FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended July 29, 2000. OR [ ] 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 000-19288 FRED'S, INC. (Exact name of registrant as specified in its charter) Tennessee 62-0634010 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 4300 New Getwell Rd., Memphis, Tennessee 38118 (Address of principal executive offices) (zip code) (901) 365-8880 ) (Registrant's telephone number, including area code) ) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X . No . ----------- ----------- The registrant had 12,042,941 shares of Class A voting, no par value common stock outstanding as of September 8, 2000. FRED'S, INC. INDEX Page No. Part I - Financial Information Item 1 - Financial Statements (unaudited): Consolidated Balance Sheets as of July 29, 2000 and January 29, 2000 3 Consolidated Statements of Income for the Thirteen Weeks Ended July 29, 2000 and July 31, 1999 and the Twenty-Six Weeks Ended July 29, 2000 and July 31, 1999 4 Consolidated Statements of Cash Flows for the Twenty-six Weeks Ended July 29, 2000 and July 31, 1999 5 Notes to Consolidated Financial Statements 6 - 7 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 8 - 11 Item 3 - Quantitative and Qualitative Disclosure about Market Risk 11 Part II - Other Information 12 Signatures 13 FRED'S, INC. CONSOLIDATED BALANCE SHEETS (unaudited) (in thousands, except for number of shares) July 29, January 29, 2000 2000 -------- -------- ASSETS: Current assets: Cash and cash equivalents $1,158 $3,036 Receivables, less allowance for doubtful accounts of $528 ($452 at January 29, 2000) 10,789 10,911 Inventories 153,818 141,612 Deferred income taxes 2,091 3,002 Other current assets 1,405 1,865 ----- ----- Total current assets 169,261 160,426 Property and equipment, at depreciated cost 75,758 73,459 Equipment under capital leases, less accumulated amortization of $1,080 ($856 at January 29,2000) 1,611 1,835 Deferred income taxes 1,394 866 Other noncurrent assets 4,152 3,636 ----- ----- Total assets $252,176 $240,222 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $42,636 $39,653 Current portion of indebtedness 2,349 30,306 Current portion of capital lease obligations 465 430 Accrued liabilities 10,645 9,680 Income taxes payable 2,611 650 ----- --- Total current liabilities 58,706 80,719 ------ ------ Long term portion of indebtedness 39,407 10,027 Capital lease obligations 1,492 1,734 Other noncurrent liabilities 1,916 1,829 ----- ----- Total liabilities 101,521 94,309 ------- ------ Shareholders' equity: Common stock, Class A voting, no par value, 12,034,354 shares issued and outstanding (11,988,276 shares at January 29, 2000) 68,081 67,326 Retained earnings 82,854 78,902 Deferred compensation on restricted stock incentive plan (280) (315) ---- ---- Total shareholders' equity 150,655 145,913 ------- ------- Total liabilities and shareholders equity $252,176 $240,222 ======== ======== See accompanying notes to consolidated financial statements FRED'S, INC. CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands, except per share amounts) Thirteen Weeks Ended Twenty-Six Weeks Ended ---------------------- ---------------------- July 29, July 31, July 29, July 31, 2000 1999 2000 1999 ---------- ---------- ---------- ------ Net sales $180,806 $156,498 $357,466 $311,432 Cost of goods sold 131,635 112,546 259,173 223,161 ------- --------- -------- -------- Gross profit 49,171 43,952 98,293 88,271 Selling, general and administrative expenses 46,036 41,659 89,198 81,080 ------ --------- -------- -------- Operating income 3,135 2,293 9,095 7,191 Interest expense, net 763 694 1,436 1,146 ------ --------- -------- -------- Income before income taxes 2,372 1,599 7,659 6,045 Provision for income taxes 645 562 2,500 2,122 -------- --------- -------- -------- Net income $ 1,727 $ 1,037 $ 5,159 $ 3,923 ======== ======== ======== ======== Net income per share Basic .14 $ .09 $ .43 $ .33 ======= ======== ======== ======== Diluted .14 $ .09 $ .42 $ .33 ======= ======== ======== ======== Weighted average shares outstanding Basic 11,928 11,826 11,919 11,819 ======== ========= ======== ======== Diluted 12,172 12,079 12,149 12,057 ======== ======== ======== ======== See accompanying notes to consolidated financial statements FRED'S, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands) Twenty-six Weeks Ended July 29, July 31, 2000 1999 ---- ---- Cash flows from operating activities: Net income $5,159 $3,923 Adjustments to reconcile net income to net cash flows from operating activities: Depreciation and amortization 6,883 5,734 Lifo reserve 400 200 Deferred income taxes 383 (151) Amortization of deferred compensation on restricted stock incentive plan 76 142 Cancellation of restricted stock (203) ---- (Increase)decrease in assets: Receivables 122 1,024 Inventories (12,606) (10,823) Other assets (780) 302 Increase (decrease) in liabilities: Accounts payable and accrued liabilities 3,948 (12,838) Income taxes payable 1,961 49 Other noncurrent liabilities 87 80 --- --- Net cash provided by (used in)operating activities 5,430 (12,358) ----- ------- Cash flows from investing activities: Capital expenditures (8,233) (6,000) ------ ------ Net cash used in investing activities (8,233) (6,000) ------ ------ Cash flows from financing activities: Reduction of indebtedness and capital lease obligations (998) (983) Proceeds from revolving line of credit, net of payments 2,214 16,800 Proceeds from term loan ---- 2,250 Proceeds from exercise of options 725 208 Tax benefit on exercise of stock options 185 28 Cash dividends paid (1,201) (1,196) ------ ------ Net cash provided by financing activities 925 17,107 --- ------ Increase (decrease) in cash and cash equivalents (1,878) (1,251) Cash and cash equivalents: Beginning of Period 3,036 2,406 ----- ----- End of period $1,158 $1,155 ====== ====== Supplemental disclosures of cash flow information: Interest paid $1,537 $1,097 ====== ====== Income taxed paid ---- $2,200 ====== ====== See accompanying notes to consolidated financial statements FRED'S, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: BASIS OF PRESENTATION Fred's, Inc. ("Fred's" or the "Company") operates 335 discount general merchandise stores, including 26 franchised Fred's stores, in eleven states in the southeastern United States. One hundred and eighty-nine of the stores have full service pharmacies. The accompanying unaudited consolidated financial statements of Fred's have been prepared in accordance with the instructions to 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 generally accepted accounting principles. 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 generally accepted accounting principles. The statements should be read in conjunction with the Notes to the Consolidated Financial Statements for the fiscal year ended January 29, 2000 incorporated into the Company's Annual Report on Form 10-K. The results of operations for the twenty-six week period ended July 29, 2000 are not necessarily indicative of the results to be expected for the full fiscal year. Certain prior quarter amounts have been reclassified to conform to the 2000 presentation. NOTE 2: INVENTORIES Wholesale inventories are stated at the lower of cost or market using the FIFO (first-in, first-out) method. Retail inventories are stated at the lower of cost or market as determined by the retail inventory method. For pharmacy inventories, which comprise approximately 19% of the retail inventories at July 29, 2000, cost was determined using the LIFO (last-in, first-out) method. For the remainder of the retail inventories, the FIFO method was applied. The current cost of inventories exceeded the LIFO cost by approximately $3,608,000 and $3,208,000 at July 29, 2000 and January 29, 2000, respectively. LIFO inventory costs can only be determined annually when inflation rates and inventory levels are finalized; therefore, LIFO inventory costs for interim financial statements are estimated. NOTE 3: NET INCOME PER SHARE Basic income per share is based on the weighted average number of common shares outstanding, and diluted net income per share is based on the weighted average number of common shares and common equivalent shares outstanding. COMPUTATION OF NET INCOME PER SHARE (unaudited) (in thousands, except per share amounts) Thirteen Weeks Ended Twenty-Six Weeks Ended ---------------------- ---------------------- July 29, July 31, July 29, July 31, 2000 1999 2000 1999 ---------- ---------- ---------- ------ Basic net income per share Net income $ 1,727 $ 1,037 $ 5,159 $3,923 ======= ======= ======= ====== Weighted average number of common shares outstanding during the period 11,928 11,826 11,919 11,819 ======= ======= ======= ====== Net income per share $ .14 $ .09 $ .43 $ .33 ======= ======= ======= ====== Diluted net income per share Net income $ 1,727 $ 1,037 $ 5,159 $3,923 ======= ======= ======= ====== Weighted average number of common shares outstanding during the period 11,928 11,826 11,919 11,819 Additional shares attributable to common stock equivalents 244 253 230 238 ------- ------- ------- ------ 12,172 12,079 12,149 12,057 ======= ======= ======= ====== Net income per share $ .14 $ .09 $ .42 $ .33 ======= ======= ======= ====== Management's Discussion and Analysis of Financial Condition and Results of Operations GENERAL Fred's business is subject to seasonal influences, but the Company has tended to experience less seasonal fluctuation than many other retailers due to the Company's mix of everyday basic merchandise and pharmacy business. The fourth quarter is typically the most profitable quarter because it includes the Christmas selling season. The overall strength of the fourth quarter is partially mitigated, however, by the inclusion of the month of January, which is generally the least profitable month of the year. The impact of inflation on labor and occupancy costs can significantly affect Fred's operations. Many of Fred's employees are paid hourly rates related to the federal minimum wage and, accordingly, any increase affects Fred's. In addition, payroll taxes, employee benefits and other employee-related costs continue to increase. Occupancy costs, including rent, maintenance, taxes and insurance, also continue to rise. Fred's believes that maintaining adequate operating margins through a combination of price adjustments and cost controls, careful evaluation of occupancy needs, and efficient purchasing practices is the most effective tool for coping with increasing costs and expenses. RESULTS OF OPERATIONS Thirteen Weeks Ended July 29, 2000 and July 31, 1999 - ------------------------------------------------------- Net sales increased to $180.8 million in 2000 from $156.5 million in 1999, an increase of $24.3 million or 15.5%. The increase was attributable to comparable store sales increases of 10.0% ($14.5 million) and sales by stores not yet included as comparable stores ($9.9 million). Sales to franchisees decreased $.1 million in 2000. The sales mix for the period was 50.9% Hardlines, 32.8% Pharmacy, 12.0% Softlines, and 4.3% Franchise. This compares with 49.7% Hardlines, 31.3% Pharmacy, 14.0% Softlines, and 5.0% Franchise for the same period last year. Gross profit decreased to 27.2% of sales in 2000 compared with 28.1% of sales in the prior-year period. Gross profit margins decreased as a result of the increased promotional activities toward soft drink and food products which carry lower margins. Selling, general and administrative expenses increased to $46.0 million in 2000 from $41.7 million in 1999. As a percentage of sales, expenses decreased to 25.5% of sales compared to 26.6% of sales last year. Selling, general and administrative expenses were improved primarily due to controlling costs and improving efficiencies in the store and pharmacy operations. Improved performance in the distribution operations and better merchandising practices have resulted in stronger control of labor and related costs at the store. Interest expense increased to $.8 million in 2000 from $.7 million in 1999, reflecting higher average revolver borrowings than last year as well as rising interest rates. Twenty-six Weeks Ended July 29, 2000 and July 31, 1999 - ------------------------------------------------------- Net sales increased to $357.5 million in 2000 from $311.4 million in 1999, an increase of $46.1 million or 14.8%. The increase was attributable to comparable store sales increases of 9.7% ($27.9 million) and sales by stores not yet included as comparable stores ($18.3 million). Sales to franchisees decreased $.1 million in 2000. The sales mix for the period was 50.0% Hardlines, 33.0% Pharmacy, 12.4% Softlines, and 4.6% Franchise. This compares with 48.9% Hardlines, 32.0% Pharmacy, 13.8% Softlines, and 5.3% Franchise for the same period last year. Gross profit decreased to 27.5% of sales in 2000 compare with 28.3% of sales in the prior-year period. Gross profit margins decreased as a result of the increased mix of certain categories in hardline sales and strong quarterly sales in pharmacy which typically carry lower margins. Selling, general and administrative expenses increased to $89.2 million in 2000 from $81.1 million in 1999. As a percentage of sales, expenses decreased to 25.0% of sales compared to 26.0% of sales last year. Selling, general and administrative expenses were improved primarily due to continued improved performance in the distribution operations and better merchandising practices which has resulted in stronger control of labor and related costs at the store. Interest expense increased to $1.4 million in 2000 from $1.1 million in 1999, reflecting higher average revolver borrowings than last year for inventory purchases to improve store in-stock positions. The provision for income taxes has been reduced by $188,000 to reflect the Work Opportunity Tax Credit that the Company has earned during the first half of the year to reduce the Federal Tax liability for the year ended February 3, 2001. LIQUIDITY AND CAPITAL RESOURCES Due to the seasonality of Fred's 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. Net cash flow provided by operating activities totaled $5.4 million during the twenty-six week period ended July 29, 2000. Cash was primarily used to increase inventories and reduce accounts payable. Total inventories increased approximately $12.6 million in the first half of 2000. This increase was primarily attributable to 17 new stores and 7 new pharmacies in the first half of 2000, coupled with the additional inventory necessary to improve store in- stock positions over 1999. Accounts payable increased approximately $3.9 million in the first half of 2000. Net cash flows used by investing activities totaled $8.2 million, and was used primarily for capital expenditures associated with the Company's store and pharmacy expansion program. During the first half of 2000, the Company opened 17 stores and closed 1 store. The Company expects to open approximately 30 to 40 stores for the year. The Company's capital expenditure plan for the year 2000 is approximately $12 million dollars and will approximate depreciation expense for the year. Net cash flows provided by financing activities totaled $.9 million and included $2.2 million of borrowings under the Company's revolver for inventory and accounts payable needs. On April 3, 2000, the Company and a bank entered into a new Revolving Loan and Credit Agreement (the "Agreement") to replace the May 15, 1992 Revolving Loan and Credit Agreement, as amended. The Agreement provides the Company with an unsecured revolving line of credit commitment of up to $40 million and bears interest at the lesser of 1.5% below prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified shareholder's equity and net income levels. The Company is required to pay a commitment fee to the bank at a rate per annum equal to .18% on the unutilized portion of the revolving line commitment over the term of the agreement. The term of the Agreement extends to April 3, 2003. The borrowings outstanding under this agreement at July 29, 2000 were $30.4 million. The borrowings