Fred's, Inc.
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 5, 2007.
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 |
incorporation or organization)
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Identification No.) |
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4300 New Getwell Rd., Memphis, Tennessee
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38118 |
(Address of principal executive offices)
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(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 o 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 x 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 x.
The registrant had 40,082,522 shares of Class A voting, no par value common stock outstanding as of
June 8, 2007.
Part 1 FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
FREDS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except for number of shares)
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May 5, |
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February 3, |
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2007 |
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2007 |
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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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$ |
2,727 |
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$ |
2,475 |
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Inventories |
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348,793 |
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304,969 |
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Receivables, less allowance for doubtful
accounts of $752 and $719, respectively |
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29,257 |
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29,097 |
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Other non-trade receivables |
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17,515 |
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18,953 |
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Prepaid expenses and other current assets |
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10,359 |
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12,224 |
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Total current assets |
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408,651 |
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367,718 |
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Property and equipment, at depreciated cost |
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136,892 |
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138,031 |
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Equipment under capital leases, less accumulated
amortization of $4,665 and $4,578, respectively |
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302 |
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390 |
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Other noncurrent assets, net |
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9,343 |
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9,570 |
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Total assets |
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$ |
555,188 |
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$ |
515,709 |
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LIABILITIES AND SHAREHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
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$ |
85,860 |
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$ |
64,349 |
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Current portion of indebtedness |
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18 |
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385 |
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Current portion of capital lease obligations |
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318 |
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352 |
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Accrued expenses and other |
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39,434 |
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42,159 |
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Deferred income taxes |
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15,369 |
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16,396 |
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Income taxes payable |
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1,764 |
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4,188 |
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Total current liabilities |
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142,763 |
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127,829 |
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Long-term portion of indebtedness |
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17,479 |
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2,216 |
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Deferred income taxes |
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11,163 |
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12,425 |
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Capital lease obligations, long term portion |
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40 |
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115 |
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Other noncurrent liabilities |
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11,253 |
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3,856 |
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Total liabilities |
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182,698 |
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146,441 |
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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, 40,082,774
and 40,068,953 shares issued and outstanding,
respectively |
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136,617 |
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135,803 |
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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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234,806 |
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232,382 |
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Accumulated other comprehensive income |
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1,067 |
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1,083 |
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Total shareholders equity |
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372,490 |
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369,268 |
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Total liabilities and shareholders equity |
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$ |
555,188 |
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$ |
515,709 |
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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 5, |
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April 29, |
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2007 |
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2006 |
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Net sales |
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$ |
442,262 |
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$ |
416,878 |
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Cost of goods sold |
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315,261 |
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297,034 |
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Gross profit |
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127,001 |
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119,844 |
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Depreciation and amortization |
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7,227 |
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7,109 |
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Selling, general and administrative
expenses |
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108,617 |
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101,687 |
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Operating income |
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11,157 |
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11,048 |
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Interest income |
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(133 |
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(47 |
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Interest expense |
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37 |
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42 |
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Income before income taxes |
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11,253 |
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11,053 |
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Income taxes |
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3,815 |
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3,755 |
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Net income |
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$ |
7,438 |
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$ |
7,298 |
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Net income per share: |
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Basic |
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$ |
.19 |
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$ |
.18 |
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Diluted |
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$ |
.19 |
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$ |
.18 |
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Weighed average shares outstanding: |
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Basic |
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39,842 |
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39,711 |
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Effect of dilutive stock options |
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118 |
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129 |
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Diluted |
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39,960 |
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39,840 |
