Table of Contents
PART I
ITEM 1. - Business
ITEM 2. - Properties
ITEM 3. - Legal Proceedings
ITEM 4. - Submission of Matters to a Vote of Security Holders
- -------------------------------------------------------------------------------
PART II
ITEM 5. - Market for the Registrant's Common Equity and Related
Stockholder Matters
ITEM 6. - Selected Financial Data
ITEM 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations
ITEM 7A. - Quantitative and Qualitative Disclosure about Market Risk
ITEM 8. - Financial Statements and Supplementary Data
ITEM 9. - Changes In and Disagreements with Accountants on
Accounting and Financial Disclosure
ITEM 9A. - Controls and Procedures
- -------------------------------------------------------------------------------
PART III
ITEM 10. - Directors and Executive Officers of the Registrant
ITEM 11. - Executive Compensation
ITEM 12. - Security Ownership of Certain Beneficial Owners and
Management
ITEM 13. - Certain Relationships and Related Transactions
ITEM 14. - Principal Accountant Fees and Services
- -------------------------------------------------------------------------------
PART IV
ITEM 15.
SIGNATURES
EXHIBIT INDEX
EX-21 (Subsidiaries of the registrant)
EX-23 (Consents of experts and counsel)
EX-31 Certification of Chief Executive Officer and Chief Financial
Officer)
EX-32 (Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350)
1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended January 29, 2005
Commission File Number 001-14565
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 Number)
4300 New Getwell Road
MEMPHIS, TENNESSEE 38118
(Address of Principal Executive Offices)
Registrant's telephone number, including area code (901) 365-8880
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act: None
Title of Each Class
Class A Common Stock, no par value
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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K [X].
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2.
Yes [X] No [ ]
Aggregate market value of the voting stock held by non-affiliates of the
Registrant, based upon the last reported sale price on such date by the NASDAQ
2
Stock Market, Inc. on July 30, 2004, the last business day of the registrant's
most recently completed second fiscal quarter, was approximately $709 million.
As of April 22, 2005, there were 39,813,381 shares outstanding of the
Registrant's Class A no par value voting common stock.
As of April 22, 2005, there were no shares outstanding of the Registrant's Class
B no par value non-voting common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Form 8-K dated July 1, 2004 are incorporated by reference into
Part II, Item 9.
Portions of the Company's Proxy Statement for the 2005 annual shareholders
meeting, to be filed within 120 days of the registrant's fiscal year end, are
incorporated by reference into Part II, Item 5 and Part III.
With the exception of those portions that are specifically incorporated herein
by reference, the aforesaid documents are not to be deemed filed as part of this
report.
Cautionary Statement Regarding Forward-looking Information
Other than statements based on historical facts, many of the matters discussed
in this Form 10-K 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. Fred's Inc. ("Fred's" or the "Company") intends to
qualify both its written and oral forward-looking statements for protection
under the Reform Act and any other similar safe harbor provisions.
The words "believe", "anticipate", "project", "plan", "expect", "estimate",
"objective", "forecast", "goal", "intend", "will likely result", or "will
continue" and similar expressions generally identify forward-looking statements.
All forward-looking statements are inherently uncertain, and concern matters
that involve risks and other factors which may cause the actual performance of
the Company to differ materially from the performance expressed or implied by
these statements. Therefore, forward-looking statements should be evaluated in
the context of these uncertainties and risks, including but not limited to:
- - Economic and weather conditions which affect buying patterns of our
customers and supply chain efficiency;
- - Changes in consumer spending and our ability to anticipate buying patterns
and implement appropriate inventory strategies;
- - Continued availability of capital and financing;
- - Competitive factors;
- - Changes in reimbursement practices for pharmaceuticals;
- - Governmental regulation;
3
- - Increases in fuel and utility rates;
- - Other factors affecting business beyond our control.
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.
PART I
Item 1: Business
General
Fred's, founded in 1947, operates 563 (as of January 29, 2005) discount general
merchandise stores in fourteen states primarily in the southeastern United
States. Fred's stores generally serve low, middle and fixed income families
located in small- to medium- sized towns (approximately 65% of Fred's stores are
in markets with populations of 15,000 or fewer people). Full service pharmacies
are included in 258 of the Company's stores. The Company also markets goods and
services to 25 franchised "Fred's" stores. The Company is headquartered in
Memphis, Tennessee.
Fred's stores stock over 12,000 frequently purchased items which address the
everyday needs of its customers, including nationally recognized brand name
products, proprietary "Fred's" label products and lower priced off-brand
products. Fred's management believes its customers shop Fred's stores as a
result of their convenient locations and sizes, everyday low prices on key
products and regularly advertised departmental promotions and seasonal specials.
Fred's stores have average selling space of 15,267 square feet and had average
sales of $2,858,000 in fiscal 2004. No single store accounted for more than 1.0%
of net sales during fiscal 2004.
Business Strategy
The Company's strategy is to meet the general merchandise and pharmacy needs of
the small- to medium- sized towns it serves by offering a wider variety of
quality merchandise and a more attractive price-to-value relationship than
either drug stores or smaller variety/dollar stores and a shopper-friendly
format which is more convenient than larger sized discount merchandise stores.
The major elements of this strategy include:
Wide variety of frequently purchased, basic merchandise - Fred's combines
everyday basic merchandise with certain specialty items to offer its customers a
wide selection of over 12,000 frequently purchased items of general merchandise.
The selection of merchandise is supplemented by seasonal specials, private label
products, and the inclusion of pharmacies in 258 of its stores.
Discount prices - The Company provides value and low prices to its customers
(i.e., a good "price-to-value relationship") through a coordinated discount
strategy and an Everyday Low Pricing program that focuses on strong values
daily, while minimizing the Company's reliance on promotional activities. As
part of this strategy, Fred's maintains low opening price points and competitive
prices on key products across all departments, and regularly offers seasonal
specials and departmental promotions supported by direct mail, television, radio
and newspaper advertising.
Convenient shopper-friendly environment - Fred's stores are typically located in
convenient shopping and/or residential areas. Approximately 33% of the Company's
stores are freestanding as opposed to being located in strip shopping center
4
sites. Freestanding sites allow for easier access and shorter distances to the
store entrance. Fred's stores are of a manageable size and have an
understandable store layout, wide aisles and fast checkouts.
Expansion Strategy - The Company expects that expansion will occur primarily
within its present geographic area and will be focused in small-to medium- sized
towns. The Company may also enter larger metropolitan and urban markets where it
already has a market presence in the surrounding area.
Fred's opened 81 stores in 2004 and closed six stores, and anticipates a net
increase of 60 to 80 new stores in 2005. The majority of new stores opened in
2004 were located in Alabama, Georgia, Florida and South Carolina. The Company's
new store prototype has 16,000 square feet of space. Opening a new store
currently costs between $450,000 and $575,000 for inventory, furniture,
fixtures, equipment and leasehold improvements. The Company has 22 stand-alone
"Xpress" locations which sell only pharmaceuticals and other health and beauty
related items. These locations range in size from 1,000 to 8,000 square feet,
and enable the Company to enter a new market with an initial investment of under
$400,000. During 2004, the Company opened four Xpress locations and closed two
locations. During 2005, the Company anticipates opening five to 10 new Xpress
locations. It is the Company's intent to expand these locations into full size
Fred's locations as market conditions permit.
The Company believes that its pharmaceuticals business will continue to be a
significant growth area. In 2004, the Company added 19 new pharmacies and closed
2 pharmacies. During 2005, the Company anticipates adding 20 to 25 additional
pharmacies. Approximately 46% of Fred's stores as of January 29, 2005 contain a
pharmacy and sell prescription drugs. The Company's primary mechanism for
obtaining customers for new pharmacies is through the acquisition of
prescription files from independent pharmacies. These acquisitions provide an
immediate sales benefit, and in many cases, the independent pharmacist will move
to Fred's, thereby providing continuity in the pharmacist-patient relationship.
The following tables set forth certain information with respect to stores and
pharmacies for each of the last five fiscal years:
2000 2001 2002 2003 2004
- ---------------------------------------------------------------------------------------------------------
Stores open at beginning of period 293 320 353 414 488
Stores opened/acquired during period 31 33 62 79 81
Stores closed during period (4) (0) (1) (5) (6)
----------------------------------------
Stores open at end of period 320 353 414 488 563
========================================
Number of stores with Pharmacies at
End of period 198 202 216 241 258
========================================
Square feet of selling space at end of
period (in thousands) 4,490 5,072 6,000 7,134 8,270
=========================================
Average square feet of selling space
per store 13,342 14,187 14,435 15,166 15,267
==========================================
Franchise stores at end of period 26 26 26 26 25
==========================================
5
Merchandising and Marketing
The business in which the Company is engaged is highly competitive. The
principal competitive factors include location of stores, price and quality of
merchandise, in-stock consistency, merchandise assortment and presentation, and
customer service. The Company competes for sales and store locations in varying
degrees with national, regional and local retailing establishments, including
department stores, discount stores, variety stores, dollar stores, discount
clothing stores, drug stores, grocery stores, outlet stores, warehouse stores
and other stores. Many of the largest retail merchandising companies in the
nation have stores in areas in which the Company operates.
Management believes that Fred's has a distinctive niche in that it offers a
wider variety of merchandise at a more attractive price-to-value relationship
than either a drug store or smaller variety/dollar store and is more
shopper-convenient than a larger discount store. The variety and depth of
merchandise offered at Fred's stores in high traffic departments, such as health
and beauty aids and paper and cleaning supplies, are comparable to those of
larger discount retailers. Management believes that its knowledge of regional
and local consumer preferences, developed in over 55 years of operation by the
Company and its predecessors, enables the Company to compete effectively in its
region. During 2004, we tested our refrigerated foods program in 14 of our
stores and based upon its success will be rolling the program out to a majority
of our Company stores during 2005.
Purchasing
The Company's primary buying activities (other than prescription drug buying)
are directed from the corporate office by the General Merchandise Manager
through three Vice Presidents-Merchandising who are supported by a staff of 20
buyers and assistants. The buyers and assistants are participants in an
incentive compensation program, which is based upon various factors primarily
relating to gross margin returns on inventory controlled by each individual
buyer. The Company purchases its merchandise from a wide variety of domestic and
import suppliers. Many of the import suppliers generally require long lead times
and orders are placed four to six months in advance of delivery. These products
are either imported directly by us or acquired from distributors based in the
United States and their purchase price are denominated in United States dollars.
The merchandising department manages all replenishment and forecasting functions
with the Company's open-to-buy reports generated by proprietary software. The
merchandise department develops vendor line reviews, assortment planning and the
testing of new products and programs to continually improve overall inventory
productivity and in-stock positions. The Company has purchased approximately 11%
of the Company's total purchases for the years 2004, 2003 and 2002 from Procter
and Gamble. Excluding the purchases made from our pharmaceutical supplier, no
other supplier accounted for more than 3% of the Company's purchases for the
years 2004, 2003 and 2002. The Company believes that adequate alternative
sources of products are available for these categories of merchandise.
During 2004, all of the Company's prescription drugs were ordered by its
pharmacies individually and shipped direct from the Company's primary
pharmaceutical wholesaler AmerisourceBergen Corporation ("Bergen"). Bergen
provides substantially all of the Company's prescription drugs. During 2004,
2003, and 2002 approximately 38%, 34%, and 34%, respectively of the Company's
total purchases were made from Bergen. Although there are alternative
wholesalers that supply pharmaceutical products, the Company operates under a
purchase and supply contract with Bergen as its primary wholesaler. Accordingly,
the unplanned loss of this particular supplier could have a short-term gross
margin impact on the Company's business until an alternative wholesaler
arrangement could be implemented.
6
Sales Mix
Sales of merchandise through Company owned stores and to franchised Fred's
locations are the only significant industry segment of which the Company is a
part.
The Company's sales mix by major category for the preceding three years was as
follows:
For the Year Ended
---------------------------------------------------------------
January 29, January 31, February 1,
2005 2004 2003
---------------------------------------------------------------
Pharmaceuticals 32.6% 32.4% 33.2%
Household Goods 23.7% 23.6% 23.0%
Apparel and Linens 14.1% 14.2% 13.6%
Food and Tobacco Products 10.7% 10.2% 9.6%
Health and Beauty Aids 8.6% 8.8% 9.0%
Paper and Cleaning Supplies 8.0% 8.1% 8.4%
Sales to Franchised Fred's Stores 2.3% 2.7% 3.2%
---------------------------------------------------------------
Total Sales Mix 100.0% 100.0% 100.0%
---------------------------------------------------------------
The sales mix varies from store to store depending upon local consumer
preferences and whether the stores include pharmacies and/or a full-line of
apparel. In 2004 the average customer transaction size was approximately $17.98,
and the number of customer transactions totaled approximately 80 million. The
average transaction size was approximately $17.78 in 2003 and $17.17 in 2002.
The private label program includes household cleaning supplies, health and
beauty aids, disposable diapers, pet foods, paper products and a variety of
beverage and other products. Private label products sold constituted
approximately 3% of total sales for the years 2004, 2003 and 2002. Private label
products afford the Company higher than average gross margins while providing
the customer with lower priced products that are of a quality comparable to that
of competing branded products. An independent laboratory-testing program is used
for substantially all of the Company's private label products.
The Company sells merchandise to its 25 franchised "Fred's" stores. These sales
during the last three years totaled approximately $33,253,000 in 2004,
$34,780,000 in 2003, and $35,261,000 in 2002. Franchise and other fees earned
totaled approximately $1,869,000 in 2004, $1,964,000 in 2003, and $2,016,000 in
2002 . These fees represent a reimbursement for use of the Fred's name and
administrative costs incurred on behalf of the franchised stores. The Company
does not intend to expand its franchise network, and therefore, expects that
this category will continue to decrease as a percentage of the Company's total
revenues.
Advertising and Promotions
Advertising and promotion costs represented approximately 1.3% of net sales in
2004, 2003, and 2002. The Company uses direct mail, television, radio and 14
major newspaper-advertising circulars, one at the first of each month and two
during the Christmas season. The Company utilizes 20 page full-color circulars
coordinated by an internal advertising staff to promote its merchandise, special
promotional events and a discount retail image.
The Company's buyers have discretion to mark down slow moving items. The Company
runs regular clearances of seasonal merchandise and conducts sales and
promotions of particular items. The Company also encourages its store managers
7
to create in-store advertising displays and signage in order to increase
customer traffic and impulse purchases. Store managers have the flexibility to
tailor the price structure at their particular store to meet competitive
conditions within each store's marketing area.
Store Operations
All Fred's stores are open six days a week (Monday through Saturday), and most
stores are open seven days a week (other than the pharmacy). Store hours are
generally from 9:00 a.m. to 9:00 p.m.; however, certain stores are open only
until 6:00 p.m. Each Fred's store is managed by a full-time store manager and
those stores with a pharmacy employ a full-time pharmacist. The Company's 36
district managers supervise the management and operation of Fred's stores.
Fred's operates 258 in-store pharmacies, which offer brand name and generic
pharmaceuticals and are staffed by licensed pharmacists. The addition of
acquired pharmacies in the Company's stores has resulted in increased store
sales and sales per selling square foot. Management believes that in-store
pharmacies in addition to the 40 merchandise departments increase customer
traffic and repeat visits and are an integral part of the store's operation.
The Company has an incentive compensation plan for store managers, pharmacists
and district managers based on meeting or exceeding targeted profit percentage
contributions. Various factors included in determining profit percentage
contribution are gross profits and controllable expenses at the store level.
Management believes that this incentive compensation plan, together with the
Company's store management training program, are instrumental in maximizing
store performance. The Company's training program covers all aspects of the
Company's operation from product knowledge to handling customers with courtesy.
Inventory Control and Distribution
Inventory Control
The Company's computerized central management information system (known as
"AURORA," which stands for Automation Utilizing Replenishment Ordering and
Receiving Accuracy) maintains a daily stock-keeping unit ("SKU") level inventory
and current and historical sales information for each store and the distribution
center. This system is supported by in-store point-of-sale ("POS") cash
registers, which capture SKU and other data at the time of sale for daily
transmission to the Company's central data processing center. The merchandise
system uses the data received from the stores to provide for integrated
inventory management, automated replenishment, promotional planning, space
management, and merchandise planning. The Company conducts annual inventory
counts at all Fred's stores and has implemented the use of radio frequency
devices (RF guns) to conduct cycle counts to insure replenishment accuracy in
the merchandise system.
Distribution
As of January 29, 2005, the Company has an 850,000 square foot centralized
distribution center in Memphis, Tennessee that services 292 stores and a 600,000
square foot distribution center in Dublin, Georgia that services 296 stores (see
"Properties" below). Approximately 52% of the merchandise received by Fred's
stores in 2004 was shipped through these distribution centers, with the
remainder (primarily pharmaceuticals, certain snack food items, greeting cards,
beverages and tobacco products) being shipped directly to the stores by
suppliers. For distribution, the Company uses owned and leased trailers and
tractors, as well as common carriers. The warehouse management system provides
complete warehouse functionality such as conveyor control, picking and put-away
processes by using portable radio-frequency terminals. This system is integrated
with the Company's central information system to provide up-to-date perpetual
8
records as well as facilitating merchandise allocation and distribution
decisions. The Company uses cycle count through out the year to insure accuracy
within the warehouse management system.
Seasonality
The Company's business is somewhat seasonal in that the Company's sales volume
is heavier around the 1st of the calendar month. Many of the customers shopping
at Fred's stores rely on government aid, social security, and other means that
are typically paid at the 1st of the month. The payment cycle coupled with the
distribution of our newspaper-advertising circular are major factors in more
sales earlier in the calendar month. Generally, the highest volume of sales and
net income occurs in the fourth fiscal quarter, coincident with the holiday
shopping season. In 2004, 2003, and 2002, the fourth quarter generated 28%, 29%,
and 30% of the Company's total annual revenue and 37%, 37%, and 39% of the
Company's net income, respectively.
Employees
At January 29, 2005, the Company had approximately 10,200 full-time and
part-time employees, comprised of 1,035 corporate and distribution center
employees and 9,165 store employees. The number of employees varies during the
year, reaching a peak during the Christmas selling season, which typically
begins after the Thanksgiving holiday. In May of 2002, certain of our Memphis
distribution center employees voted in an election conducted by the National
Labor Relations Board ("NLRB") to decide whether or not they wished to be
represented by the UNITE-HERE union. The union received a majority of the votes
cast in that election, and because the Company felt that there were
irregularities with the election, the Company appealed the results of the
election by filing objections with the NLRB. In late 2003, we received notice
that the NLRB, which investigated the Company's election objections, had decided
to dismiss the objections and to certify the union as the employee's collective
bargaining representative. Following that certification, the Company appealed
the NLRB's decision to the DC Circuit Court of Appeals, where it is currently
pending. Even though it has appealed the NLRB's decision, the Company has
engaged in bargaining with UNITE-HERE for the past year in hopes of reaching an
agreement on a collective bargaining agreement, and if it does reach an
agreement, it is the Company's intention to withdraw the appeal which is pending
in the federal appeals court. The Company believes that it continues to have
good relations with all of its other employees and that union representation in
our Memphis distribution center will not have a material effect upon the
Company's results of operations.
GOVERNMENT REGULATION
Each of our locations must comply with regulations adopted by federal and state
agencies regarding licensing, health, sanitation, safety, fire and other
regulations. In addition, we must comply with the Fair Labors Standards Act and
various state laws governing various matters such as minimum wage, overtime and
other working conditions. We must also comply with provisions of the Americans
with Disabilities Act of 1990, as amended, which requires generally that
employers provide reasonable accommodation for employees with disabilities and
that our stores be accessible to customers with disabilities. The Company's
pharmacy businesses are subject to extensive federal and state laws and
regulations governing, among other things:
Licensure and Regulation of Retail Pharmacies
There are extensive federal and state regulations applicable to the practice of
pharmacy at the retail level. Most states have laws and regulations governing
the operation and licensing of pharmacies, and regulate standards of
professional practice by pharmacy providers. These regulations are issued by an
administrative body in each state, typically a pharmacy board, which is
empowered to impose sanctions for non-compliance.
9
Future Legislative Initiatives
Legislative and regulatory initiatives pertaining to such healthcare related
issues as reimbursement policies, payment practices, therapeutic substitution
programs, and other healthcare cost containment issues are frequently introduced
at both the state and federal level. The Company is unable to predict accurately
whether or when legislation may be enacted or regulations may be adopted
relating to the Company's pharmacy operations or what the effect of such
legislation or regulations may be.
Substantial Compliance
The Company's management believes the Company is in substantial compliance with
all existing statutes and regulations material to the operation of the Company's
businesses and is unaware of any material non-compliance action against the
Company.
Available Information
Our website address is http://www.fredsinc.com. We make available through this
address, without charge, our annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K and amendments to these reports as soon
as reasonably practicable after these materials are electronically filed or
furnished to the SEC.
Item 2: Properties
As of January 29, 2005, the geographical distribution of the Company's 563
retail store locations in 14 states was as follows:
State Number of Stores
- ----- ------------------
Mississippi 98
Georgia 91
Tennessee 85
Alabama 76
Arkansas 65
Louisiana 36
South Carolina 36
North Carolina 18
Florida 17
Kentucky 11
Missouri 11
Texas 9
Illinois 8
Indiana 2
-------
Total stores: 563
=======
The Company owns the real estate and the buildings for 50 locations, and owns
the buildings at five locations which are subject to ground leases. The Company
leases the remaining 508 locations from third parties pursuant to leases that
provide for monthly rental payments primarily at fixed rates (although a number
of leases provide for additional rent based on sales). Store locations range in
size from 1,000 square feet to 27,000 square feet. Three hundred and
seventy-five of the locations are in strip centers or adjacent to a
downtown-shopping district, with the remainder being freestanding.
It is anticipated that existing buildings and buildings to be developed by
others will be available for lease to satisfy the Company's expansion program in
the near term. It is management's intention to enter into leases of relatively
moderate length with renewal options, rather than entering into long-term
leases. The Company will thus have maximum relocation flexibility in the future,
since continued availability of existing buildings is anticipated in the
Company's market areas.
10
The Company owns its distribution center and corporate headquarters situated on
approximately 60 acres in Memphis, Tennessee. The site contains the distribution
center with approximately 850,000 square feet of space, and 250,000 square feet
of office and retail space. Presently, the Company utilizes 90,000 square feet
of office space and 22,000 square feet of retail space at the site. The retail
space is operated as a Fred's store and is used to test new products,
merchandising ideas and technology. The Company financed the construction of its
600,000 square foot distribution center in Dublin, Georgia with taxable
industrial development revenue bonds issued by the City of Dublin and County of
Laurens Development Authority. Presently, both of distribution centers are able
to serve a total of approximately 750 stores.
Item 3: Legal Proceedings
The Company is party to several pending legal proceedings and claims arising in
the normal course of business. Although the outcome of the proceedings and
claims cannot be determined with certainty, management of the Company is of the
opinion that it is unlikely that these proceedings and claims will have a
material adverse effect on the financial statements as a whole. However,
litigation involves an element of uncertainty. There can be no assurance that
pending lawsuits will not consume the time and energies of our management, or
that future developments will not cause these actions or claims, individually or
in aggregate, to have a material adverse effect on the financial statements as a
whole. We intend to vigorously defend or prosecute each pending lawsuit.
Item 4: Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended January 29, 2005.
PART II
Item 5: Market for the Registrant's Common Equity and Related Stockholder
Matters
The Company's common stock is traded on the Nasdaq Stock Market under the symbol
"FRED." The following table sets forth the high and low sales prices, as
reported in the regular quotation system of NASDAQ, together with cash dividends
paid per share on the Company's common stock during each quarter in 2004 and
2003. All amounts have been adjusted for a three-for-two stock split on July 1,
2003.
- ---------------------------------------------------------------------------------------------------------
2004 First Second Third Fourth
-----------------------------------------------------------------------
Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------------------
High $28.65 $23.50 $18.82 $19.86
- ----------------------------------------------------------------------------------------------------------
Low $18.37 $17.28 $13.89 $15.27
- ----------------------------------------------------------------------------------------------------------
Dividends $0.02 $0.02 $0.02 $0.02
- ----------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------
2003 First Second Third Fourth
------------------------------------------------------------------------
Quarter Quarter Quarter Quarter
- ----------------------------------------------------------------------------------------------------------
High $22.19 $30.16 $37.80 $37.99
- ----------------------------------------------------------------------------------------------------------
Low $15.04 $20.60 $28.43 $27.49
- ----------------------------------------------------------------------------------------------------------
Dividends $0.02 $0.02 $0.02 $0.02
- ----------------------------------------------------------------------------------------------------------
The Company's stock price at the close of the market on April 22, 2005, was
$14.31. There were approximately 21,000 shareholders of record of the Company's
common stock as of April 22, 2005. The Board of Directors regularly reviews the
11
Company's dividend plans to ensure that they are consistent with the Company's
earnings performance, financial condition, need for capital and other relevant
factors. The Company has paid cash dividends on its common stock since 1993.
Information required by this item regarding the Company's equity compensation
plans is incorporated herein by reference to the proxy statement for our 2005
annual meeting.
12
Item 6: Selected Financial Data (dollars in thousands, except per share amounts)
Our selected financial data set forth below should be read in connection with
"Managements Discussion and Analysis of Financial Condition and Results of
Operation" and the consolidated financial statements and notes thereto included
elsewhere in the Form 10-K.
----------------as restated------------------------------
2004 2003 (5) 2002 (5) 2001 (5) 2000 (1&5)
Statement of Income Data:
Net sales $1,441,781 $1,302,650 $1,103,418 $910,831 $781,249
Operating income 39,426 49,100 41,487 31,022 25,373
Income before income taxes 38,633 48,702 41,284 29,411 22,147
Provision for income taxes 10,681 15,907 13,793 10,226 7,509
Net income 27,952 32,795 27,491 19,185 14,638
Net income per share:(2)
Basic .71 .85 .72 .54 .44
Diluted .71 .83 .70 .53 .43
Cash dividend paid per share(2) .08 .08 .08 .08 .08
Selected Operating Data:
Operating income as a percentage of sales 2.7% 3.8% 3.8% 3.4% 3.2%
Increase in comparable store sales (3) 2.2% 5.7% 11.2% 10.5% 9.2%(4)
Stores open at end of period 563 488 414 353 320
Balance Sheet Data (at period end):
Total assets $465,224 $408,793 $342,785 $281,986 $253,607
Short-term debt (including capital
leases) 684 743 905 1,240 2,678
Long-term debt (including capital
leases) 24,212 7,289 2,510 1,320 31,705
Shareholders' equity 314,546 286,350 247,433 216,295 157,519
- -------------------------
(1) Results for 2000 include 53 weeks.
(2) Adjusted for the 5-for-4 stock split effected on June 18, 2001, the 3-for-2
stock split effected on February 1, 2002 and the 3-for-2 stock split
effected on July 1, 2003.
(3) A store is first included in teh comparable store sales calculation after
the end of the twelfth-month following the store's grand opening month.
(4) The increase in comparable store sales for 2000 is computed on the same 53-
week period as the prior year.
(5) As discussed in Note 2 to the consolidated financial statements, in fiscal
2004 we revised our method of accounting for leases to conform to GAAP as
recently clarified by the Chief Accountant of the SEC in a February letter
to the AICPA. A cumulative non-cash adjustment net of taxes was made to
correct the accounting for rent expense (and related deferred rent
liability) to include the impact of escalating rents for periods in which
we are reasonably assured of exercising lease options and to reflect the
accrual of contingent rent expense likely to be paid. We also corrected our
calculation of depreciation expense for leasehold improvements for those
leases to not exceed the lesser of the expected useful life or the initial
lease term plus reasonably assured renewal terms, as applicable.
13
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations
General Accounting Periods
The following information contains references to years 2004, 2003, and 2002,
which represent fiscal years ending or ended January 29, 2005, January 31, 2004
and February 1, 2003, each of which was a 52-week accounting period. This
discussion and analysis should be read with, and is qualified in its entirety
by, the Consolidated Financial Statements and the notes thereto. Our discussion
contains forward-looking statements based upon current expectations that involve
risks and uncertainties such as our plans, objectives, expectations and
intentions. Actual results and the timing of events could differ materially from
those anticipated in the forward-looking statements as a result of a number of
those set forth under "Cautionary Note Regarding Forward-Looking Statements"
below and elsewhere in this report.
Executive Summary
In 2004, the Company continued the strategic growth direction to grow its store
base. We opened 81 new stores and 19 new pharmacies in 2004. We closed six
stores and two pharmacies during the year. The majority of the new store and
pharmacy openings were in Alabama, Georgia, Florida, and South Carolina. The
Company's second distribution center in Dublin, Georgia, which opened in April
2003, continued to service more stores. By the end of 2004, the Dublin
distribution center was providing service to approximately 296 stores.
We continue to focus our merchandising and store direction on improving
productivity of sales and contribution margin while maintaining a competitive
differentiation within the $25 shopping trip. Our unique store format and
strategy combine the attractive elements of a discount dollar store, drug store,
and mass merchant. Our average customer transaction was approximately $18. In
comparison, the discount dollar store averages $8 -$9 and chain drugs and mass
merchants average in the range of $40 to $80 per transaction. Our stores operate
equally well in rural and urban markets. Our everyday low pricing strategy is
supplemented by 14 promotional circulars per year. Our pharmacy department
enhances the convenience and assortment of our product selection and increases
foot traffic.
The primary factors which historically have influenced the Company's
profitability and success have been its growth in new stores and pharmacies,
comparable store sales increases, and improving operating margin through better
gross margins and leverage of operating costs. In 2004, the Company faced the
challenges of the changing economy and rising fuel costs adversely affecting the
low-to-middle income shopper. We experienced a product mix shift toward more
basic and consumable product categories, which typically carry lower gross
margins, and away from higher margin apparel, home furnishings, and gift
products, which are more discretionary to the shopper. This product mix shift
had an adverse effect on sales growth, gross margins and store operating
expenses throughout most of the year. Through most of the year, inventory
increased beyond planned levels in the product categories which experienced
sales shifts. In the fourth quarter, the Company was successful in reducing
inventory to the levels necessary to support new store growth. Additionally,
14
increases in fuel prices negatively affected store supplies and utilities costs,
freight costs of merchandise purchases, and distribution costs.
In 2005, the Company plans to open 60 to 80 new stores and 20 to 25 new
pharmacies. The majority of the new stores and pharmacies will be in the
territory of the Dublin distribution center. Selling square footage will grow in
the range of 12% to 15% in 2005 with the planned store openings. The Company
will expand its refrigerated foods program in 2005 with capital expenditures of
approximately $10 million. We anticipate adding between five and 12 cooler doors
in approximately 500 stores by the end of 2005.
Key factors that will be critical to the Company's future success include
managing the growth strategy for new stores and pharmacies, including the
ability to open and operate effectively, maintain high standards of customer
service, maximizing efficiencies in the supply chain, controlling working
capital needs through improved inventory turnover, and increasing the operating
margin through improved gross profit margin and leveraging operating costs, and
generating the adequate cash flow to fund the Company's expansion.
As we expand our chain and build the infrastructure necessary to support our
planned growth, we also have placed continued focus on refining our store
prototype and initiated programs to enhance the profitability of the selling
space in our stores.
Restatement of Financial Statements
On February 7, 2005, the Office of the Chief Accountant of the Securities and
Exchange Commission issued a letter to the American Institute of Certified
Public Accountants expressing its views regarding certain operating lease
accounting issues and their application under generally accepted accounting
principles ("GAAP"). In addition, a number of companies within the retail
industry have announced adjustments to their financial statements related to
lease accounting issues.
After discussions with its Audit Committee and its current and previous
independent registered public accounting firms, the Company has re-evaluated its
lease accounting practices. Like many other retail companies, the Company is
correcting the way it accounts for leases, specifically the accounting for the
amortization periods related to leasehold improvements, the accounting for
contingent lease payments, and the straight-line accounting of lease payments.
Previously the Company had amortized its leasehold improvements over the
estimated life of the asset. Management determined that the appropriate
interpretation of the lease term under Statement of Financial Accounting
Standards No. 13, "Accounting for Leases," ("SFAS 13") provides for an
amortization period no longer than the sum of the fixed noncancellable term and
any options where, at the inception of the lease, renewal is reasonably assured.
Management determined that renewal of the majority of lease terms, associated
with leasehold improvements whose useful lives included the option period, were
not reasonably assured under paragraph 5 of SFAS 13. For locations where the
amortization period of leasehold improvements exceeded the corresponding lease
term and any reasonably assured renewal, the Company shortened the amortization
of the leasehold improvements to coincide with the end of the lease term as
defined by SFAS 13. Management determined that renewal was reasonably assured
for lease terms following a current term in which significant leasehold
improvements were made. These significant leasehold improvements were amortized
through the following renewal period but not in excess of 120 months. The
correction required the Company to adjust accumulated amortization of leasehold
improvements and retained earnings in the consolidated balance sheets and to
record additional amortization of leasehold improvement expense in selling,
general and administrative expenses in the consolidated statements of income.
15
The Company had historically recorded contingent rent in the year in which the
amounts were paid. Management analyzed Financial Accounting Standards, EITF
98-9, "Accounting for Contingent Rent," and determined that the Company should
accrue payments which are probable for future contingent rents in the period
they become probable. The correction required the Company to record additional
deferred rent in current accrued expenses and to adjust retained earnings in the
consolidated balance sheets, as well as restate rent expense in selling, general
and administrative expenses in the consolidated statements of income.
Finally, the Company had historically recognized rent holiday periods on a
straight-line basis over the original lease term commencing on the date of
possession. During the evaluation it was noted, however, that there were
additional leases with rent holidays that had not been accounted for on a
straight-line basis. Leases not accounted for on this basis were corrected to
properly recognize rent holiday periods. Management re-evaluated Financial
Accounting Standards Board Technical Bulletin No. 85-3, "Accounting for
Operating Leases with Scheduled Rent Increases," and determined that, consistent
with the letter issued by the Office of the Chief Accountant, the lease term
should include lease renewal options for which the Company would be penalized
for non-renewal. The Company determined that the term penalty under paragraph
5(f) of SFAS 13 for non-renewal includes factors such as the addition of
significant leasehold improvements which would be forfeited if a lease term were
not renewed. The majority of the leases entered into by the Company do not
include a penalty for which the renewal would be reasonably assured. The
correction required the Company to record additional deferred rent in other
accrued expenses and other long-term liabilities and to adjust retained earnings
in the consolidated balance sheets, as well as to restate rent expense in
selling, general and administrative expenses in the consolidated statements of
income.
