We have reviewed the condensed consolidated balance sheet of Dollar General Corporation and subsidiaries (the Company) as of July 30, 2010, and the related condensed consolidated statements of operations for the three-month and six-month periods ended July 30, 2010 and July 31, 2009, and the condensed consolidated statements of cash flows for the six-month periods ended July 30, 2010 and July 31, 2009. These financial statements are the responsibility of the Companys management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Dollar General Corporation as of January 29, 2010 and the related consolidated statements of operations, shareholders equity, and cash flows for the fiscal year then ended (not presented herein) and in our report dated March 31, 2010, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of January 29, 2010, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
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 Managements 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 29, 2010. It also should be read in conjunction with the disclosure under Cautionary Disclosure Regarding Forward-Looking Statements in this report.
We are the largest discount retailer in the United States by number of stores, with 9,113 stores located in 35 states as of July 30, 2010, 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 and pet supplies; and non-consumable products such as seasonal merchandise, home decor and domestics, and 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 $10 or less) in our convenient small-box (small store) locations.
The customers we serve are value-conscious, and Dollar General has always been intensely focused on helping our customers make the most of their spending dollars. We believe our convenient store format and broad selection of high quality products at compelling values have driven our substantial growth and financial success over the years. Like other companies, over the past two years we have been operating in an environment with heightened economic challenges and uncertainties. Consumers are facing very high rates of unemployment, fluctuating food, gasoline and energy costs, rising medical costs, continued weakness in the housing and credit markets, and the timetable for economic recovery remains uncertain. Nonetheless, as a result of our long-term mission of serving the value-conscious customer, coupled with a vigorous focus on improving our operating and financial performance, we remain optimistic with regard to executing our operating priorities in 2010.
At the beginning of 2008, we defined the following four operating priorities on which we remain keenly focused:
strengthen and expand Dollar General's culture of serving others.
Our first priority is driving productive sales growth by increasing shopper frequency and transaction amount and maximizing sales per square foot. We continue to enhance our category management processes, allowing the expansion of our product offerings while also improving profitability. Our improved processes have facilitated our success in adding more productive items and eliminating unproductive items. We are better utilizing the space in our stores through more effective and productive space planning. In addition, we are currently implementing the third phase of a four phase process to raise the height of our merchandise fixtures across the store. Phase three primarily impacts expansion of the health and beauty, home and apparel sections of the store. In addition, we are making significant progress in defining and improving our store standards with a goal of developing a consistent look and feel across all stores. We are targeting both new and existing customers with our improved advertising circulars, which have allowed us to communicate our strong value proposition to consumers struggling in the current economy. Finally, we believe we have significant potential to grow sales through new stores in both existing and new markets. We plan to open approximately 600 new stores in fiscal 2010, 315 of which have been opened in the first half of the year.
Our second priority is to increase gross profit through category management, distribution efficiencies, shrink reduction, an improved pricing model, expansion of private brand offerings and increased foreign sourcing. Our merchandising team has been successful in efforts to upgrade our merchandise selection to better serve our customers while managing our everyday low price strategy. We constantly review our pricing strategy and work diligently to minimize product cost increases and to remain competitive. We are focused on sales of private brands, which generally have higher gross profit rates than national brands, while we continue to offer a wide variety of national brands to ensure an optimal mix of product offerings. We believe that our improved quality, selection, packaging and branding of our seasonal merchandise has contributed significantly to sales increases. We made significant progress over the past two years in reducing inventory shrinkage, as a percentage of sales, and we continue to be highly focused on shrink reduction initiatives. Finally, our supply chain team continues its efforts to increase capacity utilization and transportation efficiencies, while facing challenging domestic fuel costs.
Our third priority is leveraging process improvements and information technology to reduce costs. We are committed as an organization to extracting costs that do not affect the customer experience. Examples of cost reduction initiatives include our continuing focus on safety to reduce workers compensation expense, the improvement of energy management in our stores through the installation of energy management systems and increased preventive maintenance, and the reduction of waste management costs through recycling of cardboard and other materials. In addition, our real estate team has had success in negotiating favorable terms in lease renewals which we anticipate will benefit us going forward.
Our fourth priority is to strengthen and expand Dollar Generals culture of serving others. For customers, this means helping them Save time. Save money. Every day! by providing clean, well-stocked stores with quality products at low prices. For employees, this means creating an environment that attracts and retains key employees throughout the organization. For the public, this means giving back to our store communities. For shareholders, this means meeting their expectations of an efficiently and profitably run organization that operates with compassion and integrity.