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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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$ |
7,438 |
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$ |
7,298 |
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Other
comprehensive income (expense), net of tax: |
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Postretirement plan
adjustment |
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(16 |
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Comprehensive income |
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$ |
7,422 |
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$ |
7,298 |
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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 5, |
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April 29, |
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2007 |
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2006 |
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Cash flows from operating activities: |
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Net income |
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$ |
7,438 |
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$ |
7,298 |
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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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7,227 |
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7,109 |
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Net gain on asset disposition |
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307 |
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(18 |
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Stock-based compensation |
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676 |
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347 |
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Provision for uncollectible receivables |
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33 |
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84 |
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LIFO reserve increase |
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932 |
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712 |
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Deferred income tax expense |
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236 |
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1,037 |
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Provision for post retirement medical |
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(16 |
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Excess tax benefits from stock-based compensation |
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4 |
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(44 |
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(Increase) decrease in assets: |
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Trade receivables |
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1,245 |
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(7,144 |
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Inventories |
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(44,756 |
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(13,924 |
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Other assets |
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1,865 |
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1,705 |
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Increase (decrease) in liabilities: |
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Accounts payable and accrued expense |
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18,786 |
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11,415 |
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Income taxes payable |
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(2,428 |
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(3,493 |
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Other noncurrent liabilities |
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659 |
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(212 |
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Net cash (used in) provided by operating activities |
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(7,792 |
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4,872 |
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Cash flows from investing activities: |
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Capital expenditures |
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(6,005 |
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(5,087 |
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Proceeds from asset dispositions |
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270 |
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98 |
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Asset acquisitions, net (primarily intangibles) |
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(345 |
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(1,047 |
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Net cash used in investing activities |
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(6,080 |
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(6,036 |
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Cash flows from financing activities: |
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Payments of indebtedness and capital lease obligations |
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(480 |
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(514 |
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Proceeds from revolving line of credit, net of payments |
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15,267 |
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1,418 |
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Excess tax benefits from stock-based compensation |
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(4 |
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44 |
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Proceeds from exercise of stock options and issuances
under employee stock purchase plan |
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142 |
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618 |
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Cash dividends paid |
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(801 |
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(798 |
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Net cash provided by financing activities |
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14,124 |
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768 |
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Increase (decrease) in cash and cash equivalents |
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252 |
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(396 |
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Beginning of period cash and cash equivalents |
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2,475 |
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3,145 |
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End of period cash and cash equivalents |
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$ |
2,727 |
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$ |
2,749 |
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Supplemental disclosures of cash flow information: |
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Interest paid |
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$ |
25 |
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$ |
64 |
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Income taxes paid |
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$ |
6,000 |
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$ |
6,200 |
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Non-cash investing and financial activities: |
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Assets acquired with term loan |
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$ |
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$ |
100 |
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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 5,
2007, 701 discount general merchandise stores, including 24 franchised Freds stores, in 15
states in the southeastern United States. 291 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 3, 2007 incorporated into Our Annual
Report on Form 10-K.
The results of operations for the thirteen-week period ended May 5, 2007 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 issued Statement of
Financial Accounting Standards No. 157, Fair Value Measurements, (SFAS No. 157) which is
effective for fiscal years beginning after November 15, 2007 and for interim periods within
those years. This statement defines fair value, establishes a framework for measuring fair
value and expands the related disclosure requirements. This statement is effective for the
2008 fiscal year, although early adoption is permitted. The Company is in the process of
determining the effect, if any, that the adoption of SFAS 157 will have 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. We are currently
reviewing the impact of SFAS No. 159 on our Consolidated Financial Statements and expect to
complete this evaluation in 2007.
In March 2007, the Emerging Issues Task Force (EITF) reached a consensus on issue number
06-10, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Collateral
Assignment Split-Dollar Life Insurance Arrangements, (EITF 06-10). EITF 06-10 provides
guidance to help companies determine whether a liability for the postretirement benefit
associated with a collateral assignment split-dollar life insurance arrangement should be
recorded in accordance with either SFAS No. 106, Employers Accounting for Postretirement
Benefits Other Than Pensions (if, in substance, a postretirement benefit plan exists), or
Accounting Principles Board Opinion No. 12 (if the arrangement is, in substance, an
individual deferred compensation contract). EITF 06-10 also provides guidance on how a
company should recognize and measure the asset in a collateral assignment split-dollar life
insurance contract. EITF 06-10 is effective for fiscal years beginning after December 15,
2007, although early adoption is permitted. The Company is in the process of determining the
effect, if any, that the adoption of EITF 06-10 will have on its results of operations or financial
position.
6
NOTE 3: INVENTORIES
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 U.S. 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 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
7
inventory at the lower
of cost or market. For pharmacy inventories, which were approximately $35.0 million and $36.4
million at May 5, 2007 and February 3, 2007, 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 $14.7 million at May 5, 2007 and $13.8
million at February 3, 2007.
NOTE 4: STOCK-BASED COMPENSATION
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).
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):
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Thirteen Weeks Ended |
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|
|
May 5, |
|
|
April 29, |
|
|
|
2007 |
|
|
2006 |
|
Stock option expense |
|
$ |
484 |
|
|
$ |
152 |
|
Restricted stock expense |
|
|
140 |
|
|
|
107 |
|
ESPP expense |
|
|
52 |
|
|
|
89 |
|
|
|
|
|
|
|
|
Total stock-based compensation |
|
$ |
676 |
|
|
$ |
348 |
|
|
|
|
|
|
|
|
|
|
Income tax benefit on stock-based compensation |
|
$ |
114 |
|
|
$ |
38 |
|
The fair value of each option granted during the thirteen weeks ended May 5, 2007 and April
29, 2006, respectively, is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted average assumptions:
8
|
|
|
|
|
|
|
|
|
|
|
Thirteen Weeks Ended |
|
|
|
May 5, |
|
|
April 29, |
|
|
|
2007 |
|
|
2006 |
|
Stock Options |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
41.0 |
% |
|
|
41.5 |
% |
Risk-free interest rate |
|
|
4.4 |
% |
|
|
4.9 |
% |
Expected option life (in years) |
|
|
5.84 |
|
|
|
5.85 |
|
Expected dividend yield |
|
|
0.40 |
% |
|
|
0.35 |
% |
Weighted average fair value at grant date |
|
$ |
6.49 |
|
|
$ |
6.16 |
|
|
|
|
|
|
|
|
|
|
Employee Stock Purchase Plan |
|
|
|
|
|
|
|
|
Expected volatility |
|
|
32.7 |
% |
|
|
33.5 |
% |
Risk-free interest rate |
|
|
4.7 |
% |
|
|
4.8 |
% |
Expected option life (in years) |
|
|
0.25 |
|
|
|
0.5 |
|
Expected dividend yield |
|
|
0.15 |
% |
|
|
0.13 |
% |
Weighted average fair value at grant date |
|
$ |
2.66 |
|
|
$ |
3.58 |
|
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.
NOTE 5: Stock Plans
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 15,653 shares
issued during the thirteen weeks ended May 5,
9
2007. There are 1,410,928 shares approved to
be issued under the 2004 Plan and as of May 5, 2007, there were 1,279,588 shares available.
Stock Options
The following table summarizes stock option activity during the thirteen weeks ended May 5,
2007:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
Average |
|
|
Aggregate |
|
|
|
|
|
|
|
Average |
|
|
Remaining |
|
|
Intrinsic |
|
|
|
|
|
|
|
Exercise |
|
|
Contractual |
|
|
Value |
|
|
|
Options |
|
|
Price |
|
|
Life (Years) |
|
|
(Thousands) |
|
Outstanding at February 3, 2007 |
|
|
1,103,064 |
|
|
$ |
16.74 |
|
|
|
4.2 |
|
|
$ |
298 |
|
Granted |
|
|
17,500 |
|
|
$ |
14.73 |
|
|
|
|
|
|
|
|
|
Forfeited/Cancelled |
|
|
(25,500 |
) |
|
$ |
19.48 |
|
|
|
|
|
|
|
|
|
Exercised |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding at May 5, 2007 |
|
|
1,095,064 |
|
|
$ |
16.64 |
|
|
|
4.0 |
|
|
$ |
140 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable at May 5, 2007 |
|
|
400,433 |
|
|
$ |
17.40 |
|
|
|
3.2 |
|
|
$ |
28 |
|
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value
(the difference between Freds closing stock price of $13.71 on the last trading day of the
period ended May 5, 2007 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 5, 2007, total unrecognized stock-based
compensation expense net of estimated forfeitures related to non-vested stock options was
approximately $1.69 million, which is expected to be recognized over a weighted average period of
approximately 3.1 years. The total fair value of options vested during the thirteen weeks ended
May 5, 2007 was $.56 million.
Restricted Stock
The following table summarizes restricted stock activity during the thirteen weeks ended May
5, 2007:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
Average |
|
|
|
Number |
|
|
Grant Date |
|
|
|
of Shares |
|
|
Fair Value |
|
Non-vested Restricted Stock at February 3, 2007 |
|
|
229,851 |
|
|
$ |
15.03 |
|
Granted |
|
|
534 |
|
|
$ |
14.98 |
|
Forfeited/Cancelled |
|
|
(389 |
) |
|
$ |
14.46 |
|
Vested |
|
|
(4,142 |
) |
|
$ |
17.52 |
|
|
|
|
|
|
|
|
|
Non-vested Restricted Stock at May 5, 2007 |
|
|
225,854 |
|
|
$ |
15.07 |
|
The aggregate pre-tax intrinsic value of restricted stock outstanding as of May 5, 2007
is $3.1 million with a weighted average remaining contractual life of 7.2 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 6.7 years. The total fair value of restricted stock awards
that vested during the thirteen weeks ended May 5, 2007 was $.07 million.
10
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 at disposal as a component of operating income.
The following illustrates the breakdown of the major categories within Property and
Equipment:
|
|
|
|
|
|
|
|
|
|
|
May 5, |
|
|
February 3, |
|
|
|
2007 |
|
|
2007 |
|
|
|
(unaudited) |
|
|
|
|
|
Building and building improvements |
|
$ |
76,264 |
|
|
$ |
76,623 |
|
Furniture, fixtures and equipment |
|
|
218,929 |
|
|
|
216,448 |
|
Leasehold improvements |
|
|
46,819 |
|
|
|
45,097 |
|
Automobiles and vehicles |
|
|
6,514 |
|
|
|
6,429 |
|
Airplane |
|
|
4,697 |
|
|
|
4,697 |
|
|
|
|
|
|
|
|
|
|
|
353,223 |
|
|
|
349,294 |
|
Less: Accumulated Depreciation
and Amortization |
|
|
(221,068 |
) |
|
|
(215,879 |
) |
|
|
|
|
|
|
|
|
|
|
132,155 |
|
|
|
133,415 |
|
Construction in Progress |
|
|
474 |
|
|
|
353 |
|
Land |
|
|
4,263 |
|
|
|
4,263 |
|
|
|
|
|
|
|
|
Total Property and Equipment, at
depreciated cost |
|
$ |
136,892 |
|
|
$ |
138,031 |
|
|
|
|
|
|
|
|
NOTE 7: Income taxes
In June 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes
an Interpretation of FASB Statement No.109. We adopted FIN 48 as of
February 4, 2007, the first day of fiscal 2007. This interpretation clarifies the
accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS No. 109 and prescribes a minimum recognition
threshold of more-likely-than-not to be sustained upon examination that a tax position
must meet before being recognized in the financial statements. Under FIN 48, the impact
of an uncertain income tax position on the income tax return must be recognized at the
largest amount that is more-likely-than-not to be sustained upon audit by the relevant
taxing authority. An uncertain income tax position will not be recognized if it has less
than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on
de-recognition, measurement, classification, interest and penalties, accounting in
interim periods, disclosure and transition.
As a result of the adoption of FIN 48, we recognized a cumulative effect adjustment of $4.2
million decrease to beginning retained earnings and a reclassification of certain amounts
between deferred income taxes ($2.3 million decrease) and other
non-current liabilities ($6.5 million increase, including $1.0
million of interest and penalties) to conform to the balance
sheet presentation requirements of FIN 48. During the first quarter of 2007, our FIN 48
reserve increased by $0.2 million, including $0.1 million of accrued interest. The Company
includes potential interest and penalties recognized in accordance with FIN 48 in the
financial statements as a component of income tax expense.
11
The Company had approximately $8.0 million of unrecognized tax benefits as of February 3,
2007. If recognized, approximately $5.9 million of the unrecognized tax benefits would
affect the Companys effective income tax rate.
We are subject to U.S. federal income tax as well as income tax of multiple state
jurisdictions. The Company is open to federal and state tax audits until the applicable
statute of limitations expire. The tax years 2000 through 2006 remain open to examination by
the major taxing jurisdictions to which we are subject.
NOTE 8: Exit and disposal activities
During the year ended February 3, 2007, the Company recorded a below-cost inventory
adjustment of approximately $1.2 million associated with the discontinuance of the boys and
girls apparel departments. Also the Company recorded an additional below-cost inventory
adjustment of $0.9 million for planned store closings. Both adjustments were recorded in
cost of goods sold in the consolidated statements of income for the year ended February 3,
2007.
The Company also recorded approximately $0.9 million in selling, general and administrative
expense in the consolidated statements of income for the year ended February 3, 2007 to
reflect impairment charges for furniture and fixtures and leasehold improvements relating to
the planned store closures mentioned above. Liability balances related to activities
discussed above for stores closed during the quarter ended May 5, 2007 are as follows (in
millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Beginning |
|
|
Utilized during |
|
|
Ending |
|
|
|
Balance |
|
|
1st Qtr |
|
|
Balance |
|
|
|
February 3, 2007 |
|
|
2007 |
|
|
May 5, 2007 |
|
Inventory markdowns for discontinuance of boys & girls apparel |
|
$ |
1.2 |
|
|
$ |
0.4 |
|
|
$ |
0.8 |
|
Inventory markdowns for planned store closings |
|
|
0.9 |
|
|
|
0.4 |
|
|
|
0.5 |
|
Asset impairment for planned store closings |
|
|
0.9 |
|
|
|
0.1 |
|
|
|
0.8 |
|
|
|
|
$ |
3.0 |
|
|
$ |
0.9 |
|
|
$ |
2.1 |
|
|
During the current year, the Company has incurred or expects to incur the following
pretax costs associated with said store closings (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Estimated |
|
|
Incurred in |
|
|
|
|
|
|
Total |
|
|
2007 |
|
|
Remaining |
|
Lease contract termination costs |
|
$ |
1.7 |
|
|
$ |
0.5 |
|
|
$ |
1.2 |
|
|
Total |
|
$ |
1.7 |
|
|
$ |
0.5 |
|
|
$ |
1.2 |
|
|
In addition to those stores that might be closed in the ordinary course of business, the
Company is planning approximately 20 store and pharmacy closings during the course of 2007
(10 of which have been closed as of May 5, 2007).
NOTE 9:
Accumulated other comprehensive income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
May 5, |
|
|
April 29, |
|
|
February 3, |
|
(in thousands) |
|
2007 |
|
|
2006 |
|
|
2007 |
|
Accumulated
other comprehensive income |
|
$ |
1,083 |
|
|
$ |
0 |
|
|
$ |
0 |
|
Adjustment
to initially apply SFAS No. 158 (net of tax) |
|
|
|
|
|
|
|
|
|
|
1,083 |
|
Amortization
of postretirement benefit during quarter |
|
|
(16 |
) |
|
|
0 |
|
|
|
|
|
|
Ending
balance |
|
$ |
1,067 |
|
|
$ |
0 |
|
|
$ |
1,083 |
|
|
Effective
February 3, 2007, the Company began recognizing the funded status of
its postretirement benefits plan in accordance with SFAS No. 158.
SFAS No. 158 requires the Company to display the net over-or-under
funded position of a defined benefit postretirement plan as an asset
or liability, with any unrecognized prior service costs, transition
obligations or actuarial gains/losses reported as a component of
accumulated other comprehensive income in stockholders equity.
The activity within accumulated other comprehensive income in the
first quarter of 2007 represents the amortization of prior service
cost and net actuarial gains and losses through net periodic benefit
cost.
