| DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES | NOTE
1 — DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description
of business. Basis
of Presentation. During
the fourth quarter of 2017, Fred’s Board of Directors approved a plan to actively market its specialty pharmacy business.
Accordingly, the Company’s specialty pharmacy business met the criteria for “Assets Held-for-Sale” in accordance
with Accounting Standard Codification (“ASC”) Topic 360 (ASC 360), Property, Plant and Equipment Results of Operations-Discontinued
Operations Unless
otherwise noted, discussion within these notes to the consolidated financial statements relates to continuing operations. Refer
to Note 2 for additional information on discontinued operations. Subsequent
Events. has evaluated subsequent events through the financial statement issue
date. Fiscal
year. Use
of estimates. Cash
and cash equivalents. Allowance
for doubtful accounts Inventories.
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, after applying the cost to retail ratio, 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 (shrink) 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 store’s shrink rate, which
is based on the previously mentioned factors, by the interim period’s 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 Company’s 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 methodology that we have applied in
estimating shrink has resulted in variability that is not material to our financial statements. Management
believes that the Company’s retail inventory method provides an inventory valuation which reasonably approximates cost and
results in valuing inventory at the lower of cost or market. For pharmacy department inventories, which were approximately $31.6
million, and $35.2 million at February 3, 2018 and January 28, 2017, 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
highly inflationary 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 $53.9 million at February 3, 2018 and $52.6 million at January
28, 2017. The LIFO reserve increased by approximately $1.3 million and $5.1 million during 2017 and 2016, respectively. The
Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise inventory
as prescribed by U.S. GAAP. These costs include activities surrounding the procurement and storage of merchandise inventory such
as merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight.
The total amount of procurement and storage costs and inbound freight included in merchandise inventory at February 3, 2018 is
$17.3 million compared to $19.1 million at January 28, 2017. During
2016, the Company recorded impairment charges for inventory clearance of product that management identified as low-productive
and does not fit our go-forward model. The Company recorded a below-cost inventory adjustment in accordance with FASB Accounting
Standards Codification (“ASC”) 330, "Inventory," of approximately $13.0 million (including $1.6 million, for the accelerated
recognition of freight capitalization expense) in cost of goods sold to value inventory at the lower of cost or market on inventory
identified as low-productive. At the beginning of 2017, there was $9.2 million (including $1.2 million, for the accelerated recognition
of freight capitalization expense) of impairment charges remaining for inventory clearance of product related to 2016 strategic
initiatives. In the third quarter of 2017, the Company recorded additional impairment charges related to the 2016 inventory clearance
of product in the amount of $1.5 million. During 2017 the Company utilized $8.9 million of existing impairment charges (including
$1.1 million for the accelerated recognition of freight capitalization expense), leaving $1.8 million in the reserve related to
2016 strategic initiatives. During
2017, the Company recorded impairment charges for inventory clearance of product that management identified as low-productive
and does not fit our go-forward model. The Company recorded a below-cost inventory adjustment in accordance with FASB Accounting
Standards Codification (“ASC”) 330, “ Inventory The
following table illustrates the inventory impairment charges related to the inventory clearance initiatives discussed in the previous
paragraph (in millions):
Balance
at Additions Utilization Ending
Balance
Inventory
markdown on low-productive inventory (2016 initiatives) $ 8.0 $ 1.5 $ (7.8 ) $ 1.7
Inventory provision
for freight capitalization expense (2016 initiatives) 1.2 - (1.1 ) 0.1
Inventory markdown
on low-productive inventory (2017 initiatives) - 14.3 (11.0 ) 3.3
Inventory
provision for freight capitalization expense (2017 initiatives) - 2.1 (1.1 ) 1.0
Total $ 9.2 $ 17.9 $ (21.0 ) $ 6.1 Property
and equipment. The
following average estimated useful lives are generally applied:
Estimated
Useful Lives
Building
and building improvements 8 -
31.5 years
Furniture,
fixtures and equipment 3 -
10 years
Leasehold
improvements 3 -
10 years or term of lease, if shorter
Automobiles
and vehicles 3 -
10 years
Airplane 9 years Assets
under capital lease are amortized in accordance with the Company’s 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. There was no amortization expense on assets under capital lease for 2017. Leases.
The
Company recognizes contingent rental expense when the achievement of specified sales targets are considered probable in accordance
with FASB ASC 840 “Leases”. The amount expensed but not paid was $0.5 million and $0.6 million at February 3, 2018
and January 28, 2017, respectively, and is included in “Accrued expenses and other” in the consolidated balance sheet
(See Note 3 - Detail of Certain Balance Sheet Accounts). The
Company occasionally receives reimbursements from landlords to be used towards construction of the store the Company intends to
lease. The reimbursement is primarily for the purpose of performing work required to divide a much larger location into smaller
segments, one of which the Company will use for its store. This work could include the addition or demolition of walls, separation
of plumbing, utilities, electrical work, entrances (front and back) and other work as required. Leasehold improvements are recorded
at their gross costs including items reimbursed by landlords. The reimbursements are initially recorded as a deferred credit and
then amortized as a reduction of rent expense over the initial lease term. Based
upon an overall analysis of store performance and expected trends, we periodically evaluate the need to close underperforming
stores. When we determine that an underperforming store should be closed and a lease obligation still exists, we record the estimated
future liability associated with the rental obligation on the date the store is closed in accordance with FASB ASC 420, “Exit
or Disposal Cost Obligations.” Liabilities are computed based at the point of closure for the present value of any remaining
operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs,
as prescribed by FASB ASC 420. The assumptions in calculating the liability include the timeframe expected to terminate the lease
agreement, estimates related to the sublease of potential closed locations, and estimation of other related exit costs. If the
actual timing and the potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities
could vary from recorded amounts. We periodically review the liability for closed stores and make adjustments when necessary. Impairment
of long-lived assets. During
fiscal 2016, in association with the planned closure of stores and pharmacies and the impairment of assets at the corporate headquarters,
we recorded charges of $7.9 million in selling, general and administrative expenses. In the fourth quarter of 2015, the Company
recorded an additional charge of $0.5 million related to five stores that closed in early fiscal 2016. In
the second quarter of 2017, in association with the planned closure of additional underperforming stores and pharmacies, the Company
recorded charges in the amount of $0.8 million in selling, general and administrative expense for the impairment of fixed assets
associated with the closing stores and pharmacies and $1.4 million for the accelerated recognition of amortization of intangible
assets associated with the closing pharmacies. In
the third quarter of 2017, a decision was made to sell the Company-owned airplane. The Company recorded charges in the amount
of $2.6 million in selling, general and administrative expense to write down the carrying value of the fixed asset to fair value. In
the fourth quarter of 2017, the Company recorded a charge of $1.1 million in selling, general and administrative expense for the
impairment of fixed assets associated with several underperforming locations based on our review of the carrying value of assets
and the undiscounted future cash flows for these stores. (See Note 13 – Exit and Disposal Activity). Impairment
of goodwill and other intangibles. Intangibles – Goodwill and Other Estimated
fair values could change if, for example, there are changes in the business climate, changes in the competitive environment, adverse
legal or regulatory actions or developments, changes in capital structure, cost of debt, interest rates, capital expenditure levels,
operating cash flows or market capitalization. While we believe we have made reasonable assumptions to calculate the fair value,
if future results are not consistent with our estimates, we could be exposed to future impairment losses that could be material
to our results of operations. The
analysis is broken down into two reporting units: the continuing operations and the discontinued specialty pharmacy (refer to
Note 2 for more discussion surrounding discontinued operations). As of November 1, 2017 the estimated fair value of the business
enterprise of the continuing operations was below the carrying value. As a result of the analysis, management recorded an impairment
to goodwill of $87 thousand in the fourth quarter, the entire balance of goodwill for the continuing operations. The estimated
fair value of the business enterprise for the discontinued specialty pharmacy exceeded the carrying value by approximately 10
percent and as a result did not have any impairment to goodwill. On
February 3, 2018, the Company assessed the discontinued specialty pharmacy’s goodwill for impairment as a result of the
plan to actively market it for sale and the deterioration in the price of our common stock and the resulting reduced market capitalization.
