Fred's, Inc.
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|
|
|
þ |
|
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. |
For the quarterly period ended July 29, 2006.
OR
|
|
|
o |
|
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)
|
|
|
Tennessee
|
|
62-0634010 |
(State or other jurisdiction of
|
|
(I.R.S. Employer |
incorporation or organization)
|
|
Identification No.) |
|
|
|
4300 New Getwell Rd., Memphis, Tennessee
|
|
38118 |
(Address of principal executive offices)
|
|
(Zip code) |
(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 þ No o.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act.
Large accelerated filer o Accelerated filer þ Non-accelerated filer 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 þ.
The registrant had 39,971,884 shares of Class A voting, no par value common stock outstanding as of
September 1, 2006.
Part 1 FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
FREDS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except for number of shares)
|
|
|
|
|
|
|
|
|
|
|
July 29, |
|
|
January 28, |
|
|
|
2006 |
|
|
2006 |
|
|
|
(unaudited) |
|
|
|
|
|
ASSETS: |
|
|
|
|
|
|
|
|
Current assets: |
|
|
|
|
|
|
|
|
Cash and cash equivalents |
|
$ |
2,483 |
|
|
$ |
3,145 |
|
Inventories |
|
|
337,320 |
|
|
|
303,800 |
|
Receivables, less allowance for doubtful
accounts of $658 and $629, respectively |
|
|
23,777 |
|
|
|
20,622 |
|
Other non-trade receivables |
|
|
13,658 |
|
|
|
11,181 |
|
Prepaid expenses and other current assets |
|
|
9,067 |
|
|
|
10,790 |
|
|
|
|
|
|
|
|
Total current assets |
|
|
386,305 |
|
|
|
349,538 |
|
Property and equipment, at depreciated cost |
|
|
137,649 |
|
|
|
139,134 |
|
Equipment under capital leases, less accumulated
amortization of $4,347 and $4,203, respectively |
|
|
621 |
|
|
|
765 |
|
Other noncurrent assets, net |
|
|
10,432 |
|
|
|
8,704 |
|
|
|
|
|
|
|
|
Total assets |
|
$ |
535,007 |
|
|
$ |
498,141 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES AND SHAREHOLDERS EQUITY |
|
|
|
|
|
|
|
|
Current liabilities: |
|
|
|
|
|
|
|
|
Accounts payable |
|
$ |
79,243 |
|
|
$ |
78,491 |
|
Current portion of indebtedness |
|
|
243 |
|
|
|
510 |
|
Current portion of capital lease obligations |
|
|
447 |
|
|
|
543 |
|
Accrued expenses and other |
|
|
38,406 |
|
|
|
31,449 |
|
Income taxes payable |
|
|
|
|
|
|
6,196 |
|
Deferred income taxes |
|
|
18,690 |
|
|
|
18,329 |
|
|
|
|
|
|
|
|
Total current liabilities |
|
|
137,029 |
|
|
|
135,518 |
|
|
Long-term portion of indebtedness |
|
|
29,137 |
|
|
|
6,338 |
|
Deferred income taxes |
|
|
10,780 |
|
|
|
10,494 |
|
Capital lease obligations, long term portion |
|
|
287 |
|
|
|
477 |
|
Other noncurrent liabilities |
|
|
6,111 |
|
|
|
5,719 |
|
|
|
|
|
|
|
|
Total liabilities |
|
|
183,344 |
|
|
|
158,546 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Commitments and Contingencies |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shareholders equity: |
|
|
|
|
|
|
|
|
Preferred stock, nonvoting, no par value,
10,000,000 shares authorized, none outstanding |
|
|
|
|
|
|
|
|
Preferred stock, Series A junior participating
nonvoting, no par value, 224,594 shares
authorized, none outstanding |
|
|
|
|
|
|
|
|
Common stock, Class A voting, no par value,
60,000,000 shares authorized, 39,963,198
and 39,860,188 shares issued and outstanding, respectively |
|
|
133,995 |
|
|
|
134,218 |
|
Common stock, Class B nonvoting, no par value,
11,500,000 shares authorized, none outstanding |
|
|
|
|
|
|
|
|
Retained earnings |
|
|
217,668 |
|
|
|
207,643 |
|
Unearned compensation |
|
|
|
|
|
|
(2,266 |
) |
|
|
|
|
|
|
|
Total shareholders equity |
|
|
351,663 |
|
|
|
339,595 |
|
|
|
|
|
|
|
|
Total liabilities and shareholders equity |
|
$ |
535,007 |
|
|
$ |
498,141 |
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
3
FREDS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except per share amounts)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended |
|
|
Twenty-Six Weeks Ended |
|
|
|
July 29, |
|
|
July 30, |
|
|
July 29, |
|
|
July 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net sales |
|
$ |
406,925 |
|
|
$ |
373,319 |
|
|
$ |
823,803 |
|
|
$ |
756,057 |
|
Cost of goods sold |
|
|
291,881 |
|
|
|
268,587 |
|
|
|
588,915 |
|
|
|
542,296 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross profit |
|
|
115,044 |
|
|
|
104,732 |
|
|
|
234,888 |
|
|
|
213,761 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Depreciation and amortization |
|
|
7,013 |
|
|
|
6,803 |
|
|
|
14,122 |
|
|
|
13,446 |
|
Selling, general and
administrative expenses |
|
|
101,826 |
|
|
|
92,429 |
|
|
|
203,513 |
|
|
|
184,624 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating income |
|
|
6,205 |
|
|
|
5,500 |
|
|
|
17,253 |
|
|
|
15,691 |
|
Interest income |
|
|
(15 |
) |
|
|
|
|
|
|
(62 |
) |
|
|
|
|
Interest expense |
|
|
235 |
|
|
|
302 |
|
|
|
277 |
|
|
|
460 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income before income taxes |
|
|
5,985 |
|
|
|
5,198 |
|
|
|
17,038 |
|
|
|
15,231 |
|
Provision for income taxes |
|
|
1,662 |
|
|
|
1,715 |
|
|
|
5,417 |
|
|
|
5,026 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income |
|
$ |
4,323 |
|
|
$ |
3,483 |
|
|
$ |
11,621 |
|
|
$ |
10,205 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income per share |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
.11 |
|
|
$ |
.09 |
|
|
$ |
.29 |
|
|
$ |
.26 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
$ |
.11 |
|
|
$ |
.09 |
|
|
$ |
.29 |
|
|
$ |
.26 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
|
39,753 |
|
|
|
39,638 |
|
|
|
39,732 |
|
|
|
39,593 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Effect of dilutive stock options |
|
|
96 |
|
|
|
153 |
|
|
|
99 |
|
|
|
165 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
|
39,849 |
|
|
|
39,791 |
|
|
|
39,831 |
|
|
|
39,758 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Dividends per common share |
|
$ |
.02 |
|
|
$ |
.02 |
|
|
$ |
.04 |
|
|
$ |
.04 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
4
FREDS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
|
|
|
|
|
|
|
|
|
|
|
Twenty-six Weeks Ended |
|
|
|
July 29, |
|
|
July 30, |
|
|
|
2006 |
|
|
2005 |
|
Cash flows from operating activities: |
|
|
|
|
|
|
|
|
Net income |
|
$ |
11,621 |
|
|
$ |
10,205 |
|
Adjustments to reconcile net income
to net cash flows from operating activities: |
|
|
|
|
|
|
|
|
Depreciation and amortization |
|
|
14,122 |
|
|
|
13,446 |
|
Net loss on asset disposition |
|
|
15 |
|
|
|
|
|
Stock-based compensation |
|
|
1,086 |
|
|
|
|
|
(Recovery of) provision for uncollectible receivables |
|
|
(40 |
) |
|
|
12 |
|
LIFO reserve increase |
|
|
1,632 |
|
|
|
727 |
|
Deferred income taxes |
|
|
647 |
|
|
|
1,382 |
|
Amortization of unearned compensation |
|
|
|
|
|
|
325 |
|
Excess tax benefits from stock-based compensation |
|
|
(56 |
) |
|
|
126 |
|
(Increase) decrease in assets: |
|
|
|
|
|
|
|
|
Trade
receivables |
|
|
(8,284 |
) |
|
|
(3,714 |
) |
Insurance
receivables-Hurricane Katrina |
|
|
2,410 |
|
|
|
|
|
Inventories |
|
|
(35,152 |
) |
|
|
(28,013 |
) |
Other assets |
|
|
1,723 |
|
|
|
(1,135 |
) |
Increase (decrease) in liabilities: |
|
|
|
|
|
|
|
|
Accounts payable and accrued liabilities |
|
|
7,709 |
|
|
|
19,409 |
|
Income taxes payable |
|
|
(6,140 |
) |
|
|
3,935 |
|
Other noncurrent liabilities |
|
|
392 |
|
|
|
(438 |
) |
|
|
|
|
|
|
|
Net cash (used in) provided by operating activities |
|
|
(8,315 |
) |
|
|
16,267 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flows from investing activities: |
|
|
|
|
|
|
|
|
Capital expenditures |
|
|
(11,373 |
) |
|
|
(15,499 |
) |
Proceeds from asset dispositions |
|
|
98 |
|
|
|
|
|
Insurance recoveries for replacement assets |
|
|
282 |
|
|
|
|
|
Asset
acquisition, (primarily intangibles) |
|
|
(2,861 |
) |
|
|
(2,060 |
) |
|
|
|
|
|
|
|
Net cash used in investing activities |
|
|
(13,854 |
) |
|
|
(17,559 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cash flows from financing activities: |
|
|
|
|
|
|
|
|
Payments of indebtedness and capital lease obligations |
|
|
(665 |
) |
|
|
(350 |
) |
Proceeds from revolving line of credit, net of payments |
|
|
22,811 |
|
|
|
15,164 |
|
Excess tax benefits from stock-based compensation |
|
|
56 |
|
|
|
|
|
Proceeds from exercise of stock options and issuances
under employee stock purchase plan |
|
|
901 |
|
|
|
931 |
|
Cash dividends paid |
|
|
(1,596 |
) |
|
|
(1,592 |
) |
|
|
|
|
|
|
|
Net cash provided by financing activities |
|
|
21,507 |
|
|
|
14,153 |
|
|
|
|
|
|
|
|
Increase (decrease) in cash and cash equivalents |
|
|
(662 |
) |
|
|
12,861 |
|
Beginning of period cash and cash equivalents |
|
|
3,145 |
|
|
|
5,365 |
|
|
|
|
|
|
|
|
End of period cash and cash equivalents |
|
$ |
2,483 |
|
|
$ |
18,226 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Supplemental disclosures of cash flow information: |
|
|
|
|
|
|
|
|
Interest paid |
|
$ |
207 |
|
|
$ |
405 |
|
|
|
|
|
|
|
|
Income taxes paid |
|
$ |
13,141 |
|
|
$ |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-cash investing and financing activities: |
|
|
|
|
|
|
|
|
Assets acquired through term loan |
|
$ |
100 |
|
|
$ |
|
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
5
FREDS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
Freds, Inc. (We, Our or Us) operates, as of July 29, 2006, 673 discount general
merchandise stores, including 24 franchised Freds stores, in 15 states in the southeastern
United States. 282 of the stores have full service pharmacies.
The accompanying unaudited condensed 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 January
28, 2006 incorporated into Our Annual Report on Form 10-K.
The results of operations for the twenty-six week period ended July 29, 2006 are not
necessarily indicative of the results to be expected for the full fiscal year.
NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS
In February 2006, FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments an amendment of FASB Statements No. 133 and 140. SFAS No. 155 provides a fair
value measurement option for certain hybrid financial instruments that contain an embedded
derivative that would otherwise require bifurcation. SFAS No. 155 also provides clarification
of specific derivative accounting exceptions and sets forth requirements to analyze certain
financial assets to determine whether they require bifurcation. SFAS No. 155 is effective for
all financial instruments acquired or issued subsequent to fiscal years that begin after
September 15, 2006. The Company does not expect the adoption of SFAS No. 155 to have a
material impact on its results of operations or financial position.
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 156, Accounting for Servicing of Financial
Assetsan amendment of FASB Statement No. 140, which addresses the valuation of servicing
assets and servicing liabilities. SFAS No. 156 eliminates the requirement to value servicing
assets and servicing liabilities at the lower of cost or market and instead permits these
assets and liabilities to be measured at fair value. SFAS No. 156 is effective for fiscal
years that begin after September 15, 2006. The Company does not expect the adoption of SFAS
No. 156 to have a material impact on its results of operations or financial position.
In March 2006, the FASBs Emerging Issues Task Force released Issue 06-3, How Sales
Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented
in the Income Statement, or EITF 06-3. A consensus was reached that entities may adopt a
policy of presenting sales taxes in the income statement on either a gross or net basis. If
taxes are significant, an entity should disclose its policy of presenting taxes and the
amount of taxes if reflected on a gross basis in the income statement. EITF 06-3 is effective
for periods beginning after December 15, 2006. The Company presents sales net of sales taxes
in its consolidated statement of operations and does not anticipate changing its policy as a
result of EITF 06-3.
6
In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for
Uncertainty in Income Taxes an Interpretation of FASB Statement No.109. FIN 48 clarifies
the accounting for uncertainty in income taxes in an enterprises financial statements in
accordance with FASB Statement No 109, Accounting for Income Taxes. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also
provides guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning
after December 15, 2006, which will be the companys fiscal 2007 year beginning February 4,
2007. The company is currently assessing the impact FIN 48 will have on its results of
operations or financial position.
On July 26, 2006, the FASB affirmed its previous decision to make the recognition
provisions of its proposed standard, Employers Accounting for Defined Benefit Pension and
other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R),
effective for public companies for fiscal years ending after December 15, 2006. This standard
would be effective for the companys fiscal 2006 year ending February 3, 2007. The FASB is
expected to issue its final standard on or before September 29, 2006. No determination has
yet been made regarding the materiality of the potential impact of this proposed
interpretation on the Companys results of operations or financial position.
NOTE 3: INVENTORIES
Warehouse inventories are stated at the lower of cost or market using the FIFO
(first-in, first-out) method. Retail inventories are stated at the lower of cost or market
as determined by the retail inventory method (RIM). Under RIM, the valuation of inventories
at cost and the resulting gross margin are calculated by applying a calculated cost-to-retail
ratio to the retail value of inventories. RIM is an averaging method that has been widely
used in the retail industry due to its practicality. Also, it is recognized that the use of
the RIM will result in valuing inventories at lower of cost or market if markdowns are
currently taken as a reduction of the retail value of inventories. Inherent in the RIM
calculation are certain significant management judgments and estimates including, among
others, initial markups, markdowns, and shrinkage, which significantly impact the ending
inventory valuation at cost as well as resulting gross margin. These significant estimates,
coupled with the fact that the RIM is an averaging process, can, under certain circumstances,
produce distorted or inaccurate cost figures. Based upon our historical information we have
not experienced any significant change in our cost valuation to date. Management believes
that the Companys RIM provides an inventory valuation which reasonably approximates cost and
results in carrying inventory at the lower of cost or market.
For pharmacy inventories, which are $35.9 million and $35.5 million at July 29, 2006 and
January 28, 2006, respectively, cost was determined using the retail LIFO (last-in,
first-out) method in which inventory cost are maintained using the RIM 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 $13.8
million at July 29, 2006 and $12.2 million at January 28, 2006. LIFO pharmacy inventory
costs can only be determined annually when inflation rates and inventory levels are
finalized; therefore, LIFO pharmacy inventory costs for interim financial statements are
estimated.
Cost
of goods sold and gross profit margins were favorably impacted during
the quarter ended July 29, 2006 by $1.0 million due to settlement of
insurance claims related to damaged merchandise, business
interruption, etc, related to Hurricane Katrina.
NOTE 4: STOCK-BASED COMPENSATION
Effective January 29, 2006, the Company adopted the fair value recognition provisions of
SFAS No. 123(R), Share-Based Payment, using the modified prospective transition method.
Under this method, compensation expense recognized in 2006 includes: (1) compensation expense
for all share-based payments granted prior to, but not yet vested as of, January 29, 2006,
based on the grant date fair value estimated in accordance with the original provisions of
SFAS No. 123, and (2) compensation cost for all share-based payments granted subsequent to
January 29, 2006, based on the grant date fair value estimated in accordance with
7
the provisions of SFAS No. 123(R). Results for prior periods have not been restated.
In November 2005, FASB issued Staff Position No. FAS 123(R)-3, Transition Election
Related to Accounting for Tax Effects of Share-Based Payment Awards (FSP FAS 123R-3).
Effective January 29, 2006, the Company has elected to adopt the alternative transition
method provided in FSP FAS 123R-3 for calculating the income tax effects of stock-based
compensation pursuant to SFAS 123(R). The alternative transition method includes simplified
methods to establish the beginning balance of the additional paid-in-capital pool (APIC
Pool) related to the income tax effects of stock based compensation, and for determining the
subsequent impact on the APIC pool and consolidated statements of cash flows of the income
tax effects of stock-based compensation awards that are outstanding upon adoption of SFAS
123(R).
Stock-based compensation expense, post adoption of SFAS 123(R), 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. The current forfeiture estimate for stock options is 11% and for restricted stock
is 4%. For periods prior to 2006, the Company in its proforma disclosures under SFAS 123,
recognized forfeitures as they occurred.
For the 13 weeks ended July 29, 2006, the adoption of SFAS 123(R) fair value method
resulted in share-based expense (a component of selling and general and administrative
expenses) in the amount of $.74 million before income taxes and consisted of stock option,
ESPP and restricted stock expense of $.56 million, $.06 million and $.12 million,
respectively. The related total tax income benefit was $.08 million.