12
Item 2:
Managements Discussion and Analysis of Financial
Condition and Results of Operations
GENERAL
Executive Overview
During the first quarter of 2007, the Company continued its strategy of refreshing and
revitalizing our stores and capitalizing on our 60 years of experience in the discount retail
sector. We are continuing implementation of our Merchandise Refresher Program which had
commenced in 20% of our stores by quarter-end. This program refreshes the look and feel of our
stores with new paint and flooring, updated signage and the expansion and relocation of
several departments. Additionally, our new branding and advertising campaign, which focuses
on our 60 year history while emphasizing the new look and feel of Freds continued throughout
the quarter. These strategies and our unique store layout allow us to offer our customers all
the attractive elements of a discount dollar store, drug store and mass merchant under one
roof. By offering elements of all three types of businesses, we are able to provide our
customer with a ten minute Superstore experience in a smaller, easier and more convenient
store layout.
As mentioned in our 10-K for the year ended February 3, 2007, we slowed our new store growth
in the first quarter and will continue to do so through the remainder of the year. This slow
down in growth, coupled with the closing of unproductive stores should have a positive impact
on the Companys operating margin over time. In the first quarter of 2007, the Company opened
11 new stores and closed 10 stores. The majority of our new store openings were in Alabama,
Texas, and Mississippi. We did not enter into any new states during the quarter.
Additionally, we opened six new pharmacies and closed four pharmacies during the quarter.
The Company continued during the first quarter to see paybacks on productivity improvements
and key technology initiatives. Some of these include continuing enhancement of our point of
sale and radio frequency (RF) store systems, refinement and upgrades to our merchandise
planning and allocation systems and process and productivity standards improvements in our
distribution centers. Pharmacy system improvements that enhance customer service also
continue to be a key initiative.
During the remainder of 2007, we will continue with capital improvements in infrastructure,
including new store expansion, distribution center upgrades and further development of our
information technology capabilities.
As previously reported, the Company expects an increase of 12 % to 22% in earnings per diluted
share for 2007. The Company bases this increase in estimated earnings for fiscal 2007 on the
following assumptions:
|
|
Comparable store sales are anticipated to increase for the full year in the range of
3% to 5%. Total sales are expected to increase in the range of 6% to 9% for the year. |
|
|
|
The Company expects to open 35 to 40 new stores, 15 to 25 new pharmacies, and expects
to close 20 to 25 stores, netting growth in selling square footage in the range of 1% to 3%
for the year. |
|
|
|
Minimum wage legislation will benefit our customers, thereby increasing our sales,
which offset expenses of increased labor costs. |
|
|
|
The federally mandated Average Manufacturers Price (AMP) is expected to have a
negative impact on gross profit from prescription drugs. |
|
|
|
We anticipate additional costs of approximately $1.2 million associated with previously
announced store closings. |
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, controlling the effects
of inflation, especially in regard to occupancy cost, increasing the operating margin through
13
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 in 2007 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. Also, the Company expects an initial negative impact in
selling, general and administrative expenses from the raising of the Federal Minimum Wage;
however, this increase should be a positive factor over time as it will directly impact the
disposable income of our primary customer base.
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 3, 2007. 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. The only material changes in critical accounting policies during
the thirteen weeks ended May 5, 2007, was the adoption of FASB Interpretation No. 48 (FIN
48), Accounting for Uncertainty in Income Taxes an Interpretation of FASB Statement
No.109, which was discussed in detail in Note 7 of the financial statements included elsewhere
in this document.