Focus on these priorities resulted in improved performance in the second quarter of 2010 over the comparable 2009 period in many of our key financial metrics, as follows. Basis points amounts referred to below are equal to 0.01% as a percentage of sales.
Total sales increased 10.8% to $3.21 billion. Sales in same-stores increased 5.1% driven by increases in customer traffic and average transaction amount. Average sales per square foot for all stores over the 52-week period ended July 30, 2010 were approximately $199, up from $188 for the comparable prior 52-week period.
Gross profit, as a percentage of sales, increased to 32.2% compared to 31.2% in the 2009 period. This increase was primarily the result of higher average markups, partially offset by higher markdowns, and was driven by efforts to reduce our merchandise purchase costs while maintaining our everyday low prices.
Inventory turnover improved to 5.2 times on a rolling four-quarter basis compared to 5.1 times for the corresponding prior year period.
Selling, general and administrative expenses, or SG&A, as a percentage of sales, was 22.9% compared to 23.2% in the 2009 second quarter. SG&A as a percentage of sales declined due to our significant sales increase as well as our continued focus on cost reduction initiatives.
Operating profit, as a percentage of sales, was 9.4% compared to 8.0% in the 2009 second quarter, an improvement of 132 basis points.
Interest expense decreased by $20.6 million to $69.3 million in the 2010 second quarter primarily due to a $785 million reduction of long-term obligations in the 12-month period ended July 30, 2010. Total long-term obligations as of July 30, 2010 were $3.35 billion. The Company repurchased long-term obligations of $50 million in the 2010 second quarter resulting in a charge of $6.5 million ($4.0 million net of income taxes, or $0.01 per diluted share).
Net income was equal to $141.2 million, or $0.41 per diluted share, compared to net income of $93.6 million, or $0.29 per diluted share, in the 2009 second quarter.
Like other companies, we face uncertainties with regard to the future impact of healthcare reform legislation, including the Patient Protection and Affordable Care Act and the HealthCare and Education Reconciliation Act of 2010, signed into law in March 2010, which will likely affect the cost associated with employer-sponsored medical plans. Specifically, this legislation requires that employers provide a minimum level of coverage for full-time employees or pay penalties. Some of the plan coverage requirements may have an impact on our costs such as bans on exclusions for pre-existing conditions, extension of dependent coverage to age 26, and caps on employee premium sharing costs. Certain coverage provisions do not go into effect until 2014, but there are a number of dependent coverage and insurance market reforms that will take effect immediately. Although we do not expect this legislation will have a material effect on our consolidated financial statements in fiscal 2010, we continue to evaluate the impact it will have
on our costs in future years, and those costs could be material. Our analysis depends in part upon future guidance yet to be developed by federal agencies interpreting the legislation, and any estimates we develop could be significantly affected by any changes to or agency interpretation of the legislation prior to its full implementation.
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.
The following table contains results of operations data for the most recent 13-week and 26-week periods of each of 2010 and 2009, and the dollar and percentage variances among those periods:
In summary, we believe that the increase in sales reflects the impact of various operating and merchandising initiatives discussed in the Executive Overview, including the impact of improved store standards, the expansion of our merchandise offerings, improved utilization of store square footage and improved marketing efforts.
Interest Expense. The decrease in interest expense in the 2010 period from the 2009 period is due to lower outstanding borrowings, resulting from our repurchases of indebtedness in 2010 and 2009.
Other (Income) Expense. Other (income) expense in the 2010 period includes the pretax loss of $6.5 million resulting from the repurchase in the open market $50.0 million aggregate principal amount of our Senior Notes at a price of 111.0% plus accrued and unpaid interest.
Income Taxes. The effective income tax rate for the 2010 period was 37.2% compared to a rate of 35.8% for the 2009 period which represents a net increase of 1.4%. This increase in rate was due principally to an adjustment to a deferred tax valuation allowance associated with state income taxes. While both periods included a decrease in the valuation allowance (which reduces the effective income tax rate), the 2010 decrease was smaller than the decrease that occurred in 2009.
26 WEEKS ENDED JULY 30, 2010 AND JULY 31, 2009
Net Sales. The net sales increase in the 2010 period reflects a same-store sales increase of 5.9% compared to the 2009 period. Same-stores include stores that have been open at least 13 months and remain open at the end of the reporting period. For 2010, there were 8,427 same-stores which accounted for sales of $5.96 billion. The remainder of the sales increase was attributable to new stores, partially offset by sales from closed stores.
We believe that the increase in sales reflects the impact of various operating and merchandising initiatives discussed in the Executive Overview, including the impact of improved
store standards and the expansion of our merchandise offerings, in addition to improved utilization of store square footage and improved marketing efforts.
Gross Profit. The gross profit rate as a percentage of sales was 32.2% in the 2010 period compared to 31.0% in the 2009 period. The increase in the 2010 gross profit rate resulted primarily from higher purchase markups, partially offset by increased markdowns. Increased sales volumes have contributed to our ability to reduce product costs. In addition, our increased mix of private brands and our more effective category management processes have contributed to our ability to increase overall markups. These factors were partially offset by increased transportation costs in the 2010 period, driven primarily by higher fuel costs.
SG&A Expense. SG&A expense was 22.8% as a percentage of sales in the 2010 period compared to 22.9% in the 2009 period, a decrease of 11 basis points. SG&A in the 2010 period includes expenses totaling $15.0 million, or 24 basis points, relating to a secondary offering of our common stock, including $0.7 million of legal and other transaction expenses and $14.3 million relating to the acceleration of certain equity appreciation rights. In addition to the impact of increased sales, items positively affecting SG&A expense, as a percentage of sales, during the 2010 period include utilities costs in general which were aided by our improved energy management systems and lower waste management costs in particular reflecting our recycling efforts, a lower charge relating to the impairment of fixed assets, and a decrease in estimated incentive compensation, partially offset by overall increases in retail salaries due in part to an increase in certain minimum wage rates, and higher debit card processing fees resulting from increased usage.
Interest Expense. The decrease in interest expense in the 2010 period from the 2009 period is due to lower outstanding borrowings, resulting from our repurchases of indebtedness in 2009 and 2010.
Other (Income) Expense. Other (income) expense in the 2010 period includes the pretax loss of $6.5 million resulting from the repurchase in the open market $50.0 million aggregate principal amount of our Senior Notes at a price of 111.0% plus accrued and unpaid interest.
Income Taxes. The effective income tax rate for the 2010 period was 37.5% compared to a rate of 36.9% for the 2009 period which represents a net increase of 0.6%. This increase in rate was due principally to an adjustment to a deferred tax valuation allowance associated with state income taxes. While both periods included a decrease in the valuation allowance (which reduces the effective income tax rate), the 2010 decrease was smaller than the decrease that occurred in 2009.
In June 2009, the FASB issued new accounting guidance relating to variable interest entities. This standard amends previous standards and requires an enterprise to perform an analysis to determine whether the enterprises variable interest or interests give it a controlling financial interest in a variable interest entity, specifies updated criteria for determining the primary beneficiary, requires ongoing reassessments of whether an enterprise is the primary
beneficiary of a variable interest entity, eliminates the quantitative approach previously required for determining the primary beneficiary of a variable interest entity, amends certain guidance for determining whether an entity is a variable interest entity, requires enhanced disclosures about an enterprises involvement in a variable interest entity, and includes other provisions. This standard was effective as of January 30, 2010, the beginning of our fiscal year. The adoption of this guidance did not have a material impact on our consolidated financial statements and is not currently expected to be material in future periods.
Liquidity and Capital Resources
We have two senior secured credit facilities (the Credit Facilities) which provide financing of up to $2.995 billion as of July 30, 2010. The Credit Facilities consist of a $1.964 billion senior secured term loan facility (Term Loan Facility) and a senior secured asset-based revolving credit facility (ABL Facility). Total commitments under the ABL Facility are equal to $1.031 billion (of which up to $350.0 million is available for letters of credit), subject to borrowing base availability. The ABL Facility includes borrowing capacity available for letters of credit and for short-term borrowings referred to as swingline loans.
The amount available under the ABL Facility (including letters of credit) is subject to certain borrowing base limitations. The ABL Facility includes a last out tranche in respect of which we may borrow up to a maximum amount of $101.0 million.
