Dollar Tree, Inc. Q1 FY2020 Earnings Call

Good day, and welcome to Dollar Tree, Inc.'s First Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Randy Guiler, Vice President, Investor Relations. Please go ahead, sir.

Thank you, Aaron. Good morning, and welcome to our conference call to discuss Dollar Tree's performance for Q1 2019. Participating on today's call will be President and CEO, Gary Philbin; Family Dollar President, Duncan Mac Naughton; and our CFO, Kevin Wampler. Before we begin, I would like to remind everyone that various remarks that we will make about future expectations, plans, and prospects for the company constitute forward-looking statements for the purposes of the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors included in our most recent press release, 8-K, 10-Q, and Annual Report, which are on file with the SEC. We have no obligation to update our forward-looking statements, and you should not expect us to do so. At the end of our prepared remarks, we will open the call to your questions. Operator Instructions.

Thank you, Randy. Good morning, everyone. I'm proud of our team's efforts throughout the first quarter, as many of the initiatives we discussed in Q4 have been kicked off and are progressing nicely. Our Dollar Tree team delivered a solid increase in same-store sales while cycling its toughest quarterly compare from the prior year, and Family Dollar again demonstrated a sequential acceleration in comp sales. In fact, the Family Dollar segment delivered its strongest quarterly same-store sales increase since we began reporting comps for the banner. Results for the first quarter included a sales increase of 4.6% to $5.81 billion, with a consolidated same-store sales increase of 2.2%. The Dollar Tree segment delivered its 45th consecutive positive comp quarter with a 2.5% comp, and Family Dollar same-store sales delivered a positive 1.9% despite the shift of early SNAP sales into Q4 from February. GAAP earnings per share were $1.12. On an adjusted basis, excluding the accelerated rent expense for Family Dollar Stores scheduled to close in 2019 related to ASC 842, diluted EPS was $1.14, within $0.01 of the high-end of our guidance range. Other key highlights for the quarter included completing 372 Family Dollar H2 model renovations, completing 324 Dollar Tree Snack Zones, reinitiating our share buyback program, purchasing $100 million worth of shares in the quarter, and continuing to remain on track with our consolidation of store support centers, as many of our Family Dollar associates and new hires are now in the process of moving to the Chesapeake campus. As we outlined in the previous call, due to the costs associated with our store optimization initiatives and store support center consolidation project, year-over-year operating income is expected to be lower in the first half of fiscal 2019, but is expected to show improvement in the second half as the initiatives gain traction. The majority of our previously announced store closings are taking place in the second quarter along with the completion of our store support center consolidation. For Dollar Tree sales highlights in the first quarter, Dollar Tree saw nice increases in both traffic and ticket, with traffic slightly outpacing the ticket increase. Geographically, all regions comped positively. Cadence of comps through the quarter: April was the strongest comp month of the quarter, and March was negative. Both months were impacted by the timing shift of the Easter holiday. Dollar Tree continues to deliver solid positive comps in the consumables category, and our seasonal business performed very well. It remains strong, and our Dollar Tree's Easter season was one of our best sell-throughs ever. At Dollar Tree Canada, the team delivered mid-single-digit positive comps for the quarter with increases in both ticket and traffic. The consumable comp outperformed discretionary. Top-performing categories included Easter, seasonal, food, and household products. Highlights in Q1 for Dollar Tree Direct are our online business. We saw increases in our in-line comp sales, items available-for-sale, site visitors, and engagement. Our e-commerce team continues to do a great job of engaging with our customers through various avenues. Our online content is constantly evolving to reflect our changing assortment, and we are very active in promoting the Dollar Tree brand through blog posts, banner ads, and social media. The team also did a great job in producing and distributing our catalogs for the Easter holiday and the upcoming summer season. Looking at real estate for both banners in the first quarter, we opened a total of 91 new stores, 65 Dollar Trees and 26 Family Dollar Stores. We relocated or expanded 11 stores, 6 Dollar Tree and 5 Family Dollar. We renovated 372 Family Dollar Stores as part of our H2 renovation initiative, and we re-bannered 45 former Family Dollar Stores to Dollar Tree for a total of 519 projects during the quarter. We also added freezers and coolers into 102 Dollar Tree stores during the first quarter, now bringing our total Dollar Tree stores with freezers and coolers to 5,766. During the quarter, we closed 25 stores, 9 Dollar Tree and 16 Family Dollar. And we ended with 15,264 stores, with 7,102 being Dollar Trees and 8,162 being Family Dollar. Before I turn the call over to Duncan to discuss the Family Dollar business, I'd like to provide you an update on tariffs. Our merchandising teams have done a terrific job of mitigating the effects of the 25% tariffs imposed under Section 301 for Chinese goods included on List 1, 2, and 3. We are uncertain as to whether or when tariffs will be applied to the List 4 products currently being considered by the U.S. Trade Representative. If tariffs on List 4 products are implemented, we expect that it will impact our business and especially consumers in general. Until we have more clarity, our outlook excludes the impact of tariffs on List 4 products. However, our outlook continues to include the impact of tariffs on Lists 1, 2, and 3 products. Our teams are doing a great job managing the controllables and running our business. We continue to believe we are well positioned with the initiatives for both Family Dollar and Dollar Tree banners to capture the significant opportunity ahead of us. Now I'll turn the call over to Duncan.

Thank you, Gary, and good morning, everyone. While we are pleased with the Family Dollar team's same-store sale increase of 1.9% for the quarter, we recognize there is much more work to be done. As we make progress on improving the consistency of execution across our store base and accelerate our efforts to optimize the real estate portfolio, we see great opportunity to improve Family Dollar's productivity and performance in 2019 and beyond. We are very bullish on our progress to date and believe this will help transform our customer experience. Regarding Family Dollar sales highlights for the first quarter, an increase in average ticket drove the same-store sales increase in the quarter, partially offset by a decline in transaction count. Consumables performed very well, delivering its 10th consecutive quarter of positive same-store sales, and the discretionary business was slightly negative. Regarding the cadence of comps during the quarter: February was negative, impacted by the shift of early SNAP sales into Q4. March was slightly positive, and April was the strongest month of the quarter, benefiting from the later Easter in 2019. Seven of our eight lines of businesses comped positive for the quarter. From a regional perspective, six of our seven zones comped positively, with the strongest performance in the Northeast, the West, and the Southeast zones. As evidenced by our improved sales performance, our acceleration of initiatives to optimize the Family Dollar real estate portfolio is delivering results. We are seeing meaningful improvement in operational performance across the footprint of renovated Family Dollar Stores, resulting in increased traffic and low double-digit comp sales lifts. We are pleased with the results of our H2 renovation program, both with traffic and the diversity of our locations. Comps are being driven two-thirds by traffic and one-third by average ticket. Customer feedback has included the following: Customers indicate they're shopping more often and spending more for the improved assortment. Broader selection of $1 items, more frozen and refrigerated product, and cleaner stores. Our survey feedback indicates H2 shoppers have a better overall shopping experience. More than half of the H2 stores’ shoppers indicate they'll come back and spend more. In May, we closed 140 stores, and we'll close another 150 by the end of July. We're making progress on our previously announced plans. Given the results we're seeing from our store optimization initiative, we're confident it will allow us to drive substantial improvement in the quality and performance of the Family Dollar portfolio and create long-term value. We're also in the process of consolidating our store support center. This project will be completed over the next few months and provide us great opportunity as an organization. We will benefit from the stability it provides and from the enhanced communication, collaboration, and teamwork to provide our store teams with greater support. I will now turn the call to Kevin to provide more detail on our first quarter performance and our updated outlook for 2019.

Thanks, Duncan, and good morning. Total sales for the first quarter increased 4.6% to $5.81 billion comprised of $2.96 billion of Dollar Tree and $2.85 billion of Family Dollar. Enterprise same-store sales increased 2.2%. On a segment basis, same-store sales for the Dollar Tree segment increased 2.5% or 2.4% when adjusted for Canadian currency, and the Family Dollar comp increased 1.9%. Overall, gross profit increased 1.6% to $1.73 billion compared to $1.7 billion in the prior year's quarter. As a percentage of sales, gross margin decreased to 29.7% compared to 30.6% in Q1 of 2018. Gross profit margin for the Dollar Tree segment was flat at 34.5% when compared to the prior year's quarter. Factors impacting the segment's gross margin performance for the quarter included higher distribution, depreciation and payroll costs, increased freight costs, primarily outbound freight, as well as a higher proportion of sales in the lower-margin consumable category. These increases were offset by improved shrink and improved initial merchandise markdown. Gross profit margin for the Family Dollar segment was 24.8% during the first quarter compared with 26.7% in the comparable prior year period. The year-over-year decline was due to the following: merchandise costs, including freight, increased approximately 90 basis points, primarily due to increased sales of lower-margin consumable merchandise, higher domestic freight costs, and inventory markdowns for stores being closed and re-bannered in Q1. Shrink increased approximately 50 basis points, resulting from unfavorable physical inventory results in the current year and an increase in the accrual rate. Distribution costs increased approximately 35 basis points, resulting primarily from higher merchandising and distribution payroll-related costs. Occupancy costs increased approximately 20 basis points, resulting from the $6.7 million of accelerated amortization of the right-of-use assets for Family Dollar Stores we plan to close during 2019. Excluding these costs, occupancy costs would have delevered slightly as a percentage of sales. Consolidated selling, general, and administrative expenses as a percentage of net sales in the quarter increased 40 basis points to 23.1% from 22.7% in the same quarter last year. For the first quarter, the SG&A rate for the Dollar Tree segment as a percentage of sales increased to 21.3% compared to 21.1% for the first quarter of 2018. The increase was due to the following: payroll costs increased approximately 20 basis points, primarily due to an increase in store hourly payroll due to an increased average hourly rate, support of company initiatives, and an increase in incentive compensation resulting from prior year adjustments due to lower performance of target. These increases were partially offset by a decrease in retirement plan expense. Operating and corporate expense increased approximately 5 basis points resulting from higher debit and credit fees, primarily due to increased card penetration. Store operating costs decreased approximately 5 basis points due to lower utility costs, specifically electricity, resulting primarily from the benefit of the LED lighting program in the stores. Selling, general, and administrative expenses for the Family Dollar segment was 21.6% as a percentage of sales in the first quarter compared to 21.5% for the same period last year. The increase in SG&A as a percentage of sales was due to the net of the following: payroll expenses increased approximately 25 basis points, primarily due to an increased store hourly payroll, increased average hourly rate, and support of the company's initiatives related to the costs per store renovations, re-banners, and closures. Store operating costs increased approximately 10 basis points, due primarily to higher refrigeration repairs and maintenance costs in the current quarter. And depreciation and amortization expense decreased approximately 25 basis points as a result of certain assets becoming fully depreciated or amortized. Corporate and support expenses increased 20 basis points as a result of $7.6 million of store support center consolidation costs and higher legal fees. On a consolidated basis, operating income was $385.5 million compared with $437.6 million in the same period last year, and operating income margin was 6.6% compared to 7.9% in last year's first quarter. Operating income margin for the Dollar Tree segment declined 20 basis points to 13.2% when compared to the prior year's quarter. Operating income margin for the Family Dollar segment was 3.2% for the quarter. Non-operating expenses for the quarter totaled $41.6 million, which was comprised primarily of net interest expense. Our effective tax rate for the quarter was 22.1% compared to 22.6% in the prior year's first quarter. For the first quarter, on a GAAP basis, the company had net income of $267.9 million or $1.12 per diluted share compared to net income of $160.5 million or $0.67 per diluted share in the prior year's quarter. This year's first quarter included $6.7 million or $0.02 per diluted share of accelerated rent expense related to the adoption of ASC 842 for lease accounting that was not included in our previous company outlook. Adjusted EPS was $1.14. The prior year's quarter included $0.52 of costs associated with debt refinancing. Today's press release includes a reconciliation of non-GAAP financial measures for details on these adjustments. Combined cash and cash equivalents at quarter end totaled $725.8 million compared to $422.1 million at the end of fiscal 2018. Our outstanding debt as of May 4, 2019, was approximately $4.3 billion. During the first quarter, we invested $100 million in the repurchase of approximately 960,000 shares of stock. At quarter end, we had $900 million remaining in our share repurchase authorization. We will provide updates on additional share repurchases, if any, following the quarter in which they may occur. Inventory for the Dollar Tree segment at quarter end increased 10.6% from the same time last year, while selling square footage increased 5.7%. Inventory per selling square foot increased 4.6%. We believe that current inventory levels are appropriate to support the scheduled new store openings, re-banners, and our sales initiatives for the second quarter. Inventory for the Family Dollar segment at quarter end decreased 3.8% from the same period last year and increased 3% on a selling square-foot basis. Capital expenditures were $209.2 million in the first quarter versus $180.9 million in the first quarter of last year. For fiscal 2019, we're planning for consolidated capital expenditures to be approximately $1 billion, consistent with our initial 2019 outlook. Depreciation and amortization totaled $151.2 million for the first quarter. Depreciation and amortization expense was $151.5 million in the first quarter last year. For fiscal 2019, we expect consolidated depreciation and amortization to range from $635 million to $645 million. Our updated outlook for fiscal 2019 includes the following assumptions: calendar considerations for the remainder of the year include that there will be six fewer selling days between Thanksgiving and Christmas, which will negatively impact Q4 sales. Our guidance includes the expectation that Section 301 tariffs will be 25% on Lists 1, 2, and 3 goods. However, our guidance does not include potential tariffs on List 4 goods. Our company outlook on March 6, 2019, included $95 million in discrete costs related to our Family Dollar store optimization initiative and our store support center consolidation. With the increased visibility of our cadence of projects, we now expect to incur approximately 90% of these costs in the first half of the year. In Q1, we incurred approximately $28 million for these initiatives. Our Q2 outlook includes an estimated $57 million in costs related to these initiatives. As noted with our company outlook on March 6, we did not include charges for lease obligations and related expenses for any closed doors in 2019 as we could not estimate the P&L impact until after the adoption of ASC 842, the new lease accounting standard. We now expect to incur approximately $30 million or $0.10 per diluted share of costs in Q2 related to store closings for lease obligations and related costs. We entered into new import freight contracts effective May 1 based on negotiations in April. The new contracts were unfavorable compared to our prior outlook and will add approximately $15 million or $0.05 per diluted share of expense in the back half of the year that was not included in our original company outlook for fiscal 2019 provided on March 6. We expect continued pressure on store payroll based on competitive markets, states increasing minimum wages, and completing the company's initiatives plans. We expect year-over-year domestic freight costs as a percentage of sales to increase in the first half of the year and then flatten out in the second half. Net interest expense will be approximately $40.5 million in Q2 and approximately $161.8 million for fiscal 2019. We cannot predict future currency fluctuations, so we've not adjusted our guidance for changes in currency rates. Our guidance assumes no additional share repurchases for the year. Our guidance assumes a tax rate of 22.6% for the second quarter and 22.4% for fiscal 2019. Weighted average diluted share counts are assumed to be 238.6 million shares for Q2 and 238.8 million shares for the full year. For the second quarter, we are forecasting total sales to range from $5.66 billion to $5.76 billion and diluted earnings per share in the range of $0.64 to $0.73. These estimates are based on a low single-digit increase in same-store sales and include approximately $57 million of discrete costs. Additionally, as I've noted, our outlook now includes approximately $30 million or $0.10 per diluted share of costs related to Q2 store closures for lease obligations and related costs that was not included in the company's previous outlook. For fiscal 2019, we are now forecasting total sales to range between $23.51 billion and $23.83 billion based on a low-single-digit same-store sales increase of approximately 1% of selling square footage growth. The company anticipates GAAP net income per diluted share for full year fiscal 2019 will range between $4.77 and $5.07. This includes discrete costs of $95 million or $0.31 per share, as previously disclosed. Additionally, our outlook now includes $30 million or $0.10 per diluted share in store closure related costs and import freight costs of $15 million or $0.05 per diluted share related to increased import freight rates, as previously described in our updated outlook. I'll now turn the call back over to Gary.

Thanks, Kevin. Before turning the call to your questions, I'd like to share some information about our Dollar Tree Plus! test. As announced last quarter, we are conducting a test by lifting the dollar price point restriction. Testing is not new to us, and we've got a long track record of using an analytical approach to challenge our own thinking. It's the kind of approach and process that led to the development of our H2 stores in Family Dollar and gave us the confidence to accelerate our store optimization program across the Family Dollar portfolio. We spent the past several months laying the groundwork for this test, carefully and thoughtfully designing a test that we believe will allow us to measure the impact of different price points, items, and categories on shopping behavior, store profitability, and our loyal customers' affinity for the Dollar Tree brand. We'll be leveraging Family Dollar and Dollar Tree distribution center systems and combined merchandise to efficiently get the new products into Dollar Tree stores without disrupting our normal operations. For the test, we have selected sales stores located in urban, suburban, and rural markets, and we will be measuring the performance versus prior results as well as against our control stores in similar markets. As part of the planning for the test, our Dollar Tree team has been working closely with the Family Dollar merchants to identify the right products to include. We'll be offering a range of items across a number of categories. We will be testing primarily at price points of $3, $4, and $5, and the products will be displayed in 4-foot sections or end caps clearly branded as Dollar Tree Plus! in order to minimize confusion with our dollar values that our customers have come to expect. We believe the wow factor of what we have created at Dollar Tree should carry over to this test and continue to build our brand. This is not raising items from our dollar price point to a higher retail; this is about adding new items and categories to add sales and margin. The test officially launched a few weeks ago with products hitting the shelves of the first batch of stores. We are in the process of rolling it out to more than 100 test stores, and we'll measure, analyze, and adjust products, layout, and other variables to ensure we are responding to customer feedback in our continued merchandising efforts. Because it's an iterative process, we do not have a set time frame for the test. It’s in the early days right now, but we will have more details to share on our progress in the future. Lastly, my thanks to all of our store teams that are engaged daily to deliver great service and value to our customers, and a call-out to all of our Family Dollar Tree members that are in the process of moving while we consolidate campuses or are staying on to train as necessary. I'm proud of everyone's efforts and achievements during this first quarter. Now we're ready to take your questions.

