Increases in customer traffic and average transaction amount contributed to the increase in same-store sales. The remainder of the sales increase was attributable to new stores, partially offset by sales from closed stores. Gross Profit. For the 2014 period, gross profit increased by 5.3%, and as a percentage of sales, decreased by 54 basis points to 30.4%. The gross profit rate decrease in the 2014 period as compared to the 2013 period was impacted by an increase in markdowns, primarily due to increased promotional activity. In addition, consumables comprised a larger portion of our net sales, primarily as a result of increased sales of lower margin consumables such as tobacco and perishable products. These factors were partially offset by higher initial markups on inventory purchases. SG&A Expense. SG&A expense was 21.7% as a percentage of sales in the 2014 period compared to 21.6% in the 2013 period, an increase of 8 basis points. The 2013 results include expenses of $8.5 million, or 10 basis points as a percentage of sales, for a legal settlement of a previously decertified collective action. Rent and utilities expenses contributed to the increase in 27 --------------------------------------------------------------------------------
SG&A expense as a percentage of sales. Retail labor expense increased at a rate lower than our increase in sales, and workers' compensation and general liability expenses declined in the 2014 period compared to the 2013 period.
Interest Expense. Interest expense in the 2014 period is comparable to the same period in 2013.
Other (Income) Expense. In the 2013 period, we recorded pretax losses of
Income Taxes. The effective income tax rate for the 2014 period was 38.0% compared to a rate of 37.4% for the 2013 period which represents a net increase of 0.6 percentage points. The effective tax rate increase was due to the expiration of various federal job credit programs (primarily the Work Opportunity Tax Credit) for eligible employees hired after
December 31, 2013. When these credit programs have expired in the past, most recently impacting our 2012 fiscal year, Congresshas re-instated them on a retroactive basis. It is uncertain as to whether or when this will occur on this occasion. Partially offsetting the tax rate increase associated with federal jobs credits were benefits recognized in the 2014 period due to the favorable resolution of state tax examinations.
Liquidity and Capital Resources
April 2013, we consummated a refinancing pursuant to which we terminated our existing senior secured credit agreements, entered into a five-year $1.85 billionunsecured credit agreement, and issued senior notes with a face value of $1.3 billion. Our senior unsecured credit facilities (the "Facilities") consisted of an initial $1.0 billionsenior unsecured term loan facility (the "Term Facility") and an $850.0 millionsenior unsecured revolving credit facility (the "Revolving Facility") which provides for the issuance of letters of credit up to $250.0 million. We may request, subject to agreement by one or more lenders, increased revolving commitments and/or incremental term loan facilities in an aggregate amount of up to $150.0 million. Borrowings under the Facilities bear interest at a rate equal to an applicable margin plus, at our option, either (a) LIBOR or (b) a base rate (which is usually equal to the prime rate). The applicable margin for borrowings as of August 1, 2014was 1.275% for LIBOR borrowings and 0.275% for base-rate borrowings. We must also pay a facility fee on any used and unused amounts of the Facilities and letter of credit fees. The applicable margins for borrowings, the facility fees and the letter of credit fees under the Facilities are subject to adjustment each quarter based on our long-term senior unsecured debt ratings. The Term Facility amortizes in quarterly installments of $25.0 million, and the first such payment was made on August 1, 2014. The final quarterly payment of the then-remaining balance will be due at maturity on April 11, 2018. The Facilities can be prepaid in whole or in part at any time. The Facilities contain certain covenants which place limitations on the incurrence of liens; change of business; mergers or sales of all or substantially all assets; and subsidiary indebtedness, among other limitations. The Facilities also contain financial covenants 28
-------------------------------------------------------------------------------- which require the maintenance of a minimum fixed charge coverage ratio and a maximum leverage ratio. As of
August 1, 2014, we were in compliance with all such covenants. The Facilities also contain customary affirmative covenants and events of default.
For the remainder of fiscal 2014, we anticipate potential borrowings under the Revolving Facility up to a maximum of approximately
$450.0 millionoutstanding at any one time, including any anticipated borrowings to fund repurchases of common stock. Senior Notes On April 11, 2013, as part of our refinancing, we issued $400.0 millionaggregate principal amount of 1.875% senior notes due 2018 (the "2018 Senior Notes"), net of discount of $0.5 million, which mature on April 15, 2018, and issued $900.0 millionaggregate principal amount of 3.25% senior notes due 2023 (the "2023 Senior Notes"), net of discount of $2.4 million, which mature on April 15, 2023. We also have outstanding $500.0 millionaggregate principal amount of 4.125% senior notes due 2017 (the "2017 Senior Notes") which mature on July 15, 2017. Collectively, the 2017 Senior Notes, the 2018 Senior Notes and the 2023 Senior Notes comprise the "Senior Notes", each of which were issued pursuant to an indenture as modified by supplemental indentures relating to each series of Senior Notes (as so supplemented, the "Senior Indenture"). Interest on the 2018 Senior Notes and the 2023 Senior Notes is payable in cash on April 15and October 15of each year beginning October 15, 2013. Interest on the 2017 Senior Notes is payable in cash on January 15and July 15of each year. We may redeem some or all of the Senior Notes at any time at redemption prices set forth in the Senior Indenture. Upon the occurrence of a change of control triggering event, which is defined in the Senior Indenture, each holder of our Senior Notes has the right to require us to repurchase some or all of such holder's Senior Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to the repurchase date. The Senior Indenture contains covenants limiting, among other things, our ability (subject to certain exceptions) to consolidate, merge, or sell or otherwise dispose of all or substantially all of our assets; and our ability and the ability of our subsidiaries to incur or guarantee indebtedness secured by liens on any shares of voting stock of significant subsidiaries. The Senior Indenture also provides for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on our Senior Notes to become or to be declared due and payable.
Current Financial Condition / Recent Developments
August 1, 2014, we had total outstanding debt (including the current portion of long-term obligations) of approximately $2.98 billion. We had $628.8 millionavailable for borrowing under our Revolving Facility at that date. We believe our cash flow from operations and existing 29 -------------------------------------------------------------------------------- cash balances, combined with availability under the Facilities, will provide sufficient liquidity to fund our current obligations, projected working capital requirements and capital spending for a period that includes the next twelve months as well as the next several years.
Our inventory balance represented approximately 53% of our total assets exclusive of goodwill and other intangible assets as of
As described in Note 7 to the unaudited condensed consolidated financial statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments. Adverse developments in those actions could materially and adversely affect our liquidity. We also have certain income tax-related contingencies as disclosed in Note 3 to the unaudited condensed consolidated financial statements. Future negative developments could have a material adverse effect on our liquidity. On
August 18, 2014, as a result of the Company's proposal to acquire Family Dollar Stores, Inc., Standard and Poor's placed all of the Company's credit ratings on watch with negative implications and Moody's placed all of the Company's credit ratings on review for downgrade. The Company's current credit ratings are BBB- from Standard and Poor's and Baa3 from Moody's. Our current credit ratings, as well as future rating agency actions, could (i) impact our ability to finance our operations on satisfactory terms; (ii) affect our financing costs; and (iii) affect our insurance premiums and collateral requirements necessary for our self-insured programs. There can be no assurance that we will be able to maintain or improve our current credit ratings. Cash flows from operating activities. Cash flows from operating activities were $486.9 millionin the 2014 period, an increase of $2.8 millioncompared to the 2013 period. Changes in merchandise inventories and accounts payable generally had an offsetting impact on overall changes in working capital. The increase in accounts payable during the 2014 period was due primarily to increases in domestic merchandise receipts. Inventory balances increased by a greater amount in the 2014 period than in the 2013 period. On an ongoing basis, we closely monitor and manage our inventory balances, and they may fluctuate from period to period based on new store openings, the timing of purchases, and other factors. Merchandise inventories rose 9% during the first half of 2014 compared to a 6% increase in the first half of 2013. In the 2014 period compared to the respective 2013 period, changes in inventory balances in our four inventory categories were as follows: the consumables category increased 11% in both periods; the seasonal category increased by 4% compared to a 2% increase; the home products category increased by 10% compared to a 6% increase; and apparel increased by 6% compared to a 13% decline. Cash flows from investing activities. Significant components of property and equipment purchases in the 2014 period included the following approximate amounts: $66 millionfor improvements, upgrades, remodels and relocations of existing stores; $58 millionrelated to new leased stores, primarily for leasehold improvements, fixtures and equipment; $27 millionfor distribution and transportation-related capital expenditures; $21 millionfor information systems upgrades and technology-related projects; and $16 millionfor stores built by us. The timing of new, remodeled and relocated store openings along with other factors may affect the relationship 30 -------------------------------------------------------------------------------- between such openings and the related property and equipment purchases in any given period. During the 2014 period, we opened 426 new stores and remodeled or relocated 585 stores, including the limited scope remodels discussed below. Significant components of property and equipment purchases in the 2013 period included the following approximate amounts: $127 millionfor improvements, upgrades, remodels and relocations of existing stores; $66 millionrelated to new leased stores, primarily for leasehold improvements, fixtures and equipment; $52 millionfor stores purchased or built by us; $49 millionfor distribution and transportation-related capital expenditures; and $12 millionfor information systems upgrades and technology-related projects. During the 2013 period, we opened 375 new stores and remodeled or relocated 377 stores. Capital expenditures during 2014 are projected to be in the range of $450 millionto $500 million. We anticipate funding 2014 capital requirements with existing cash balances, cash flows from operations, and if necessary, our Revolving Facility. We plan to continue to invest in store growth and development with approximately 700 new stores and approximately 500 stores to be relocated or remodeled in our traditional manner. We are also testing a limited-scope remodeling program to refresh some of our older, smaller stores with the goal of increasing sales by making them more appealing to our customers. We currently plan to have completed 400 of these limited-scope remodels by the end of 2014. Capital expenditures for the remainder of 2014 are anticipated to support our store growth as well as our remodel and relocation initiatives, including capital outlays for leasehold improvements, fixtures and equipment; the construction of new stores; costs to support and enhance our supply chain and technology initiatives; and routine and ongoing capital requirements. Cash flows from financing activities. Net borrowings under the Revolving Facility were $190.0 millionduring the 2014 period compared to net repayments of $78.9 millionduring the 2013 period. During the 2014 and 2013 periods, we repurchased 14.1 million and 4.3 million outstanding shares of our common stock at a total cost of $800.1 millionand $220.0 million, respectively. Proceeds from the issuance of long-term obligations in the 2013 period include the $1.0 billionunsecured Term Facility and the issuance of the Senior Notes totaling approximately $1.3 billion, the proceeds from which were used to extinguish our previous secured term loan and revolving credit facilities. We also paid debt issuance costs and hedging fees totaling $29.2 millionin the 2013 period related to our refinancing. Share Repurchase Program
We have an existing common stock repurchase program with a total remaining authorization of approximately