The cumulative effect of these corrections is a reduction to retained earnings
of $4.3 million (net of taxes of $2.6 million) as of the beginning of fiscal
2002 and reductions to retained earnings of $7.0 million (net of taxes of $4.3
million) and $5.5 million (net of taxes of $3.3 million) as of January 2003 and
2002, respectively. These adjustments did not have any impact on the overall
cash flows of the Company.
Public Company Accounting Oversight Board ("PCAOB") Auditing Standard No. 2
identifies a number of circumstances that, because of their likely significant
negative effect on internal control over financial reporting, are to be regarded
as strong indicators that a material weakness in internal control over financial
reporting exists, including the restatement of previously issued financial
statements to reflect the correction of a misstatement. Management has evaluated
the impact of the aforementioned restatement on the Company's assessment of its
system of internal control over financial reporting and has concluded that the
control deficiency that resulted in the incorrect lease accounting represented a
material weakness in internal control over financial reporting as of January 29,
2005.
See Note 2 to the consolidated financial statements for a summary of the effects
of this restatement on the Company's consolidated balance sheet as of January
31, 2004, as well as the Company's consolidated statement of income and cash
flows for fiscal 2003 and 2002. The impact on previously reported quarterly
results is discussed in Note 12 to the Consolidated Financial Statements. The
accompanying discussion in Management's Discussion and Analysis of Financial
Condition and Results of Operations gives effect to these corrections.
16
Critical Accounting Policies
The preparation of Fred's financial statements requires management to make
estimates and judgments in the reporting of assets, liabilities, revenues,
expenses and related disclosures of contingent assets and liabilities. Our
estimates are based on historical experience and on other assumptions that we
believe are applicable under the circumstances, the results of which form the
basis for making judgments about the values of assets and liabilities that are
not readily apparent from other sources. While we believe that the historical
experience and other factors considered provide a meaningful basis for the
accounting policies applied in the consolidated financial statements, the
Company cannot guarantee that the estimates and assumptions will be accurate
under different conditions and/or assumptions. A summary of our critical
accounting policies and related estimates and judgments, can be found in Note 1
to the consolidated financial statements and the most critical accounting
policies are as follows:
Inventories. Warehouse inventories are stated at the lower of cost or market
using the FIFO (first-in, first-out) method. Retail inventories are stated at
the lower of cost or market as determined by the retail inventory method
("RIM"). Under RIM, the valuation of inventories at cost and the resulting gross
margin are calculated by applying a calculated cost-to-retail ratio to the
retail value of inventories. RIM is an averaging method that has been widely
used in the retail industry due to its practicality. Also, it is recognized that
the use of the RIM will result in valuing inventories at lower of cost or market
if markdowns are currently taken as a reduction of the retail value of
inventories. Inherent in the RIM calculation are certain significant management
judgments and estimates including, among others, initial markups, markdowns, and
shrinkage, which significantly impact the ending inventory valuation at cost as
well as resulting gross margin. These significant estimates, coupled with the
fact that the RIM is an averaging process, can, under certain circumstances,
produce distorted or inaccurate cost figures. Based upon our historical
information we have not experienced any significant change in our cost valuation
for the years 2004 and 2003. Management believes that the Company's RIM provides
an inventory valuation which reasonably approximates cost and results in
carrying inventory at the lower of cost or market. For pharmacy inventories,
which are $35,105,000 and $33,129,000 at January 29, 2005 and January 31, 2004,
respectively, cost was determined using the retail LIFO (last-in, first-out)
method in which inventory cost are maintained using the RIM method, then
adjusted by application of the Producer Price Index published by the U.S.
Department of Labor for the cumulative annual periods. The current cost of
inventories exceeded the LIFO cost by $9,720,000 at January 29, 2005 and
$7,778,000 at January 31, 2004. The LIFO reserve increased by $1,942,000,
$1,640,000, and $1,535,000, during 2004, 2003, and 2002, respectively.
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, whichever is lesser. Gains or losses on the
sale of assets are recorded at disposal as a component of operating income. The
following average estimated useful lives are generally applied:
Estimated Useful Lives
----------------------
Building and building improvements 8 - 30 years
Furniture, fixtures and equipment 3 - 10 years
Leasehold improvements 3 - 10 years or term of lease, if shorter
Automobiles and vehicles 3 - 5 years
Airplane 9 years
17
Assets under capital leases 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.
In the fourth quarter of 2004, the Company changed the estimated lives of
certain store fixtures from five to ten years. Based on the Company's historical
experience, ten years is a closer approximation of the actual lives of these
assets. The change in estimate is applied prospectively. Expenses for the fourth
quarter of 2004 were favorably impacted by approximately $1.3 million [$.02 per
diluted share] as a result of this change. The Company expects this change in
estimate to have a positive effect on earnings across all four quarters of 2005.
Vendor rebates. The Company receives vendor rebates for achieving certain
purchase or sales volume and receives vendor allowances to fund certain
expenses. The Emerging Issues Task Force ("EITF") Issue No. 02-16, "Accounting
by a Customer (including a Reseller) for Certain Consideration Received from a
Vendor" ("EITF 02-16") is effective for arrangements with vendors initiated on
or after January 1, 2003. EITF 02-16 addresses the accounting and income
statement classification for consideration given by a vendor to a retailer in
connection with the sale of the vendor's products or for the promotion of sales
of the vendor's products. The EITF concluded that such consideration received
from vendors should be reflected as a decrease in prices paid for inventory and
recognized in cost of sales as the related inventory is sold, unless specific
criteria are met qualifying the consideration for treatment as reimbursement of
specific, identifiable incremental costs. The provisions of this consensus have
been applied prospectively. The adoption of EITF 02-16 did not have a material
impact on the Company's financial statements as a whole.
For vendor funding arrangements that were entered into prior to December 31,
2002 and have not been modified subsequently, the Company recognizes a reduction
to selling, general and administrative expenses or cost of goods sold when
earned. If these arrangements are modified in the future, the provisions of EITF
02-16 will apply and the effect may be material to the financial statements as a
whole. One such arrangement is the Company's contract with our primary
pharmaceutical wholesaler AmerisourceBergen Corporation ("Bergen"), which
presently expires in 2006. Should the Company elect to renew the contract with
Bergen prior to its expiration date, there could be a material impact on the
Company's 2005 financial statements as a whole, because rebates subsequent to
the renewal would initially reduce inventory-carrying values.
Insurance reserves. The Company is largely self-insured for workers
compensation, general liability and medical insurance. The Company's liability
for self-insurance is determined based on known claims and estimates for future
claims cost and incurred but not reported claims. Estimates for future claims
costs would include costs and other factors such as the type of injury or claim,
required services by providers, healing time, age of claimant, case management
costs, location of the claim, and governmental regulations. If future claim
trends deviate from recent historical patterns, the Company may be required to
record additional expense or expense reductions which could be material to the
Company's results of operations. Additional insurance coverage exists for
excessive or catastrophic claims.
Stock-based compensation. The Company grants stock options having a fixed number
of shares and an exercise price equal to the fair value of the stock on the date
of grant to certain executive officers, directors and key employees. The Company
18
accounts for stock option grants in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and
related interpretations because the Company believes the alternative fair value
accounting provided for under SFAS No. 123, "Accounting for Stock-Based
Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," requires the use of option valuation
models that were not developed for use in valuing employee stock options. Under
APB No. 25, compensation expense is generally not recognized for plans in which
the exercise price of the stock options equals the market price of the
underlying stock on the date of grant and the number of shares subject to
exercise is fixed. Had compensation cost for the Company's stock-based
compensation plans been determined based on the fair value at the grant date for
awards under these plans consistent with the methodology prescribed under SFAS
No. 123, net income and earnings per share would have been reduced to the pro
forma amounts indicated in the following table: (in thousands, except per share
amounts)
2004 2003 (1) 2002 (1)
-------------- ------------------- ----------------------
Net income
As reported $27,952 $ 32,795 $ 27,491
Less pro forma effect of stock option grants 838 900 330
Pro forma $27,114 $ 31,895 $ 27,161
Basic earnings per share
As reported $0.71 $ 0.85 $ 0.72
Pro forma 0.69 0.82 0.71
Diluted earnings per share
As reported 0.71 0.83 0.70
Pro forma 0.69 0.80 0.69
(1) (as restated, see Note 2 to the Consolidated Financial Statements)
In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004),
"Share-Based Payment." SFAS No. 123R establishes standards that require
companies to record the cost resulting from all share-based payment transactions
using the fair value method. Transition under SFAS No. 123R requires using a
modified version of prospective application under which compensation costs are
recorded for all unvested share-based payments outstanding or a modified
retrospective method under which all prior periods impacted by SFAS No. 123 are
restated. In April 2005, the Securities and Exchange Commission ("SEC")
announced the adoption of a new rule that delays the compliance date for the
adoption of SFAS No. 123R. The SEC's new rule will allow implementation at the
beginning of the next fiscal year that begins after June 15, 2005, with early
adoption permitted. The Company intends to adopt SFAS No. 123R in 2006.
The Company also periodically awards restricted stock having a fixed number of
shares at a purchase price that is set by the Compensation Committee of the
Company's Board of Directors, which purchase price may be set at zero, to
certain executive officers, directors and key employees. The Company also
accounts for restricted stock grants in accordance with APB No. 25 and related
interpretations. Under APB No. 25, the Company calculates compensation expense
as the difference between the market price of the underlying stock on the date
of grant and the purchase price, if any, and recognizes such amount on a
19
straight-line basis over the period in which the restricted stock award is
earned by the recipient. The Company recognized compensation expense relating to
its restricted stock awards of approximately $110,000, $28,000, and $54,000 in
2004, 2003, and 2002, respectively. (See Note 8 to the Consolidated Financial
Statements for further disclosure relating to stock incentive plans).
Results of Operations
The following table provides a comparison of Fred's financial results for the
past three years. In this table, categories of income and expense are expressed
as a percentage of sales.
2004 2003 2002
- -------------------------------------------------------------------------------------------------------
Net sales 100.0% 100.0% 100.0%
Cost of goods sold (1) 71.9 71.8 72.4
--------------------------------------
Gross profit 28.1 28.2 27.6
Selling, general and administrative expenses (2) 25.4 24.5 23.8
--------------------------------------
Operating income 2.7 3.7 3.8
Interest expense, net 0.1 0.0 0.0
--------------------------------------
Income before taxes 2.6 3.7 3.8
Income taxes .7 1.2 1.3
--------------------------------------
Net income 1.9% 2.5% 2.5%
--------------------------------------
(1) Cost of goods sold includes various types of transportation and delivery
costs incurred in connection with inventory purchases and distribution. These
costs are included as a component of the overall cost of inventories and
recognized as a cost of merchandise sold as inventory is sold.
(2) Costs incurred at the Company's distribution centers for receiving,
warehousing and preparing product for delivery are expensed as incurred. These
costs are included in selling, general and administrative expense.
Fiscal 2004 Compared to Fiscal 2003
Sales
Net sales increased 10.7% ($139.1 million) in 2004. Approximately $111.6 million
of the increase was attributable to a net addition of 81 new stores, and a net
addition of 17 pharmacies during 2004, together with the sales of 74 store
locations and 25 pharmacies that were opened or upgraded during 2003 and
contributed a full year of sales in 2004. During 2004, the Company closed 6
stores and 2 pharmacy locations. Comparable store sales, consisting of sales
from stores that have been open for more than one year, increased 2.2% in 2004
which accounted for $ 27.5 million in sales.
The Company's front store (non-pharmacy) sales increased approximately 10.9%
over 2003 front store sales. Front store sales growth benefited from the above
mentioned store additions and improvements, and sales increases in certain
apparel categories such as ladies, girls, and infants & toddler apparel, food,
beverages, tobacco, greeting cards, prepaid products, pets, lawn & garden,
electronics, automotive, hardware and small appliances.
Fred's pharmacy sales were 32.6% of total sales in 2004 from 32.4% of total
sales in 2003 and continues to rank as the largest sales category within the
20
Company. The total sales in this department, including the Company's mail order
operation, increased 11.6% over 2003, with third party prescription sales
representing approximately 89% of total pharmacy sales, an increase from the 86%
as the prior year. The Company's pharmacy sales growth continued to benefit from
an ongoing program of purchasing prescription files from independent pharmacies
and the addition of pharmacy departments in existing store locations.
Sales to Fred's 25 franchised locations decreased approximately $1.5 million in
2004 and represented 2.3% of the Company's total sales, as compared to 2.7% in
2003. The decrease in sales to franchised locations results primarily from the
closing of one franchise store. It is anticipated that this category of business
will continue to decline as a percentage of total Company sales since the
Company has not added and does not intend to add any additional franchisees.
Gross Margin
Gross margin as a percentage of sales decreased to 28.1% in 2004 compared to
28.2% in 2003. The decrease in gross margin results primarily from a product mix
shift during the third and fourth quarters of the year towards more basic and
consumable product categories which typically have lower gross margins than
other more discretionary categories such as apparel and home products. We
believe a primary reason for this product mix shift was the impact of rising
fuel prices on our low-to-middle income shopper. The impact of this product mix
shift on the initial margin was approximately .3% for the year. This reduction
was offset by the positive impact of better store shrinkage control.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were 25.4% of net sales in 2004
compared with 24.5% of net sales in 2003. The increase for the year results from
labor expenses and occupancy costs in the stores, higher corporate professional
fees associated with our Sarbanes-Oxley 404 internal control compliance work,
insurance costs, and fuel price increases affecting distribution costs. During
the fourth quarter the Company changed the estimated lives of certain store
fixtures from five to ten years. This change resulted in the favorable impact on
expenses by approximately $1.3 million.
Operating Income
Operating income decreased approximately $9.7 million or 19% to $39.4 million in
2004 from $49.1 million in 2003. Operating income as a percentage of sales was
2.7% in 2004 from 3.7% in 2003, due primarily to the above-mentioned increases
in selling, general and administrative expenses.
Interest Expense, Net
Interest expense for 2004 totaled $.8 million or .1% of sales) compared to
expense of $.4 million (less than .1% of sales) in 2003. The increase in
interest expense were attributed to higher inventory levels throughout the year
and to a lesser extent increases in the bank prime rate.
Income Taxes
The effective income tax rate decreased to 27.6% in 2004 from 32.7% in 2003. The
lower tax rate for 2004 resulted primarily from realization of income tax
credits that originated in 2003 and 2004 related to the Company's distribution
center in Dublin, Georgia. These credits recognized in 2004 amounted to $1.7
million. These tax credits will continue to benefit the Company in future years.
21
State net operating loss carry-forwards are available to reduce state income
taxes in future years. These carry-forwards total approximately $94.5 million
for state income tax purposes and expire at various times during the period 2005
through 2024. If certain substantial changes in the Company's ownership should
occur, there would be an annual limitation on the amount of carry-forwards that
can be utilized.
The Company's estimates of income taxes and the significant items resulting in
the recognition of deferred tax assets and liabilities are described in Note 5
to the Consolidated Financial Statements and reflect the Company's assessment of
future tax consequences of transactions that have been reflected in the
Company's financial statements or tax returns for each taxing authority in which
it operates. Actual income taxes to be paid could vary from these estimates due
to future changes in income tax law or the outcome of audits completed by
federal and state taxing authorities. We maintain income tax contingency
reserves for potential assessments from the federal or other taxing authority.
The reserves are determined based upon the Company's judgment of the probable
outcome of the tax contingencies and are adjusted, from time to time, based upon
changing facts and circumstances. Changes to the tax contingency reserve could
materially affect the Company's future consolidated operating results in the
period of change.
Net Income
Net income for 2004 was $28.0 million (or $.71 per diluted share) or
approximately 15% lower than the $32.8 million (or $.83 per diluted share)
reported in 2003.
Fiscal 2003 Compared to Fiscal 2002
Sales
Net sales increased 18.1% ($199.2 million) in 2003. Approximately $138.6 million
of the increase was attributable to a net addition of 74 new stores, upgraded
stores, and a net addition of 25 pharmacies during 2003, together with the sales
of 62 store locations and 14 pharmacies that were opened or upgraded during 2002
and contributed a full year of sales in 2003. During 2003, the Company closed
two pharmacy locations. Comparable store sales, consisting of sales from stores
that have been open for more than one year, increased 5.7% in 2003.
The Company's front store (non-pharmacy) sales increased approximately 20.5%
over 2002 front store sales. Front store sales growth benefited from the above
mentioned store additions and improvements, and solid sales increases in
categories such as ladies, ladies accessories, missy, footwear, home
furnishings, small appliances, photo supplies, prepaid products, stationery,
electronics, and tobacco.
Fred's pharmacy sales were 32.4% of total sales in 2003 from 33.2% of total
sales in 2002 and continues to rank as the largest sales category within the
Company. The total sales in this department, including the Company's mail order
operation, increased 15.0% over 2002, with third party prescription sales
representing approximately 85% of total pharmacy sales, the same percentage as
the prior year. The Company's pharmacy sales growth continued to benefit from an
ongoing program of purchasing prescription files from independent pharmacies and
the addition of pharmacy departments in existing store locations.
Sales to Fred's 26 franchised locations decreased approximately $.5 million in
2003 and represented 2.7% of the Company's total sales, as compared to 3.2% in
2002. It is anticipated that this category of business will continue to decline
as a percentage of total Company sales since the Company has not added and does
not intend to add any additional franchisees.
22
Gross Margin
Gross margin as a percentage of sales increased to 28.2% in 2003 compared to
27.6% in 2002. The increase in gross margin is a result of higher initial
markup, vendor slotting allowances, other vendor allowances and better control
of shrinkage.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were 24.5% of net sales in 2003
compared with 23.8% of net sales in 2002. The increase for the year was
attributed to costs associated with the Company's expansion of store and
distribution facilities.
Operating Income
Operating income increased approximately $7.6 million or 19% to $49.1 million in
2003 from $41.5 million in 2002. Operating income as a percentage of sales was
3.7% in 2003 from 3.8% in 2002.
Interest Expense, Net
Interest expense for 2003 totaled $.4 million (less than .1% of sales) compared
to net interest expense of $.2 million (less than .1% of sales) in 2002. The
increase in interest expense was attributed to the Company's expansion program.
Income Taxes
The effective income tax rate decreased to 32.7% in 2003 from 33.4% in 2002,
primarily due to realization of income tax credits in the amount of $.8 million
related to empowerment zone and renewal communities, vesting of restricted stock
previously granted to employees and state income tax planning that allowed
utilization of $7.2 million of state operating losses that were previously
reserved.
State net operating loss carry-forwards are available to reduce state income
taxes in future years. These carry-forwards total approximately $57.5 million
for state income tax purposes and expire at various times during the period 2004
through 2023. If certain substantial changes in the Company's ownership should
occur, there would be an annual limitation on the amount of carry-forwards that
can be utilized.
Net Income
Net income for 2003 was $32.8 million (or $.83 per diluted share) or
approximately 19% higher than the $27.5 million (or $.70 per diluted share)
reported in 2002.
Liquidity and Capital Resources
The Company's principal capital requirements include funding new stores and
pharmacies, remodeling existing stores and pharmacies, maintenance of stores and
distribution centers, and the ongoing investment in corporate information
technology. Fred's primary sources of working capital have traditionally been
cash flow from operations and borrowings under its credit facility. In June 2003
the Company raised proceeds of $5.5 million from the offering of 150,000 Company
shares. In March 2002 the Company raised proceeds of $3.5 million from the
offering of 98,756 Company shares. The Company had working capital of $203.6
million, $164.9 million, and $137.9 million at year-end 2004, 2003 and 2002,
respectively. Working capital fluctuates in relation to profitability, seasonal
inventory levels, net of trade accounts payable, and the level of store openings
and closings. Working capital at year-end 2004 increased by approximately $38.7
million from 2003. The increase was primarily attributed to inventory purchased
for new store openings scheduled for the first quarter of 2005. The Company
plans to open 17 new stores and 6 new pharmacies during the first quarter of
2005.
23
Net cash flow provided by operating activities totaled $21.2 million in 2004,
$36.2 million in 2003, and $43.7 million in 2002.
In fiscal 2004, cash was primarily used to increase inventories by approximately
$37.6 million, or 15%, during the fiscal year. This increase is primarily
attributable to our adding a net of 75 new stores, upgrading 30 stores and
adding a net of 17 new pharmacies, as well as supporting the increase in
comparable store sales. Accounts payable and accrued liabilities increased by
$2.3 million due primarily to higher accrued expenses. Income taxes payable
decreased by approximately $.9 million.
In fiscal 2003, cash was primarily used to increase inventories by approximately
$47.9 million during the fiscal year. This increase is primarily attributable to
our adding a net of 74 new stores, upgrading 26 stores and adding a net of 25
new pharmacies, as well as supporting the improved comparable store sales.
Accounts payable and accrued liabilities increased by $16.4 million due
primarily to higher inventory purchases. Income taxes payable increased by
approximately $.9 million and the net deferred income tax liability increased by
approximately $6.0 million primarily as a result of first-year depreciation
allowance for income tax purposes.
Capital expenditures in 2004 totaled $34.6 million compared with $48.0 million
in 2003 and $50.8 million in 2002. The 2004 capital expenditures included
approximately $25.3 million for new stores and pharmacies, $1.8 million for
upgrading existing stores, $5.0 million for the Memphis and Dublin distribution
center and $2.5 million for technology, corporate and other capital
expenditures. The 2003 capital expenditures included approximately $23.2 million
for new stores and pharmacies, $3.4 million for existing stores, $9.0 million
related to the completion of the new Georgia distribution center that was
completed in April 2004, $2.2 million for the Memphis distribution center and
$10.2 million for technology, corporate and other capital expenditures. The 2002
capital expenditures included approximately $23.9 million for the new
distribution center constructed in Dublin, Georgia. Expenditures totaling
approximately $24.2 million were associated with upgraded, remodeled, or new
stores and pharmacies. Approximately $2.7 million in expenditures related to
technology upgrades, distribution center equipment, freight equipment, and
capital maintenance. Cash used for investing activities also includes $2 million
in 2004, $.9 million in 2003, and $1.8 million in 2002 for the acquisition of
customer lists and other pharmacy related items.
In 2005, the Company is planning capital expenditures totaling approximately
$35.7 million. Expenditures are planned totaling $27.5 million for the upgrades,
remodels, expansion of our refrigerated foods program, and new stores and
pharmacies. Planned expenditures also include approximately $5.1 million for
technology upgrades, approximately $3.1 million for distribution center
equipment and capital maintenance. Technology upgrades in 2005 will be made in
the areas of financial reporting software, stores POS systems, and pharmacy. In
addition the Company also plans expenditures of $2.6 million in 2005 for the
acquisition of customer lists and other pharmacy related items.
Cash and cash equivalents were $5.4 million at the end of 2004 compared to $4.7
million at year-end 2003. Short-term investment objectives are to maximize
yields while minimizing company risk and maintaining liquidity. Accordingly,
limitations are placed on the amounts and types of investments the Company can
select.
On July 31, 2004, the Company and Union Planters Bank, N.A. ("Union Planters")
entered into a new Revolving Loan and Credit Agreement (the "Agreement") to
replace the April 3, 2000 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 1.5% below the prime rate
or a LIBOR-based rate. Under the most restrictive covenants of the Agreement,
24
the Company is required to maintain specified shareholders' equity (which was
$260,338,000 at January 29, 2005) and net income levels. The Company is required
to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the
unutilized portion of the revolving line commitment over the term of the
Agreement. The term of the Agreement extends to July 31, 2006. There were $23.1
million and $5.5 million of borrowings outstanding under the Agreement at
January 29, 2005 and January 31, 2004, respectively.
On June 28, 2004 the Company and Union Planters providing the credit facility
entered into a Fourth Modification Agreement of the Revolving Loan and Credit
Agreement to provide a temporary increase in commitment of $10 million and
increasing the available credit line to $50 million. The term of the agreement
was from June 28, 2004 until December 28, 2004. All terms, conditions and
covenants remained in place for the Note and credit facility
On October 19, 2004 the Company and Union Planters providing the credit facility
entered into a Fifth Modification Agreement of the Revolving Loan and Credit
Agreement to provide a temporary increase of commitment of $10 million and
increasing the available credit line to $60 million. The term of the agreement
was from October 20, 2004 until December 15, 2004, superseding the expiration of
the Fourth Modification. On December 15, 2004, the available credit line
reverted to $40 million. All terms, conditions and covenants remained in place
for the Note and credit facility
On March 6, 2002, the Company filed a Registration Statement on Form S-3
registering 750,000 shares of Class A common stock. The common stock may be used
from time to time as consideration in the acquisition of assets, goods, or
services for use or sale in the conduct of our business. On March 22, 2002, the
Company raised proceeds of $3.5 million from the offering of 148,134 shares. On
June 6, 2003, the Company raised proceeds of $5.5 million from the offering of
225,000 shares. On September 3, 2003, the Company sold 75,000 shares in common
stock for $2.6 million with the intention of purchasing an airplane. Later, the
Company decided not to purchase the airplane, whereupon the Company purchased
and retired $2.6 million of common stock from the CEO. A Limited Liability
Company (LLC) of which the CEO is the sole member purchased the airplane for
$4.7 million. The Company entered into a dry lease agreement with the LLC for
its usage at the annualized rate of 2.5%. On December 30, 2003, the Company
purchased the LLC for $4.7 million. As of January 29, 2005, the Company has
301,866 shares of Class A common stock available to be issued from the March 6,
2002 Registration Statement.
The Company believes that sufficient capital resources are available in both the
short-term and long-term through currently available cash, cash generated from
future operations and, if necessary, the ability to obtain additional financing.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet financing arrangements.
Effects of Inflation and Changing Prices. The Company believes that inflation
and/or deflation had a minimal impact on its overall operations during fiscal
years 2004, 2003 and 2002.
Contractual Obligations and Commercial Commitments
As discussed in Note 6 to the consolidated financial statements, the Company
leases certain of its store locations under noncancelable operating leases
expiring at various dates through 2029. Many of these leases contain renewal
options and require the Company to pay taxes, maintenance, insurance and certain
other operating expenses applicable to the leased properties. In addition, the
25
Company leases various equipment under noncancelable operating leases and
certain transportation equipment under capital leases.
The following table summarizes the Company's significant contractual obligations
as of January 29, 2005, which excludes the effect of imputed interest:
(Dollars in thousands) Payments due by period
Contractual Obligations Total < 1 yr 1-3 yrs 3-5 yrs >5 yrs
Capital Lease obligations (1) $1,957 $814 $1,014 $129 $0
Revolving loan (2) 23,098 - 23,098 - -
Operating leases (3) 165,678 37,514 62,537 34,591 31,036
Inventory purchase obligations (4) 136,513 131,565 4,948 0
Industrial revenue bonds (5) 34,587 - - - 34,587
Miscellaneous financing 101 18 44 39 0
--------------------------------------------------------------------------------
Total Contractual Obligations $361,934 $169,911 $91,641 $34,759 $65,623
--------------------------------------------------------------------------------
(1) Capital lease obligations include related interest.
(2) Revolving loan represents principle maturity for the Company's revolving
credit agreement and does not include interest.
(3) Operating leases are described in Note 6 to the Consolidated Financial
Statements.
(4) Inventory purchase obligations represent open purchase orders and any
outstanding purchase commitments as of January 29, 2005.
(5) Industrial revenue bonds are described in Note 4 to the Consolidated
Financial Statements.
As discussed in Note 10 to the consolidated financial statements, the Company
had commitments approximating $12.6 million at January 29, 2005 on issued
letters of credit, which support purchase orders for merchandise. Additionally,
the Company had outstanding letters of credit aggregating $9.1 million at
January 29, 2005 utilized as collateral for their risk management programs.
The Company financed the construction of its Dublin, Georgia distribution center
with taxable industrial development revenue bonds issued by the City of Dublin
and County of Laurens development authority. The Company purchased 100% of the
bonds and intends to hold them to maturity, effectively financing the
construction with internal cash flow. The Company has offset the investment in
the bonds ($34,587) against the related liability and neither is reflected in
the consolidated balance sheet.
Recent Accounting Pronouncements
In December 2004, the FASB published FASB Statement No. 123 (revised 2004),
"Share-Based Payment" ("SFAS 123(R)" or the "Statement"). SFAS 123(R) requires
that the compensation cost relating to share-based payment transactions,
including grants of employee stock options, be recognized in financial
statements. That cost will be measured based on the fair value of the equity or
liability instruments issued. SFAS 123(R) covers a wide range of share-based
compensation arrangements including stock options, restricted share plans,
performance-based awards, share appreciation rights, and employee share purchase
plans.
SFAS 123(R) specifies that the fair value of an employee stock option must be
based on an observable market price or, if an observable market price is not
26
available, the fair value must be estimated using a valuation technique meeting
specific criteria established in the statement.
In accordance with recent SEC rules, the statement is effective for public
companies at the beginning of the first annual period beginning after June 15,
2005 (the first quarter of fiscal 2006 for the Company), with early adoption
permitted. The Statement will have no impact on the Company's overall financial
position. The impact of this Statement on the Company's results of operations in
fiscal 2006 and beyond could be significant and will depend upon various
factors, among them being future compensation strategies. The impact of adoption
of this Statement cannot be predicted at this time because it will depend on
levels of share based payments granted in the future. The pro-forma compensation
costs presented in Note 1 to the Consolidated Financial Statements and in prior
filings for the Company have been calculated using a Black-Scholes option
pricing model and may not be indicative of amounts which should be expected in
future years. As of the date of this filing, the Company has not determined
which option-pricing model is most appropriate for future option grants or which
method of adoption the Company will apply.
In November 2004, the FASB issued Statement of Financial Accounting Standards
No. 151, "Inventory Costs, an Amendment of ARB No. 43, Chapter 4" ("SFAS 151").
The purpose of this statement is to clarify the accounting of abnormal amounts
of idle facility expense, freight, handling costs and waste material. ARB No. 43
stated that under some circumstances these costs may be so abnormal that they
are required to be treated as current period costs. SFAS 151 requires that these
costs be treated as current period costs regardless if they meet the criteria of
"so abnormal." The provisions of SFAS 151 shall be effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. Although the Company
will continue to evaluate the application of SFAS 151, management does not
believe adoption will have a material impact on its results of operations or
financial position.
In December 2004, the FASB issued Statement of Financial Accounting Standards
No. 153, "Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29"
("SFAS 153"). SFAS 153 is based on the principle that exchanges of nonmonetary
assets should be measured based on the fair value of the assets exchanged. SFAS
153 is effective for nonmonetary asset exchanges occurring in fiscal periods
beginning after June 15, 2005, with earlier application permitted. Although the
Company will continue to evaluate the application of SFAS 153, management does
not believe adoption will have a material impact on its results of operations or
financial position.
Item 7a: Quantitative and Qualitative Disclosure about Market Risk
The Company has no holdings of derivative financial or commodity instruments as
of January 29, 2005. 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 never had a
significant impact on the Company, and they are not expected to in the
foreseeable future.
Item 8: Financial Statements and Supplementary Data Reports of Independent
Registered Public Accounting Firms
Board of Directors and Stockholders
Fred's, Inc.
Memphis, Tennessee
27
We have audited the accompanying consolidated balance sheet of Fred's, Inc. as
of January 29, 2005 and the related consolidated statements of income,
stockholders' equity, and cash flows for the year then ended. We have also
audited the 2005 schedules listed in the accompanying index. These financial
statements and schedules are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedules based on our audits.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements and schedule are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements and schedules, assessing the accounting principles used
and significant estimates made by management, as well as evaluating the overall
presentation of the financial statements and schedules. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Fred's, Inc. at
January 29, 2005, and the results of its operations and its cash flows for the
year then ended, in conformity with accounting principles generally accepted in
the United States of America.
Also, in our opinion, the 2005 schedules present fairly, in all material
respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Fred's, Inc.'s
internal control over financial reporting as of January 29, 2005, based on
criteria established in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our
report dated April 15, 2005 expressed an adverse opinion thereon.
/s/
BDO Seidman, LLP
Memphis, Tennessee
April 15, 2005
28
To the Board of Directors and Shareholders
of Fred's, Inc.
We have audited the accompanying consolidated balance sheet of Fred's, Inc. and
subsidiaries as of January 31, 2004 and the related consolidated statements of
income, shareholders' equity, and cash flows for the years ended January 31,
2004 and February 1, 2003. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. We were not engaged to perform an
audit of the Company's internal control over financial reporting. Our audit
included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the
Company's internal control over financial reporting. Accordingly we express no
such opinion. An audit also includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Fred's, Inc. and
subsidiaries at January 31, 2004 and the consolidated results of their
operations and their cash flows for the years ended January 31, 2004 and
February 1, 2003 in conformity with U.S. generally accepted accounting
principles.
As discussed in Note 2 to the accompanying consolidated financial statements,
the Company has restated its 2002 and 2003 financial statements.
/s/Ernst & Young LLP
Memphis, Tennessee
April 5, 2004,
except for Note 2 as to which the date is April 29, 2005
29
Fred's, Inc.
Consolidated Balance Sheets
(in thousands, except for number of shares)
- --------------------------------------------------------------------------------
January 29, January 31,
2005 2004
--------------------- ---------------------
ASSETS (as restated,
- ------ see Note 2)
Current assets:
Cash and cash equivalents $ 5,365 $ 4,741
Inventories 275,365 239,748
Receivables, less allowance for doubtful accounts of $629 and
$1,437, respectively 19,449 20,070
Other non trade receivables 11,821 3,861
Prepaid expenses and other current assets 6,967 4,094
--------------------- ---------------------
Total current assets 318,967 272,514
Property and equipment, at depreciated cost 139,302 130,476
Equipment under capital leases, less accumulated amortization of
$3,722, and $3,169, respectively 1,245 1,798
Other noncurrent assets, net 5,710 4,005
--------------------- ---------------------
Total assets $ 465,224 $ 408,793
--------------------- ---------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 70,503 $ 74,799
Current portion of indebtedness 18 18
Current portion of capital lease obligations 666 725
Accrued expenses and other 26,708 20,422
Deferred income taxes 17,490 10,688
Income taxes payable - 930
--------------------- ---------------------
Total current liabilities 115,385 107,582
Long-term portion of indebtedness 23,181 5,603
Deferred income taxes 7,701 4,397
Long-term portion of capital lease obligations 1,031 1,686
Other noncurrent liabilities 3,380 3,175
--------------------- ---------------------
Total liabilities 150,678 122,443
--------------------- ---------------------
Commitments and contingencies (Notes 6 and 10)
Shareholders' equity:
Preferred stock, nonvoting, no par value, 10,000,000 shares
authorized, none outstanding - -
Preferred stock, Series A junior participating nonvoting,
no par value, 224,594 shares authorized, none outstanding - -
Common stock, Class A voting, no par value, 60,000,000 shares
authorized, 39,692,091 shares and 39,105,639 shares
respectively 132,511 126,430
Common stock, Class B nonvoting, no par value, 11,500,000
shares authorized, none outstanding - -
Retained earnings 184,732 159,920
Unearned compensation (2,697) -
--------------------- ---------------------
Total shareholders' equity 314,546 286,350
--------------------- ---------------------
Total liabilities and shareholders' equity $ 465,224 $ 408,793
===================== =====================
See accompanying notes to consolidated financial statements.
30
Fred's, Inc.
Consolidated Statements of Income
(in thousands, except per share amounts)
- --------------------------------------------------------------------------------
For the Years Ended
--------------------------------------------------------------------
January 29, January 31, February 1,
2005 2004 2003
------------------ -------------------- -----------------------
(as restated, (as restated,
see Note 2) see Note 2)
Net sales $ 1,441,781 $ 1,302,650 $ 1,103,418
Cost of goods sold 1,036,474 934,665 798,441
------------------ -------------------- -----------------------
Gross profit 405,307 367,985 304,977
Depreciation and amortization 28,148 26,709 21,897
Selling, general and administrative expenses 337,733 292,176 241,593
------------------ -------------------- -----------------------
Operating income 39,426 49,100 41,487
Interest income (10) (45) (264)
Interest expense 803 443 467
------------------ -------------------- -----------------------
Income before income taxes 38,633 48,702 41,284
Income taxes 10,681 15,907 13,793
------------------ -------------------- -----------------------
Net income $ 27,952 $ 32,795 $ 27,491
================== ==================== =======================
Net income per share
Basic $ .71 $ .85 $ .72
================== ==================== =======================
Diluted $ .71 $ .83 $ .70
================== ==================== =======================
Weighted average shares outstanding
Basic 39,252 38,754 38,255
================== ==================== =======================
Diluted 39,532 39,652 39,251
================== ==================== =======================
See accompanying notes to consolidated financial statements.
31
Fred's, Inc.
Consolidated Statements of Changes in Shareholders' Equity
(in thousands, except share data)
- --------------------------------------------------------------------------------
Common Stock Retained Deferred
-----------------------------------
Shares Amount Earnings Compensation Total
------------------- --------------- ---------------- --------------------- ------------
Balance, February 2, 2002 38,041,668 $110,508 $108,462 $ (63) $218,907
(as previously reported)
Cumulative effect of restatement on
prior years (see note 2) - - (2,612) - (2,612)
------------------- --------------- ---------------- --------------------- ------------
Balance, February 2, 2002
(as restated, see note 2) 38,041,668 $110,508 $105,850 $ (63) $216,295
Cash dividends paid ($.08 per share) - - (3,089) - (3,089)
Issuance of restricted stock 1,125 19 - (19) -
Amortization of unearned compensation - - - 54 54
Other issuances 151,083 3,592 - - 3,592
Exercises of stock options 316,012 1,684 - - 1,684
Income tax benefit on exercise of stock
options - 1,406 - - 1,406
Net income (as restated, see note 2) - - 27,491 - 27,491
------------------- --------------- ---------------- --------------------- ------------
Balance, February 1, 2003 38,509,888 $117,209 $130,252 $ (28) $247,433
Cash dividends paid ($.08 per share) - - (3,127) - (3,127)
Issuance of restricted stock 1,406 7 - - 7
Amortization of unearned compensation - - - 28 28
Other issuances 304,167 8,110 - - 8,110
Other cancellation (75,000) (2,646) - - (2,646)
Exercises of stock options 365,178 2,276 - - 2,276
Income tax benefit on exercise of stock
options - 1,474 - - 1,474
Net income (as restated, see note 2) - - 32,795 - 32,795
---------------------------------------------------------------------------------------
Balance, January 31, 2004 39,105,639 $126,430 $159,920 $ - $286,350
Cash dividends paid ($.08 per share) - - (3,140) - (3,140)
Issuance of restricted stock 175,969 2,807 - (2,807) -
Amortization of unearned compensation - - - 110 110
Other cancellation (12) - - - -
Exercises of stock options 410,495 2,297 - - 2,297
Income tax benefit on exercise of stock
options - 977 - - 977
Net income - - 27,952 - 27,952
------------------- --------------- ---------------- --------------------- ------------
Balance, January 29, 2005 39,692,091 $132,511 $184,732 $ (2,697) $314,546
=================== =============== ================ ===================== ============
See accompanying notes to consolidated financial statements.
32
Fred's, Inc.
Consolidated Statements of Cash Flows
(in thousands)
- --------------------------------------------------------------------------------
For the Years Ended
January 29, January 31, February 1,
2005 2004 2003
--------------- ------------------ --------------------
(as restated, (as restated,
see Note 2) see Note 2)
Cash flows from operating activities:
Net income $ 27,952 $ 32,795 $ 27,491
Adjustments to reconcile net income to net cash flows
from operating activities:
Depreciation and amortization 28,148 26,709 21,897
Provision for uncollectible receivables (808) 462 318
LIFO reserve increase 1,942 1,640 1,535
Deferred income tax expense 10,106 5,992 11,864
Amortization of unearned compensation 110 28 54
Income tax benefit upon exercise of stock options 977 1,474 1,406
(Increase) decrease in operating assets:
Receivables (3,291) (5,992) (3,014)
Inventories (37,559) (47,882) (31,424)
Other assets (7,614) 3,668 (365)
Increase (decrease) in operating liabilities:
Accounts payable and accrued expenses 2,250 16,428 20,323
Income taxes payable (930) 930 (6,778)
Other noncurrent liabilities (55) (14) 400
--------------- ----------------- ------------------
Net cash provided by operating activities 21,228 36,238 43,707
--------------- ----------------- ------------------
Cash flows from investing activities:
Capital expenditures (34,619) (48,020) (50,835)
Asset acquisition(primarily intangibles) (2,006) (916) (1,844)
--------------- ----------------- ------------------
Net cash used in investing activities (36,625) (48,936) (52,679)
--------------- ----------------- ------------------
Cash flows from financing activities:
Payments of indebtedness and capital lease obligations (734) (883) (855)
Proceeds from revolving line of credit, net of payments 17,598 5,500 -
Proceeds from public offering, net of expenses - 8,110 3,535
Repurchase of shares - (2,646) -
Proceeds from exercise of stock options 2,297 2,276 1,684
Dividends (3,140) (3,127) (3,089)
--------------- ----------------- ------------------
Net cash provided by financing activities 16,021 9,230 1,275
--------------- ----------------- ------------------
Increase (decrease) in cash and cash equivalents 624 (3,468) (7,697)
Cash and cash equivalents:
Beginning of year 4,741 8,209 15,906
--------------- ----------------- ------------------
End of year $ 5,365 $ 4,741 $ 8,209
--------------- ----------------- ------------------
Supplemental disclosures of cash flow information:
Interest paid $ 757 $ 417 $ 180
Income taxes paid $ 6,400 $ 7,600 $ 7,300
Non-cash investing and financing activities:
Assets acquired through capital lease obligations $ - $ - $ 1,585
Common stock issued for business acquisition $ - $ - $ 57
See accompanying notes to consolidated financial statements.
33
Notes to Consolidated Financial Statements
(in thousands, except share and per share amounts)
NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business. The primary business of Fred's, Inc. and subsidiaries
(the "Company") is the sale of general merchandise through its retail discount
stores and full service pharmacies. In addition, the Company sells general
merchandise to its 25 franchisees. As of January 29, 2005, the Company had 563
retail stores and 258 pharmacies located in 14 states mainly in the Southeastern
United States.
Consolidated financial statements. The consolidated financial statements include
the accounts of the Company and its subsidiaries. All significant intercompany
accounts and transactions are eliminated.
Fiscal year. The Company utilizes a 52 - 53 week accounting period which ends on
the Saturday closest to January 31. Fiscal years 2004, 2003, and 2002, as used
herein, refer to the years ended January 29, 2005, January 31, 2004, and
February 1, 2003, respectively.
Use of estimates. The preparation of financial statements in accordance with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reported period. Actual results could differ
from those estimates and such differences could be material to the financial
statements.
Cash and cash equivalents. Cash on hand and in banks, together with other highly
liquid investments which are subject to market fluctuations and having original
maturities of three months or less, are classified as cash equivalents. Included
in accounts payable are outstanding checks in excess of funds on deposit, which
totaled $17,851 at January 29, 2005 and $25,111 at January 31, 2004.
Allowance for doubtful accounts. The Company is reimbursed for drugs sold by its
pharmacies by many different payors including insurance companies, Medicare and
various state Medicaid programs. The Company estimates the allowance on a
payor-specific basis, given its interpretation of the contract terms or
applicable regulations. However, the reimbursement rates are often subject to
interpretations that could result in payments that differ from the Company's
estimates. Additionally, updated regulations and contract negotiations occur
frequently, necessitating the Company's continual review and assessment of the
estimation process. Senior management reviews accounts receivable on a quarterly
basis to determine if any receivables are potentially uncollectible. The Company
includes any accounts receivable balances that are determined to be
uncollectible in our overall allowance for doubtful accounts. After all attempts
to collect a receivable have failed, the receivable is written off against the
allowance account.
Inventories. Warehouse inventories are stated at the lower of cost or market
using the FIFO (first-in, first-out) method. Retail inventories are stated at
the lower of cost or market as determined by the retail inventory method
("RIM"). Under RIM, the valuation of inventories at cost and the resulting gross
margin are calculated by applying a calculated cost-to-retail ratio to the
retail value of inventories. RIM is an averaging method that has been widely
used in the retail industry due to its practicality. Also, it is recognized that
the use of the RIM will result in valuing inventories at lower of cost or market
34
if markdowns are currently taken as a reduction of the retail value of
inventories. Inherent in the RIM calculation are certain significant management
judgments and estimates including, among others, initial markups, markdowns, and
shrinkage, which significantly impact the ending inventory valuation at cost as
well as resulting gross margin. These significant estimates, coupled with the
fact that the RIM is an averaging process, can, under certain circumstances,
produce distorted or inaccurate cost figures. Management believes that the
Company's RIM provides an inventory valuation which reasonably approximates cost
and results in carrying inventory at the lower of cost or market.
For pharmacy inventories, which are $35,105 and $33,129 at January 29, 2005 and
January 31, 2004, respectively, cost was determined using the RIM LIFO (last-in,
first-out) method in which inventory costs are maintained using the RIM, 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
pharmacy inventories exceeded the LIFO cost by $9,720 at January 29, 2005 and
$7,778 at January 31, 2004. The LIFO reserve increased by $1,942, $1,640, and
$1,535, during 2004, 2003, and 2002, respectively.
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, whichever is lesser. Gains or losses on the
sale of assets are recorded at disposal. The following average estimated useful
lives are generally applied:
Estimated Useful Lives
----------------------
Building and building improvements 8 - 30 years
Furniture, fixtures and equipment 3 - 10 years
Leasehold improvements 3 - 10 years or term of lease, if shorter
Automobiles and vehicles 3 - 5 years
Airplane 9 years
Assets under capital leases 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.
LEASES. Certain operating leases include rent increases during the initial lease
term. For these leases, the Company recognizes the related rental expense on a
straight-line basis over the term of the lease (which includes the pre-opening
period of construction, renovation, fixturing and merchandise placement) and
records the difference between the amounts charged to operations and amounts
paid as a rent liability. Rent is recognized on a straight-line basis over the
lease term, which includes any rent holiday period. Some of our leases provide
for contingent rent payments. The company accrues for contingent rents in the
period they become probable.
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 of demising walls,
separation of plumbing, utilities, electric 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 (see Note 2).
35
Impairment of Long-lived assets. The Company's policy is to review the carrying
value of all long-lived assets annually and whenever events or changes indicate
that the carrying amount of an asset may not be recoverable. The Company adjusts
the net book value of the underlying assets if the sum of expected future cash
flows is less than the book value. The adjustment is computed as the difference
between estimated fair value and net book value. Assets to be disposed of are
adjusted to the fair value less the cost to sell if less than the book value.
Based upon the Company's review as of January 29, 2005 and January 31, 2004, no
material adjustments to the carrying value of such assets were necessary.
Vendor rebates and allowances. The Company receives vendor rebates for achieving
certain purchase or sales volume and receives vendor allowances to fund certain
expenses. The Emerging Issues Task Force ("EITF") Issue No. 02-16, "Accounting
by a Customer (including a Reseller) for Certain Consideration Received from a
Vendor" ("EITF 02-16") is effective for arrangements with vendors initiated on
or after January 1, 2003. EITF 02-16 addresses the accounting and income
statement classification for consideration given by a vendor to a retailer in
connection with the sale of the vendor's products or for the promotion of sales
of the vendor's products. The EITF concluded that such consideration received
from vendors should be reflected as a decrease in prices paid for inventory and
recognized in cost of sales as the related inventory is sold, unless specific
criteria are met qualifying the consideration for treatment as reimbursement of
specific, identifiable incremental costs. The provisions of this consensus have
been applied prospectively. The adoption of EITF 02-16 did not have a material
impact on the Company's financial statements as a whole.
For vendor funding arrangements that were entered into prior to December 31,
2002 and have not been modified subsequently, the Company recognizes a reduction
to selling, general and administrative expenses or cost of goods sold when
earned. If these arrangements are modified in the future, the provisions of EITF
02-16 will apply and the effect may be material to the financial statements as a
whole.
Selling, general and administrative expenses. The Company includes buying,
warehousing, distribution, depreciation and occupancy costs in selling, general
and administrative expenses.
Advertising. The Company charges advertising, including production costs, to
expense on the first day of the advertising period. Advertising expense for
2004, 2003, and 2002, was $18,084, $16,956, and $14,124, respectively.
Preopening costs. The Company charges to expense the preopening costs of new
stores as incurred. These costs are primarily labor to stock the store,
preopening advertising, store supplies and other expendable items.
Revenue Recognition. The Company markets goods and services through Company
owned stores and 25 franchised stores as of January 29, 2005. Net sales includes
sales of merchandise from Company owned stores, net of returns and exclusive of
sales taxes. Sales to franchised stores are recorded when the merchandise is
shipped from the Company's warehouse. Revenues resulting from layaway sales are
recorded upon delivery of the merchandise to the customer. In addition, the
Company charges the 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 and are therefore netted against selling, general and administrative
expenses. Total franchise income for 2004, 2003, and 2002 was $1,869, $1,964,
and $2,016, respectively.
Other intangible assets. Other identifiable intangible assets, which are
included in other noncurrent assets, primarily represent customer lists
associated with acquired pharmacies and are being amortized on a straight-line
36
basis over five years. During 2002 the Company issued 2,949 shares for pharmacy
acquisitions. Intangibles, net of accumulated amortization, totaled $4,115 at
January 29, 2005,and $3,913 at January 31, 2004. Accumulated amortization at
January 29, 2005 and at January 31, 2004 totaled $10,686 and $8,882,
respectively. Amortization expense for 2004, 2003, and 2002, was $1,804, $1,664,
and $1,945, respectively. Estimated amortization expense for each of the next 5
years is as follows: 2005 - $1,630, 2006 - $1,148, 2007 - $761, 2008- $435, and
2009 - $141.
Financial instruments. At January 29, 2005, 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.
Insurance reserves. The Company is largely self-insured for workers
compensation, general liability and medical insurance. The Company's liability
for self-insurance is determined based on known claims and estimates for future
claims cost and incurred but not reported claims. Estimates for future claims
costs would include costs and other factors such as the type of injury or claim,
required services by providers, healing time, age of claimant, case management
costs, location of the claim, and governmental regulations. If future claim
trends deviate from recent historical patterns, the Company may be required to
record additional expense or expense reductions which could be material to the
Company's results of operations.
Stock-based compensation. The Company grants stock options having a fixed number
of shares and an exercise price equal to the fair value of the stock on the date
of grant to certain executive officers, directors and key employees. The Company
accounts for stock option grants in accordance with Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and
related interpretations. Under APB No. 25, compensation expense is generally not
recognized for plans in which the exercise price of the stock options equals the
market price of the underlying stock on the date of grant and the number of
shares subject to exercise is fixed. Had compensation cost for the Company's
stock-based compensation plans been determined based on the fair value at the
grant date for awards under these plans consistent with the methodology
prescribed under SFAS No. 123 "Accounting for Stock-Based Compensation," as
amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition
and Disclosure," net income and earnings per share would have been reduced to
the pro forma amounts indicated in the following table.
37
2004 2003 (1) 2002 (1)
-------------- ------------------- ---------------------
Net income
As reported $27,952 $ 32,795 $ 27,491
Less pro forma effect of stock option grants 838 900 330
-------------- ------------------- ---------------------
Pro forma $27,114 $ 31,895 $ 27,161
Basic earnings per share
As reported $0.71 $ 0.85 $ 0.72
Pro forma 0.69 0.82 0.71
Diluted earnings per share
As reported 0.71 0.83 0.70
Pro forma 0.69 0.80 0.69
(1) (as restated, see Note 2 to the Consolidated Financial Statements)
In December 2004, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 123 (revised 2004), "Share-Based Payment." SFAS No. 123R establishes
standards that require companies to record the cost resulting from all
share-based payment transactions using the fair value method. Transition under
SFAS No. 123R requires using a modified version of prospective application under
which compensation costs are recorded for all unvested share-based payments
outstanding or a modified retrospective method under which all prior periods
impacted by SFAS No. 123 are restated. SFAS No. 123R is effective for the
Company on January 29, 2006, with early adoption permitted. The Company intends
to adopt SFAS No. 123R in 2006.
The Company also periodically awards restricted stock having a fixed number of
shares at a purchase price that is set by the Compensation Committee of the
Company's Board of Directors, which purchase price may be set at zero, to
certain executive officers, directors and key employees. The Company also
accounts for restricted stock grants in accordance with APB No. 25 and related
interpretations. Under APB No. 25, the Company calculates compensation expense
as the difference between the market price of the underlying stock on the date
of grant and the purchase price, if any, and recognizes such amount on a
straight-line basis over the period in which the restricted stock award is
earned by the recipient. The Company recognized compensation expense relating to
its restricted stock awards of approximately $110, $28, and $54, in 2004, 2003,
and 2002, respectively. (See Note 8 for further disclosure relating to stock
incentive plans).
Income taxes. The Company reports income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Under SFAS No. 109, the asset and liability
method is used for computing future income tax consequences of events, which
have been recognized in the Company's consolidated financial statements or
income tax returns. Deferred income tax expense or benefit is the net change
during the year in the Company's deferred income tax assets and liabilities.
Business segments. The Company's operates in a single reportable operating
segment.
Comprehensive income. Comprehensive income does not differ from the consolidated
net income presented in the consolidated statements of income.
Reclassifications. Certain prior year amounts have been reclassified to conform
to the 2004 presentation.
Recent Accounting Pronouncements. In December 2004, the FASB published FASB
Statement No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123(R)" or the
"Statement"). SFAS 123(R) requires that the compensation cost relating to
38
share-based payment transactions, including grants of employee stock options, be
recognized in financial statements. That cost will be measured based on the fair
value of the equity or liability instruments issued. SFAS 123(R) covers a wide
range of share-based compensation arrangements including stock options,
restricted share plans, performance-based awards, share appreciation rights, and
employee share purchase plans.
SFAS 123(R) specifies that the fair value of an employee stock option must be
based on an observable market price or, if an observable market price is not
available, the fair value must be estimated using a valuation technique meeting
specific criteria established in the statement.
In April 2005, the Securities and Exchange Commission ("SEC") announced the
adoption of a new rule that delays the compliance date for the adoption of SFAS
No. 123R. The SEC's new rule will allow implementation at the beginning of the
next fiscal year that begins after June 15, 2005, with early adoption permitted.
The Company intends to adopt SFAS No. 123R in 2006. The Statement will have no
impact on the Company's overall financial position. The impact of this Statement
on the Company's results of operations in fiscal 2006 and beyond could be
significant and will depend upon various factors, among them being future
compensation strategies. The impact of adoption of this Statement cannot be
predicted at this time because it will depend on levels of share based payments
granted in the future. The pro-forma compensation costs presented in Note 1 to
the Consolidated Financial Statements and in prior filings for the Company have
been calculated using a Black-Scholes option pricing model and may not be
indicative of amounts which should be expected in future years. As of the date
of this filing, the Company has not determined which option-pricing model is
most appropriate for future option grants or which method of adoption the
Company will apply.
In November 2004, the FASB issued Statement of Financial Accounting Standards
No. 151, "Inventory Costs, an Amendment of ARB No. 43, Chapter 4" ("SFAS 151").
The purpose of this statement is to clarify the accounting of abnormal amounts
of idle facility expense, freight, handling costs and waste material. ARB No. 43
stated that under some circumstances these costs may be so abnormal that they
are required to be treated as current period costs. SFAS 151 requires that these
costs be treated as current period costs regardless if they meet the criteria of
"so abnormal." The provisions of SFAS 151 shall be effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. Although the Company
will continue to evaluate the application of SFAS 151, management does not
believe adoption will have a material impact on its results of operations or
financial position.
In December 2004, the FASB issued Statement of Financial Accounting Standards
No. 153, "Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29"
("SFAS 153"). SFAS 153 is based on the principle that exchanges of nonmonetary
assets should be measured based on the fair value of the assets exchanged. SFAS
153 is effective for nonmonetary asset exchanges occurring in fiscal periods
beginning after June 15, 2005, with earlier application permitted. Although the
Company will continue to evaluate the application of SFAS 153, management does
not believe adoption will have a material impact on its results of operations or
financial position.
Note 2 - RESTATEMENT OF FINANCIAL STATEMENTS
On February 7, 2005, the Office of the Chief Accountant of the Securities and
Exchange Commission issued a letter to the American Institute of Certified
Public Accountants expressing its views regarding certain operating lease
accounting issues and their application under generally accepted accounting
principles ("GAAP"). In addition, a number of companies within the retail
industry have announced adjustments to their financial statements related to
lease accounting issues.
After discussions with its Audit Committee and its current and previous
independent registered public accounting firms, the Company has re-evaluated its
lease accounting practices. Like many other retail companies, the Company is
39
correcting the way it accounts for leases, specifically the accounting for the
amortization periods related to leasehold improvements, the accounting for
contingent lease payments, and the straight-line accounting of lease payments.
Previously the Company had amortized its leasehold improvements over the
estimated life of the asset. Management determined that the appropriate
interpretation of the lease term under Statement of Financial Accounting
Standards No. 13, "Accounting for Leases," ("SFAS 13") provides for an
amortization period no longer than the sum of the fixed noncancellable term and
any options where, at the inception of the lease, renewal is reasonably assured.
Management determined that renewal of the majority of lease terms, associated
with leasehold improvements whose useful lives included the option period, were
not reasonably assured under paragraph 5 of SFAS 13. For locations where the
amortization period of leasehold improvements exceeded the corresponding lease
term and any reasonably assured renewal, the Company shortened the amortization
of the leasehold improvements to coincide with the end of the lease term as
defined by SFAS 13. Management determined that renewal was reasonably assured
for lease terms following a current term in which significant leasehold
improvements were made. These significant leasehold improvements were amortized
through the following renewal period but not in excess of 120 months. The
correction required the Company to adjust accumulated amortization of leasehold
improvements and retained earnings in the consolidated balance sheets and to
record additional amortization of leasehold improvement expense in selling,
general and administrative expenses in the consolidated statements of income.
The Company had historically recorded contingent rent in the year in which the
amounts were paid. Management analyzed Financial Accounting Standards, EITF
98-9, "Accounting for Contingent Rent," and determined that the Company should
accrue payments which are probable for future contingent rents in the period
they become probable. The correction required the Company to record additional
deferred rent in current accrued expenses and to adjust retained earnings in the
consolidated balance sheets, as well as restate rent expense in selling, general
and administrative expenses in the consolidated statements of income.
Finally, the Company had historically recognized rent holiday periods on a
straight-line basis over the original lease term commencing on the date of
possession. During the evaluation it was noted, however, that there were
additional leases with rent holidays that had not been accounted for on a
straight-line basis. Leases not accounted for on this basis were corrected to
properly recognize rent holiday periods. Management re-evaluated Financial
Accounting Standards Board Technical Bulletin No. 85-3, "Accounting for
Operating Leases with Scheduled Rent Increases," and determined that, consistent
with the letter issued by the Office of the Chief Accountant, the lease term
should include lease renewal options for which the Company would be penalized
for non-renewal. The Company determined that the term penalty under paragraph
5(f) of SFAS 13 for non-renewal includes factors such as the addition of
significant leasehold improvements which would be forfeited if a lease term were
not renewed. The majority of the leases entered into by the Company do not
include a penalty for which the renewal would be reasonably assured. The
correction required the Company to record additional deferred rent in other
accrued expenses and other long-term liabilities and to adjust retained earnings
in the consolidated balance sheets, as well as to restate rent expense in
selling, general and administrative expenses in the consolidated statements of
income.
The cumulative effect of these corrections is a reduction to retained earnings
of $4.3 million (net of taxes of $2.6 million) as of the beginning of fiscal
2002 and reductions to retained earnings of $7.0 million (net of taxes of $4.3
million) and $5.5 million (net of taxes of $3.3 million) as of January 2003 and
2002, respectively. These adjustments did not have any impact on the overall
cash flows of the Company.
40
The following is a summary of the line items impacted by the restatement for the
2003 Consolidated Balance Sheet and the 2003 and 2002 Consolidated Statements of
Income and Shareholders' Equity (in thousands, except per share data):
41
January 31, 2004
----------------
As previously
reported Adjustments Restated
-------- ----------- --------
Property and equipment, net $ 135,433 $ (4,957) $130,476
Total assets 413,750 (4,957) 408,793
Accrued expenses and other 19,113 1,309 20,422
Current deferred income taxes 11,487 (799) 10,688
Noncurrent deferred income taxes 6,335 (1,938) 4,397
Other noncurrent liabilities 2,441 734 3,175
Retained earnings 164,183 (4,263) 159,920
Total shareholders' equity 290,613 (4,263) 286,350
Total liabilities and shareholders equity 413,750 (4,957) 408,793
February 1, 2003
----------------
As previously
reported Adjustments Restated
-------- ----------- --------
Total shareholders' equity $ 250,770 $ (3,337) $247,433
February 2, 2002
----------------
As previously
reported Adjustments Restated
-------- ----------- --------
Total shareholders' equity $ 218,907 $ (2,612) $216,295
January 31, 2004
----------------
As previously
reported Adjustments Restated
-------- ----------- --------
Selling, general and administrative expenses $ 291,693 $ 483 $292,176
Depreciation and amortization 25,671 1,038 26,709
Income from operations 50,621 (1,521) 49,100
Income tax expense 16,502 (595) 15,907
Net income 33,721 (926) 32,795
Net income per share - basic 0.87 (0.02) 0.85
Net income per share - diluted 0.85 (0.02) 0.83
February 1, 2003
----------------
As previously
reported Adjustments Restated
-------- ----------- --------
Selling, general and administrative expenses $ 241,268 $ 325 $241,593
Depreciation and amortization 21,032 865 21,897
Income from operations 42,677 (1,190) 41,487
Income tax expense 14,258 (465) 13,793
Net income 28,216 (725) 27,491
Net income per share - basic 0.74 (0.02) 0.72
Net income per share - diluted 0.72 (0.02) 0.70
42
NOTE 3 - Detail of Certain Balance Sheet Accounts
2004 2003
------------------- --------------------
Property and equipment, at cost: (as restated,
see Note 2)
Buildings and building improvements $ 104,779 $ 93,572
Furniture, fixtures and equipment 195,997 171,523
------------------- --------------------
300,776 265,095
Less accumulated depreciation and amortization (166,321) (143,642)
------------------- --------------------
134,455 121,453
Construction in progress 571 4,781
Land 4,276 4,242
------------------- --------------------
Total property and equipment, at depreciated cost $ 139,302 $ 130,476
------------------- --------------------
Depreciation expense totaled $25,791, $24,418, and $19,259, for 2004, 2003 (as
restated), and 2002 (as restated), respectively. In the fourth quarter of 2004,
the Company changed the estimated lives of certain store fixtures from five to
ten years. Based on the Company's historical experience, ten years is a closer
approximation of the actual lives of these assets. The change in estimate is
applied prospectively. Expenses for the fourth quarter of 2004 were favorably
impacted by approximately $1.3 million [$.02 per diluted share] as a result of
this change. The Company expects this change in estimate to have a positive
effect on earnings across all four quarters of 2005.
2004 2003
-------------------- --------------------
Other non trade receivables:
Landlord receivables $ 1,008 $ -
Vendor receivables 5,309 3,252
Income tax receivable 4,911 -
Other 593 609
-------------------- --------------------
Total non trade receivables $ 11,821 $ 3,861
-------------------- --------------------
2004 2003
------------------- --------------------
Accrued expenses and other: (as restated,
see Note 2)
Payroll and benefits $ 5,821 $ 5,729
Sales and use taxes 3,682 3,439
Insurance 7,887 5,145
Other 9,318 6,109
------------------- --------------------
Total accrued expenses and other $ 26,708 $ 20,422
------------------- --------------------
NOTE 4 - INDEBTEDNESS
On July 31, 2004, the Company and Union Planters Bank, N.A. ("Union Planters")
entered into a new Revolving Loan and Credit Agreement (the "Agreement") to
replace the April 3, 2000 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 1.5% below the prime rate
or a LIBOR-based rate. Under the most restrictive covenants of the Agreement,
the Company is required to maintain specified shareholders' equity (which was
$260,338 at January 29, 2005) and net income levels. The Company is required to
pay a commitment fee to the bank at a rate per annum equal to 0.15% on the
unutilized portion of the revolving line commitment over the term of the
Agreement. The term of the Agreement extends to July 31, 2006. There were $23.1
million and $5.5 million of borrowings outstanding under the Agreement at
January 29, 2005 and January 31, 2004, respectively.
43
On June 28, 2004 the company and Union Planters providing the credit facility
entered into a Fourth Modification Agreement of the Revolving Loan and Credit
Agreement to provide a temporary increase in commitment of $10 million and
increasing the available credit line to $50 million. The term of the agreement
was from June 28, 2004 until December 28, 2004. All terms, conditions and
covenants remained in place for the Note and credit facility
On October 19, 2004 the company and Union Planters providing the credit facility
entered into a Fifth Modification Agreement of the Revolving Loan and Credit
Agreement to provide a temporary increase of commitment of $10 million and
increasing the available credit line to $60 million. The term of the agreement
was from October 20, 2004 until December 15, 2004, superseding the expiration of
the Fourth Modification. On December 15, 2004, the available credit line
reverted to $40 million. All terms, conditions and covenants remained in place
for the Note and credit facility
The Company has other miscellaneous financing obligations at January 29, 2005,
totaling $101, which relate primarily to business acquisitions. The Company's
indebtedness under miscellaneous financing matures as follows: 2005 - $18; 2006
- - $21; 2007 - $23; 2008 - $24; and 2009 - $15.
The Company financed the construction of its Dublin, Georgia distribution center
with taxable industrial development revenue bonds issued by the City of Dublin
and County of Laurens Development Authority. The Company purchased 100% of the
issued bonds and intends to hold them to maturity, effectively financing the
construction with internal cash flow. Because a legal right of offset exists,
the Company has offset the investment in the bonds ($34,587) against the related
liability and neither is reflected on the consolidated balance sheet.
NOTE 5 - INCOME TAXES
The provision for income taxes consists of the following:
2004 2003 2002
---------------- ------------------ --------------------
(as restated, (as restated,
see Note 2) see Note 2)
Current
Federal $ 2,399 $ 9,960 $ 1,929
State (1,824) (45) -
---------------- ------------------ --------------------
575 9,915 1,929
---------------- ------------------ --------------------
Deferred
Federal 11,102 6,222 12,267
State (996) (230) (403)
---------------- ------------------ --------------------
10,106 5,992 11,864
---------------- ------------------ --------------------
$ 10,681 $ 15,907 $ 13,793
================ ================== ====================
The income tax effects of temporary differences that give rise to significant
portions of the deferred income tax assets and deferred income tax liabilities
are presented below:
44
2004 2003
----------------- ------------------
(as restated,
see Note 2)
Deferred income tax assets:
Accrual for incentive compensation $ 132 $ 187
Allowance for doubtful accounts 344 659
Insurance accruals 2,425 1,829
Prepaid expenses - 798
Net operating loss carryforwards 3,940 2,407
Postretirement benefits other than pensions 933 999
Restructuring costs 32 45
Amortization of intangibles 2,619 2,365
----------------- ------------------
Total deferred income tax assets 10,425 9,289
Less: valuation allowance (430) (580)
----------------- ------------------
Deferred income tax assets, net of valuation allowance 9,995 8,709
----------------- ------------------
Deferred income tax liabilities:
Property, plant, and equipment (14,795) (9,632)
Inventory valuation (19,907) (14,162)
Prepaid expenses (484) -
----------------- ------------------
Total deferred income tax liability (35,186) (23,794)
----------------- ------------------
Net deferred income tax liability $ (25,191) $ (15,085)
================= ==================
The net operating loss carryforwards are available to reduce state income taxes
in future years. These carryforwards total approximately $94.5 million for state
income tax purposes and expire at various times during the period 2005 through
2024.
During 2004, the valuation allowance decreased $150, and during 2003, the
valuation allowance decreased $120. Based upon expected future income,
management believes that it is more likely than not that the results of
operations will generate sufficient taxable income to realize the deferred tax
asset after giving consideration to the valuation allowance.
A reconciliation of the statutory federal income tax rate to the effective tax
rate is as follows:
2004 2003 2002
------------------- --------------------- -------------------
(as restated, (as restated,
see Note 2) see Note 2)
Income tax provision at statutory rate 35.0% 35.0% 35.0%
Tax credits, principally jobs (6.0) (1.9) -
State income taxes, net of federal benefit (1.3) (0.1) 1.2
Permanent differences 0.2 (0.2) (1.0)
Change in valuation allowance (0.3) (0.2) (2.0)
Other - 0.1 0.2
------------------- --------------------- -------------------
Effective income tax rate 27.6% 32.7% 33.4%
------------------- --------------------- -------------------
NOTE 6 - LONG-TERM LEASES
The Company leases certain of its store locations under noncancelable operating
leases that require monthly rental payments primarily at fixed rates (although a
number of the leases provide for additional rent based upon sales) expiring at
45
various dates through 2029. Many of these leases contain renewal options and
require the Company to pay taxes, maintenance, insurance and certain other
operating expenses applicable to the leased properties. In addition, the Company
leases various equipment under noncancelable operating leases and certain
transportation equipment under capital leases. Total rent expense under
operating leases was $41,573, $34,770, and $27,169, for 2004, 2003 (as
restated), and 2002 (as restated), respectively. Total contingent rentals
included in operating leases above was $1,319, $1,253,and $1,165, for 2004, 2003
(as restated), and 2002 (as restated), respectively. Amortization expense on
assets under capital lease for 2004, 2003, and 2002 was $553, $627, and $693,
respectively.
Future minimum rental payments under all operating and capital leases as of
January 29, 2005 are as follows:
Operating Capital
Leases Leases
- --------------------------------------------------------------------------------------------------------------------------
2005 $ 37,514 $ 814
2006 33,532 628
2007 29,005 386
2008 21,146 129
2009 13,445 -
Thereafter 31,036 -
------------------- ------------------
Total minimum lease payments $ 165,678 1,957
===================
Imputed interest (260)
------------------
Present value of net minimum lease payments, including
$666 classified as current portion of capital lease obligations $ 1,697
------------------
The gross amount of property and equipment under capital leases at January 29,
2005 and January 31, 2004, was $4,967. Accumulated depreciation on property and
equipment under capital leases at January 29, 2005 and January 31, 2004, was
$3,722 and $3,169, respectively.
NOTE 7 - SHAREHOLDERS' EQUITY
In 1998, the Company adopted a Shareholders Rights Plan which granted a dividend
of one preferred share purchase right (a "Right") for each common share
outstanding at that date. Each Right represents the right to purchase
one-hundredth of a preferred share of stock at a preset price to be exercised
when any one individual, firm, corporation or other entity acquires 15% or more
of the Company's common stock. The Rights will become dilutive at the time of
exercise and will expire, if unexercised, in October 2008.
On March 6, 2002, the Company filed a Registration Statement on Form S-3
registering 750,000 shares of Class A common stock. The common stock may be used
from time to time as consideration in the acquisition of assets, goods, or
services for use or sale in the conduct of our business. On March 22, 2002, the
Company raised proceeds of $3.5 million from the offering of 148,134 shares. On
June 6, 2003, the Company raised proceeds of $5.5 million from the offering of
225,000 shares. On September 3, 2003, the Company sold 75,000 shares of common
stock for $2.6 million with the intention of purchasing an airplane. Later, the
Company decided not to purchase the airplane, whereupon the Company purchased
and retired $2.6 million of common stock of the CEO. A Limited Liability Company
(LLC) of which the CEO is the sole member purchased the airplane for $4.7
million. The Company entered into a dry lease agreement with the LLC for its
usage at the annualized rate of 2.5%. On December 30, 2003, the Company
purchased the LLC for $4.7 million. As of January 29, 2005, the Company has
301,866 shares of Class A common stock available to be issued from the March 6,
2002 Registration Statement.
46
On June 5, 2003, the Company announced a three-for-two stock split of its common
stock, Class A voting, no par value. The new shares, one additional share for
each two shares held by stockholders, were distributed on July 1, 2003 to
stockholders of record on June 26, 2003. All share and per share amounts
included in the accompanying financial statements have been adjusted to reflect
this stock split.
NOTE 8 - EMPLOYEE BENEFIT PLANS
Incentive stock option plan. The Company has a long-term incentive plan under
which an aggregate of 2,535,902 shares (3,013,652 shares as of January 31, 2004)
as of January 29, 2005 are available to be granted. These options expire five
years to seven and one-half years from the date of grant. Options outstanding at
January 29, 2005 expire in 2005 through 2011.
Under the plan, stock option grants are made to key employees including
executive officers, as well as other employees, as prescribed by the
Compensation Committee (the "Committee") of the Board of Directors. The number
of options granted is directly linked to the employee's job classification.
Options, which include non-qualified stock options and incentive stock options,
are rights to purchase a specified number of shares of Fred's common stock at a
price fixed by the Committee. The exercise price for stock options issued under
the plan that qualify as incentive stock options within the meaning of Section
422(b) of the Code shall not be less than 100% of the fair value as of the date
of grant. The option exercise price may be satisfied in cash or by exchanging
shares of Fred's common stock owned by the optionee for at least six months, or
a combination of cash and shares. Options have a maximum term of five to seven
and one-half years from the date of grant. Options granted under the plan
generally become exercisable ten percent during each of the first four years on
the anniversary date and sixty percent on the fifth anniversary date. The plan
also contains a provision that if the Company meets or exceeds a specified
operating income margin during the most recently completed fiscal year that the
annual vesting percentage will accelerate from ten to twenty percent during that
vesting period. The plan also provides for annual stock grants at the fair value
of the stock on the grant date to non-employee directors according to a
non-discretionary formula. The number of shares granted is dependent upon
current director compensation levels.
A summary of activity in the plan follows:
2004 2003 2002
-------------------------------- --------------------------------- -------------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
-------------------------------- --------------------------------- -------------------------------
Outstanding at beginning
of year 1,471,269 $ 12.61 1,207,799 $ 7.71 1,386,053 $ 5.77
Granted 307,315 17.41 669,401 17.69 262,473 13.96
Forfeited/ canceled (80,327) 6.86 (40,753) 7.81 (124,715) 5.29
Exercised (410,495) 5.60 (365,178) 6.27 (316,012) 5.33
----------------- ------------------ -----------------
Outstanding at end of year 1,287,762 16.35 1,471,269 12.61 1,207,799 7.71
----------------- ------------------ -----------------
Exercisable at end of year 461,916 13.08 740,568 7.65 658,589 6.83
----------------- ------------------ -----------------
47
The weighted average remaining contractual life of all outstanding options was
4.4 years at January 29, 2005.
The following table summarizes information about stock options outstanding at
January 29, 2005.
Options Outstanding Options Exercisable
------------------------------------------------------------ -------------------------------------
Weighted
Average
Remaining Weighted Weighted
Number Contractual Average Number Average
Range of Outstanding at Life Exercise Exercisable at Exercise
Exercise Prices January 29, 2005 (in Years) Price January 29, 2005 Price
- ------------------------------- ------------------------------------------------------------ -------------------------------------
$4.09 to $7.95 108,842 0.9 $ 5.33 108,842 $ 5.33
$8.00 to $17.67 857,152 4.9 $ 15.66 262,958 $ 13.60
$18.27 to $30.16 321,768 4.2 $ 21.91 90,116 $ 20.94
--------------------------- --------------------------
1,287,762 461,916
--------------------------- --------------------------
Pro forma information regarding net income and earnings per share, as disclosed
in Note 1, has been determined as if the Company had accounted for its employee
stock-based compensation plans under the fair value method of SFAS No. 123. The
weighted average fair value of options granted during 2004, 2003, and 2002 was
$5.61, $6.68, and $6.69, respectively. The fair value of each stock option grant
was estimated on the date of grant using the Black-Scholes option-pricing model
with the following assumptions:
2004 2003 2002
--------------- --------------- --------------
Average expected life (years) 5.7 5.0 3.0
Average expected volatility 41.1% 35.7% 46.1%
Risk-free interest rates 1.3% 1.1% 2.1%
Dividend yield 0.3% 0.3% 0.5%
The Black-Scholes option model was developed for use in estimating the fair
value of traded options, which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock volatility. Because the
Company's employee stock options have characteristics significantly different
from those of traded options, and because changes in the subjective assumptions
can materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the fair
value of its employee stock options.
Restricted Stock. During 2004, 2003, and 2002, the Company issued a net of
175,969, 1,406, and 1,125 restricted shares, respectively. Compensation expense
related to the shares issued is recognized over the period for which
restrictions apply.
48
Employee stock ownership plan. The Company has a non-contributory employee stock
ownership plan for the benefit of qualifying employees who have completed one
year of service and attained the age of 18. Benefits are fully vested upon
completion of seven years of service. The Company has not made any contributions
to the plan since 1996 and the plan owns 376,812 shares of Company stock. All
shares are included in shares outstanding for computation of net income per
share.
Salary reduction profit sharing plan. The Company has a defined contribution
profit sharing plan for the benefit of qualifying employees who have completed
one year of service and attained the age of 21. Participants may elect to make
contributions to the plan up to a maximum of 15% of their compensation. Company
contributions are made at the discretion of the Company's Board of Directors.
Participants are 100% vested in their contributions and earnings thereon.
Contributions by the Company and earnings thereon are fully vested upon
completion of six years of service. The Company's contributions for 2004, 2003,
and 2002 were $175, $207, and $176, respectively.
Postretirement benefits. The Company provides certain health care benefits to
its full-time employees that retire between the ages of 58 (effective January 1,
2004 this was changed to 62) and 65 with certain specified levels of credited
service. Health care coverage options for retirees under the plan are the same
as those available to active employees. The Company's change in benefit
obligation based upon an actuarial valuation is as follows:
-----------------------------------------
January 29, January 31,
2005 2004
----------------------------------------
Benefit obligation at beginning of year $ 759 $ 2,501
Service cost 28 36
Interest cost 34 45
Plan admendments (195) -
Actuarial gain (11) (1,782)
Benefits paid (32) (41)
----------------------------------------
Benefit obligation at end of year $ 583 $ 759
----------------------------------------
A reconciliation of the Plan's funded status to accrued benefit cost follows:
January 29, January 31,
2005 2004
------------------- ------------------
Funded status $ (583) $ (759)
Unrecognized net actuarial gain (1,586) (1,678)
Unrecognized prior service cost (185) (4)
------------------- ------------------
Accrued benefit costs $ (2,354) $ (2,441)
------------------- ------------------
The medical care cost trend used in determining this obligation is 10.0%
effective December 1, 2003, decreasing annually before leveling at 5.0% in 2014.
To illustrate the trend rate used, increasing the health care cost trend by 1%
would increase the effect on the total of service cost and interest cost by $7
and the accumulated postretirement benefit obligation by $53. Decreasing the
health care cost trend by 1% would decrease the effect on the total of service
cost and interest cost by $6 and the accumulated postretirement benefit
obligation ("APBO") by $48. The discount rate used in calculating the obligation
was 5.75% in 2004 and 6.25% in 2003. The net periodic benefit cost decreased in
2004 due to changes in actuarial assumptions regarding turnover, participation
49
in the plan, the medical inflation rate and the rate of contribution by
participants. The reduction in APBO related to benefits attributed to past
service was $115 and the effect on the measurement of the net periodic
postretirement benefit cost was $13 as of January 29, 2005.
The annual net postretirement cost is as follows:
For the Year Ended
-----------------------------------------------------
January 29, January 31, February 1,
2005 2004 2003
-----------------------------------------------------
Service cost $ 28 $ 36 $ 213
Interest cost 34 45 152
Amortization of prior service cost (14) (1) -
Amortization of unrecognized prior service cost (103) (107) 1
-----------------------------------------------------
Net periodic postretirement benefit cost $ (55) $ (27) $ 366
-----------------------------------------------------
The Company's policy is to fund claims as incurred.
Information about the expected cash flows for the postretirement medical plan
follows:
Expected Benefit Payments Postretirement
(net of retiree contributions) Medical Plan
2005 $ 45,747
2006 36,684
2007 40,760
2008 46,794
2009 49,255
2010 - 2014 304,564
NOTE 9 - NET INCOME PER SHARE
Basic earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted-average number of common shares
outstanding for the period. Diluted earnings per share reflects the potential
dilution that could occur if securities to issue common stock were exercised
into common stock or resulted in the issuance of common stock that then shared
in the earnings of the entity. Restricted stock is considered contingently
issuable and is excluded from the computation of basic earnings per share.
A reconciliation of basic earnings per share to diluted earnings per share
follows:
Year Ended
--------------------------------------------------------------------------------------------------------
January 29, 2005 January 31, 2004 February 1, 2003
------------------------------- -------------------------------------- ---------------------------------
(as restated, see note 2) (as restated, see note 2)
Per Per Per
Share Share Share
Income Shares Amount Income Shares Amount Income Shares Amount
- ------------------------------------------------------------------------------------------------------------------------------------
Basic EPS $27,952 39,252 $ .71 $32,795 38,754 $ .85 $27,491 38,255 $ .72
Effect of Dilutive
Securities 280 898 996
------------- ----------- ------------ ------------- ----------- ------------ ------------- ----------- -----------
Diluted EPS $27,952 39,532 $ .71 $32,795 39,652 $ .83 $27,491 39,251 $ .70
------------- ----------- ------------ ------------- ----------- ------------ ------------- ----------- -----------
50
Options to purchase shares of common stock that were outstanding at the end of
the respective fiscal year were not included in the computation of diluted
earnings per share when the options' exercise prices were greater than the
average market price of the common shares. There were no such options
outstanding at the end of fiscal 2003 and there were 94,028 and 84,938 such
options outstanding at January 29, 2005 and February 1, 2003, respectively.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Commitments. The Company had commitments approximating $12.6 million at January
29, 2005 and $11.1 million at January 31, 2004 on issued letters of credit,
which support purchase orders for merchandise. Additionally, the Company had
outstanding letters of credit aggregating approximately $10.8 million at January
29, 2005 and $8.5 million at January 31, 2004 utilized as collateral for its
risk management programs.
Litigation. The Company is a party to several pending legal proceedings and
claims arising in the normal course of business. Although the outcome of the
proceedings and claims cannot be determined with certainty, management of the
Company is of the opinion that it is unlikely that these proceedings and claims
will have a material adverse effect on the financial statements as a whole.
However, litigation involves an element of uncertainty. Future developments
could cause these actions or claims to have a material adverse effect on the
results of the financial statements as a whole.
Note 11 - Sales Mix
The Company manages its business on the basis of one reportable segment. See
Note 1 for a brief description of the Company's business. As of January 29,
2005, all of the Company's operations were located within the United States.
The Company's sales mix by major category during the last 3 years was as
follows:
For the Year Ended
---------------------------------------------------------------
January 29, January 31, February 1,
2005 2004 2003
---------------------------------------------------------------
Pharmaceuticals 32.6% 32.4% 33.2%
Household Goods 23.7% 23.6% 23.0%
Apparel and Linens 14.1% 14.2% 13.6%
Food and Tobacco Products 10.7% 10.2% 9.6%
Health and Beauty Aids 8.6% 8.8% 9.0%
Paper and Cleaning Supplies 8.0% 8.1% 8.4%
Sales to Franchised Fred's Stores 2.3% 2.7% 3.2%
---------------------------------------------------------------
Total Sales Mix 100.0% 100.0% 100.0%
---------------------------------------------------------------
51
Note 12 - QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------------- -------------------- -------------------- --------------------
Year Ended January 29, 2005
Net sales $ 341,486 $ 340,850 $ 349,139 $ 410,306
Gross profit 96,794 93,970 101,249 113,294
Net income, as reported 7,424 3,094 7,521 10,412
Net income, as adjusted (see note 2) 7,202 2,922 7,416 10,412
Net income per share, as reported
Basic 0.19 0.08 0.19 0.27
Diluted 0.19 0.08 0.19 0.27
Net income per share, as adjusted
Basic 0.18 0.07 0.19 0.27
Diluted 0.18 0.07 0.19 0.27
Cash dividends paid per share 0.02 0.02 0.02 0.02
Year Ended January 31, 2004
Net sales $ 310,689 $ 302,270 $ 311,668 $ 378,023
Gross profit 87,948 84,944 91,191 103,902
Net income, as reported 7,857 4,385 9,028 12,451
Net income, as adjusted (see note 2) 7,648 4,179 8,797 12,171
Net income per share, as reported
Basic 0.21 0.11 0.23 0.32
Diluted 0.20 0.11 0.23 0.31
Net income per share, as adjusted
Basic 0.20 0.11 0.23 0.31
Diluted 0.19 0.11 0.22 0.31
Cash dividends paid per share 0.02 0.02 0.02 0.02
Item 9: Changes In and Disagreements With Accountants on Accounting and
Financial Disclosure
The information required by this item is incorporated herein by reference to
Form 8-K/A dated July 1, 2004, filed on July 30, 2004.
52
ITEM 9A. CONTROLS AND PROCEDURES
(a) Conclusion Regarding the Effectiveness of 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 Company's 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 Company's
disclosure controls and procedures are effective in timely alerting them to
material information required to be included in the Company's periodic SEC
reports, subject to the effectiveness of the Company's 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.
53
(b) Management's Annual Report on Internal Control Over Financial Reporting. The
management of Fred's, Inc. is responsible for establishing and maintaining
adequate internal control over financial reporting. Fred's, Inc. internal
control system was designed to provide reasonable assurance to the company's
management and board of directors regarding the fair and reliable preparation
and presentation of the consolidated financial statements.
All internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.
The management of Fred's, Inc. assessed the effectiveness of the company's
internal control over financial reporting as of January 29, 2005. In making its
assessment, the Company used criteria set forth by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) in Internal Control - Integrated
Framework. This assessment identified two matters considered to be material
weaknesses in the Company's internal control over financial reporting. A
material weakness is a significant deficiency, or aggregation of deficiencies,
that results in more than a remote likelihood that a misstatement having more
than an inconsequential effect on the financial statements could occur. The
material weaknesses identified were as follows:
- - A lack of internal controls related to the accounting for leases and
leasehold improvements, more specifically, controls related to
straight-line rent and depreciable lives of leasehold improvements. While
the Company's accounting in these areas was consistent with prior industry
practice, correspondence from the SEC to the AICPA in February 2005 led
management to believe that a detailed review of lease accounting was
necessary. Upon completion of the detailed review, management concluded
that its prior lease accounting was not in accordance with Generally
Accepted Accounting Principles, as defined in the SEC correspondence
mentioned above, that a material weakness in internal control existed and
that a restatement of its previously issued consolidated financial
statements was necessary. See Note 2 to the consolidated financial
statements for the effects of these changes to the Company's consolidated
balance sheet as of February 2, 2002 as well as on the Company's
consolidated statements of income and cash flows for fiscal years ended
February 1, 2003 and January 31, 2004.
- - A failure of internal controls related to the year-end close process.
Certain controls related to reconciliation, review and analysis of
information contained in the consolidated financial statements failed.
These control failures caused management to conclude that the year-end
close process was not sufficient, and therefore resulted in a material
weakness in the Company's system of internal control.
Management intends to respond to these material weaknesses by strengthening
pertinent controls and making staffing changes, as follows:
- - Implement procedures to ensure that lease terms and leasehold improvements
are accounted for in accordance with Generally Accepted Accounting
Principles.
- - Add additional staff with responsibility for completing the close process.
- - Strengthen procedures surrounding the close process, including, but not
limited to reconciliation of all major accounts.
- - Improve cut-off procedures to ensure that transactions are recorded in the
proper period.
These changes will act to remediate the material weaknesses discussed above, and
will be conducted throughout the first and second quarters of fiscal 2005.
54
However, we do not believe that all changes will be in effect at the end of the
first quarter of 2005, and therefore, will likely report that material
weaknesses in internal control continue to exist in our Quarterly Report on Form
10-Q for the first quarter of fiscal 2005.
Our assessment of the effectiveness of internal control over financial reporting
as of January 29, 2005 has been audited by BDO Seidman, LLP, the independent
registered public accounting firm who also audited our consolidated financial
statements. BDO Seidman's attestation report on management's assessment of
internal control over financial reporting is included herein.
Report of Independent Registered Public Accounting Firm on Internal Control Over
Financial Reporting
Report of Independent Public Accounting Firm
Board of Directors and Stockholders
Fred's Inc.
Memphis, Tennessee
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting that Fred's,
Inc. and subsidiaries (the "Company") did not maintain effective internal
control over financial reporting as of January 29, 2005, because of the effect
of the two material weaknesses identified in management's assessment, based on
criteria identified in Internal Control - Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (the COSO
criteria). The Company's management is responsible for maintaining effective
internal control over financial reporting. Our responsibility is to express an
opinion on management's assessment and an opinion on the effectiveness of the
Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
aspects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the Company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the Company are
being made only in accordance with authorizations of management and directors of
the Company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the Company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
the effectiveness of future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected. The following material weaknesses have been identified and included
in management's assessment as of January 29, 2005:
1. Deficiencies related to the selection, monitoring and review of assumptions
and factors related to accounting for operating leases and leasehold
improvements, more specifically, controls related to straight-line rent,
provisions for probable contingent rent liabilities and selection of
depreciable lives for leasehold improvements. This weakness resulted in the
restatement of previously issued consolidated financial statements.
2. Deficiencies related to the financial statement close process, included
insufficient controls to ensure that transactions and account analysis and
reconciliations performed in connection with the financial statement close
process have been adequately performed and reviewed. This weakness in
controls related to reconciliation, review and analysis of information
contained in the consolidated financial statements could result in an error
not being detected.
These material weaknesses were considered in determining the nature, timing, and
extent of audit test applied in our audit of the financial statements for the
year ended January 29, 2005, and this report does not affect our report dated
April 15, 2005 on those financial statements.
In our opinion, management's assessment that the Company did not maintain
effective internal control over accounting for leases and leasehold improvements
and financial reporting as of January 29, 2005, is fairly stated, in all
material respects, based on the COSO control criteria. Also, in our opinion,
because of the effect of the material weaknesses described above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective internal control over financial reporting as of January 29,
2005, based on the COSO control criteria.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements of the Company as of and for the year ended January 29, 2005, and our
report dated April 15, 2005 expressed an unqualified opinion on those financial
statements.
Memphis, Tennessee
April 15, 2005
PART III
Item 10: Directors and Executive Officers of the Registrant
The following information is furnished with respect to each of the directors and
executive officers of the Company:
Name Age Positions and Offices
----------------------------------------------------
Michael J. Hayes (1) 63 Director, Chairman of the Board, Chief Executive Officer
John R. Eisenman (1) 63 Director
Roger T. Knox (1) 67 Director
John Reier (1) 65 President and Director
Thomas H. Tashjian(1) 50 Director
Jerry A Shore 52 Executive Vice President and Chief Financial Officer
James R. Fennema 55 Executive Vice-President - General Merchandise Manager
Dennis K Curtis 45 Executive Vice-President - Store Operation
John A. Casey 58 Executive Vice President - Pharmacy Acquisitions
Rick A Chambers 41 Senior Vice President - Pharmacy Operations
Charles S. Vail 62 Corporate Secretary, Vice President - Legal Services
and General Counsel
(1) Five directors, constituting the entire Board of Directors, are to be
elected at the Annual Meeting to serve one year or until their successors are
elected.
Michael J. Hayes was elected a director of the Company in January 1987. Mr.
Hayes served as Managing Director of the Company from October 1989 until March
2002 when he was elected Chairman of the Board. He has been Chief Executive
Officer since October 1989. He was previously employed by Oppenheimer & Company,
Inc. in various capacities from 1976 to 1985, including Managing Director and
Executive Vice President - Corporate Finance and Financial Services.
John R. Eisenman is involved in real estate investment and development with
REMAX Island Realty, Inc., located in Hilton Head Island, South Carolina. Mr.
Eisenman has been engaged in commercial and industrial real estate brokerage and
development since 1983. Previously, he founded and served as President of
55
Sally's, a chain of fast food restaurants from 1976 to 1983, and prior thereto
held various management positions in manufacturing and in securities brokerage.
Roger T. Knox is President Emeritus of the Memphis Zoological Society and
was its President and Chief Executive Officer from January 1989 through March
2003. Mr. Knox was the President and Chief Operating Officer of Goldsmith's
Department Stores, Inc. (a full-line department store in Memphis and Jackson,
Tennessee) from 1983 to 1987 and its Chairman of the Board and Chief Executive
Officer from 1987 to 1989. Prior thereto, Mr. Knox was with Foley's Department
Stores in Houston, Texas for 20 years. Mr. Knox is also a director of Hancock
Fabrics, Inc. John D. Reier is President and a Director. Mr. Reier joined the
Company in May of 1999 as President and was elected a Director of the Company in
August 2000. Prior to joining the company, Mr. Reier was President and Chief
Executive Officer of Sunny's Great Outdoors Stores, Inc. from 1997 to 1999, and
was President, Chief Operating Officer, Senior Vice President of Merchandising,
and General Merchandise Manager at Family Dollar Stores, Inc. from 1987 to 1997.
John D. Reier is President and a Director. Mr. Reier joined the Company in
May of 1999 as President and was elected a Director of the Company in August
2000. Prior to joining the company, Mr. Reier was President and Chief Executive
Officer of Sunny's Great Outdoors Stores, Inc. from 1997 to 1999, and was
President, Chief Operating Officer, Senior Vice President of Merchandising, and
General Merchandise Manager at Family Dollar Stores, Inc. from 1987 to 1997.
Thomas H. Tashjian was elected a director of the Company in March 2001. Mr.
Tashjian is a private investor. Mr. Tashjian has served as a managing director
and consumer group leader at Banc of America Montgomery Securities in San
Francisco. Prior to that, Mr. Tashjian held similar positions at First Manhattan
Company, Seidler Companies, and Prudential Securities. Mr. Tashjian's earlier
retail operating experience was in discount retailing at the Ayrway Stores,
which were acquired by Target, and in the restaurant business at Noble Roman's.
Jerry A. Shore joined the Company in April 2000 as Executive Vice President
and Chief Financial Officer. Prior to joining the Company, Mr. Shore was
employed by Wang's International, a major importing and wholesale distribution
company as Chief Financial Officer from 1989 to 2000, and in various financial
management capacities with IPS Corp., and Caterpillar, Inc. from 1975 to 1989.
56
James R. Fennema joined the Company in December 2004 as Executive
Vice-President - General Merchandise Manager. Prior to joining the Company, Mr.
Fennema was employed by Duckwall-Alco Stores, Inc. as Senior Vice-President and
General Merchandise Manager from 1993 to 2004, and in various management
positions with Sears, Caldor, Fisher's Big Wheel, Shopko and Richman-Gordon from
1973 to 1993.
Dennis K. Curtis was promoted to Executive Vice-President in July 2003.
Prior to this position, Mr. Curtis joined the Company in 1980 as a management
trainee in store operations. Mr. Curtis was recently held the position of Senior
Vice-President - Divisional Merchandising Manager of Hardlines.
John A. Casey was named Executive Vice President - Pharmacy Acquisitions in
June of 2004 and was previously Executive Vice President - Pharmacy Operations
since February 1997. Mr. Casey joined the Company in 1979 and has served in
various positions in Pharmacy Operations. Mr. Casey is a registered Pharmacist.
Rick A. Chambers was named Senior Vice President - Pharmacy Operations in
June of 2004. Mr. Chambers joined the Company in July of 1992 and has served in
various positions in Pharmacy Operations. Mr. Chambers earned a Doctor of
Pharmacy Degree in 1992.
Charles S. Vail has served the Company as General Counsel since 1973, as
Corporate Secretary since 1975, and as Vice President - Legal since 1984. Mr.
Vail joined the Company in 1968.
The remainder of the information required by this item is incorporated herein by
reference to the proxy statement for our 2004 annual meeting.
Item 11: Executive Compensation
Information required by this item is incorporated herein by reference to
the proxy statement for our 2005 annual meeting.
Item 12: Security Ownership of Certain Beneficial Owners and Management
Information required by this item is incorporated herein by reference to
the proxy statement for our 2005 annual meeting.
Item 13: Certain Relationships and Related Transactions
Information required by this item is incorporated herein by reference to
the proxy statement for our 2005 annual meeting.
ITEM 14. Principal Accountants Fees and Services
Information required by this item is incorporated herein by reference to
the proxy statement for our 2005 annual meeting.
PART IV
Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) Consolidated Financial Statements (See Item 8)
57
Report of Independent Registered Public Accounting Firm - BDO Seidman, LLP.
Report of Independent Registered Public Accounting Firm - Ernst & Young, LLP.
(a)(2) Financial Statement Schedules
Schedule II - Valuation and Qualifying Accounts
(a)(3) Those exhibits required to be filed as Exhibits to this Annual Report on
Form 10-K pursuant to Item 601 of Regulation S-K are as follows:
3.1 Certificate of Incorporation, as amended [incorporated herein by
reference to Exhibit 3.1 to the registration statement on Form
S-8 as filed with the Securities and Exchange Commission ("SEC")
on March 18, 2003 (SEC File No. 333-103904) (such registration
statement, the "Form S-8")].
3.2 By-laws, as amended [incorporated herein by reference to Exhibit
3.2 to the Form S-8].
4.1 Specimen Common Stock Certificate [incorporated herein by
reference to Exhibit 4.2 to Pre-Effective Amendment No. 3 to the
Registration Statement on Form S-1 (SEC File No. 33-45637) (such
Registration Statement, the "Form S-1")].
4.2 Preferred Share Purchase Plan [incorporated herein by reference
to the Company's Report on Form 10-Q for the quarter ended
October 31, 1998].
10.1 Form of Fred's, Inc. Franchise Agreement [incorporated herein by
reference to Exhibit 10.8 to the Form S-1].
10.2 401(k) Plan dated as of May 13, 1991 [incorporated herein by
reference to Exhibit 10.9 to the Form S-1].
10.3 Employee Stock Ownership Plan (ESOP) dated as of January 1, 1987
[incorporated herein by reference to Exhibit 10.10 to the Form
S-1].
10.4 Lease Agreement by and between Hogan Motor Leasing, Inc. and
Fred's, Inc. dated February 5, 1992 for the lease of truck
tractors to Fred's, Inc. and the servicing of those vehicles and
other equipment of Fred's, Inc. [incorporated herein by reference
to Exhibit 10.15 to Pre-Effective Amendment No. 1 to the Form
S-1].
*10.5 1993 Long Term Incentive Plan dated as of January 21, 1993
[incorporated herein by reference to the Company's report on Form
10-Q for the quarter ended July 31, 1993].
***10.6 Term Loan Agreement between Fred's, Inc. and First American
National Bank dated as of April 23, 1999 [incorporated herein by
reference to the Company's Report on Form 10-Q for the quarter
ended May 1, 1999].
***10.7 Prime Vendor Agreement between Fred's Stores of Tennessee, Inc.
and Bergen Brunswig Drug Company, dated as of November 24, 1999
[incorporated herein by reference to Company's Report on Form
10-Q for the quarter ended October 31, 1999].
***10.8 Addendum to Leasing Agreement and Form of Schedules 7 through 8
of Schedule A, by and between Hogan Motor Leasing, Inc. and
Fred's, Inc dated September 20, 1999 (modifies the Lease
Agreement included as Exhibit 10.4) [incorporated herein by
reference to the Company's report on Form 10-K for the year ended
January 29, 2000].
58
***10.9 Revolving Loan Agreement between Fred's, Inc.and Union Planters
Bank, NA and SunTrust Bank dated April 3, 2000 [incorporated
herein by reference to the Company's report on Form 10-K for year
ended January 29, 2000].
***10.10 Loan modification agreement dated May 26, 2000 (modifies the
Revolving Loan Agreement included as Exhibit 10.9) [incorporated
herein by reference to the Company's report on Form 10-K for the
year ended January 29, 2000].
***10.11 Seasonal Over line Agreement between Fred's, Inc. and Union
Planters National Bank dated as of October 11, 2000 [incorporated
herein by reference to the Company's Report on Form 10-Q for the
quarter ended October 28, 2000].
***10.12 Second Loan modification agreement dated April 30, 2002 (modifies
the Revolving Loan and Credit Agreement included as exhibit
10.9). [incorporated herein by reference to the Company's Report
on Form 10-Q for the quarter ended August 3, 2002].
10.15 Third loan modification agreement dated July 31, 2003 (modified
the Revolving Loan and Credit Agreement dated April 3, 2000.)
[incorporated herein by reference to the Company's Report on Form
10-Q for the quarter ended August 2, 2003].
10.16 Fourth modification agreement dated June 28, 2004 modifying the
Revolving Loan and Credit Agreement to grant a temporary over
line. [incorporated herein by reference to the Company's Report
on Form 10-Q for the quarter ended October 30, 2004].
10.17 Fifth modification agreement dated October 19, 2004 modifying the
Revolving Loan and Credit Agreement to grant a temporary over
line. [incorporated herein by reference to the Company's Report
on Form 10-Q for the quarter ended October 30, 2004].
**21.1 Subsidiaries of Registrant
**23.1 Consent of BDO Seidman, LLP
**23.2 Consent of Ernst & Young LLP
**31.1 Certification of Chief Executive Officer pursuant to Exchange
Rule 13a-14(a) of the Securities Exchange Act.
**31.2 Certification of Chief Financial Officer pursuant to Exchange
Rule 13a-14(a) of the Securities Exchange Act.
**32. Certification of Chief Financial Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350.
(b) Reports on Form 8-K
None.
* Management Compensatory Plan
** Filed herewith
*** (SEC File No. under the Securities Exchange Act of 1934 is 00-19288)
59
Exhibit 23.1
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Fred's, