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Fred's Inc. (FRED - Analyst Report) reported first-quarter 2012 adjusted earnings of 28 cents, which exceeded the prior-year quarter earnings of 24 cents by 17%. However, earnings were in line with the Zacks Consensus Estimate. The earnings were at the higher end of management’s guidance range of 26 to 28 cents per share. Results were driven by strong sales in the pharmacy department and decent same-store sales.

Revenue and Margin Performance

Total sales increased 3% year over year to $500.5 million. Sales for the first quarter of fiscal 2012 surpassed the Zacks Consensus Estimate of $475 million. Fred’s comparable store sales slipped 0.4% during the quarter compared to a 1.0% rise in the year-ago quarter.

Gross profits grew 7% to $147.8 million, while gross margin expanded 100 basis points to 29.5% from the year-ago quarter. The improved margin was the result of promotional markdowns and higher rebates and allowances from vendors.

Selling, general and administrative expense margin, including depreciation and amortization, increased 70 basis points to 26.1% from 25.4% in the year-ago quarter, driven by higher depreciation and amortization, group medical expenses and legal and professional fees.

Operating income went up 13% to $17.1 million in the quarter, while margins expanded 30 basis points to 3.4% of sales.

Store Update

As part of the fiscal 2012 operating plan of opening 22 to 28 stores, Fred's opened 3 new stores and 4 express pharmacy stores during the quarter.

Fred's operates 707 discount general merchandise stores, which includes 21 franchised stores. Fred's stores are located in southeast U.S.

Other Financial Update

At the end of April 28, 2012, Fred’s cash and cash equivalents came down to $7.8 million from $57.1 million as of April 30, 2011.The company used cash for renovating its pharmacy stores and give it a new look. There were also number of new acquisitions in the pharmacy department which attributed to the significant decline in cash held by the company.

Guidance

Management expects tough retail conditions to continue across the markets in fiscal 2012. The company estimates that fiscal 2012 will witness the largest conversion of branded drugs to generic drugs. This will negatively affect comparable store sales. Comparable store sales are estimated to remain flat in the second quarter of 2012.

For the second quarter of 2012, Fred’s forecasts its total sales to increase 4% to 6%. The company expects earnings to grow between15% and 30% and remain within the range of 15 cents - 17 cents per share in the second quarter of 2012. Fred’s expects its 2012 earnings to be in the range of 98 cents to $1.04 per share.

Fred’s faces stiff competition from Dollar General Corporation (DG - Analyst Report), Walgreen Co. (WAG - Analyst Report) and Wal-Mart Stores Inc. (WMT - Analyst Report). Currently, we have a long-term Neutral recommendation on Fred’s, which carries a Zacks #2 Rank (short-term Buy rating).

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