Borrowings under the Credit 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 is (i) under the term loan facility, 2.75% for LIBOR borrowings and 1.75% for base-rate borrowings (ii) as of July 30, 2010, under the ABL Facility (except in the last out tranche described above), 1.25% for LIBOR borrowings and 0.25% for base-rate borrowings; and for any last out borrowings, 2.25% for LIBOR borrowings and 1.25% for base-rate borrowings. The applicable margins for borrowings under the ABL Facility (except in the case of last out borrowings) are subject to adjustment each quarter based on average daily excess availability under the ABL Facility. We are also required to pay a commitment fee to the lenders under the ABL Facility for any unutilized commitments at a rate of 0.375% per annum. We also must pay customary letter of credit fees.
Under the Term Loan Facility we are required to prepay outstanding term loans, subject to certain exceptions, with up to 50% of our annual excess cash flow (as defined in the credit agreement) which will be reduced to 25% and 0% if we achieve and maintain a total net leverage ratio of 6.0 to 1.0 and 5.0 to 1.0, respectively; the net cash proceeds of certain non-ordinary course asset sales or other dispositions of property; and the net cash proceeds of any incurrence of debt other than proceeds from debt permitted under the senior secured credit agreement. Through July 30, 2010, no prepayments have been required under the prepayment provisions listed above. The Term Loan Facility can be prepaid in whole or in part at any time.
We voluntarily prepaid $325.0 million of the Term Loan Facility in January 2010 and, as a result, no further principal payments will be required prior to its maturity on July 6, 2014, assuming no mandatory prepayment provisions are triggered before such date. There is no amortization under the ABL Facility. The entire principal amounts (if any) outstanding under the ABL Facility are due and payable in full at maturity on July 6, 2013.
In addition, we are required to prepay the ABL Facility, subject to certain exceptions, with the net cash proceeds of all non-ordinary course asset sales or other dispositions of revolving facility collateral (as defined in the senior secured credit agreement); and to the extent such extensions of credit exceed the then current borrowing base. Through July 30, 2010, no prepayments have been required under any prepayment provisions.
We may voluntarily repay outstanding loans under the Term Loan Facility or the ABL Facility at any time without premium or penalty, other than customary breakage costs with respect to LIBOR loans.
All obligations under the Credit Facilities are unconditionally guaranteed by substantially all of our existing and future domestic subsidiaries (excluding certain immaterial subsidiaries and certain subsidiaries designated by us under our senior secured credit agreements as unrestricted subsidiaries), referred to, collectively, as U.S. Guarantors.
All obligations and related guarantees under the Term Loan Facility are secured by:
a second-priority security interest in all existing and after-acquired inventory, accounts receivable, and other assets arising from such inventory and accounts receivable, of our company and each U.S. Guarantor (the Revolving Facility Collateral), subject to certain exceptions;
a first-priority security interest in, and mortgages on, substantially all of our and each U.S. Guarantors tangible and intangible assets (other than the Revolving Facility Collateral); and
a first-priority pledge of 100% of the capital stock held by us, or any of our domestic subsidiaries that are directly owned by us or one of the U.S. Guarantors and 65% of the voting capital stock of each of our existing and future foreign subsidiaries that are directly owned by us or one of the U.S. Guarantors.
All obligations and related guarantees under the ABL Facility are secured by the Revolving Facility Collateral, subject to certain exceptions.
The senior secured credit agreements contain a number of covenants that, among other things, restrict, subject to certain exceptions, our ability to: incur additional indebtedness; sell assets; pay dividends and distributions or repurchase our capital stock; make investments or acquisitions; repay or repurchase subordinated indebtedness (including the Senior Subordinated Notes discussed below) and the Senior Notes discussed below; amend material agreements governing our subordinated indebtedness (including the Senior Subordinated Notes discussed
below) or our Senior Notes discussed below; or change our lines of business. The senior secured credit agreements also contain certain customary affirmative covenants and events of default.
At July 30, 2010, we had no borrowings, $24.2 million of commercial letters of credit, and $66.7 million of standby letters of credit outstanding under our ABL Facility.
Senior Notes due 2015 and Senior Subordinated Toggle Notes due 2017
As of July 30, 2010, we have $929.3 million aggregate principal amount of 10.625% senior notes due 2015 (the Senior Notes) outstanding (reflected in our consolidated balance sheet net of a $13.0 million discount), which mature on July 15, 2015, pursuant to an indenture dated as of July 6, 2007 (the senior indenture), and $450.7 million aggregate principal amount of 11.875%/12.625% senior subordinated toggle notes due 2017 (the Senior Subordinated Notes) outstanding, which mature on July 15, 2017, pursuant to an indenture dated as of July 6, 2007 (the senior subordinated indenture). The Senior Notes and the Senior Subordinated Notes are collectively referred to herein as the Notes. The senior indenture and the senior subordinated indenture are collectively referred to herein as the indentures.
Interest on the Notes is payable on January 15 and July 15 of each year. Interest on the Senior Notes is payable in cash. Cash interest on the Senior Subordinated Notes accrues at a rate of 11.875% per annum, and PIK interest (as defined below) if applicable, accrues at a rate of 12.625% per annum. For any interest period subsequent to the initial interest period through July 15, 2011, we may elect to pay interest on the Senior Subordinated Notes (i) in cash, (ii) by increasing the principal amount of the Senior Subordinated Notes or issuing new Senior Subordinated Notes (PIK interest) or (iii) by paying interest on half of the principal amount of the Senior Subordinated Notes in cash interest and half in PIK interest. After July 15, 2011, all interest on the Senior Subordinated Notes will be payable in cash. Through July 30, 2010, all interest on the Senior Subordinated Notes has been paid in cash.
We may redeem some or all of the Notes at any time at redemption prices described or set forth in the indentures. We also may seek, from time to time, to retire some or all of the Notes through cash purchases in the open market, in privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. On May 6, 2010, we repurchased in the open market $50.0 million aggregate principal amount of Senior Notes at a price of 111.0% plus accrued and unpaid interest. The pretax loss on this transaction of $6.5 million is reflected in our condensed consolidated financial statements for the 13- and 26-week periods ended July 30, 2010.
Upon the occurrence of a change of control, which is defined in the indentures, each holder of the Notes has the right to require us to repurchase some or all of such holders 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 indentures contain covenants limiting, among other things, our ability and the ability of our restricted subsidiaries to (subject to certain exceptions): incur additional debt; issue disqualified stock or issue certain preferred stock; pay dividends on or make certain distributions
and other restricted payments; create certain liens or encumbrances; sell assets; enter into transactions with affiliates; make payments to us; consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; or designate our subsidiaries as unrestricted subsidiaries.
The indentures also provide for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on the Notes to become or to be declared due and payable.
Under the agreements governing the Credit Facilities and the indentures, certain limitations and restrictions could arise if we are not able to satisfy and remain in compliance with specified financial ratios. Management believes the most significant of such ratios is the senior secured incurrence test under the Credit Facilities. This test measures the ratio of the senior secured debt to Adjusted EBITDA. This ratio would need to be no greater than 4.25 to 1 to avoid such limitations and restrictions. As of July 30, 2010, this ratio was 1.2 to 1. Senior secured debt is defined as our total debt secured by liens or similar encumbrances less cash and cash equivalents. EBITDA is defined as income (loss) from continuing operations before cumulative effect of change in accounting principles plus interest and other financing costs, net, provision for income taxes, and depreciation and amortization. Adjusted EBITDA is defined as EBITDA, further adjusted to give effect to adjustments required in calculating this covenant ratio under our Credit Facilities. EBITDA and Adjusted EBITDA are not presentations made in accordance with U.S. GAAP, are not measures of financial performance or condition, liquidity or profitability, and should not be considered as an alternative to (1) net income, operating income or any other performance measures determined in accordance with U.S. GAAP or (2) operating cash flows determined in accordance with U.S. GAAP. Additionally, EBITDA and Adjusted EBITDA are not intended to be measures of free cash flow for managements discretionary use, as they do not consider certain cash requirements such as interest payments, tax payments and debt service requirements and replacements of fixed assets.
Our presentation of EBITDA and Adjusted EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under U.S. GAAP. Because not all companies use identical calculations, these presentations of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. We believe that the presentation of EBITDA and Adjusted EBITDA is appropriate to provide additional information about the calculation of this financial ratio in the Credit Facilities. Adjusted EBITDA is a material component of this ratio. Specifically, non-compliance with the senior secured indebtedness ratio contained in our Credit Facilities could prohibit us from making investments, incurring liens, making certain restricted payments and incurring additional secured indebtedness (other than the additional funding provided for under the senior secured credit agreement and pursuant to specified exceptions).
The calculation of Adjusted EBITDA under the Credit Facilities is as follows: