FRED'S, INC. - FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. |
For the quarterly period ended May 3, 2008.
OR
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TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934. |
For the transition period from ___________________ to _________________.
Commission file number 001-14565
FREDS, INC.
(Exact name of registrant as specified in its charter)
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TENNESSEE
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62-0634010 |
(State or Other Jurisdiction of
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(I.R.S. Employer
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Incorporation or Organization)
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Identification Number) |
4300 New Getwell Road
Memphis, Tennessee 38118
(Address of Principal Executive Offices)
(901) 365-8880
(Registrants telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes x No o.
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a
non-accelerated filer or a smaller reporting company. See definitions of large accelerated filer,
accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
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Large accelerated filer o
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Accelerated filer x |
Non-accelerated filer o
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Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act. Yes o No x.
The registrant had 39,942,488 shares of Class A voting, no par value common stock outstanding as of
June 12, 2008.
Part I FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
FREDS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except for number of shares)
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May 3, |
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February 2, |
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2008 |
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2008 |
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(unaudited) |
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ASSETS: |
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Current assets: |
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Cash and cash equivalents |
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$ |
11,434 |
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$ |
10,266 |
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Receivables, less allowance for doubtful
accounts of $615 and $879, respectively |
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30,818 |
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30,972 |
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Inventories |
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334,079 |
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320,268 |
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Other non-trade receivables |
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15,668 |
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20,536 |
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Assets held for sale |
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745 |
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0 |
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Prepaid expenses and other current assets |
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11,734 |
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11,792 |
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Total current assets |
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404,478 |
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393,834 |
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Property and equipment, at depreciated cost |
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144,026 |
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145,985 |
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Equipment under capital leases, less accumulated
amortization of $4,892 and $4,836, respectively |
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76 |
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132 |
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Other noncurrent assets, net |
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9,807 |
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10,621 |
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Total assets |
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$ |
558,387 |
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$ |
550,572 |
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LIABILITIES AND SHAREHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
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$ |
69,344 |
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$ |
70,416 |
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Current portion of indebtedness |
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159 |
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159 |
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Current portion of capital lease obligations |
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51 |
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126 |
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Accrued expenses and other |
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39,845 |
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39,469 |
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Deferred income taxes |
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14,423 |
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13,151 |
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Total current liabilities |
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123,882 |
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123,321 |
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Long-term portion of indebtedness |
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34,689 |
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35,653 |
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Deferred income taxes |
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7,101 |
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6,698 |
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Other noncurrent liabilities |
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13,572 |
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12,841 |
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Total liabilities |
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179,184 |
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178,513 |
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Commitments and Contingencies |
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Shareholders equity: |
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Preferred stock, nonvoting, no par value,
10,000,000 shares authorized, none outstanding |
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Preferred stock, Series A junior participating
nonvoting, no par value, 224,594 shares
authorized, none outstanding |
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Common stock, Class A voting, no par value,
60,000,000 shares authorized, 39,922,983
and 39,880,836 shares issued and outstanding,
respectively |
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136,038 |
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135,335 |
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Common stock, Class B nonvoting, no par value,
11,500,000 shares authorized, none outstanding |
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Retained earnings |
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242,136 |
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235,684 |
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Accumulated other comprehensive income |
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1,029 |
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1,040 |
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Total shareholders equity |
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379,203 |
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372,059 |
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Total liabilities and shareholders equity |
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$ |
558,387 |
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$ |
550,572 |
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See accompanying notes to condensed consolidated financial statements.
3
FREDS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except per share amounts)
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Thirteen Weeks Ended |
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May 3, |
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May 5, |
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2008 |
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2007 |
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Net sales |
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$ |
464,292 |
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$ |
442,262 |
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Cost of goods sold |
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331,811 |
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315,261 |
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Gross profit |
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132,481 |
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127,001 |
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Depreciation and amortization |
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7,083 |
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7,227 |
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Selling, general and administrative
expenses |
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113,660 |
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108,617 |
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Operating income |
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11,738 |
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11,157 |
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Interest income |
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(98 |
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(133 |
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Interest expense |
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271 |
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37 |
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Income before income taxes |
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11,565 |
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11,253 |
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Income taxes |
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4,315 |
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3,815 |
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Net income |
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$ |
7,250 |
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$ |
7,438 |
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Net income per share: |
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Basic |
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$ |
.18 |
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$ |
.19 |
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Diluted |
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$ |
.18 |
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$ |
.19 |
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Weighed average shares outstanding: |
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Basic |
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39,804 |
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39,842 |
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Effect of dilutive stock options |
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168 |
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118 |
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Diluted |
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39,972 |
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39,960 |
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Dividends declared per common share |
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$ |
.02 |
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$ |
.02 |
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Comprehensive income: |
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Net income |
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$ |
7,250 |
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$ |
7,438 |
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Other comprehensive income (expense),
net of tax postretirement plan adjustment |
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(11 |
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(16 |
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Comprehensive income |
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$ |
7,239 |
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$ |
7,422 |
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See accompanying notes to condensed consolidated financial statements.
4
FREDS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
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Thirteen Weeks Ended |
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May 3, |
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May 5, |
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2008 |
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2007 |
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Cash flows from operating activities: |
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Net income |
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$ |
7,250 |
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$ |
7,438 |
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Adjustments to reconcile net income
to net cash flows from operating activities: |
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Depreciation and amortization |
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7,083 |
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7,227 |
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Net (gain) loss on asset disposition |
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(870 |
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307 |
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Stock-based compensation |
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576 |
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676 |
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(Recovery of) Provision for uncollectible receivables |
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(264 |
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33 |
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LIFO reserve increase |
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1,347 |
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932 |
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Deferred income tax expense |
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1,675 |
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236 |
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Provision for post retirement medical |
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(11 |
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(16 |
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Excess tax benefits from stock-based compensation |
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6 |
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4 |
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(Increase) decrease in assets: |
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Trade receivables |
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5,286 |
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1,245 |
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Inventories |
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(15,158 |
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(44,756 |
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Other assets |
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58 |
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1,865 |
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Increase (decrease) in liabilities: |
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Accounts payable and accrued expense |
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(696 |
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18,786 |
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Income taxes payable |
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(6 |
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(2,428 |
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Other noncurrent liabilities |
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731 |
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659 |
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Net cash
provided (used in) by operating activities |
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7,007 |
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(7,792 |
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Cash flows from investing activities: |
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Capital expenditures |
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(5,452 |
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(6,005 |
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Proceeds from asset dispositions |
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1,411 |
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270 |
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Asset acquisitions, net (primarily intangibles) |
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(88 |
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(345 |
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Net cash used in investing activities |
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(4,129 |
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(6,080 |
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Cash flows from financing activities: |
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Payments of indebtedness and capital lease obligations |
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(115 |
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(480 |
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Proceeds from revolving line of credit |
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135,701 |
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27,927 |
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Payments on revolving line of credit |
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(136,625 |
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(12,660 |
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Excess tax benefits from stock-based compensation |
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(6 |
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(4 |
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Proceeds from exercise of stock options and issuances
under employee stock purchase plan |
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133 |
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142 |
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Cash dividends paid |
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(798 |
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(801 |
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Net cash (used)provided by financing activities |
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(1,710 |
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14,124 |
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Increase in cash and cash equivalents |
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1,168 |
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252 |
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Beginning of period cash and cash equivalents |
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10,266 |
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2,475 |
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End of period cash and cash equivalents |
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$ |
11,434 |
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$ |
2,727 |
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Supplemental disclosures of cash flow information: |
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Interest paid |
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$ |
387 |
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$ |
25 |
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Income taxes paid |
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$ |
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$ |
6,000 |
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See accompanying notes to condensed consolidated financial statements.
5
FREDS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: BASIS OF PRESENTATION
Freds, Inc. and subsidiaries (We, Our, Us or Company) operates as of May 3,
2008, 707 discount general merchandise stores, including 24 franchised Freds stores, in 15
states in the southeastern United States. 275 of the stores have full service pharmacies.
The accompanying unaudited consolidated financial statements have been prepared in
accordance with U.S. generally accepted accounting principles (GAAP) for interim financial
information and are presented in accordance with the requirements of Form 10-Q and therefore
do not include all information and notes necessary for a fair presentation of financial
position, results of operations and cash flows in conformity with GAAP. The statements do
reflect all adjustments (consisting of only normal recurring accruals) which are, in the
opinion of management, necessary for a fair presentation of financial position in conformity
with GAAP. The statements should be read in conjunction with the Notes to the Consolidated
Financial Statements for the fiscal year ended February 2, 2008 incorporated into Our Annual
Report on Form 10-K.
The results of operations for the thirteen-week period ended May 3, 2008 are not necessarily
indicative of the results to be expected for the full fiscal year.
NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements(SFAS No. 157).
SFAS No. 157 provides a single definition of fair value, together with a framework for
measuring it, and requires additional disclosure about the use of fair value to measure
assets and liabilities. SFAS No. 157 also emphasizes that fair value is a market-based
measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the
highest priority being quoted prices in active markets. Under SFAS No. 157, fair value
measurements are required to be disclosed by level within that hierarchy. SFAS No. 157 is
effective for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. However, FASB Staff Position (FSP) No. FAS 157-2, Effective Date of
FASB Statement No. 157, (SFAS No. 157-2) issued in February 2008, delays the effective
date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for
items that are recognized or disclosed at fair value in the financial statements on a
recurring basis, to fiscal years beginning after November 15, 2008, and interim periods
within those fiscal years. The Company adopted SFAS No. 157 effective February 3, 2008,
and its adoption did not have a material effect on its results of operations or financial
position. The Company has also evaluated FSP No. FAS 157-2 and determined that it will have
no impact on its results of operations or financial position.
In February 2007, the Financial Accounting Standards Board issued SFAS No. 159, The Fair
Value Option for Financial Assets and Financial LiabilitiesIncluding an Amendment of FASB
Statement No. 115, (SFAS No. 159). SFAS No. 159 allows companies the choice to measure
many financial instruments and certain other items at fair value. This gives a company the
opportunity to mitigate volatility in reported earnings caused by measuring related assets
and liabilities differently without having to apply complex hedge accounting provisions. SFAS
No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is in
the process of determining the effect, if any, that the adoption of SFAS No. 159 will have on
its results of operations or financial position.
In June 2007, the Emerging Issues Task Force (EITF) of the FASB ratified their consensus
position 06-11 (EITF 06-11), Accounting for Income Tax Benefits of Dividends on
Share-Based Payment Awards. EITF 06-11 provides guidance on how a company should recognize
the income tax benefit received on dividends that are
6
paid to employees holding equity-classified nonvested shares, equity-classified nonvested
share units, or equity-classified outstanding share options charged to retained earnings
under FASB Statement 123(R), Share-Based Payment. The Company is required to apply the
guidance provided in EITF 06-11 prospectively to income tax benefits of dividends on
equity-classified employee share-based payment awards that are declared in fiscal years
beginning after September 15, 2007. Early application of EITF 06-11 is permitted for the
income tax benefit of dividends on equity-classified employee share-based payment awards that
are declared in periods for which financial statements have not yet been issued. The Company
has evaluated EITF 06-11 and determined that it will have no impact on its results of operations or financial position.
In December 2007, the FASB issued FASB Statement No. 141 (R), Business Combinations (SFAS
141(R)), which establishes accounting principles and disclosure requirements for all
transactions in which a company obtains control over another business. SFAS No. 141(R)
applies prospectively to business combinations for which the acquisition date is on or after
the beginning of the first annual reporting period beginning on or after December 15, 2008.
Earlier adoption is prohibited. The Company is in the process of determining the effect, if
any, that the adoption of SFAS No. 141(R) will have on its results of operations or financial
position.
In December 2007, the FASB issued FASB Statement No. 160, Noncontrolling Interests in
Consolidated Financial Statements An Amendment of ARB No. 51. (SFAS No. 160). SFAS No.
160 establishes new accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal
years, and interim periods within those fiscal years, beginning on or after December 15,
2008. Earlier adoption is prohibited. The Company is in the process of determining the
effect, if any, that the adoption of SFAS No. 160 will have on its results of operations or
financial position.
Merchandise inventories are valued at the lower of cost or market using the retail first-in,
first-out (FIFO) method for goods in our stores and the cost first-in, first-out (FIFO)
method for goods in our distribution centers. The retail inventory method is a reverse
mark-up, averaging method which has been widely used in the retail industry for many years.
This method calculates a cost-to-retail ratio that is applied to the retail value of
inventory to determine the cost value of inventory and the resulting cost of goods sold and
gross margin. The assumption that the retail inventory method provides for valuation at
lower of cost or market and the inherent uncertainties therein are discussed in the following
paragraphs.
In order to assure valuation at the lower of cost or market, the retail value of our
inventory is adjusted on a consistent basis to reflect current market conditions. These
adjustments include increases to the retail value of inventory for initial markups to set the
selling price of goods or additional markups to adjust pricing for inflation and decreases to
the retail value of inventory for markdowns associated with promotional, seasonal or other
declines in the market value. Because these adjustments are made on a consistent basis and
are based on current prevailing market conditions, they approximate the carrying value of the
inventory at net realizable value (market value). Therefore, the cost value of our inventory
is stated at the lower of cost or market as is prescribed by GAAP.
Because the approximation of net realizable value (market value) under the retail inventory
method is based on estimates such as markups, markdowns and inventory losses (shrink), there
exists an inherent uncertainty in the final determination of inventory cost and gross margin.
In order to mitigate that uncertainty, the Company has a formal review by product class
which considers such variables as current market trends, seasonality, weather patterns and
age of merchandise to ensure that markdowns are taken currently, or a markdown reserve is
established to cover future anticipated markdowns. This review also considers current
pricing trends and inflation to ensure that markups are taken if necessary. The
estimation of inventory losses is a significant element in approximating the
7
carrying value
of inventory at net realizable value, and as such the following paragraph describes our
estimation method as well as the steps we take to mitigate the risk of this estimate in the
determination of the cost value of inventory.
The Company calculates inventory losses (shrink) based on actual inventory losses occurring
as a result of physical inventory counts during each fiscal period and estimated inventory
losses occurring between yearly physical inventory counts. The estimate for shrink occurring
in the interim period between physical counts is calculated on a store- specific basis and is
based on history, as well as performance on the most recent physical count. It is calculated
by multiplying each stores shrink rate, which is based on the previously mentioned factors,
by the interim periods sales for each store. Additionally, the overall estimate for shrink
is adjusted at the corporate level to a three-year historical average to ensure that the
overall shrink estimate is the most accurate approximation of shrink based on the Companys
overall history of shrink. The three-year historical estimate is calculated by dividing the
book to physical inventory adjustments for the trailing 36 months by the related sales for
the same period. In order to reduce the uncertainty inherent in the shrink calculation, the Company first
performs the calculation at the lowest practical level (by store) using the most current
performance indicators. This ensures a more reliable number, as opposed to using a higher
level aggregation or percentage method. The second portion of the calculation ensures that
the extreme negative or positive performance of any particular store or group of stores does
not skew the overall estimation of shrink. This portion of the calculation removes
additional uncertainty by eliminating short-term peaks and valleys that could otherwise cause
the underlying carrying cost of inventory to fluctuate unnecessarily. The Company has not
experienced any significant change in shrink as a percentage of sales from year to year
during the subject reporting periods.
Management believes that the Companys Retail Inventory Method provides an inventory
valuation which reasonably approximates cost and results in carrying inventory at the lower
of cost or market. For pharmacy inventories, which were approximately $32.6 million and $30.5
million at May 3, 2008 and February 2, 2008, respectively, cost was determined using the
retail LIFO (last-in, first-out) method in which inventory cost is maintained using the
Retail Inventory Method, then adjusted by application of the Producer Price Index published
by the U.S. Department of Labor for the cumulative annual periods. The current cost of
inventories exceeded the LIFO cost by approximately $16.8 million at May 3, 2008 and $15.4
million at February 2, 2008.
The Company includes an estimate of inbound freight and certain general and administrative
expenses in merchandise inventory as prescribed by Generally Accepted Accounting Principles.
These costs include activities surrounding the procurement and storage of merchandise
inventory such as buying, warehousing, accounting, merchandise planning, information
technology and human resources, as well as inbound freight. The total amount of expenses and
inbound freight included in merchandise inventory at May 3, 2008 is $22.2 million, with the
corresponding amount of $21.9 million at February 2, 2008.
NOTE 4: EQUITY INCENTIVE PLANS
The Company accounts for its stock-based compensation plans in accordance with Statement
of Financial Accounting Standards No. 123(R), Share-Based Payment(SFAS No. 123(R)).
Under SFAS No. 123(R) stock-based compensation expense is based on awards ultimately expected
to vest, and therefore has been reduced for estimated forfeitures. Forfeitures are estimated
at the time of grant based on the Companys historical forfeiture experience and will be
revised in subsequent periods if actual forfeitures differ from those estimates.
SFAS 123(R) also requires the benefits of income tax deductions in excess of recognized
compensation cost to be reported as a financing cash flow, rather than as an operating cash
flow as required prior to SFAS 123(R).