Operator Instructions. We'll take our first question from Robby Ohmes with Bank of America Merrill Lynch.

My question is about the H2 format. Gary and Duncan, could you discuss the inclusion of the party freezer and cooler? You're experiencing a 10-point comparable sales increase. How far do you believe you can expand the Dollar Tree assortment over time? Additionally, how does incorporating that assortment into the H2 format affect store-level operations? Does it significantly alter the payroll structure? What is the anticipated EBIT margin for a Family Dollar store operating in the H2 format?

So Robby, I'll start and hand it over to Duncan. From the standpoint of what H2 has done, it's added some key dollar sections throughout the store. The opportunity there is to leverage what we've done at Dollar Tree for years, and it gives our customers the opportunity to see these great values. Obviously, we’ve added more frozen food doors that drive traffic, but as you've pointed out, we've also expanded seasonal party. We have a queuing line that gives our customers the last chance to find great values. Let me turn it to Duncan on what we see as part of the opportunity to keep driving sales. We're pretty proud of a 10-point comp in this fleet of stores, and we're going to continue to drive some additional efforts to see how high it can go. But Duncan?

Yes. Thanks, Gary. Thank you, Robby, for your question. As Gary stated, we're pretty excited about the success we've had to date. It's very exciting to see customers as well as our team members when you walk these stores. It's not uncommon to get hugs and thanks from both customers and store people because the people really enjoy the store environment. So we're very excited about it. Just one other thing I've noticed that we did fix the adjacencies of these stores to make our shopping experience much easier and more thoughtful for our customer. And as we added the freezer and cooler doors with primarily food and dairy, we also added six doors of immediate-consumption products, which drive good gross margin for our business. Really in there are the soft drinks, the teas, the waters, the flavored energy drinks that are so popular among our customers. More appropriately, we also added adult beverages, which drives foot traffic for our primary customer. So we're very excited about that. We do have 21 sections across the store with the Dollar Tree items in the store. A number of things it does is it creates a halo of strong price impression for our customers, and we get feedback that says it looks like prices are lower. We're getting great engagement from our customers in those sections, but the real magic there is that the categories are actually starting to rise. It's not just the dollar sections alone, but we get better penetration in some categories that we have seen in our traditional format. So I'm very excited about that. We provide additional labor when we reset these stores just because of the workload. Then we want to make sure that we don't test how high is high with this. So we do invest additional labor, but then we wean the store back off and let it self-fund. In about four weeks, it can get on a self-funding basis. We train one specific person in the store to handle the Dollar Tree items as they are different and they behave differently from our Family Dollar products. They're not planogrammed. We show them a section flow. So the work is relatively easy and also allows us to get in and get out of these categories pretty quickly without disappointing a customer. And I would tell you that we're very bullish on what we're seeing today, both from the store teams, the labor, and how it balances right back to the stores pretty quickly and the customer interaction.

So if I envision the scenario, as we incorporate more Dollar Tree products into a Family Dollar store, does the EBIT margin of that store begin to resemble that of a Dollar Tree store more closely?

Robby, this is Kevin. I think as we think about it, obviously, we're working to drive top line, first and foremost, right, because that helps leverage all of our fixed costs at the end of the day. We've got a limited number of stores we've completed this time. Still a lot of work going on. The freezers and the coolers, adult beverage tend to drive a little bit lower margin at the end of the day. So we have to offset that with the party and the things like that. So it's a little bit too early, given the small number of stores in general. But generally, obviously, we're looking for an EBITDA lift. I don't think that the model is built such that we'll ever have EBITDA of a Dollar Tree store. Just given the amount of consumables we sell to our core customer for our Family Dollar banners versus discretionary business we've had in our Dollar Tree business, they will never quite equate at the end of the day. But the idea, obviously, is to drive sales and drive improvement in that overall EBITDA margin as we go forward.

Operator Instructions. We'll go next to Brad Thomas with KeyBanc Capital Markets.

I also wanted to follow up on the H2 performance. Really encouraging. I guess, when you look at Family Dollar here for this quarter, could you talk a little bit about how much of the comp lift you're seeing was explicitly from some of the initiatives that you have in place versus maybe just the cadence of the overall consumer? And as you're looking out through the balance of the year, do you still believe these initiatives are going to be a 1.5% tailwind to comps for Family Dollar? Or is there reason to perhaps get a little bit more optimistic at this point?

Brad, thanks for your question. We're excited about what we're seeing really across the portfolio. I will tell you that this is just not H2-driven; this is really watching the entire performance of the company going up. And that was demonstrated by seven out of eight of our lines of businesses, positive comp in six of our seven zones. So we're seeing a nice balance across the chain. H2 obviously is a highlight amongst where we're investing those dollars when we get that nice lift. And we believe that is a sustainable lift as we start to continue to roll this across the United States and most of our store base over time. I will tell you that we've had great balance across our promotional sales, our baseline sales, and when we're preparing to close some of these stores, we're seeing good clearance sales. So we're getting a real nice, balanced approach. So we feel good about that. And the key here is the base business is solid.

We'll take our next question from Michael Lasser with UBS.

If we back out the $0.15 of incremental, one-time item from your guidance, the midpoint's going up $0.02, but the high-end of the range is coming down quite significantly. Why is that?

If we look at the guidance we provided at the beginning of the year, you would need to decrease the high-end by $0.03 and increase the low end by about $0.08. That gives us that adjustment. As we progress further into the quarter and the year, the range narrows. Initially, we had a $0.40 range, and now we are down to a $0.30 range with three quarters remaining. Aside from this, it's mainly due to the initiatives and the two new items we've introduced. There’s not much else to consider beyond that. The only adjustments to our guidance relate to the lease obligation costs, which we couldn't disclose at the start of the year because we needed to implement ASC 842 first. Additionally, we have new contracts related to our import freight.

And Kevin, should we still be expecting 14% to 18% EPS growth into next year? And what number should we be basing that growth off of? Should we be excluding the incremental $0.15 hit from those items that you mentioned?

No, Michael, I believe that as we consider our outlook from March, we wanted to provide a longer-term perspective due to the significant investments we're making this year, particularly focused on initiatives to enhance the performance of our Family Dollar Stores. We are strongly dedicated to all our store initiatives and projects. As Gary and Duncan mentioned, we are making excellent progress, and we feel confident about our direction. That's very encouraging. Regarding another point in time, I don't think we've altered our perspective. We stated previously that our outlook was based on the GAAP number, and we haven't updated anything at this moment. So, I believe nothing has changed, and we'll continue to provide updates later in the year as we gather more data and progress through the year.

And Michael, it's Gary. From my perspective, as we move through this year, with the initiatives we've outlined, we're closing almost 400 Family Dollar Stores; a significant investment in the second half will contribute to building momentum at Family Dollar. For Dollar Tree, I'm quite proud of what the team has achieved this quarter in navigating the 25% tariffs, and we feel confident as we move forward with the season responding positively, with strong sell-throughs. Our customers are engaged, and we're well-positioned for the summer season following successful spring sales on Mother's Day and Easter. I believe that as we progress through the latter half of the year, we'll experience momentum in the second half.

And can I just clarify one thing? We recognize that you didn't include the final list of tariffs in your guidance, given all the uncertainty there, but can you help us understand the exposure? What percent of Dollar Tree's cost of goods come from China and would be at risk if the full list of tariffs go through?

Here's how I think about it, Michael. If I had met with you last September to discuss our exposure on those three items, I would have been mistaken because our team managed to mitigate almost all of it during our buying trips. We're applying the same strategy with List 4. I can't predict when or the extent to which items will be excluded or what those items will be. We all know the details are still unclear. What I can confirm is that our team is following the same process and approach: focusing on mitigation. This includes considerations of what we buy, how we make those purchases, where we source them, and how we ship them. We'll utilize all the strategies in our playbook to arrive at a solution. As developments occur, we will keep everyone informed, but we are actively addressing this issue. We're also planning how to mitigate it if it happens.

We'll go next to Peter Keith with Piper Jaffray.

So just a follow-up on Michael's question. With the current tariff exposure of List 3, you guys did a really nice job of mitigating that impact. If there was broader exposure to the rest of the Dollar Tree business, are there differences with some of the other categories that may receive new tariff exposure that would limit your mitigation? Or is it sort of a similar approach that you would use for the whole store?

Well, I think the way we operate is that we import products from both banners, and not all of it comes from China, although the majority does. During our January trip, we relocated $100 million worth of seasonal purchases out of China. We also adjusted some specifications for the items we were shipping to maximize packing efficiency, allowing us to fit more cases into containers and successfully deal with the tariffs. We are exploring other countries as well. The approach will remain consistent. Our merchants now have a better understanding of our practices, focusing on product specifications, sourcing locations, and negotiating costs. These elements will be essential as we move into the next phase.