outstanding under the previous Agreement at July 31, 1999 were $27.1 million. On May 5, 1998, the Company and a bank entered into a Loan Agreement (the "1998 Loan Agreement"). The 1998 Loan Agreement provided the Company with an unsecured term loan of $12 million to finance the modernization and automation of the Company's distribution center and corporate facilities. The 1998 Loan Agreement bears interest of 6.82% per annum and matures on November 1, 2005. Borrowings outstanding under this 1998 Loan Agreement totaled $9.7 million at July 29, 2000 and $11.1 million at July 31, 1999. On April 23, 1999, the Company and a bank entered into a Loan Agreement (the "1999 Loan Agreement"). The 1999 Loan Agreement provided the Company with a four-year unsecured term loan of $2,250,000 to finance the replacement of the Company's mainframe computer system. The 1999 Loan Agreement bears interest of 6.15% per annum and matures on April 15, 2003. Borrowings outstanding under this 1999 Loan Agreement totaled $1.6 million at July 29, 2000 and $2.1 million at July 31, 1999. The Company believes 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. RECENT ACCOUNTING PRONOUNCEMENTS In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements" (SAB 101). SAB 101 deals with various revenue recognition issues, several which are common within the retail industry including treatment of revenue recognition on layaway sales. The Company has not implemented the changes of Staff Accounting Bulletin No. 101. The most recent announcement by the SEC delays the implementation date of SAB 101 and would require the Company to implement changes by the fourth quarter of this fiscal year. The new accounting treatment of layaway sales would cause an adjustment of earnings from the third quarter to the fourth quarter since revenue would not be recorded until the layaway sale is complete. However based on historicial customer patterns, the financial effect on the year end result of the Company is not expected to be material. Historically, layaway purchases not totally complete by fiscal year end are minimal in relation to total revenues and the effect on Earnings Per Share of the Company would be less than $.01 per share. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company has no holdings of derivative financial or commodity instruments as of July 29, 2000. The Company is exposed to financial market risks, including changes in interest rates. All borrowings under the Company's 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 the Company's income. All of the Company's business is transacted in U.S. dollars and, accordingly, foreign exchange rate fluctuations have not had a significant impact on the Company, and they are not expected to in the foreseeable future CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION Statements, other than those based on historical facts, are forward-looking statements which are based upon a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Actual events and results may materially differ from anticipated results described in such statements. The Company's ability to achieve such results is subject to certain risks and uncertainties, including, but not limited to, economic and weather conditions which affect buying patterns of the Company's customers, changes in consumer spending and the Company's ability to anticipate buying patterns and implement appropriate inventory strategies, continued availability of capital and financing, competitive factors, and other factors affecting business beyond the Company's control. Consequently, all of the forward- looking statements are qualified by these cautionary statements and there can be no assurance that the results or developments anticipated by the Company will be realized or that they will have the expected effects on the Company or its business or operations. PART II. OTHER INFORMATION Item 1. Legal Proceedings Not Applicable. Item 2. Changes in Securities Not Applicable. Item 3. Defaults Upon Senior Securities Not Applicable. Item 4. Submission of Matters to a Vote of Securities Holders The Annual Meeting of the Shareholders of Fred's, Inc. was held on June 21, 2000. Michael J. Hayes, David A. Gardner, John R. Eisenman and Roger T. Knox were elected to continue as directors of the Company. The shareholders also ratified the appointment of PricewaterhouseCoopers LLP as independent public accountants for the fiscal year ending February 3, 2001. The results of the voting were as follows: Abstain/ For Against Withheld Broker Non-Vote --- ------- -------- --------------- Election of Directors: Michael J. Hayes 9,900,469 212,414 1,863,845 David A. Gardner 8,606,048 1,112,940 2,257,740 John R. Eisenman 10,115,627 56 1,861,045 Roger T. Knox 10,144,157 56 1,832,515 Appointment of PricewaterhouseCoopers LLP: 10,167,759 698 7,715 1,800,556 Item 5. Other Information Not Applicable. Item 6. Exhibits and Reports on Form 8-K Exhibits: Exhibit 27 - Financial Data Schedule (Edgar Filing only) Reports on Form 8-K: Not Applicable. 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. FRED'S, INC. Date: September 12, 2000 /s/ Michael J. Hayes - ------------------------- ------------------------- Michael J. Hayes Chief Executive Officer Date: September 12, 2000 /s/ Jerry A. Shore - ------------------------ ------------------------- Jerry A. Shore Chief Financial Officer