8
A summary of the Companys stock-based compensation (a component of selling and general and
administrative expenses) and related income tax benefit is as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
13 Weeks Ended |
|
|
|
May 3, |
|
|
May 5, |
|
|
|
2008 |
|
|
2007 |
|
|
|
(unaudited) |
|
|
|
|
|
Stock option expense |
|
$ |
371 |
|
|
$ |
484 |
|
Restricted stock expense |
|
|
161 |
|
|
|
140 |
|
ESPP expense |
|
|
44 |
|
|
|
52 |
|
|
|
|
|
|
|
|
Total stock-based compensation |
|
|
576 |
|
|
|
676 |
|
Income tax benefit on stock-based compensation |
|
|
115 |
|
|
|
114 |
|
The fair value of each option granted during the thirteen weeks ended May 3, 2008 and May 5,
2007, is estimated on the date of grant using the Black-Scholes option-pricing model with the
following weighted average assumptions:
|
|
|
|
|
|
|
|
|
|
|
13 Weeks Ended |
|
|
|
May 3, |
|
|
May 5, |
|
|
|
2008 |
|
|
2007 |
|
|
|
(unaudited) |
|
|
|
|
|
Stock Options |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
40.3 |
% |
|
|
41.0 |
% |
Risk-free interest rate |
|
|
3.5 |
% |
|
|
4.4 |
% |
Expected option life (in years) |
|
|
5.84 |
|
|
|
5.84 |
|
Expected dividend yield |
|
|
0.45 |
% |
|
|
0.40 |
% |
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date |
|
$ |
4.57 |
|
|
$ |
6.49 |
|
|
|
|
|
|
|
|
|
|
Employee Stock Purchase Plan |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
41.0 |
% |
|
|
32.7 |
% |
Risk-free interest rate |
|
|
3.1 |
% |
|
|
4.7 |
% |
Expected option life (in years) |
|
|
0.25 |
|
|
|
0.25 |
|
Expected dividend yield |
|
|
0.17 |
% |
|
|
0.15 |
% |
|
|
|
|
|
|
|
|
|
Weighted average fair value at grant date |
|
$ |
2.19 |
|
|
$ |
2.66 |
|
|
The following is a summary of the methodology applied to develop each assumption:
Expected Volatility This is a measure of the amount by which a price has
fluctuated or is expected to fluctuate. The Company uses actual historical changes in
the market value of our stock to calculate expected price volatility because
management believes that this is the best indicator of future volatility. The Company
calculates weekly market value changes from the date of grant over a past period
representative of the expected life of
the options to determine volatility. An increase in the expected volatility will
increase compensation expense.
9
Risk-free Interest Rate This is the yield of a U.S. Treasury zero-coupon
bond issue effective at the grant date with a remaining term equal to the expected
life of the option. An increase in the risk-free interest rate will increase
compensation expense.
Expected Life This is the period of time over which the options granted are
expected to remain outstanding and is based on historical experience. Options granted
have a maximum term of seven and one-half years. An increase in the expected life will
increase compensation expense.
Dividend Yield This is based on the historical yield for a period
equivalent to the expected life of the option. An increase in the dividend yield will
decrease compensation expense.
Forfeiture Rate This is the estimated percentage of options granted
that are expected to be forfeited or cancelled before becoming fully vested. This
estimate is based on historical experience. An increase in the forfeiture rate will
decrease compensation expense.
Stock Options
The following table summarizes stock option activity during the thirteen weeks ended May 3,
2008 (unaudited):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
Average |
|
|
Aggregate |
|
|
|
|
|
|
|
Average |
|
|
Remaining |
|
|
Intrinsic |
|
|
|
|
|
|
|
Exercise |
|
|
Contractual |
|
|
Value |
|
|
|
Options |
|
|
Price |
|
|
Life (Years) |
|
|
(Thousands) |
|
Outstanding at February 2, 2008 |
|
|
1,216,451 |
|
|
$ |
15.40 |
|
|
|
4.6 |
|
|
$ |
0 |
|
Granted |
|
|
26,000 |
|
|
$ |
10.93 |
|
|
|
|
|
|
|
|
|
Forfeited / Cancelled |
|
|
(33,240 |
) |
|
$ |
16.64 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at May 3, 2008 |
|
|
1,209,211 |
|
|
$ |
15.27 |
|
|
|
4.5 |
|
|
$ |
237 |
|
|
Exercisable at May 3, 2008 |
|
|
429,829 |
|
|
$ |
16.62 |
|
|
|
3.0 |
|
|
$ |
24 |
|
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value
(the difference between Freds closing stock price of $11.46 on the last trading day of the
period ended May 3, 2008 and the exercise price of the option multiplied by the number of
in-the-money options) that would have been received by the option holders had all option
holders exercised their options on that date. As of May 3, 2008, total unrecognized
stock-based compensation expense net of estimated forfeitures related to non-vested stock
options was approximately $1.48 million, which is expected to be recognized over a weighted
average period of approximately 3.3 years. The total fair value of options vested during the
thirteen weeks ended May 3, 2008 was $350,000.
Restricted Stock
The following table summarizes restricted stock activity during the thirteen weeks ended May
3, 2008 (unaudited):
10
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
Average |
|
|
|
Number |
|
|
Grant Date |
|
|
|
of Shares |
|
|
Fair Value |
|
Non-vested Restricted Stock at February 2, 2008 |
|
|
285,635 |
|
|
$ |
13.83 |
|
Granted |
|
|
41,500 |
|
|
$ |
8.67 |
|
Forfeited / Cancelled |
|
|
(14,292 |
) |
|
$ |
12.96 |
|
Vested |
|
|
(2,924 |
) |
|
$ |
14.98 |
|
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at May 3, 2008 |
|
|
309,919 |
|
|
$ |
13.17 |
|
The aggregate pre-tax intrinsic value of restricted stock outstanding as of May 3, 2008 is
$3.3 million with a weighted average remaining contractual life of 6.5 years. The
unrecognized compensation expense net of estimated forfeitures, related to the outstanding
stock is approximately $2.9 million, which is expected to be recognized over a weighted
average period of approximately 5.9 years. The total fair value of restricted stock awards
that vested during the thirteen weeks ended May 3, 2008 was $.04 million.
Employee Stock Purchase Plan
The 2004 Employee Stock Purchase Plan (the 2004 Plan), which was approved by Freds
stockholders, permits eligible employees to purchase shares of our common stock through
payroll deductions at the lower of 85% of the fair market value of the stock at the time of
grant or 85% of the fair market value at the time of exercise. There were 17,814 shares
issued during the thirteen weeks ended May 3, 2008. There are 1,410,928 shares approved to
be issued under the 2004 Plan and as of May 3, 2008, there were 1,206,133 shares available.
NOTE 5: Assets Held for Sale
In the first quarter of fiscal 2008, the Company purchased the home of a recently hired
executive for $875,000. The asset was for sale immediately upon purchase from the executive
and was actively being marketed throughout the first quarter. Near the end of the first
quarter the Company received an offer on the home for $805,000 subject to the normal closing
process for an asset of this type. Since the offer was $70,000 below the carrying amount of
the asset, the Company recorded a loss of $70,000 in the first quarter in selling, general
and administrative expenses in order to value the asset at its current market value. The
Company also accrued $60,000 against the market value of the asset as an estimate of the
costs necessary to sell the asset.
NOTE 6: Property and Equipment
Property and Equipment are carried at cost. Depreciation is recorded using the
straight-line method over the estimated useful lives of the assets. Improvements to leased
premises are amortized using the straight-line method over the shorter of the initial term
of the lease or the useful life of the improvement. Leasehold improvements added late in
the lease term are amortized over the shorter of the remaining term of the lease (including
the upcoming renewal option, if the renewal is reasonably assured) or the useful life of the
improvement. Assets under capital leases are amortized in accordance with the Companys
normal depreciation policy for owned assets or over the lease term (regardless of renewal
options), if shorter, and the charge to earnings is included in depreciation expense in the
consolidated financial statements. Gains or losses on the sale of assets are recorded as a
component of operating income.
11
The following illustrates the breakdown of the major categories within Property and
Equipment:
|
|
|
|
|
|
|
|
|
|
|
May 3, |
|
|
February 2, |
|
|
|
2008 |
|
|
2008 |
|
|
|
(unaudited) |
|
|
|
|
|
Building and building improvements |
|
$ |
88,511 |
|
|
$ |
88,459 |
|
Furniture, fixtures and equipment |
|
|
226,072 |
|
|
|
224,734 |
|
Leasehold improvements |
|
|
50,218 |
|
|
|
50,859 |
|
Automobiles and vehicles |
|
|
5,201 |
|
|
|
5,500 |
|
Airplane |
|
|
4,697 |
|
|
|
4,697 |
|
|
|
|
|
|
|
|
|
|
|
374,699 |
|
|
|
374,249 |
|
Less: Accumulated Depreciation and
Amortization |
|
|
(237,920 |
) |
|
|
(235,281 |
) |
|
|
|
|
|
|
|
|
|
|
136,779 |
|
|
|
138,968 |
|
Construction in Progress |
|
|
1,064 |
|
|
|
1,034 |
|
Land |
|
|
6,183 |
|
|
|
5,983 |
|
|
|
|
|
|
|
|
Total Property and Equipment, at
depreciated cost |
|
$ |
144,026 |
|
|
$ |
145,985 |
|
|
|
|
|
|
|
|
NOTE 7: Exit and disposal activities
During the year ended February 2, 2008, we recorded a below-cost inventory adjustment of
approximately $10.0 million to reduce the value of inventory to lower of cost or market in
stores that were planned for closure as part of the Companys strategic plan to improve
profitability and operating margin. The adjustment was recorded in cost of goods sold in
the consolidated statement of income for the year ended February 2, 2008.
Also during the year ended February 2, 2008 we closed twenty-two under performing stores and
recorded lease contract termination costs of $1.6 million in rent expense in conjunction with
those closings.
During the current year, the Company expects to incur $9.8 million in lease contract
termination costs, of which $1.2 million was incurred in the first quarter and charged to
rent expense.
The following table illustrates the activity in the reserves (liability) related to
activities discussed in the previous paragraphs (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Additions |
|
|
Utilized |
|
|
Ending |
|
|
|
Beginning |
|
|
1st Qtr |
|
|
1st Qtr |
|
|
Balance |
|
|
|
Balance |
|
|
2008 |
|
|
2008 |
|
|
May 3, 2008 |
|
|
|
February 2, 2008 |
|
|
(unaudited) |
|
|
(unaudited) |
|
|
(unaudited) |
|
Inventory markdowns for planned store closings |
|
$ |
10.0 |
|
|
|
|
|
|
$ |
2.8 |
|
|
$ |
7.2 |
|
Lease contract termination costs |
|
$ |
0.6 |
|
|
$ |
1.2 |
|
|
$ |
0.1 |
|
|
$ |
1.7 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
10.6 |
|
|
$ |
1.2 |
|
|
$ |
2.9 |
|
|
$ |
8.9 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
During the course of 2008, the Company is planning approximately 75 store closings and 22
pharmacy closings (of which 17 stores and 21 pharmacies have been closed as of May 3, 2008).
12
NOTE 8: Accumulated other comprehensive income
Comprehensive income consists of two components, net income and other comprehensive income
(loss). Other comprehensive income (loss) refers to gains and losses that under generally
accepted accounting principles are recorded as an element of stockholders equity but are
excluded from net income. The Companys accumulated other comprehensive income includes the
unrecognized prior service costs, transition obligations and actuarial gains/losses associated
with our postretirement benefit plan.
The following table illustrates the activity in accumulated other comprehensive income:
|
|
|
|
|
|
|
|
|
|
|
May 3, |
|
|
May 2, |
|
(in thousands) |
|
2008 |
|
|
2007 |
|
|
|
(unaudited) |
|
|
|
|
|
Accumulated other comprehensive income |
|
$ |
1,040 |
|
|
$ |
1,083 |
|
Amortization of postretirement benefit during quarter |
|
|
(11 |
) |
|
|
(16 |
) |
|
|
|
|
|
|
|
Ending balance |
|
$ |
1,029 |
|
|
$ |
1,067 |
|
|
|
|
|
|
|
|
Note 9: Related Party Transactions
The Company leases twelve of its store locations from Atlantic Retail Partners, LLC, which is
partially owned by Michael J. Hayes, a director and officer of the Company. The terms and
conditions regarding the leases on these locations are consistent in all material respects
with other store leases of the Company. Rent payments on these locations were $314,000 and $0
for the quarter ended May 3, 2008 and the quarter ended May 5, 2007, respectively.
Item 2:
Managements Discussion and Analysis of Financial
Condition and Results of Operations
Executive Overview
During the first quarter of 2008, the Company continued its strategy of slowing growth and
closing underperforming stores. This slow down in growth, coupled with the closing of
underperforming stores will have a positive impact on the Companys cash flow and operating
margin over time. In the first quarter of 2008, we opened 8 new stores and closed 17 stores
and 21 pharmacies. In addition we accelerated our store closing schedule by commencing going
out of business sales in an additional 50 locations. These going out of business sales and
the resulting store closures will be completed in the second quarter of 2008. The majority of
our new store openings were in Alabama and South Carolina. We did not enter into any new
states during the quarter.
Our Battleship Store Program, which was developed late in 2007 and was fully operational in
the first quarter, is intended to sharpen focus on our upper tier of profit producing stores.
This program is designed to reward our customers with additional benefits such as expanded
selections of products, one time or one-of-a-kind type items, or special events such as treasure hunts or outdoor activities. Customer and
employee appreciation are key tenets of the Battleship Program.
13
Also in the first quarter of 2008, we continued to focus on building our private label line of
products which should build and solidify customer loyalty while simultaneously increasing
gross margin. We are currently developing additional private label brand names that we
believe the customer will find appealing and will become synonymous with Freds promise to
deliver quality products at low prices.
Another key area of concentration in the quarter was our We Got It program, which focuses on
our highest demand consumable type items (700 800 items). These are items that we have
promised, through our We Got It branding campaign, to always have on our shelves and
available for our customers. We continued in the first quarter of 2008 to implement supply
chain and distribution procedures to ensure that our We Got It pledge is fulfilled.
We also began work in the first quarter on a new pricing strategy and marketing campaign.
This program will focus the customers attention on particular items in our stores that are
value priced and attractive to any budget, especially during current economic conditions.
This marketing campaign will be chain-wide and will be delivered to the customer in the second
and third quarters through print and media advertising as well as a specifically designed
in-store signing package.
Over the course of 2008, we intend to continue with capital improvements in infrastructure,
including new and existing store expansions and remodels, distribution center upgrades and
further development of our information technology capabilities. Technology upgrades will be
made in the areas of direct store delivery systems, stores POS systems, and pharmacy systems.
As previously reported, the Company expects total earnings per diluted share for 2008 to be in
the range of $0.52 to $0.58 including costs in 2008 related to the announced store closings.
Excluding the estimated store closing expenses of $10.8 million, earnings per diluted share
for 2008 are expected to be in the range of $0.70 to $0.76. These earnings projections
include the following significant events affecting the balance of the year:
|
|
The second year incremental raising of the federal minimum wage which will negatively
impact our labor expense by approximately $5.2 million. |
|
|
|
A decrease in the Mississippi State Medicaid reimbursement rate which was imposed on
May 1, 2008, will have a negative impact on gross profit of $1.5 to $2.0 million. |
|
|
|
The continued product mix shift to more basic and consumable type items, coupled with
inflationary pressures, will continue to negatively affect gross margin. |
|
|
|
The positive impact of our initiatives to drive traffic into our stores. |
Key factors that will be critical to the Companys future success include managing the
strategy for opening new stores and pharmacies, including the ability to open and operate
efficiently, maintaining high standards of customer service, maximizing efficiencies in the
supply chain, controlling working capital needs through improved inventory turnover,
controlling the effects of inflation, especially in regard to occupancy costs, controlling
product mix, increasing operating margin through improved gross margin and leveraging
operating costs, and generating adequate cash flow to fund the Companys future needs.
Additionally, managing the store closing process effectively and efficiently will be a key
factor in delivering projected benefits in 2008 and beyond.
Other factors that will affect Company performance in 2008 include the continuing management
of the impacts of the changing regulatory environment in which our pharmacy department
operates, especially the anticipated implementation of the federally approved change in
pricing of generic pharmaceuticals to Average Manufacturers Price (AMP), which could
negatively affect gross margin. Additionally, inflated oil and gas prices continue to have a
negative impact on our business in terms of reducing our customers disposable income, as well
as increasing the cost of our petroleum based products and increasing our
transportation costs. We also believe that the current housing crisis is having an impact on
the disposable income of our customers and will continue to do so well into 2008. Also, the
Company will again experience an initial negative
14
impact in selling, general and
administrative expenses from the second year incremental raising of the Federal minimum wage;
however, the increase should be a positive factor over time because it will directly impact
the disposable income of our primary customer base. We also believe that the Economic
Stimulus Package of 2008 and lower interest rates could be positive factors and may benefit
our customers in the upcoming quarter.
Our business is subject to seasonal influences, but has tended to experience less seasonal
fluctuation than many other retailers due to the mix of everyday basic merchandise and
pharmacy business. Our fiscal fourth quarter is typically the most profitable quarter because
it includes the Christmas selling season. The overall strength of the fourth quarter is
partially mitigated, however, by the inclusion of the month of January, which is generally the
least profitable month of the year.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Companys discussion and analysis of its financial condition and results of operations are
based upon the Companys condensed financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States. The critical
accounting matters that are particularly important to the portrayal of the Companys financial
condition and results of operations and require some of managements most difficult,
subjective and complex judgments are described in detail in the Companys Annual Report on
Form 10-K for the fiscal year ended February 2, 2008. The preparation of condensed financial
statements requires the Company to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent
assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including
those related to inventories, income taxes, insurance reserves, contingencies and litigation.
The Company bases its estimates on historical experience and on various other assumptions that
are believed to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates under different
assumptions or conditions.
Thirteen Weeks Ended May 3, 2008 and May 5, 2007
Net sales increased to $464.3 million in 2008 from $442.3 million in
2007, an increase of $22.0 million or 5.0%. The increase was
attributable to comparable store sales increases of 2.1% ($9.3
million) and sales by stores not yet included as comparable stores
($12.7 million). Sales to franchisees increased $1.1 million in 2008
compared to the same quarter last year. The sales mix for the period
was 31.8% Pharmaceuticals, 24.4% Household Goods, 8.7% Apparel and
Linens, 15.5% Food and Tobacco, 9.2% Paper and Cleaning Supplies, 8.2%
Health and Beauty Aids, and 2.2% Franchise. This compares with 33.2%
Pharmaceuticals, 23.1% Household Goods, 10.4% Apparel and Linens,
14.2% Food and Tobacco, 8.2% Health and Beauty Aids, 8.8% Paper and
Cleaning Supplies, and 2.1% Franchise for the same period last year.
Gross margin for the first quarter of 2008 was 28.5% of sales as
compared to 28.7% of sales in the first quarter of 2007. The
reduction in gross margin during the first quarter resulted from
pricing pressures, an unfavorable shift in the product mix toward
lower margin basic and consumable products, and higher inbound freight
costs. These negative factors were partially offset by the positive
margin effect of a mix shift in the pharmacy department from branded
to generic drugs.
Selling, general and administrative expenses increased to $120.7
million in 2008 from $115.8 million in 2007. This quarter over
quarter increase is primarily
attributable to payroll and supplies ($3.3 million) and occupancy related costs ($0.6
million), both as a result of having more stores in the first quarter of 2008 versus the
first quarter of 2007. Additionally, insurance expense ($.3 million) was unfavorable in the
first quarter when compared to the prior year due to unfavorable claims experience. Also,
lease related costs of closed stores
15
($0.7 million) were unfavorable in the first quarter
when compared to the prior year quarter. On the positive side, selling, general and
administrative expenses leveraged by 20 basis points as a percent of sales primarily due to
controlling labor and other expenses in the stores. As a percentage of sales, expenses
decreased to 26.0% of sales compared to 26.2% of sales last year.
For the first quarter of 2008, the Company incurred net interest expense of $0.2 million.
For the first quarter of 2008, the effective income tax rate was 37.3%, as compared to 33.9%
in the first quarter of last year. The increase in the effective tax rate was primarily due
to expiration of federal and state job related income tax credits.
LIQUIDITY AND CAPITAL RESOURCES
Due to the seasonality of our business and the continued increase in the number of stores and
pharmacies, inventories are generally lower at year-end than at each quarter-end of the
following year.
Cash provided by operating activities totaled $7.0 million during the thirteen-week period
ended May 3, 2008. Cash was generated primarily from cash basis net income of $16.7 million
coupled with a reduction in accounts receivable of $5.3 million. These cash inflows were
partially offset by cash outflows of $15.2 million used to increase inventories for the
spring and summer sales seasons.
Cash used in investing activities totaled $4.1 million, and consisted primarily of capital
expenditures associated with the store and pharmacy expansion program ($3.0 million),
expenditures related to existing stores ($1.3 million) and technology and other corporate
expenditures ($1.2 million). During the first quarter of 2008, we opened 8 stores, closed 17
stores and closed 21 pharmacies. We expect to open 18 stores and 15 pharmacies for the year,
and expect to close 75 stores and 22 pharmacies. In 2008, the Company is planning capital
expenditures totaling approximately $18.3 million. Expenditures are planned totaling
approximately $11.3 million for upgrades, remodels, or new stores and pharmacies; $3.7
million for technology upgrades, $1.3 million for distribution center equipment and capital
replacements. In addition, the Company also plans expenditures of $2.0 million for the
acquisition of customer lists and other pharmacy related items. Depreciation expense for 2008
will be approximately $26.5 million.
Cash used by financing activities totaled $1.7 million and included $0.9 million in
repayments under the Companys revolving credit facility and $0.8 million for the payment of
cash dividends. There were $34.9 million in borrowings outstanding at May 3, 2008 and $35.9
million in borrowings outstanding at February 2, 2008.
We believe that sufficient capital resources are available in both the short-term
and long-term through currently available cash and cash generated from future
operations and, if necessary, the ability to obtain additional financing.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
Other than statements based on historical facts, many of the matters discussed in this
Form 10-Q relate to events which we expect or anticipate
may occur in the future. Such statements are defined as forward-looking statements
under the Private Securities Litigation Reform Act of 1995 (the Reform Act), 15
U.S.C. Sections 77z-2 and 78u-5. The Reform Act created a safe harbor to protect
companies from securities law liability in connection with forward-looking statements.
We intend to qualify both our written and oral forward-looking statements for
protection under the Reform Act and any other similar safe harbor provisions.
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The words believe, anticipate, project, plan, expect, estimate,
objective, forecast, goal, intend, will likely result, or will continue and
similar expressions generally identify forward-looking statements. All forward-looking
statements are inherently uncertain, and concern matters that involve risks and other
factors that may cause the actual performance of the Company to differ materially from
the performance expressed or implied by these statements. Therefore, forward-looking
statements should be evaluated in the context of these uncertainties and risks,
including but not limited to:
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Economic and weather conditions which affect buying patterns of our
customers and supply chain efficiency. |
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Changes in consumer spending and our ability to anticipate buying
patterns and implement appropriate inventory strategies. |
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Continued availability of capital and financing. |
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Competitive factors. |
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Changes in reimbursement practices for pharmaceuticals. |
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Governmental regulation. |
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Increases in fuel and utility rates. |
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Other factors affecting business beyond our control, including (but not
limited to) those discussed under Part 1, ITEM 1A Risk Factors of the Companys
Annual Report on Form 10-K for the fiscal year ended February 2, 2008. |
Consequently, all forward-looking statements are qualified by this cautionary
statement. Readers should not place undue reliance on any forward-looking statements.
We undertake no obligation to update any forward-looking statement to reflect events
or circumstances arising after the date on which it was made.
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have no holdings of derivative financial or commodity instruments as of May 3, 2008. We
are exposed to financial market risks, including changes in interest rates. All borrowings
under our Revolving Credit Agreement bear interest at 1.5% below prime rate or a LIBOR-based
rate. An increase in interest rates of 100 basis points would not significantly affect our
income. All of our business is transacted in U.S. dollars and, accordingly, foreign exchange
rate fluctuations have not had a significant impact on us, and they are not expected to in
the foreseeable future.
Item 4.
(a) Disclosure Controls and Procedures. As of the end of the period
covered by this report, the Company carried out an evaluation, under the supervision
and with the participation of our Chief Executive Officer and Chief Financial Officer, of
the effectiveness of the Companys disclosure controls and procedures (as defined in
Rules 13a-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange
Act)). Based on that evaluation, the Chief Executive Officer and the Chief Financial
Officer, concluded that, as of the date of their evaluation, the Companys disclosure
controls and procedures are effective in timely alerting them to material information
required to be included in the Companys periodic SEC reports,
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subject to the
effectiveness of the Companys internal control over financial reporting. Consistent
with the suggestion of the Securities and Exchange Commission, the Company has formed a
Disclosure Committee consisting of key Company personnel designed to review the accuracy
and completeness of all disclosures made by the Company.
(b) Changes in Internal Control over Financial Reporting. There have been no changes in
the Companys internal control over financial reporting that occurred during the Companys
first fiscal quarter that have materially affected or are reasonably likely to materially
affect the Companys internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In June 2006, a lawsuit entitled Sarah Ziegler, et al. v. Freds Discount Store was
filed in the United States District Court for the Northern District of Alabama in which
the plaintiff alleges that she and other current and former Freds Discount assistant
store managers were improperly classified as exempt executive employees under the Fair
Labor Standards Act (FLSA) and seeks to recover overtime pay, liquidated damages, and
attorneys fees and court cost. In July 2006, the plaintiffs filed an emergency motion
to facilitate notice pursuant to the FLSA that would give current and former assistant
managers information about their rights to opt-in to the lawsuit. After initially
denying the motion, in October 2006, the judge granted plaintiffs motion to facilitate
notice pursuant to the FLSA. Notice was sent to some 2,055 current and former assistant
store managers and approximately 450 persons opted into the case. The cut off date for
individuals to advise of their interest in becoming part of this lawsuit was February 2,
2007.
The Company believes that its assistant store managers are and have been properly
classified as exempt employees under the FLSA and that the actions described above are
not appropriate for collective action treatment. The Company is and will continue to
vigorously defend these actions in this matter. Discovery is ongoing and data continues
to be reviewed. Following the close of the discovery period in this case, the Company
will have an opportunity to seek decertification of the class, and the Company expects
to file such a decertification and other motions.
In addition to the matters disclosed above, the Company is party to several pending
legal proceedings and claims arising in the normal course of business including those
mentioned in Part I Item 3. Legal Proceedings in the Annual Report on Form 10-K for
the fiscal year ended February 2, 2008. There have been no material developments in
those proceedings and claims. Although the outcome of the proceedings and claims cannot
be determined with certainty, management of the Company is of the opinion that it is
unlikely that these proceedings and claims will have a material adverse effect on the
financial statements as a whole. However, litigation involves an element of
uncertainty. There can be no assurance that pending lawsuits will not consume the time
and energy of our management, or that future developments will not cause these actions
or claims, individually or in aggregate, to have
a material adverse effect on the financial statements as a whole. We intend to
vigorously defend or prosecute each pending lawsuit.
Item 1A. Risk Factors
The risk factors listed in Part I Item 1A. Risk Factors in the Annual Report on Form 10-K
for the fiscal year ended February 2, 2008, should be considered with the information
provided elsewhere in this Quarterly Report on Form 10-Q, which
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could materially adversely
affect the business, financial condition or results of operations. There have been no
material changes to the risk factors as previously disclosed in such Annual Report on Form
10-K.
Item 6. Exhibits
Exhibits:
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31.1 |
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Certification of Chief Executive Officer. |
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Certification of Chief Financial Officer. |
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Certification of Chief Executive Officer and Chief
Financial Officer pursuant to rule 13a14(b) under the Securities
Exchange Act of 1934 and 18 U.S.C. Section 1350. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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FREDS, INC.
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Date: June 12, 2008 |
/s/ Michael J. Hayes
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Michael J. Hayes |
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Chief Executive Officer |
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Date: June 12, 2008 |
/s/ Jerry A. Shore
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Jerry A. Shore |
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Chief Financial Officer |
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