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Fred's Inc.’s (FRED - Analyst Report) third quarter 2012 earnings of 18 cents declined 25% from the prior-year quarter earnings of 24 cents. Earnings also missed the Zacks Consensus Estimate of 21 cents and the company guidance range of 22 cents to 26 cents. The ongoing tough retail environment and higher operating expenses also led to the decline.

Revenue and Margin Performance

Total sales increased 1% year over year to $450.6 million, in line with the Zacks Consensus Estimate. Despite a decline in comparable sales, Fred’s exhibited positive growth on the back of higher merchandise sales and improved consumer traffic, resulting from marketing initiatives. Fred’s comparable store sales slipped 2.5% during the quarter compared to a 1.5% rise in the year-ago quarter.

Gross profits grew 2% to $138.1 million while gross margin expanded 10 basis points to 30.7% from the year-ago quarter. The improved margin was the result of higher pharmacy department gross margin, partially offset by increased charges on pharmacy department inventory, as well as promotional markdowns and shrinkage.

Selling, general and administrative expense margin increased 90 basis points to 28.5% in the quarter, due to higher depreciation and amortization expenses and labor and occupancy costs.

Operating income plummeted 25.7% to $10.1 million in the quarter while margins shrank 80 basis points to 2.2% of sales due to higher operating expenses.

Other Financial Update

Fred's board declared a special dividend of 19 cents per share in the quarter, in addition to the company's regular quarterly dividend of 6 cents per share. The combined dividend of 25 cents will be paid on December 17, 2012, to shareholders as of December 3, 2012.

Guidance

Management expects tough retail conditions to continue across the markets in fiscal 2012. For the fourth quarter of 2012, Fred’s forecasts its total sales, including one extra week, to increase 9% to 11%.

Comparable store sales, including one extra week, are expected to increase 6% to 8%. The company expects earnings to increase in a range of 19% to 38% and remain within a range of 31 cents - 36 cents per share in the fourth quarter of 2012.

Fred’s lowered its 2012 earnings guidance to a range of 94 cents to 99 cents per share from 97 cents to $1.04 per share forecasted earlier.

The Zacks Consensus Estimate is pegged at earnings of 32 cents for the fourth quarter and 96 cents for fiscal 2012.

We currently have a long-term Neutral recommendation on Fred’s. The stock carries a Zacks #3 Rank (a short-term Hold rating). Its peers, Dollar General Corporation (DG - Analyst Report) and Wal-Mart Stores Inc. (WMT - Analyst Report), both carry a Zacks #3 Rank (short-term Hold rating).

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