For the 26 weeks ended July 29, 2006, the adoption of SFAS 123(R) fair value method
resulted in share-based expense (a component of selling and general and administrative
expenses) in the amount of $1.09 million before income taxes and consisted of stock option,
ESPP and restricted stock expense of $.71 million, $.15 million and $.23 million,
respectively. The related total tax income benefit was $.15 million.
Prior to January 28, 2006, the Company accounted for share-based payments using the
intrinsic-value-based recognition method prescribed by Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to Employees, (APB 25). As stock options were granted
at an exercise price equal to the market value of the underlying common stock on the date of
grant, no stock option compensation expense was reflected in net income prior to adopting
SFAS 123(R).
As a result of adopting SFAS 123(R), the Companys income before income taxes and net
income for the thirteen weeks ended July 29, 2006 were $.62 million and $.58 million lower,
respectively, and the Companys income before income taxes and net income for the twenty-six
weeks ended July 29, 2006 were $.86 million and $.79 million lower, respectively, than if it
had continued to account for share-based compensation under APB 25. Basic and diluted
earnings per share for the thirteen and twenty-six weeks ended July 29, 2006 were $.02 lower,
than if the Company had continued to account for share-based compensation under APB 25.
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). The impact of adopting SFAS 123(R) on future results
will depend on, among other things, levels of share-based payments granted in the future,
actual forfeiture rates and the timing of option exercises.
The following table illustrates the effect on net income and earnings per share for the
13 and 26 weeks ended July 30, 2005, as if the Company had applied the fair value recognition
provisions of SFAS No. 123(R) to stock based employee compensation.
8
|
|
|
|
|
|
|
|
|
|
|
July 30, 2005 |
|
|
|
13 Weeks |
|
|
26 Weeks |
|
(Amounts in thousands, except per share data) |
|
Ended |
|
|
Ended |
|
Net income, as reported |
|
$ |
3,483 |
|
|
$ |
10,205 |
|
SFAS No. 123 pro forma compensation expense, net of
income taxes |
|
|
(201 |
) |
|
|
(539 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
SFAS No. 123 pro forma
Net income |
|
$ |
3,282 |
|
|
$ |
9,666 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earnings per share, as reported: |
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.09 |
|
|
$ |
.26 |
|
|
|
|
|
|
|
|
Diluted |
|
$ |
0.09 |
|
|
$ |
.26 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Pro forma earnings per share: |
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.08 |
|
|
$ |
.24 |
|
|
|
|
|
|
|
|
Diluted |
|
$ |
0.08 |
|
|
$ |
.24 |
|
|
|
|
|
|
|
|
The amounts in this table have been adjusted from the amounts reported in our Quarterly
Report on Form 10-Q for the thirteen and twenty-six weeks ended July 30, 2005 to be
calculated following the same method that has been utilized under SFAS No. 123(R). The total
impact of the change was to increase the incremental stock option expense per SFAS No.
123(R), net of taxes by $.12 million for the thirteen weeks ended July 30, 2005 and $.29
million for the twenty-six weeks ended July 30, 2005.
The Company uses the Black-Scholes option-pricing model to measure the fair value of
stock options granted to employees. The Black-Scholes option model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly subjective
assumptions including the expected stock volatility. Because the Companys employee stock
options have characteristics significantly different from those of traded options, and
because changes in the subjective assumptions can materially affect the fair value estimate,
in managements opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options. Stock options granted have exercise
prices equal to the market price of Freds common stock on the grant date.
The fair value of each option granted during the thirteen and twenty-six weeks ended
July 29, 2006 is estimated on the date of grant using the Black-Scholes option-pricing model
with the following weighted average assumptions:
9
|
|
|
|
|
|
|
|
|
|
|
July 29, 2006 |
|
|
13 Weeks Ended |
|
26 Weeks Ended |
Stock Options |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
41.6 |
% |
|
|
41.5 |
% |
Risk-free interest rate |
|
|
4.4 |
% |
|
|
4.8 |
% |
Expected option life (in years) |
|
|
5.84 |
|
|
|
5.84 |
|
Expected dividend yield |
|
|
0.35 |
% |
|
|
0.35 |
% |
Weighted average fair value at grant date |
|
$ |
6.05 |
|
|
$ |
6.15 |
|
|
Employee Stock Purchase Plan |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
33.5 |
% |
|
|
33.5 |
% |
Risk-free interest rate |
|
|
4.8 |
% |
|
|
4.8 |
% |
Expected option life (in years) |
|
|
0.5 |
|
|
|
0.38 |
|
Expected dividend yield |
|
|
0.13 |
% |
|
|
0.13 |
% |
Weighted average fair value at grant date |
|
$ |
3.91 |
|
|
|
3.67 |
|
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.
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 Lives 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.
10
NOTE 5: Stock Plans
Stock Option Plans
The Company grants stock options to key employees including executive officers, as well
as other employees, as prescribed by the Compensation Committee (the Committee) of the
Board of Directors. The number of options granted is directly linked to the employees job
classification. Options, which include non-qualified stock options and incentive stock
options, are rights to purchase a specified number of shares of Freds common stock at a
price fixed by the Committee. The exercise price for stock options issued under the plan
that qualify as incentive stock options within the meaning of Section 422(b) of the Code
shall not be less than 100% of the fair value as of the date of grant. The option exercise
price may be satisfied in cash or by exchanging shares of Freds common stock owned by the
optionee for at least six months, or a combination of cash and shares. Options have a maximum
term of five to seven and one-half years from the date of grant. Options granted under the
plan generally become exercisable ten percent during each of the first four years on the
anniversary date and sixty percent on the fifth anniversary date. The rest vest ratably over
the requisite service period. Stock option expense is generally recognized using the graded
vesting attribution method. The plan also contains a provision that if the Company meets or
exceeds a specified operating income margin during the most recently completed fiscal year
that the annual vesting percentage will accelerate from ten to twenty percent during that
vesting period. The plan also provides for annual stock grants at the fair value of the stock
on the grant date to non-employee directors according to a non-discretionary formula. The
number of shares granted is dependent upon current director compensation levels.
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 16,748 shares
issued during the thirteen weeks ended July 29, 2006 and 32,016 shares issued during the
twenty-six weeks ended July 29, 2005. There are 1,000,000 shares approved to be issued under
the 2004 Plan and as of July 29, 2006, there were 935,401 shares available.
Stock Options
The following table summarizes stock option activity during the twenty-six weeks ended July
29, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
Average |
|
|
Aggregate |
|
|
|
|
|
|
|
Average |
|
|
Remaining |
|
|
Intrinsic |
|
|
|
|
|
|
|
Exercise |
|
|
Contractual |
|
|
Value |
|
|
|
Options |
|
|
Price |
|
|
Life (years) |
|
|
(Thousands) |
|
Outstanding at January 28, 2006 |
|
|
1,190,019 |
|
|
$ |
16.89 |
|
|
|
|
|
|
|
|
|
Granted |
|
|
320,203 |
|
|
$ |
13.58 |
|
|
|
|
|
|
|
|
|
Forfeited/ cancelled |
|
|
(200,975 |
) |
|
$ |
15.66 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
(33,852 |
) |
|
$ |
9.89 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at July 29, 2006 |
|
|
1,275,395 |
|
|
$ |
16.44 |
|
|
|
4.4 |
|
|
$ |
0 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at July 29, 2006 |
|
|
391,928 |
|
|
$ |
16.86 |
|
|
|
2.7 |
|
|
$ |
0 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic
value (the difference between Freds closing stock price of $11.78 on the last trading day of the
period ended July 29, 2006 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. This amount changes based on changes in the market value
of Freds stock. The total pre-tax intrinsic value of options exercised during the thirteen and
twenty-six weeks ended July 29, 2006 was $.05 million and $.13 million, respectively. Cash
received from the exercise of stock options during the thirteen weeks ended July 29, 2006 totaled
$.12 million and the related tax benefits recognized from the exercise of stock options totaled
$.02 million. Cash received from the exercise of stock options during the twenty-six weeks ended
July 29, 2006 totaled $.34 million and the related tax benefits recognized from the exercise of
stock options totaled $.05
million. As of July 29, 2006, total unrecognized stock-based compensation expense
11
net of
estimated forfeitures related to non-vested stock options was approximately $2.9 million, which
is expected to be recognized over a weighted average period of approximately 3.9 years. The
total fair value of options vested during the thirteen weeks ended July 29, 2006 was $.03
million. The total fair value of options vested during the twenty-six weeks ended July 29, 2006
was $.23 million.
The following table summarizes information about stock options outstanding at July 29, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options Outstanding |
|
Options Exercisable |
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Remaining |
|
Weighted |
|
|
|
|
|
Weighted |
|
|
Number |
|
Contractual |
|
Average |
|
Number |
|
Average |
Range of |
|
Outstanding at |
|
Life |
|
Exercise |
|
Exercisable at |
|
Exercise |
Exercise Prices |
|
July 29, 2006 |
|
(in Years) |
|
Price |
|
July 29, 2006 |
|
Price |
$12.35 to $14.60 |
|
|
617,028 |
|
|
|
5.3 |
|
|
$ |
13.67 |
|
|
|
163,511 |
|
|
$ |
13.08 |
|
$14.68 to $20.60 |
|
|
578,430 |
|
|
|
3.8 |
|
|
$ |
18.13 |
|
|
|
179,730 |
|
|
$ |
18.21 |
|
$23.05 to $34.48 |
|
|
79,937 |
|
|
|
2.6 |
|
|
$ |
25.53 |
|
|
|
48,687 |
|
|
$ |
24.54 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
1,275,395 |
|
|
|
4.4 |
|
|
$ |
16.44 |
|
|
|
391,928 |
|
|
$ |
16.86 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Restricted Stock
The Companys stock incentive plans also allow for granting of restricted stock having a
fixed number of shares at a purchase price that is set by the Compensation Committee of the
Companys Board of Directors, which purchase price may be set at zero, to certain executive
officers, directors and key employees. The Company calculates compensation expense as the
difference between the market price of the underlying stock on the date of grant and the
purchase price if any. Restricted shares granted under the plan have various vesting types,
which include cliff vesting and graded vesting with a requisite service period of three to
ten years. Restricted stock has a maximum term of five to ten years from grant date.
Compensation expense is recorded on a straight-line basis for shares that cliff vest and
under the graded vesting attribution method for those that have graded vesting.
The following table summarizes restricted stock activity during the twenty-six weeks
ended July 29, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
Average |
|
|
|
Number |
|
|
Grant Date |
|
|
|
Of Shares |
|
|
Fair Value |
|
Non-vested Restricted Stock at January 28, 2006 |
|
|
172,532 |
|
|
$ |
15.48 |
|
Granted |
|
|
46,443 |
|
|
$ |
14.84 |
|
Forfeited / Cancelled |
|
|
(9,797 |
) |
|
$ |
15.48 |
|
Vested |
|
|
(8,055 |
) |
|
$ |
9.23 |
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at July 29, 2006 |
|
|
201,123 |
|
|
$ |
15.59 |
|
|
|
|
|
|
|
|
12
The aggregate pre-tax intrinsic value of restricted stock outstanding as of July 29, 2006 is
$2.4 million with a weighted average remaining contractual life of 8.0 years. The
unrecognized compensation expense net of estimated forfeitures, related to the outstanding
stock is approximately $2.5 million, which is expected to be recognized over a weighted
average period of approximately 7.5 years. The total fair value of restricted stock awards
that vested during the thirteen weeks ended July 29, 2006 was $.04 million. The total fair
value of restricted stock awards that vested during the twenty-six weeks ended July 29, 2006
was $.07 million.
The unrecognized compensation expense related to outstanding restricted stock awards was
recorded as unearned compensation in shareholders equity at January 28, 2006. With the
adoption of SFAS 123 (R), the unrecognized compensation expense related to outstanding
restricted stock awards granted prior to January 29, 2006 was charged to common stock.
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
or the lease of 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, whichever is lesser. 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 condensed consolidated financial statements. Gains or losses on
the sale of assets are recorded at disposal as a component of operating income. The
following illustrates the breakdown of the major categories within Property and Equipment:
|
|
|
|
|
|
|
|
|
|
|
July 29, |
|
|
January 28, |
|
|
|
2006 |
|
|
2006 |
|
|
|
(unaudited) |
|
|
|
|
|
Building and building improvements |
|
$ |
75,310 |
|
|
$ |
74,960 |
|
Furniture, fixtures and equipment |
|
|
208,297 |
|
|
|
200,049 |
|
Leasehold improvements |
|
|
40,285 |
|
|
|
38,901 |
|
Automobiles and vehicles |
|
|
6,305 |
|
|
|
6,232 |
|
Airplane |
|
|
4,697 |
|
|
|
4,697 |
|
|
|
|
|
|
|
|
|
|
$ |
334,894 |
|
|
$ |
324,839 |
|
Less: Accumulated Depreciation and
Amortization |
|
|
(202,821 |
) |
|
|
(190,306 |
) |
|
|
|
|
|
|
|
|
|
$ |
132,073 |
|
|
$ |
134,533 |
|
Construction in Progress |
|
|
1,300 |
|
|
|
325 |
|
Land |
|
|
4,276 |
|
|
|
4,276 |
|
|
|
|
|
|
|
|
Total Property and Equipment, at
depreciated cost |
|
$ |
137,649 |
|
|
$ |
139,134 |
|
|
|
|
|
|
|
|
13
Item 2:
Managements Discussion and Analysis of Financial
Condition and Results of Operations
GENERAL
Executive Overview
Throughout the first half of 2006, the Company has continued its strategy of growth
initiatives and productivity improvements. In the first six months of 2006, the Company
opened 30 new stores and closed 2 stores. The majority of our new store openings were in
Georgia, Mississippi, and North Carolina. This has caused a decline in the rate of our new
store openings in 2006 because of the stricter building codes being imposed in areas that
were affected by last years catastrophic hurricane season. We did not enter into any new
states in the quarter. Additionally, we opened eight new pharmacies and closed one pharmacy
during the first six months of 2006.
For the balance of the year, the Company plans to open 30 35 new stores and 12 17 new
pharmacies, with the net effect being an increase in selling space in the range of 8% to 10%.
Increased selling space will help drive increases in total sales, while comparable store
sales increases will be driven by our continued focus on merchandising, with initiatives such
as our Merchandising Refresher program. Additionally, our cooler program, which was
implemented in the latter half of last year, is expected to continue to drive increases in
comparable store sales. Also, the new store prototype, which was introduced on a limited
basis in the second quarter of 2006, changes our merchandise presentation by moving higher
margin items to the front of the store and lower margin items to the back with the intention
of increasing overall gross margin. The Company will continue in the second half of 2006 with
capital investment in infrastructure, including new store expansion, distribution center
upgrades and further development of our information technology capabilities.
Key factors that will be critical to the Companys future success include managing the growth
strategy for new stores and pharmacies, including the ability to open and operate effectively,
maintaining high standards of customer service, maximizing efficiencies in the supply chain,
controlling working capital needs through improved inventory turnover, increasing the
operating margin through improved gross profit margin and leveraging operating costs, and
generating adequate cash flow to fund the Companys expansion.
Other factors that will affect Company performance for the remainder of 2006 include managing
the impacts of the implementation of Medicare Part D, which has a negative effect on gross
margin with a partial positive offset from increasing Part D scripts, and the implementation
of the federally approved change in pricing of generic pharmaceuticals to Average
Manufacturers Price (AMP), which could negatively affect gross margin. Additionally, the
implementation in the first quarter of Financial Accounting Standard No 123(R), Share Based
Payments, will continue to increase compensation expense over historical periods. Also,
because of our location geographically, weather, particularly in the form of hurricanes, could
be a factor in the third and fourth quarters of the year.
We continue to focus our merchandising and store direction on maintaining a competitive
differentiation within the $25 shopping trip. Our unique store format and strategy combine
the attractive element of a discount dollar store, drug store and mass merchant. During the
first six months of 2006, our average comparable customer transaction was approximately
$18.19. In comparison, the discount dollar stores average $8 $9 and chain drugs and mass
merchants average in the range of $40 $80 per transaction. Our stores operate equally well
in rural and urban markets. Our everyday low pricing strategy is supplemented by 14
promotional circulars per year. Our product selection is enhanced by a private label program
and opportunistic buys.
As previously reported, the Company expects an increase in earnings per diluted share for
2006. The Company bases this increase in estimated earnings for fiscal 2006, which will be a
53-week year, on the following assumptions:
The Company expects a charge of $0.04 per diluted share relating to the
expensing of stock options as required by Statement of Financial Accounting
14
Standards No. 123(R), Share-Based Payment.
Comparable store sales are anticipated to increase for the full year in the range of
3%-5%. Comparable store sales are anticipated in the 5%-7% in the third quarter and 3%-5% in
the fourth quarter. Total sales are expected to increase in the range of 11%-15% for the
year. Total sales are anticipated in the 13%-15% in the third quarter and 18%-20% in the
fourth quarter.
The Company expects to open 60-65 new stores and 20-25 new pharmacies in 2006 and
close 5-10 stores and 5-10 pharmacies, with the net effect being an increase in selling space
in the range of 8%-10%.
A net effect of $0.05-$0.06 per diluted share from the implementation of Medicare
Part D, reflecting a lower margin on pharmacy sales, which contains a partial offset from
increasing Part D scripts.
A lower estimated tax rate resulting from additional Work Opportunity Tax Credits
offered in the areas affected by Hurricane Katrina.
Excludes any estimated potential impact to our pharmacy department from the federally
approved Average Manufacturers Price (AMP) program that will become effective in 2007, which
could be initiated earlier by individual states.
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.
The impact of inflation on labor and occupancy costs can significantly affect our
operations. Many of our employees are paid hourly rates related to the federal and state
minimum wage regulations and, accordingly, any increase affects us. In addition, payroll
taxes, employee benefits and other employee-related costs continue to increase. Occupancy
costs, including rent, maintenance, taxes and insurance, also continue to rise. We believe
that maintaining adequate operating margins through a combination of price adjustments and
cost controls, careful evaluation of occupancy needs, and efficient purchasing practices are
the most effective tools for coping with increasing costs and expenses.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Companys discussion and analysis of its financial condition and results of operations are
based upon the Companys condensed consolidated 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 January 28, 2006. The preparation of condensed
consolidated 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. The only material changes in
critical accounting policies during the twenty-six weeks ended July 29, 2006, were the
adoption of SFAS No. 123(R), Share-Based Payment and FAS No. 123 (R)-3, Transition Election
Related to Accounting for Tax Effects of Share-Based Payment Awards.
Included in ending inventory are capitalized costs of the product itself, inbound freight and
duties and the costs associated with purchasing, receiving, handling, and securing the
product.
Cost of merchandise sold includes the cost of the product sold, along with all costs
associated with inbound freight.
15
Selling, general and administrative expenses include the costs associated with purchasing,
receiving, handling, securing, and storing the product. These costs are associated with
products that have been sold and no longer remain in ending inventory.
RESULTS OF OPERATIONS
Thirteen Weeks Ended July 29, 2006 and July 30, 2005
Net sales increased to $406.9 million in 2006 from $373.3 million in 2005, an increase of
$33.6 million or 9.0%. The increase was attributable to comparable store sales increases of
2.6% ($9.3 million) and sales by stores not yet included as comparable stores ($23.7
million). Sales to franchisees increased $.6 million in 2006 compared to the same quarter
last year. It is anticipated that this category of business will continue to decline as a
percentage of total Company sales since the Company has not added and does not intend to add
any additional franchises. The sales mix for the period was 33.0% Pharmaceuticals, 22.5%
Household Goods, 12.8% Food and Tobacco, 12.4% Apparel and Linens, 9.0% Paper and Cleaning
Supplies, 8.2% Health and Beauty Aids, and 2.1% Franchise. This compares with 32.8%
Pharmaceuticals, 23.0% Household Goods, 13.4% Apparel and Linens, 11.9% Food and Tobacco,
8.7% Paper and Cleaning Supplies, 8.0% Health and Beauty Aids, and 2.2% Franchise for the
same period last year.
Gross profit for the second quarter increased to 28.3% of sales in 2006 from 28.1% of sales
in 2005. The improvement is primarily a result of managing our initial mark-up and
controlling markdowns in the general merchandise departments. Additionally, the pharmacy
margins benefited from our new supply agreement in effect this year. This benefit partially
offset the reduction in reimbursement rates for Medicare Part D sales. Also in the current
quarter, gross profit margin was favorably affected by the recording of hurricane Katrina
insurance proceeds of approximately $1.0 million.
Selling, general and administrative expenses increased to $108.8 million in 2006 from $99.2
million in 2005. Selling, general and administrative expenses increased primarily due to
higher labor ($4.1 million), property and equipment rent ($1.6 million), utilities expenses
($1.6 million) and fuel prices ($.8 million). Approximately $1.6 million of the increased
labor costs are directly attributable to the net addition of 50 stores and 12 pharmacies
when compared to last year. As a percentage of sales, expenses increased to 26.8% of sales
compared to 26.6% of sales last year. On the positive side, store labor improved by 32 basis
points as a percentage of store sales due to better management of labor dollars to store
sales.
For the second quarter of 2006 net interest expense was $.2 million compared to $.3 million
in 2005.
For the second quarter, the effective income tax rate was 27.8%, as compared to 33.0% in the
second quarter of last year. This reduction in effective rate was due to additional work
opportunity tax credits and Gulf Opportunity credits available to the Company and the
benefit of the year-to-date effect was recorded in the quarter. We anticipate the tax rate
for the remainder of the year to be in the 32% to 33% range.
16
Twenty-six Weeks Ended July 29, 2006 and July 30, 2005
Net sales increased to $823.8 million in 2006 from $756.1 million in 2005, an
increase of $67.7 million or 9.0%. The increase was attributable to comparable store sales
increases of 2.0% ($14.5 million) and sales by stores not yet included as comparable stores
($52.3 million). Sales to franchisees increased $0.9 million in 2006. The sales mix for the
period was 32.6% Pharmaceuticals, 22.3% Household Goods, 13.1% Food and Tobacco, 13.0%
Apparel and Linens, 8.7% Paper and Cleaning Supplies, 8.2% Health and Beauty Aids, and 2.1%
Franchise. This compares with 33.4% Pharmaceuticals, 22.2% Household Goods, 13.7% Apparel
and Linens, 11.8% Food and Tobacco, 8.5 % Paper and Cleaning Supplies, 8.2% Health and
Beauty Aids, and 2.2% Franchise for the same period last year. For the year to date period
we opened 30 new stores and 8 new pharmacies and we closed two stores and one pharmacy.
Gross profit increased to 28.5% of sales in 2006 compared with 28.3% of sales in the
prior-year period. Gross profit margin for the first six months was favorably affected by
the same factors as listed for the second quarter.
Selling, general and administrative expenses increased to $217.6 million in 2006 from $198.1
million in 2005. As a percentage of sales, expenses increased to 26.4% of sales compared to
26.2% of sales last year. The increase is primarily due to stock compensation expenses
(0.1%), which resulted from the adoption of SFAS No. 123(R), and expenses related to fuel and
energy usage such as transportation and utilities (0.1%).
For the first six months of 2006, we incurred net interest expense of $0.2 million as
compared to interest expense of $0.5 million last year. The decrease in interest results
from better management of cash flow.
For the first six months of 2006, the effective income tax rate was 31.8%, compared with
33.0% for last year. The decrease in the rate is due to certain federal jobs credits
available to the Company. We anticipate the tax rate for the balance of the year to remain
in the 32% to 33% range.
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 flows used by operating activities totaled $8.3 million during the twenty-six week
period ended July 29, 2006. Cash was primarily used to increase inventories by approximately
$35.2 million in the first six months of 2006. This increase in inventory was primarily
attributable to 30 new stores and 9 remodeled stores in the first six months of 2006 and
increased store square footage of 8.0% over the same period last year. Accounts payable and
accrued liabilities increased by approximately $7.7 million due to the increase in inventory
and the number of stores and income taxes payable decreased by $6.1 million due to estimated
tax payments in the first 6 months of 2006. Accounts receivable increased by approximately
$8.3 million partially due to increases in pharmacy third-party receivables.
Cash flows used in investing activities totaled $13.9 million, and consisted primarily of
capital expenditures associated with the store and pharmacy expansion program ($9.4 million),
acquisitions of customer lists ($2.9 million), and for technology and other corporate
expenditures ($2.0 million). In 2006, the Company is planning capital expenditures totaling
approximately $34.6 million. Expenditures for the balance of the year are planned totaling
approximately $13.0 million for upgrades, remodels, or new stores and pharmacies customer
list and other pharmacy related items; $6.1 million for technology upgrades, $1.2 million for
distribution center equipment and capital replacements. Depreciation expense for the year
will
be approximately $30 million.
17
Cash flows provided by financing activities totaled $21.5 million and consisted primarily
of $22.8 million of borrowings under the Companys revolving credit agreement for inventory
needs. There were $28.5 million in borrowings outstanding at July 29, 2006 and $5.7 million in
borrowings outstanding at January 28, 2006.
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.
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have no holdings of derivative financial or commodity instruments as of July 29,
2006. We are exposed to financial market risks, including changes in interest rates. All
borrowings under our Revolving Loan and 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.
CONTROLS AND PROCEDURES
(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, 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
last fiscal quarter that have materially affected or are reasonably likely to materially
affect the Companys internal control over financial reporting.
18
PART II. OTHER INFORMATION
ITEM 1A. RISK FACTORS
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION/ RISK FACTORS
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.A. Sections 77z-2 and 78u-5
(Supp. 1996). The Reform Act created a safe harbor to protect companies from
securities law liability in connection with forward-looking statements. Freds, Inc.
(Freds or the Company) intends to qualify both its written and oral
forward-looking statements for protection under the Reform Act and any other similar
safe harbor provisions.
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, which 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:
|
o |
|
Economic and weather conditions which affect buying patterns of our
customers and supply chain efficiency; |
|
|
o |
|
Changes in consumer spending and our ability to anticipate buying
patterns and implement appropriate inventory strategies; |
|
|
o |
|
Continued availability of capital and financing; |
|
|
o |
|
Competitive factors; |
|
|
o |
|
Changes in reimbursement practices for pharmaceuticals; |
|
|
o |
|
Governmental regulation; |
|
|
o |
|
Increases in fuel and utility rates; |
|
|
o |
|
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 January 28, 2006. There have been no material changes
during the quarter to the Risk Factors indicated in Form 10-K for the year ended January
28, 2006. |
Consequently, all forward-looking statements are qualified by this cautionary statement.
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 4. Submission of Matters to a Vote of Securities Holders
The Annual Meeting of the Shareholders of Freds, Inc. was held on June
21, 2006. Michael J. Hayes, John R. Eisenman, Roger T. Knox, John D.
Reier, Thomas H. Tashjian, B. Mary McNabb and Gerald E. Thompson were elected as
directors of the Company. The shareholders also ratified the appointment of BDO
Seidman, LLC as registered public accounting firm for the fiscal year ending
February 3, 2007.
The results of the voting were as follows:
19
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Abstain/ |
|
|
|
|
|
|
For |
|
Against |
|
Withheld |
|
Broker Non-Vote |
Election of Directors: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Michael J. Hayes |
|
|
36,693,728 |
|
|
|
|
|
|
|
1,806,583 |
|
|
|
1,410,138 |
|
John R. Eisenman |
|
|
36,528,344 |
|
|
|
|
|
|
|
1,971,967 |
|
|
|
1,410,138 |
|
Roger T. Knox |
|
|
36,528,606 |
|
|
|
|
|
|
|
1,971,705 |
|
|
|
1,410,138 |
|
John D. Reier |
|
|
37,174,529 |
|
|
|
|
|
|
|
1,325,782 |
|
|
|
1,410,138 |
|
Thomas H. Tashjian |
|
|
37,179,743 |
|
|
|
|
|
|
|
1,320,568 |
|
|
|
1,410,138 |
|
B. Mary McNabb |
|
|
37,377,111 |
|
|
|
|
|
|
|
1,123,200 |
|
|
|
1,410,138 |
|
Gerald E. Thompson |
|
|
37,414,182 |
|
|
|
|
|
|
|
1,086,129 |
|
|
|
1,410,138 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Appointment of
BDO Seidman, LLP |
|
|
38,468,583 |
|
|
|
31,728 |
|
|
|
1,410,138 |
|
|
|
|
|
Item 6. Exhibits
|
|
|
Exhibits: |
|
|
31.1
|
|
Certification of Chief Executive Officer. |
|
|
|
31.2
|
|
Certification of Chief Financial Officer. |
|
|
|
32
|
|
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. |
All other information in Part II are either not applicable to the Company during
the quarter ended July 29, 2006, the answer is negative, or a response has been
previously reported and an additional report of information is not required, pursuant
to the instructions to Part II.
20
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.
|
|
|
|
|
|
FREDS, INC.
|
|
|
/s/ Michael J. Hayes
|
|
|
Michael J. Hayes |
|
Date: September 7, 2006 |
Chief Executive Officer |
|
|
|
|
|
|
/s/ Jerry A. Shore
|
|
|
Jerry A. Shore |
|
Date: September 7, 2006 |
Chief Financial Officer |
|
21