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Fred's Inc. (FRED - Analyst Report) second quarter 2012 adjusted earnings of 13 cents per share missed the Zacks Consensus Estimate of 18 cents per share by 5 cents. Earnings exclude the favorable impact from certain tax adjustments, store closings and product transitioning. However, reported earnings were flat year over year.

Earnings were below management’s guidance range of 15 cents to 17 cents per share, owing to a decline in comparable stores sales.

The company reported second quarter 2012 GAAP diluted earnings per share (including $4.0 million of income tax settlement with the state of Tennessee and other items) of 17 cents, which exceeded the prior-year quarter earnings of 13 cents by 31%.

Revenue

Total sales increased 4% year over year to $470.8 million, in line with the company’s guidance, driven by strong sales in the pharmacy department, higher gross margin and contributions from latest acquisitions and new stores. Sales for the second quarter of fiscal 2012 also beat the Zacks Consensus Estimate of $468 million.

Fred’s comparable store sales slipped 1.0% during the quarter compared with a 0.4% drop in the year-ago quarter, owing to the conversion of branded drugs to generic drugs in the pharmaceutical department.

Quarter Highlights

Fred’s completed 13 pharmacy acquisitions during the second quarter 2012, including six new stores and seven incremental acquisitions. The company has also opened two cold start pharmacies during the first two quarters of 2012.

During the second quarter, Fred's opened three new stores and two Xpress pharmacies. Fred's also closed down 14 stores during the quarter. At the end of the second quarter, Fred’s has a total of 698 stores and 332 pharmacies.
 
At the end of July 28, 2012, Fred’s cash and cash equivalents increased to $23 million from $7.8 million as of April 28, 2012. The company used cash to finance share repurchase programs and increase dividends.

Guidance

Management expects tough retail conditions to continue for the rest of  fiscal 2012. The company also expects the conversion of branded drugs to generic drugs to negatively impact comparable store sales. The company intends to achieve sales growth by investing in brand building and aggressively pursuing pharmacy acquisitions.

For the third quarter of 2012, Fred’s forecasts its total sales to increase 2% to 4%. Comparable store sales are expected to dip 1% to 3% for the third of quarter 2012. The company expects earnings to remain within the range of 22 cents to 26 cents per share in the third quarter of 2012.

Based on the results of the previous two quarters of 2012, Fred’s expects its 2012 earnings to be in the range of 97 cents to $1.04 per share, down from the previous guidance of 98 cents to $1.04 per share. The company expects full year 2012 effective tax rate in the range of 36.5% to 37.5%. The company intends to open 25 to 30 new stores and 25 to 30 new pharmacies during fiscal 2012.

Our Recommendation

We currently have a Neutral recommendation on Fred's Inc. The stock carries a Zacks #3 Rank (short-term ‘Hold’ rating).

We are positive about Fred’s initiative of revamping its stores and upgrading stocks to attract more traffic. Also, continued sluggish economy is likely to compel consumer spending to shift from high-end products to low priced goods, which would benefit the company.

However, we prefer to stay on the sidelines as the company has been experiencing low comparable store sales growth for the past several months. Also, the absence of international exposure deprives Fred’s of the benefits of high growth opportunities in the developing nations like China, Brazil, India, Mexico, Russia and Southeast Asia.

Based in Memphis, Tennessee, Fred's Inc. sells frequently purchased items, like household goods, apparel, food, tobacco, and healthcare and paper products through company owned discount general merchandise stores, franchised "Fred's" stores.

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