Yes, this is Kevin. I'll provide some background on that. We are certainly disappointed with our results, and we take responsibility for that. We have not performed at the level we anticipated. This is a priority for everyone, including the operations team, the loss prevention team, the logistics team, and management. One of the challenges we have faced is our inventory levels, which have increased. However, for the first time this quarter, we have actually managed to reduce our inventory levels, and this will continue to be a focus for Duncan and the team. We have made changes to the reporting structure and leadership regarding the oversight of the Family Dollar banners and the loss prevention team. We have also implemented several new programs and are introducing new analytics software. We are undertaking many initiatives, and while it may take some time to see the benefits, I expect the negative impact to lessen as we move into the second half of the year. We still have work to do, and while it's a disappointing trend, significant efforts are being made to address the situation comprehensively.

We'll take our next question from Scott Mushkin with Wolfe Research.

I wanted to clarify the profit figures for the second half. Are the EBIT dollars in those converted stores increasing, remaining the same, or decreasing?

No, they're absolutely up.

They're up? Okay, great. I want to delve deeper into the gross margin for Family Dollar. What changes have we seen there? Clearly, margins have decreased significantly. Is shrink mainly due to theft? What do you see as the primary cause of that shrink? Additionally, as we work to improve Family Dollar's gross margins, what are your thoughts on how much we can recover?

As we evaluate the gross margin for Family Dollar, it’s helpful to consider it in segments. Overall, when we look at product margin, including freight, we faced significant challenges last year from freight costs, which are also a bit of an issue in the first half of this year. However, we anticipate that these costs will stabilize in the latter half. Merchandise costs are under some pressure, primarily due to the increase in lower-margin consumable goods. We are actively working to revitalize the discretionary business, which should help counterbalance these challenges. As the discretionary segment shows improvement, it should enable us to mitigate some of that pressure going forward. This year will be particularly tough regarding markdowns due to various initiative markdowns affecting the P&L. On the positive side, occupancy costs performed well in Q1. Excluding the $6.7 million related to the adoption of ASC 842, we would have seen a slight decline in occupancy costs as a percentage of sales. While we expect continued pressure throughout this year due to some one-time costs and ongoing initiatives, improving sales will help alleviate some of these burdens and guide us back toward our desired margin levels.

Scott, this is Gary. I want to share my thoughts on our logistics costs and the impact of the shortage of truck drivers we've experienced this year. I expect things to stabilize in the latter half of the year. We've invested more in getting people to work in our distribution centers, but I believe our productivity will eventually catch up and surpass these costs. Regarding shrink, everyone is on high alert. We will address it proactively by looking both internally and externally and responding more swiftly. Duncan and his team are focused on training our staff. As for margins, we still see significant opportunities, particularly with our private brands, which are set to grow from their current penetration levels. In terms of imports, the Chinese tariffs have highlighted additional opportunities, not just for items sourced from China, but also for optimizing our supply chain from domestic sources to FOB China. Overall, we still have room for growth, which represents the upside potential for margins at Family Dollar.

We'll take our next question from Scot Ciccarelli with RBC.

A question on the Dollar Tree Plus!. Really two questions. First, philosophically, why are you not testing $2, but focusing on $3 and $5? Just trying to understand that. And then number two, how much of the store or SKU base will be, let's call it, repriced as you run through that test?

Well, a couple of important points, Scot. I mean, you may see some $2 in there. I think the point I was trying to make is we're going to see full price points. You're not going to see $3.25. You're not going to see $4.65. I think our customer, we're going to make this very easy for her to figure out as we go through it. And I just want to emphasize, we're not raising retails on the dollar items that our folks have come to love and count on. And I've gotten more letters from schoolteachers that are threatening me in a nice way that I don't dare do that. But I think our opportunity here is to find some additional categories, items that can add to sales, and that's really the intent of this. It's does our customer understand the wow factor that we've worked so hard on all these years to make Dollar Tree a breakthrough brand in America? And can we take that wow factor and put it into the store and make our customers understand it and they understand the wow as we lift the dollar price point. So I think it's going to be very clear to the customer what these items are. They'll see the items with a sticker on them or pre-priced in some fashion. That will be very clear to them. Our folks are being trained to answer all those questions. We want our customers, when they raise their hand and say, 'How much is this?' it's not going to be because they're confused on the price; it's going to be because they still see these incredible values. So we're all over this in terms of getting good execution first during rollout, what do we learn as we do that, following up with customer feedback as we go through the process.

Yes. The full price point certainly makes sense. How much of the store's SKU base will be, let's call it, changed?

Well, I mentioned you're going to see over 100 SKUs. And listen, in the same way we do at Dollar Tree today, you're going to see items come and go while you see it. It's not always going to be there. And so when you think about the SKU base, we're going to start someplace and probably end up somewhere else, but that's about where we're going to start and just learn as we go.

