ITEM 2.            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

General

This discussion and analysis is based on, should be read with, and is qualified in its entirety by, the accompanying unaudited condensed consolidated financial statements and related notes, as well as our consolidated financial statements and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations as contained in our Annual Report on Form 10-K for the fiscal year ended February 2, 2018. It also should be read in conjunction with the disclosure under “Cautionary Disclosure Regarding Forward-Looking Statements” in this report.

Executive Overview

We are among the largest discount retailers in the United States by number of stores, with 14,761 stores located in 44 states as of May 4, 2018. Our greatest concentration of stores is in the southern, southwestern, midwestern and eastern United States. We offer a broad selection of merchandise, including consumable products such as food, paper and cleaning products, health and beauty products and pet supplies, and non-consumable products such as seasonal merchandise, home decor and domestics, and basic apparel. Our merchandise includes national brands from leading manufacturers, as well as our own private brand selections. We offer our customers these national brand and private brand products at everyday low prices (typically $10 or less) in our convenient small-box locations.

We believe our convenient store formats, locations, and broad selection of high-quality products at compelling values have driven our substantial growth and financial success over the years and through a variety of economic cycles. We are mindful that the majority of our customers are value-conscious, and many have low or fixed incomes. As a result, we are intensely focused on helping our customers make the most of their spending dollars. Our core customers are often among the first to be affected by negative or uncertain economic conditions, and are among the last to feel the effects of improving economic conditions particularly when trends are inconsistent and of an uncertain duration. The primary macroeconomic factors that affect our core customers include the unemployment rate, the underemployment rate, wage growth, fuel prices, and changes to certain government assistance programs, such as the Supplemental Nutrition Assistance Program. Additionally, our customers are impacted by increases in those expenses that generally comprise a large portion of their household budget, such as rent and healthcare. Finally, significant unseasonable weather patterns, such as occurred in the first quarter as discussed in “Results of Operations” below, can impact customer shopping behaviors. 

We remain committed to the following long-term operating priorities as we consistently strive to improve our performance while retaining our customer-centric focus: 1) driving profitable sales growth, 2) capturing growth opportunities, 3) enhancing our position as a low-cost operator, and 4) investing in our people as a competitive advantage.

We seek to drive profitable sales growth through initiatives aimed at increasing customer traffic and average transaction amount, as well as an ongoing focus on enhancing our gross margins while maintaining both everyday low price and affordability. Several of these initiatives are also designed to capture growth opportunities and are discussed in more detail below. Even as we work to provide everyday low prices and meet our customers’ affordability needs, we also remain focused on enhancing our margins through effective category management, inventory shrink reduction initiatives, private brands penetration, distribution and transportation efficiencies, global sourcing and pricing and markdown optimization.

Historically, our sales of consumables, which tend to have lower gross margins, have been the key drivers of net sales and customer traffic, while sales of non-consumables, which tend to have higher gross margins, have contributed to more profitable sales growth and an increase in average transaction amount. In the 2018 first quarter, our sales mix continued to shift slightly toward consumables, and, within consumables, slightly toward lower margin departments such as perishables and tobacco. We expect these trends to continue throughout at least the first half of 2018. Certain of our initiatives, including those related to the non-consumables categories, are intended to address these trends, although there can be no assurance we will be successful in their reversal.

To support our other operating priorities, we remain focused on capturing other growth opportunities. In the first quarter of 2018, we opened 241 new stores, remodeled 322 stores, and relocated 31 stores. For 2018, we plan to open approximately 900 new stores, remodel approximately 1,000 mature store locations, and relocate approximately 100 stores for an approximate total of 2,000 real estate projects.

We continue to innovate within our channel and are able to utilize the most productive of our various store formats based on the specific market opportunity.  We expect that our traditional 7,300 square foot store format will continue to be the primary store layout for new stores, relocations and remodels in 2018. We expect approximately 400 of the planned 1,000 remodels in 2018 to include a higher cooler count for increased selection of perishable items. In addition, our smaller format store (less than 6,000 square feet) allows us to capture growth opportunities in metropolitan areas as well as in rural areas with a low number of households. We continue to incorporate lessons learned from our various store formats and layouts into our existing store base with a goal of driving increased customer traffic, average transaction amount, same-store sales and overall store productivity.

We continue to make progress on certain strategic initiatives that we believe will help drive profitable sales growth and capture long-term growth opportunities. Such opportunities include leveraging existing, and developing new, digital tools and technology to provide our customers with additional shopping access points and even greater convenience. Following an in-depth analysis, we are also refreshing our approach to our non-consumables product offerings.

To support our new store growth and drive productivity, we continue to make investments in our distribution center network. Our sixteenth and seventeenth distribution centers in Longview, Texas and Amsterdam, New York, respectively, are currently under construction. We expect both of these distribution centers to open in 2019.

We have established a position as a low-cost operator, always seeking ways to reduce or control costs that do not affect our customers’ shopping experience. We plan to continue enhancing this position over time as we aim to continually streamline our business while also employing ongoing cost discipline to reduce certain expenses as a percentage of sales. Nonetheless, we seek to maintain flexibility to invest in the business as necessary to enhance our long-term profitability. We exercised this flexibility in the 2018 first quarter through specific planned investments, such as investments in store manager pay and training. These investments, combined with softer sales in the 2018 first quarter compared to the 2017 first quarter and additional expenses incurred in the 2018 first quarter relating to increased store openings in the second half of 2017, resulted in higher Selling, General & Administrative (“SG&A”) expenses as a percentage of sales in the first quarter of 2018 than in the first quarter of 2017, as discussed in more detail below under “Results of Operations.”

Our employees are a competitive advantage, and we are always searching for ways to continue investing in them.  We invest in our employees in an effort to create an environment that attracts and retains talented personnel, as we believe that, particularly at the store level, employees who are promoted from within our company generally have longer tenures and are greater contributors to improvements in our financial performance. We believe our investments in compensation and training for our store managers are contributing to improved customer experience scores, higher sales and improved turnover metrics. 

Highlights of our 2018 first quarter results of operations compared to the 2017 first quarter and our financial condition at May 4, 2018 are set forth below. Basis points amounts referred to below are equal to 0.01% as a percentage of net sales.

The above discussion is a summary only. Readers should refer to the detailed discussion of our results of operations below in the current year periods as compared with the prior year periods as well as our financial condition at May 4, 2018.

Results of Operations

Accounting Periods . We utilize a 52-53 week fiscal year convention that ends on the Friday nearest to January 31. The following text contains references to years 2018 and 2017, which represent the 52-week fiscal years ending or ended February 1, 2019 and February 2, 2018, respectively. References to the first quarter accounting periods for 2018 and 2017 contained herein refer to the 13-week accounting periods ended May 4, 2018 and May 5, 2017, respectively.

Seasonality. The nature of our business is somewhat seasonal. Primarily because of sales of Christmas-related merchandise, operating profit in our fourth quarter (November, December and January) has historically been higher than operating profit achieved in each of the first three quarters of the fiscal year. Expenses, and to a greater extent operating profit, vary by quarter. Results of a period shorter than a full year may not be indicative of results expected for the entire year. Furthermore, the seasonal nature of our business may affect comparisons between periods.

The following table contains results of operations data for the first 13-week periods of 2018 and 2017, and the dollar and percentage variances among those periods:

13 WEEKS ENDED MAY 4, 2018 AND MAY 5, 2017

Net Sales . The net sales increase in the 2018 period reflects a same-store sales increase of 2.1% compared to the 2017 period. Same-stores include stores that have been open for at least 13 months and remain open at the end of the reporting period. For the 2018 period, there were 13,320 same-stores which accounted for sales of $5.7 billion. The increase in same-store sales reflects an increase in average transaction amount, partially offset by a decline in customer traffic that we believe was somewhat weather-related. The increase in average transaction amount was driven by both higher average units sold and higher average retail prices. Same-store sales increased in the consumables category and declined in each of our three non-consumables categories. The net sales increase was positively affected by sales from new stores, modestly offset by sales from closed stores.

Gross Profit. For the 2018 period, gross profit increased by 9.6%, and as a percentage of net sales increased by 17 basis points to 30.5% compared to the 2017 period.  Higher initial markups on inventory purchases and an improved rate of inventory shrinkage contributed to the increase in the gross profit rate. These factors were partially offset by a greater proportion of sales of consumables, which generally have a lower gross profit rate than our other product categories, the sales of lower margin products comprising a higher proportion of consumables sales, and increased transportation costs. We believe our improved rate of inventory shrinkage reflects our continued implementation of in-store defensive merchandising and technology-based tools, including a significant increase in the number of stores utilizing Electronic Article Surveillance (“EAS”). We believe that the results from those stores in which EAS has been implemented suggests that EAS improves not only inventory shrinkage but also improves our in-stock position. Our transportation costs increased, pressuring our overall gross margin in the first quarter, as a result of  increasing carrier and fuel rates. To mitigate these pressures, we continue to pursue opportunities such as stem mile reduction, shipment load optimization and private fleet expansion to improve our distribution and transportation efficiencies.

Selling, General & Administrative Expenses (“SG&A”). SG&A was 22.4% as a percentage of net sales in the 2018 period compared to 21.8% in the comparable 2017 period, an increase of 60 basis points. The 2018 period results reflect increased retail labor expenses, due in part to our investment in store manager compensation, and increases in occupancy costs, utilities and property taxes on leased stores, each of which increased at a rate greater than the increase in net sales.  

Income Taxes. The effective income tax rate for the 2018 period was 21.6% compared to a rate of 37.2% for the 2017 period which represents a net decrease of 15.6 percentage points. The tax rate for the 2018 period was lower than the comparable 2017 period primarily due to the federal tax law changes contained in the Tax Cuts and Jobs Act, including the change in the federal income tax rate to 21% in the 2018 period compared to 35% in the 2017 period.

Accounting Standards

In February 2016, the FASB issued new guidance related to lease accounting, which when effective will require a dual approach for lessee accounting under which a lessee will account for leases as finance leases or operating leases. Both finance leases and operating leases will result in the lessee recognizing a right-of-use asset and a corresponding lease liability on its balance sheet, with differing methodology for income statement recognition. This guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2018, and early adoption is permitted. Currently, a modified retrospective approach is required for all leases existing or entered into after the beginning of the earliest comparative period in the consolidated financial statements. The FASB has proposed guidance which would allow companies to record the cumulative effect of applying the new standard as an adjustment to the opening balance of retained earnings in the year of adoption, although such guidance has not yet been formally issued. We formed a project team to assess and implement the standard, which has completed its evaluation of existing contractual arrangements for embedded leases. The project team is also testing computations in our lease administration system, integrating interfaces between the lease administration system and the enterprise resource planning systems, and comparing our current accounting policies to the new standard. As a result of the efforts of this project team, we have identified store leases as the area in which we would most likely be affected by the new guidance. Our assessment of the impact that adoption of this guidance will have on our consolidated financial statements is ongoing and we are anticipating a material impact because we are party to a significant number of lease contracts for our stores.

In January 2017, the FASB issued amendments to existing guidance related to the subsequent measurement of goodwill. These amendments modify the concept of impairment from the condition that exists when the carrying amount of goodwill exceeds its implied fair value to the condition that exists when the carrying amount of a reporting unit exceeds its fair value. Subsequent to adoption, an entity will perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. This guidance is effective for public business entities for fiscal years, and interim periods within those years, beginning after December 15, 2019, and early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The amendments should be applied on a prospective basis. An entity is required to disclose the nature of and reason for the change in accounting principle upon transition.  Our assessment of the impact that adoption of this guidance will have on our consolidated financial statements is ongoing, but we do not anticipate a material effect on our consolidated results of operations, financial position or cash flows.

Liquidity and Capital Resources

At May 4, 2018, we had a $1.4 billion unsecured credit agreement (the “Facilities”), $2.5 billion aggregate principal amount of senior notes, and a commercial paper program that may provide borrowing availability of up to $1.0 billion. At May 4, 2018, we had total outstanding debt (including the current portion of long-term obligations) of $2.9 billion, which includes balances under the Term Facility (as defined below), commercial paper, and senior notes, all of which are described in greater detail below. Our borrowing availability under the Facilities may be effectively limited by borrowings under the commercial paper program as further described below.

We believe our cash flow from operations and existing cash balances, combined with availability under the Facilities, the commercial paper program and access to the debt markets will provide sufficient liquidity to fund our current obligations, projected working capital requirements, capital spending and anticipated dividend payments for a period that includes the next twelve months as well as the next several years.  However, our ability to maintain sufficient

liquidity may be affected by numerous factors, many of which are outside of our control.  Depending on our liquidity levels, conditions in the capital markets and other factors, we may from time to time consider the issuance of debt, equity or other securities, the proceeds of which could provide additional liquidity for our operations.

For the remainder of fiscal 2018, we anticipate potential combined borrowings under the Revolving Facility (defined below) and our commercial paper program to be a maximum of approximately $800 million outstanding at any one time, including any anticipated borrowings to fund repurchases of common stock.

Credit Facilities

On February 22, 2017, we entered into the Facilities, which consist of a $175.0 million senior unsecured term loan facility (the “Term Facility”) and a $1.25 billion senior unsecured revolving credit facility (the “Revolving Facility”) of which up to $175.0 million is available for the issuance of letters of credit. The Term Facility is scheduled to mature on October 20, 2020, and the Revolving Facility is scheduled to mature on February 22, 2022.

Borrowings under the Facilities bear interest at a rate equal to an applicable interest rate margin plus, at our option, either (a) LIBOR or (b) a base rate (which is usually equal to the prime rate). The applicable interest rate margin for borrowings as of May 4, 2018 was 1.10% for LIBOR borrowings and 0.10% for base-rate borrowings. We must also pay a facility fee, payable on any used and unused commitment amounts of the Facilities, and customary fees on letters of credit issued under the Revolving Facility. As of May 4, 2018, the commitment fee rate was 0.15%. The applicable interest rate margins for borrowings, the facility fees and the letter of credit fees under the Facilities are subject to adjustment from time to time based on our long-term senior unsecured debt ratings. The weighted average all-in interest rate for borrowings under the Facilities was 3.0% as of May 4, 2018.

The Facilities can be voluntarily prepaid in whole or in part at any time without penalty. There is no required principal amortization under the Facilities. The Facilities contain a number of customary affirmative and negative covenants that, among other things, restrict, subject to certain exceptions, our (including our subsidiaries’) ability to: incur additional liens; sell all or substantially all of our assets; consummate certain fundamental changes or change in our lines of business; and incur additional subsidiary indebtedness. The Facilities also contain financial covenants that require the maintenance of a minimum fixed charge coverage ratio and a maximum leverage ratio.  As of May 4, 2018, we were in compliance with all such covenants.  The Facilities also contain customary events of default.

As of May 4, 2018, the entire balance of the Term Facility was outstanding, and under the Revolving Facility, we had no outstanding borrowings, outstanding letters of credit of $9.1 million, and borrowing availability of $1.24 billion that, due to our intention to maintain borrowing availability related to the commercial paper program described below, could contribute incremental liquidity of $861.9 million at May 4, 2018. In addition, as of May 4, 2018 we had outstanding letters of credit of $31.8 million which were issued pursuant to separate agreements.

Commercial Paper

As of May 4, 2018, our condensed consolidated balance sheet reflected outstanding unsecured CP Notes of $193.0 million classified as long-term obligations due to our intent and ability to refinance these obligations as long-term debt. An additional $186.0 million of outstanding CP Notes were held by a wholly-owned subsidiary and are therefore not reflected on the condensed consolidated balance sheet.  Under this program, we may issue the CP Notes from time to time in an aggregate amount not to exceed $1.0 billion outstanding at any time.  The CP Notes may have maturities of up to 364 days from the date of issue and rank equal in right of payment with all of our other unsecured and unsubordinated indebtedness.  We intend to maintain available commitments under the Revolving Facility in an amount at least equal to the amount of CP Notes outstanding at any time.  As of May 4, 2018, the outstanding CP Notes had a weighted average borrowing rate of 2.3%.  