RESULTS OF OPERATIONS
Thirteen Weeks Ended May 5, 2007 and April 29, 2006
Net sales increased to $442.3 million in 2007 from $416.9 million in
2006, an increase of $25.4 million or 6.1%. The increase was
attributable to comparable store sales increases of 1.9% ($7.9
million) and sales by stores not yet included as comparable stores
($17.3 million). Sales to franchisees increased $.2 in 2007 compared
to the same quarter last year. The sales mix for the period was 33.2%
Pharmaceuticals, 23.1% Household Goods, 10.4% Apparel and Linens,
14.2% Food and Tobacco, 8.8% Paper and Cleaning Supplies, 8.2% Health
and Beauty Aids, and 2.1% Franchise. This compares with 32.4%
Pharmaceuticals, 23.4% Household Goods, 12.2% Apparel and Linens,
13.3% Food and Tobacco, 8.2% Health and Beauty Aids, 8.4% Paper and
Cleaning Supplies, and 2.1% Franchise for the same period last year.
Gross profit for the first quarter was 28.7% of sales in 2007, the
same as in 2006. During the quarter, the initial markup was slightly
lower than a year ago due to an unfavorable shift in the product mix
toward basic and consumable products which was mostly offset by lower
markdowns and additional vendor rebates.
Selling, general and administrative expenses increased to $115.8
million in 2007
14
from $108.8 million in 2006. Selling, general and
administrative expenses increased primarily from lease related costs
of closed stores ($0.5 million) and additional stock option expenses
($0.3 million) over the first quarter of last year. Excluding these
components, selling, general and administrative expenses as
a percentage of sales were flat with the first quarter of last year. On the positive side,
labor expenses leveraged by 14 basis points as a percent of sales despite the added work in
the stores as we implement our Store Refresher Program. As a percentage of sales, expenses
increased to 26.2% of sales compared to 26.0% of sales last year.
For the first quarter of 2007, the Company earned net interest income of $0.1 million.
For the first quarter of 2006, the effective income tax rate was 33.9%, as compared to 34.0%
in the first quarter of last year. We continue to see positive impact from Katrina related
jobs credits and anticipate the income tax rate for the remainder of the year to be in the
33% to 35% 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 used in operating activities totaled $7.8 million during the thirteen-week period ended
May 5, 2007. Cash was primarily used to increase inventories by approximately $44.8 million
in the first quarter of 2007. This increase was primarily attributable to 11 new stores and
increases in our basic product inventories to improve in-stock positions, and additional
inventories related to the new stationery program and check-out aisle resets. Accounts
payable and accrued expenses increased by approximately $18.8 million in the first quarter of
2007 due to the increase in inventory.
Cash used in investing activities totaled $6.1 million, and consisted primarily of capital
expenditures associated with the store and pharmacy expansion program ($3.5 million),
expenditures related to the Store Refresher Program ($2.3 million) and technology and other
corporate expenditures ($.2 million). During the first quarter of 2007, we opened 11 stores,
closed 10 stores, opened 6 pharmacies, and closed 4 pharmacies. We expect to open 5 to 7
stores in the second quarter and approximately 35 to 40 stores for the year. In 2007, the
Company is planning capital expenditures totaling approximately $27.5 million. Expenditures
are planned totaling approximately $20.3 million for upgrades, remodels, or new stores and
pharmacies; $5.2 million for technology upgrades, $2.0 million for distribution center
equipment and capital replacements. In addition, the Company also plans expenditures of $2.6
million for the acquisition of customer lists and other pharmacy related items. Depreciation
expense for 2007 will be approximately $29 million.
Cash provided by financing activities totaled $14.1 million and included $15.3 million of
borrowings under the Companys revolving credit agreement for inventory needs. There were
$17.4 million in borrowings outstanding at May 5, 2007 and $2.2 million in borrowings
outstanding at February 3, 2007.
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.
15
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.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. 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.
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 3,
2007. |
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 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We have no holdings of derivative financial or commodity instruments as of May 5, 2007.
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.
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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
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 6. Exhibits
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Exhibits:
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31.1 |
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Certification of Chief Executive Officer. |
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31.2 |
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Certification of Chief Financial Officer. |
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32. |
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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. |
17
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 14, 2007 |
/s/ Michael J. Hayes
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Michael J. Hayes |
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Chief Executive Officer |
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Date: June 14, 2007 |
/s/ Jerry A. Shore
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Jerry A. Shore |
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Chief Financial Officer |
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18