Fred’s Losses Widen on DIR Charges and Lower Sales

Retail chain feels the sting of generic deflation, reimbursement pressure, and DIR fees

a1Discount retail chain Fred’s Inc. (NASDAQ: FRED) announced its Q2 FY16 and H1 FY16 financial results on August 30th, 2016.

The Memphis, Tennessee-based Company, together with its subsidiaries, sells general merchandise through its retail discount stores and full service pharmacies. It offers household cleaning supplies, health and beauty aids, disposable diapers, pet foods, paper products, various food and beverage products, and pharmaceuticals to low, middle, and fixed income families in small- to medium- sized towns. It also sells general merchandise to franchised Fred’s stores.

As of January 30th, 2016, Fred’s operated 641 company-owned stores, including 60 express stores in 15 states and 18 franchised stores under the Fred’s name, as well as 372 pharmacies and 3 specialty pharmacy facilities primarily in the southeastern U.S. Read more about Fred’s financial results below.

Q2 FY16 financial highlights

During Q2 FY16, Fred’s total sales declined 3% to $529.5 million compared to $546.0 million in the year-ago period. Comparable store sales fell 2% versus an increase of 0.9% in the year-ago period.

Separately, Fred’s also reported sales for the four weeks ended August 27th, 2016, which again presented a dismal picture. Sales again fell 3.5% to $159.6 million from $165.3 million in August 2015. Moreover, comparable store sales for August 2016 declined 3% versus an increase of 1.2% in the year-earlier month.

During Q2 FY16, Fred’s gross profit slipped 2.9% to $128.1 million from $131.9 million in the prior-year period. Gross margin for the reporting quarter remained flat at 24.2% compared to the same quarter last year. Fred’s recorded a last in first out (LIFO) adjustment of $0.2 million in Q2 FY16, compared to $2.9 million in the same quarter last year. Also during Q2 FY16, Fred’s recorded high direct and indirect remuneration (DIR) charges of $4.0 million compared to $2.0 million last year. On a year-to-date basis, DIR charges totaled $4.5 million in 2016 versus $3.4 million last year.

During Q2 FY16, Fred’s selling, general, and administrative (SG&A) expenses, including depreciation and amortization, grew by 70 basis points to 26.3% of sales from 25.6% of sales in the prior-year quarter. The higher SG&A was mainly due to a decrease in sales volume, partially offset by a decrease in insurance expense as well as a decrease in labor expense mostly due to implementation of pharmacy labor optimization initiatives.

Consequently, Fred’s operating loss widened to $10.9 million, or (2.1%) of sales, during Q2 FY16, compared to a loss of $7.8 million, or (1.4%) of sales, in the prior-year period. Adjusted EBITDA nosedived 76% to $1.8 million, or 0.3% of sales, compared to $7.3 million, or 1.3% of sales, in the year-earlier quarter. As a result, Fred’s went deeper into the red with losses of $6.9 million, or ($0.18) per share, compared to a net loss of $4.9 million, or ($0.13) per share, for the prior year period.

H1 FY16 financial highlights

For H1 FY16, Fred’s total sales grew 2.3% to $1,079 million versus the prior-year period. Comparable store sales decreased 0.6% versus an increase of 0.7% in the prior-year period. Fred’s gross profit inched up 0.2% to $269.5 million from $269.0 million in the prior-year period, while gross margin deleveraged 50 basis points to 25.0% from 25.5% in the prior-year period. During H1 FY16, Fred’s recorded a LIFO adjustment of $1.1 million compared with $3.3 million last year.

For H1 FY16, Fred’s SG&A expenses, including depreciation and amortization, decreased 40 basis points to 25.8% of sales from 26.2% of sales in the prior-year period, mainly driven by the growth in specialty pharmacy sales. Despite the decreases in costs, Fred’s operating loss widened to $8.5 million, or (0.8%) of sales, compared to a loss of $7.7 million, or (0.7%) of sales, in the year-ago period. Adjusted EBITDA also fell 8% to $17.4 million, or 1.6% of sales, in H1 FY16, compared to $18.9 million, or 1.8% of sales, last year. Consequently, Fred’s net loss widened to $5.7 million, or ($0.15) per share, compared to a net loss of $4.9 million, or ($0.13) per share, for the same period last year.

Other highlights

a2Store update: As of the end of Q2 FY16, Fred’s operated 651 discount general merchandise stores and 3 specialty pharmacy-only locations in 15 states in the southeastern U.S. This includes 18 franchised locations and 372 full-service pharmacy departments located within Fred’s stores, including 4 franchised locations.

Mary Lou Gardner promoted to Executive Vice President/Chief Merchandising and Marketing Officer: On August 18th, 2016, Fred’s announced that it has promoted Mary Lou Gardner to Executive Vice President/Chief Merchandising and Marketing Officer, effective immediately. She replaces Bryan Pugh, who has resigned from the Company.

a3Timothy Liebmann promoted to COO-Pharmacy: On August 18th, 2016, Fred’s announced that Timothy A. Liebmann, Vice President of Pharmacy Services, has been promoted to newly created role of Chief Operating Officer – Pharmacy, effective immediately. Liebmann succeeds Rick A. Chambers, Executive Vice President – Pharmacy Operations, who is retiring from the Company.

Michael Bloom named CEO: On August 29th, 2016, Fred’s announced that CEO Jerry A. Shore will retire from the Company in February 2017. The Board of Directors named Michael K. Bloom to take over as CEO with immediate effect.

Craig Barnes promoted to COO-Front Store: On August 29th, 2016, Fred’s announced that Craig Barnes, Executive Vice President of Supply Chain, Global and Domestic Logistics, has been promoted to the newly created role of Chief Operating Officer – Front Store. In this role, Barnes will be responsible for Merchandising, Marketing, Supply Chain, Store Operations and Real Estate, and will report directly to Michael K. Bloom, CEO.

Guidance for H2 FY16

For H2 FY16, based on recent sales trends and near-term outlook, Fred’s expect changes in both total sales and comparable store sales to range from negative 1% to a positive 1%. Fred’s also predicts a loss per diluted share to range between ($0.18) to ($0.23), with Q3 FY16 loss deeper than Q4 FY16 loss. Adjusted EBITDA is expected to be in the range of $18 million to $21 million during the latter half period.

Stock Performance

a4Fred’s stock ended the day at $10.62, slipping 3.45%, at the close on Thursday, September 8th, 2016, having vacillated between an intraday high of $11.00 and a low of $10.51 during the session. The stock’s trading volume was at 262,160 for the day. The Company’s market cap was at $399.63 million as of Thursday’s close.

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