As a result of the interim impairment test, the Company recognized a goodwill impairment charge of $10.8 million to its discontinued
specialty pharmacy business. The
Company determined the fair value of the reporting units using a weighted combination of the discounted cash flow method and the
guideline company method. Determining the fair value of a reporting unit requires judgment and the use of significant estimates
and assumptions. Such estimates and assumptions include revenue growth rates, operating margins, weighted average costs of capital
and future market conditions, among others. The Company believes the estimates and assumptions used in our impairment assessments
are reasonable and based on available market information, but variations in any of the assumptions could result in a materially
different calculations of fair value and determinations of whether or not an impairment is indicated. Under the discount cash
flow method, the Company determined fair value based on estimated future cash flows of each reporting unit including estimates
for capital expenditures, discounted to present value using the risk-adjusted industry rate, which reflect the overall level of
inherent risk of the reporting unit. Cash flow projections are derived from one year budgeted amounts and five year operating
forecasts plus an estimate of later period cash flows, all of which are evaluated by management. Subsequent period cash flows
are developed for each reporting unit using growth rates that management believes are reasonably likely to occur. Under the guideline
company method, the Company determined the estimated fair value of each of our reporting units by applying valuation multiples
of comparable publicly-traded companies to each reporting unit’s projected revenue and EBITDA to determine the preliminary
enterprise value. From that preliminary enterprise value it is further adjusted by adding cash and cash equivalents and subtracting
interest-bearing debt to determine the cash-adjusted equity value. In addition, the Company estimated a reasonable control premium
representing the incremental value that accrues to the majority owner from the opportunity to dictate the strategic and operational
actions of the business. One
key assumption for the measurement of an impairment is management’s estimate of future cash flows and EBITDA. These estimates
are based on the annual budget for the upcoming year and forecasted amounts for multiple subsequent years. The annual budget process
is typically completed near the annual goodwill impairment testing date, and management uses the most recent information for the
annual impairment tests. The forecast is also subjected to a comprehensive update annually in conjunction with the annual budget
process and is revised periodically to reflect new information and/or revised expectations. The estimates of future cash flows
and EBITDA are subjective in nature and are subject to impacts from the business risks described in “Item 1A. Risk Factors.”
Therefore, the actual results could differ significantly from the amounts used for goodwill impairment testing, and significant
changes in fair value estimates could occur in a given period. Such changes in fair value estimates could result in additional
impairments in future periods; however, management does not believe that any of the goodwill balances in its reporting units as
of February 3, 2018 is at significant risk of impairment other than that $87 thousand impairment discussed above. Therefore, the
actual results could differ significantly from the amounts used for goodwill impairment testing, and significant changes in fair
value estimates could occur in a given period, resulting in additional impairments. Additionally,
during the fourth quarter 2017 the Company recorded a $628 thousand impairment related to the trade name for the specialty pharmacy.
Refer to Note 2 for more discussion on discontinued operations. Revenue
recognition. Revenue
from sales of pharmaceutical products is recognized at the time the prescription is filled. This approximates when a customer
picks up the prescription or when the prescription has been delivered and is recorded net of an allowance for prescriptions that
were filled but not picked up by the customer. For all periods presented, there is no material difference between the revenue
recognized at the time the prescription is filled and that which would be recognized when the customer picks up the prescription.
