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Shares of discount retailer Fred's Inc.’s (FRED - Analyst Report) decreased 2% after it posted second-quarter fiscal 2014 loss of 19 cents which was wider than the Zacks Consensus Estimate of a loss of 18 cents per share. The results compared unfavorably to earnings of 9 cents reported a year ago as well as the company’s expectation of earnings of 15 to 20 cents. Lower comps and weak margins resulted in the earnings miss.

The earnings in the second quarter exclude provisions to establish reserves for inventory clearance and store closings related Fred’s reconfiguration plan.

 

Fred’s embarked on a 3-year reconfiguration plan in fiscal 2012, to enhance its focus on higher-margin categories and move away from the lower-margin consumable categories. The company is remodeling and refreshing its store layouts and allocating space to highlight the key revenue-generating categories.

Fred’s is geared to increase pharmacy departments in all its stores, keeping in view its substantial contribution to the overall profit. As part of this strategy, Fred’s plans to do away with low-productive inventory that does not fit its store model. It also plans to close 60 stores that have no pharmacies and do not meet operational performance targets.

Revenues and Margin Performance

Total second-quarter sales increased 2% to $491.2 million from $482.2 million in the year-ago quarter. Sales were in line the Zacks Consensus Estimate of $491.0 million. Comparable store sales slipped 0.1% versus an increase of 2.2% in the year-ago period.

Sales of segments like Household goods, Apparel and linen, Paper and chemical and Food and tobacco declined from the last year However, Pharmaceuticals sales improved as a result of the availability of cheaper medicines due to the ongoing generic conversion of drugs.

Gross margin shrank 260 basis points (bps) to 25.6% of sales, excluding the impact of the inventory provision. Margins were under pressure due to increased promotional environment and competitive activity in the discount retail industry that increased the cost of sales during the quarter.

Disciplined expense management was offset by higher occupancy-related cost and transitional costs associated with the restructuring of Fred’s’ store models. As a result selling, general and administrative (SG&A) expenses in the quarter stood at 27.9% of sales, up 80 bps from the prior year. The company incurred operating loss of $26.1 million versus income of $5.2 million a year ago.

Strategic Initiatives to Improve Sales

Fred’s plans to accelerate its pharmacy acquisition that will help the company to achieve its target of reaching a 65% to 70% penetration rate of stores with a pharmacy. The company also plans to initiate a new marketing plan, directed at driving customer traffic through multiple avenues, including expanded ad circulars and in-store programs.

Guidance

Third-Quarter Fiscal 2014

The Zacks Rank #5 (Strong Sell) company provided a conservative outlook for third-quarter fiscal 2014.

For third-quarter fiscal 2014, Fred’s expects total sales to increase in the range of 3% to 5% on a year-over-year basis. Comparable store sales are expected to increase in the range of 1% to 3%.. Loss per share is forecasted in the range of 5 to 11 cents for the third quarter compared with earnings of 9 cents in the year-ago quarter. The Zacks Consensus Estimate is pegged at 12 cents per share.

Fiscal 2014 and Fiscal 2015 Outlook

Management expects general merchandise and pharmacy department to turn positive in the second half of the year backed by new programs to reconfigure its stores. Net sales are expected to rise in the range of 3% to 5%. Comparable store sales are expected to increase in the range of 1% to 3%. The company expects to incur a loss in the range of 5 cents to 11 cents. The Zacks Consensus Estimate is pegged at 22 cents earnings per share.

For fiscal 2014, earnings per share for 2014 are expected in the range of 72 to 82 cents up 8% from 2013.

Some better-ranked stocks to consider in the apparel industry include Crocs, Inc. (HBI - Analyst Report), Columbia Sports Inc. (COLM - Snapshot Report) and Micheal Kors Holding Limited. (KORS - Analyst Report), all carrying a Zacks Rank #2 (Buy).

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