Senior Notes

In April 2013 we issued $900.0 million aggregate principal amount of 3.25% senior notes due 2023 (the “2023 Senior Notes”) at a discount of $2.4 million, which are scheduled to mature on April 15, 2023. In October 2015 we issued $500.0 million aggregate principal amount of 4.150% senior notes due 2025 (the “2025 Senior Notes”) at a discount of $0.8 million, which are scheduled to mature on November 1, 2025. In April 2017 we issued $600.0 million aggregate principal amount of 3.875% senior notes due 2027 (the “2027 Senior Notes”) at a discount of $0.4 million,

which are scheduled to mature on April 15, 2027.  In April 2018 we issued $500.0 million aggregate principal amount of 4.125% senior notes due 2028 (the “2028 Senior Notes”) at a discount of $0.5 million, which are scheduled to mature on May 1, 2028.  Collectively, the 2023 Senior Notes, 2025 Senior Notes, 2027 Senior Notes and 2028 Senior Notes comprise the “Senior Notes”, each of which were issued pursuant to an indenture as supplemented and amended by supplemental indentures relating to each series of Senior Notes (as so supplemented and amended, the “Senior Indenture”). Interest on the 2023 Senior Notes and the 2027 Senior Notes is payable in cash on April 15 and October 15 of each year. Interest on the 2025 and 2028 Senior Notes is payable in cash on May 1 and November 1 of each year, with interest on the 2028 Senior Notes commencing on November 1, 2018.  

We may redeem some or all of the Senior Notes at any time at redemption prices set forth in the Senior Indenture. Upon the occurrence of a change of control triggering event, which is defined in the Senior Indenture, each holder of our Senior Notes has the right to require us to repurchase some or all of such holder’s Senior Notes at a purchase price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any, to, but excluding, the repurchase date.

The Senior Indenture contains covenants limiting, among other things, our ability (subject to certain exceptions) to consolidate, merge, or sell or otherwise dispose of all or substantially all of our assets; and our ability and the ability of our subsidiaries to incur or guarantee indebtedness secured by liens on any shares of voting stock of significant subsidiaries.

The Senior Indenture also provides for events of default which, if any of them occurs, would permit or require the principal of and accrued interest on our Senior Notes to become or to be declared due and payable, as applicable.

Contractual Obligations

The issuance of the 2028 Senior Notes and the redemption of the 2018 Senior Notes discussed above resulted in changes to the contractual obligations reported in our Annual Report on Form 10-K for the fiscal year ended February 2, 2018. The following table summarizes our significant contractual obligations for long-term debt obligations and related interest as of May 4, 2018 (in thousands):

Current Financial Condition / Recent Developments

Our inventory balance represented approximately 52% of our total assets exclusive of goodwill and other intangible assets as of May 4, 2018. Our ability to effectively manage our inventory balances can have a significant impact on our cash flows from operations during a given fiscal year. Inventory purchases are often somewhat seasonal in nature, such as the purchase of warm-weather or Christmas-related merchandise. Efficient management of our inventory has been and continues to be an area of focus for us.

As described in Note 6 to the unaudited condensed consolidated financial statements, we are involved in a number of legal actions and claims, some of which could potentially result in material cash payments. Adverse developments in those actions could materially and adversely affect our liquidity. Future negative developments could have a material adverse effect on our liquidity.

Our senior unsecured debt is rated “Baa2,” by Moody’s with a stable outlook and “BBB” by Standard & Poor’s with a stable outlook, and our commercial paper program is rated “P-2” by Moody’s and “A-2” by Standard and Poor’s. Our current credit ratings, as well as future rating agency actions, could (i) impact our ability to finance our operations on satisfactory terms; (ii) affect our financing costs; and (iii) affect our insurance premiums and collateral requirements necessary for our self-insured programs. There can be no assurance that we will maintain or improve our current credit ratings.

Unless otherwise noted, all references to the “2018 period” and the “2017 period” in the discussion of “Cash flows from operating activities,” “Cash flows from investing activities,” and “Cash flows from financing activities” below refer to the 13-week periods ended May 4, 2018 and May 5, 2017, respectively.  

Cash flows from operating activities.   Cash flows from operating activities were $548.7 million in the 2018 period, which represents a $38.2 million increase compared to the 2017 period. Changes in merchandise inventories resulted in a $12.4 million increase in the 2018 period as compared to a decrease of $42.5 million in the 2017 period. Changes in accounts payable resulted in a $5.0 million increase in the 2018 period compared to a $56.6 million increase in the 2017 period, due primarily to the timing of receipts and payments.

On an ongoing basis, we closely monitor and manage our inventory balances, and they may fluctuate from period to period based on new store openings, the timing of purchases, and other factors. Merchandise inventories were essentially unchanged in the 2018 period and increased 1% in the 2017 period. In the 2018 period compared to the 2017 period, changes in inventory balances in our four inventory categories were as follows: the consumables category increased by 4% compared to a 7% increase; the seasonal category decreased 6% compared to a 5%  decrease; the home products category decreased by 10% compared to a 7%  decrease; and apparel decreased by 10% compared to a 12% decrease.

Cash flows from investing activities .  Significant components of property and equipment purchases in the 2018 period included the following approximate amounts: $70 million for improvements, upgrades, remodels and relocations of existing stores; $41 million related to new leased stores, primarily for leasehold improvements, fixtures and equipment; $39 million for distribution and transportation-related capital expenditures; and $12 million for information systems upgrades and technology-related projects. The timing of new, remodeled and relocated store openings along with other factors may affect the relationship between such openings and the related property and equipment purchases in any given period. During the 2018 period, we opened 241 new stores and remodeled or relocated 353 stores.

Significant components of property and equipment purchases in the 2017 period included the following approximate amounts: $54 million for distribution and transportation-related capital expenditures; $50 million for improvements, upgrades, remodels and relocations of existing stores; and $35 million related to new leased stores, primarily for leasehold improvements, fixtures and equipment. During the 2017 period, we opened 293 new stores and remodeled or relocated 301 stores.

Capital expenditures for 2018 are currently projected to be in the range of $725 million to $800 million. We anticipate funding 2018 capital requirements with a combination of some or all of the following: existing cash balances, cash flows from operations, availability under our Revolving Facility and/or the issuance of additional CP Notes. We plan to continue to invest in store growth through the development of new stores and the remodel or relocation of existing stores. Capital expenditures in 2018 are anticipated to support our store growth as well as our remodel and relocation initiatives, including capital outlays for leasehold improvements, fixtures and equipment; the construction of new stores; costs to support and enhance our supply chain initiatives including new and existing distribution center facilities and our private fleet; technology and other strategic initiatives; as well as routine and ongoing capital requirements.

Cash flows from financing activities .  Net proceeds from the issuance of the 2028 Senior Notes in the 2018 period were $499.5 million and net proceeds from the issuance of the 2027 Senior Notes in the 2017 period were $599.6 million. In the 2018 period, we redeemed the 2018 Senior Notes for $400.0 million. In the 2017 period, we redeemed the 2017 Senior Notes for $500.0 million and made a principal payment on the Term Facility of $250.0 million. We had a net decrease in commercial paper borrowings in the 2018 period of $237.2 million. There were no borrowings or repayments under the Revolving Facility during the 2018 or 2017 periods.  Also during the 2018 and 2017 periods, we repurchased 1.6 million and 1.3 million shares of our common stock at a total cost of $150.0 million and $88.8 million, respectively, and paid cash dividends of $77.7 million and $71.3 million, respectively.

Share Repurchase Program

At May 4, 2018, our common stock repurchase program had a total remaining authorization of approximately $1.2 billion, which included the increase of $1.0 billion to the authorization available under this common stock repurchase program approved by our Board of Directors on March 14, 2018.  Under the authorization, purchases may be made in the open market or in privately negotiated transactions from time to time subject to market and other conditions. The authorization has no expiration date and may be modified or terminated from time to time at the discretion of our Board of Directors. For more information about our share repurchase program, see Note 8 to the condensed consolidated financial statements contained in Part I, Item 1 of this report and Part II, Item 2 of this report.