Prescriptions are generally not returnable. The
Company also sells gift cards for which revenue is recognized at the time of redemption. The Company records a gift card liability
on the date the gift card is issued to the customer. Revenue is recognized and the gift card liability is reduced as the customer
redeems the gift card. The Company will recognize aged liabilities as revenue when the likelihood of the gift card being redeemed
is remote. During 2017, we recognized $0.3 million of gift card revenue, or less than $0.01 per share. During 2016 we recognized
$0.2 million of gift revenue, or less than $0.01 per share, while in 2015 we recognized $0.1 million of gift card revenue, or
less than $0.01 per share. In
addition, the Company charges its franchised stores a fee based on a percentage of their purchases from the Company. These fees
represent a reimbursement for use of the Fred's name and other administrative costs incurred on behalf of the franchised stores.
Total franchise income for 2017, 2016 and 2015 was $0.7 million, $1.2 million and $1.5 million, respectively. Cost
of goods sold. Vendor
rebates and allowances. Selling,
general and administrative expenses. Advertising.
Pre-opening
costs. Intangible
assets. Other
identifiable intangible assets, net of accumulated amortization, totaled $54.9 million at February 3, 2018, and $73.0 million
at January 28, 2017. Accumulated amortization at February 3, 2018 and January 28, 2017 totaled $118.0 million and $100.7 million,
respectively.
(in
millions) February
3, 2018 January
28, 2017 Estimated
Useful
Customer
prescription files $ 48,369 $ 64,505 $ 7
Non-compete agreements 5,356 6,575 3 - 15
Software 1,048 1,845 3
Other 115 115 -
$ 54,888 $ 73,040 Amortization
expense for 2017, 2016 and 2015, was $17.9 million, $18.0 million and $16.3 million, respectively. Estimated
amortization expense for the assets recognized as of February 3, 2018, in millions for each of the next 7 years is as follows: Continuing
(in
millions) 2018 2019 2020 2021 2022 2023 2024
Estimated
amortization expense $ 16.7 $ 13.9 $ 11.4 $ 7.4 $ 3.7 $ 1.3 $ 0.1 Goodwill .
Fair
value of financial instruments.
· Level 1, defined
as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at
the measurement date.
· Level 2, defined
as inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly
or indirectly.
· Level 3, defined
as unobservable inputs for the asset or liability, which are based on an entity’s own assumptions as there is little,
if any, observable activity in identical assets or liabilities. At
February 3, 2018, the Company did not have any outstanding derivative instruments. The recorded value of the Company’s financial
instruments, which include cash and cash equivalents, receivables, accounts payable and indebtedness, approximates fair value.
The following methods and assumptions were used to estimate fair value of each class of financial instrument: (1) the carrying
amounts of current assets and liabilities approximate fair value because of the short maturity of those instruments and (2) the
fair value of the Company’s indebtedness is estimated based on the current borrowing rates available to the Company for
bank loans with similar terms and average maturities. Most of our indebtedness is under variable interest rates. Insurance
reserves Stock-based
compensation. Effective
January 29, 2006, the Company elected to adopt the alternative transition method provided in FASB ASC 718 for calculating
the income tax effects of stock-based compensation. 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 FASB ASC 718. FASB
ASC 718 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. The impact of adopting FASB ASC 718 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. Stock-based
compensation expense, post adoption of FASB ASC 718, 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 Company’s historical forfeiture experience
and will be revised in subsequent periods if actual forfeitures differ from those estimates. The
Company adopted the provisions of ASU 2016-09 beginning with its fiscal 2017 first quarter. The ASU provisions did not have a
material impact on the Company’s income tax expense as a result of the valuation allowance position eliminating the tax
effects on the income statement. Income
Taxes In
June 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 (“FASB ASC 740”),
Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No.109 that is codified in FASB ASC 740. We adopted
FASB ASC 740 as of February 4, 2007, the first day of fiscal 2007. This interpretation clarifies the accounting for uncertainty
in income taxes recognized in an enterprise’s financial statements in accordance with FASB ASC 740 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 FASB ASC 740, 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.
The Company recognizes and measures tax benefits from uncertain tax positions if it is "more likely than not" that the position
is sustainable, based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that
has a greater than 50 percent likelihood of being realized upon final settlement with a taxing authority fully knowing all relevant
information. Additionally, FASB ASC 740 provides guidance on de-recognition, measurement, classification, interest and penalties,
accounting in interim periods, disclosure and transition (see Note 6 - Income Taxes). FASB
ASC 740 further requires that interest and penalties required to be paid on the underpayment of taxes should be accrued on the
difference between the amount claimed or expected to be claimed on the tax return and the tax benefit recognized in the financial
statements. The Company includes potential interest and penalties recognized in accordance with FASB ASC 740 in the financial
statements as a component of income tax expense. Accrued interest and penalties related to our unrecognized tax benefits are recorded
in the consolidated balance sheet within “Other non-current liabilities.” The
Company records valuation allowances to reduce deferred tax assets when it is more likely than not that a tax benefit will not
be realized. Significant judgment is required in evaluating the need for and magnitude of appropriate valuation allowances against
deferred tax assets. The realization of these assets is dependent on generating future taxable income, as well as successful implementation
of various tax planning strategies. Valuation allowances against the deferred tax assets totaled $59.3 million and $20.3 million
on February 3, 2018 and January 28, 2017, respectively. Business
segments. Comprehensive
income. Reclassifications.
Recent
Accounting Pronouncements. Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification
of Certain Tax Effects from Accumulated Other Comprehensive Income. In
January 2017, the FASB issued ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill
Impairment. In
November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash In
October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than
Inventory In
August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and
Cash Payments In
March 2016, the FASB issued ASU 2016-04, Liabilities – Extinguishments of Liabilities (Subtopic 405-20): Recognition
of Breakage for Certain Prepaid Stored-Value Products In
March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation (Topic 718): Improvement to Employee Share-based
Payment Accounting. In
February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) In
August 2015, the FASB issued ASU 2015-14, Revenue from Contracts with Customers (Topic 606), an update to ASU 2014-09. This ASU
amends ASU 2014-09 to defer the effective date by one year for annual reporting periods beginning after December 15, 2017. Subsequently,
the FASB has also issued accounting standards updates which clarify the guidance. This ASU removes inconsistencies, complexities
and allows transparency and comparability of revenue transactions across entities, industries, jurisdictions and capital markets
by providing a single comprehensive principles-based model with additional disclosures regarding uncertainties. The principles-based
revenue recognition model has a five-step analysis of transactions to determine when and how revenue is recognized. The core principle
is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that
reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. Early adoption
is permitted for annual reporting periods beginning after December 15, 2016. In transition, the ASU may be applied retrospectively
to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company
is actively working to comply with this guidance as it relates to gift cards sales, loyalty programs, coupons and discounts and
other areas of the business impacted by the pronouncement. The Company has evaluated the impact that this ASU will have and has
determined that there will be no material impact on the Company’s statement of position, results of operations, or statement
of cash flow. The Company will implement this standard in its first quarter of fiscal year 2018. Termination
of Asset Purchase Agreement On
December 19, 2016, Fred’s and its wholly-owned subsidiary, AFAE, LLC (“Buyer”), entered into an Asset Purchase
Agreement (the “Asset Purchase Agreement”) with Rite Aid Corporation (“Rite Aid”) and Walgreens Boots
Alliance, Inc. (“Walgreens”), pursuant to which Buyer agreed to purchase 865 stores, certain intellectual property
and other tangible assets (collectively, the “Assets”) and to assume certain liabilities for a cash purchase price
of $950 million (the “Rite Aid Transaction”). Pursuant to Section 8.01(g) of the Asset Purchase Agreement,
each of Buyer, Walgreens or Rite Aid was permitted to terminate the Asset Purchase Agreement upon the termination of that certain
Agreement and Plan of Merger, dated as of October 27, 2015, among Walgreens, Rite Aid and the other parties thereto (as amended,
the “Merger Agreement”). On
June 29, 2017, the Merger Agreement was terminated and, accordingly, the Asset Purchase Agreement was also terminated, effective
immediately. In connection with the termination of the Asset Purchase Agreement, the Company received a termination fee payment
of $25 million on June 30, 2017 from Walgreens. |