Operator Instructions. We'll go next to Paul Trussell with Deutsche Bank.

Appreciate all the color on updated outlook and margins, but I wanted to just follow up and just maybe get a little bit more detail on specific expectations for 2Q versus the second half on some of those key items like freight and shrink payroll. If you can just give us a little bit more detail on how we should think about the cadence.

Yes, freight has been a challenge for us in the first half of the year, but I expect it to stabilize in the second half. Inbound logistics are starting to normalize, although domestic freight costs remain somewhat elevated. We shared that the import costs are around $0.05, which are more relevant to the latter half of the year. Store hourly payroll is likely to see a slight increase throughout the year, similar to what we experienced in the first quarter. We are observing a rise in average hourly rates in our stores. Regarding shrinkage, I anticipate it will continue to increase in the second quarter, but I expect it to stabilize by the second half of the year. Additionally, when we discussed costs associated with our initiatives earlier this year, we mentioned that approximately 75% of those costs would occur in the first half. Today, I can confirm that it's closer to 90% based on the progress we've made and the efficiencies we've gained. This sets the stage for about $57 million in costs for the second quarter related to these initiatives, which impact various areas including labor and markdowns.

Got it. And then bigger picture, as we think about the fact you are doing a lot of remodels, closing a number of Family Dollar Stores, just wanted to take a step back and get your current outlook on the opportunity still for new door growth in the dollar store industry. Maybe speak to new store productivity that you're seeing today and just where the white space is.

So a few years back, we mentioned aiming for 25,000 stores in the U.S. and 1,000 in Canada. I still see significant potential in the U.S. for both Dollar Tree and Family Dollar. Over time, our development of Family Dollar stores has leaned more towards urban areas, but I anticipate a shift towards more rural locations. Although the split may not exactly reach 70-30, it will likely become closer to that. We believe there is a strong opportunity to provide a quality shopping environment, especially given the struggles of independent drugstores and grocery stores, which opens up avenues for growth for both brands. Family Dollar particularly has potential in rural America. Dollar Tree remains a strong brand that stands out in the market, and we see opportunities across a wide range of locations, although Family Dollar may be better suited for areas inside the beltway and extreme rural settings. We plan to invest significantly in renovations, touching 1,000 Dollar Tree stores this year. We see potential for expanding our store count further in the coming years. By the end of next year, roughly 40% of our Family Dollar locations will have undergone renovations or opened in the past four years, representing a shift in what our customers have experienced previously. We're optimistic about the prospects for the second half of the year and continue to be selective about new Dollar Tree sites. Overall, both brands have a growth trajectory as we move forward.

We'll take our final question from John Heinbockel with Guggenheim Securities.

For either Gary or Duncan, how do you view Family Dollar's ability to implement changes, especially regarding real estate? Considering the 1,000 renovations planned, is that the limit? Can the platform accommodate more? Additionally, in terms of store performance, once we complete the closures this year and looking ahead to another round of closures next year or beyond, how does that impact the overall success?

Thank you for the question, Duncan. The Dollar Tree enterprise team at our headquarters in Chesapeake oversees all store development efforts nationwide for both brands. This is supported locally by a combination of Dollar Tree and Family Dollar staff in the field. We are not operating at full capacity yet. We are adding freezers and coolers across the chain, introducing 1,000 beverage licenses at Family Dollar, and implementing 1,000 Snack Zones as discussed by Gary. Additionally, we plan to open 200 new Family Dollar stores and 350 Dollar Tree stores. As we roll out more locations in the second half of the year, we are also improving our efficiency in managing operations with our teams and suppliers to expedite these processes. Looking ahead, we typically close about 70 to 80 stores each year due to standard closures and performance maintenance.

And John, it's Gary. Just from the standpoint of the store closures, we took a look at what needed to close outside of lease term, and that's what we're doing in the second quarter this year. As always, we take a look at end of lease terms for our fleet of stores to figure out how to optimize where they're headed for and actually reach out to our landlords to get input and contributions from them to now help us reinvigorate some of their properties on H2 as we go forward. So we'll be doing more of that, but as we go forward, the second quarter is going to be where we particularly hit on the stores closing out a lease as we go through the out years either at 75 to 100, depending on the number of stores coming up on any quarter is probably closer to where we'll end up.

Thank you, Aaron. Thank you for joining us for today's call and especially your continued interest in Dollar Tree. Our next quarterly earnings conference call to discuss Q2 results is tentatively scheduled for Thursday, August 29, 2019. Have a good day.

Ladies and gentlemen, this does conclude today's conference. We thank you for your participation. You may now disconnect.