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Fred's Inc.’s (FRED - Analyst Report) second-quarter fiscal 2013 earnings of 9 cents increased 50% year over year from 6 cents (favorable tax credits related to a state income tax settlement as well as adjustments for other tax related assumptions) in the year ago period. Earnings were at the higher end of the company’s expected range of 6 cents to 9 cents. Improved margins and cost savings made up for the soft revenues to boost earnings. Earnings were, however, in line with the Zacks Consensus Estimate.

Revenues and Margin Performance

Total sales increased only 2.0% year over year to $482.2 million, missing the Zacks Consensus Estimate of $483.0 million. Sales were also at the bottom end of Fred’s top line growth expectations of 2%-4%. Categories like tobacco, consumables, paper, pet, beverage and lawn and garden reported modest sales in the quarter.

Fred’s’ comparable store sales climbed 2.2% during the quarter better than a % decline a year ago. Comparable sales improved on the back of higher customer traffic and average ticket during the quarter. Comps in expanded Hometown Auto & Hardware departments improved during the quarter. Comparable stores were better than management’s expectation of flat year-over-year comps during the quarter.

Gross profits grew 3% to $136.0 million while gross margin expanded 20 basis points (bps) to 28.2% from the year-ago quarter. The improvement in gross margin primarily results from higher pharmacy department margins on generic prescriptions. Penetration of stores with pharmacies increased from 50% to 52%.

Disciplined cost management led to lower selling, general and administrative (SG&A) expenses. SG&A expense margin leveraged 20 bps to 27.1% in the quarter. During the quarter, Fred's closed 21 stores and opened three locations, one being at a new Xpress pharmacy location and the other two store locations.

Operating income soared 55.0% to $5.2 million in the quarter while margins inflated 40 bps to 1.1% due to prudent expense management.

Guidance

Third quarter of fiscal 2013

For the third quarter of fiscal 2013, Fred’s forecasts its total sales to increase in the range of 1% to 3%, while it expects comparable store sales to be flat to up to 2% in the third quarter better than a decline of 2.5% a year ago. The company expects earnings to remain within a range of 19 cents–23 cents per share in the quarter, up 6%-8% from the year-ago level.

Fiscal 2013 Outlook Retained

Management expects competitive climate to be intense and the operating environment to be challenging in the second half of the year. Discretionary spending is expected to remain low, especially of the lower income consumers which comprise Fred’s principal customers. For the fiscal 2013, Fred’s continues to expect earnings in the range of 81 cents–86 cents per share, representing a growth of 17% to 25% over the year-ago level.

Management is well on track to improve its pharmacy department growth, expand its specialty drug program and roll out its expanded auto and hardware program. However, the company continues to expect tough retail conditions to continue across the markets in fiscal 2013.

The Zacks Consensus Estimate is pegged at 22 cents per share for the third quarter and 85 cents for fiscal 2013.

Fred’s currently carries a Zacks Rank #3 (Hold). Other stocks in the retail and wholesale sector worth considering include Hanesbrands Inc. (HBI - Analyst Report), Micheal Kors Inc. (KORS - Analyst Report) and Columbia Sports Inc. (COLM - Snapshot Report). While Hanesbrands and Micheal Korscarry a Zacks Rank #1 (Strong Buy), Columbia Sports carries a Zacks Rank #2 (Buy).

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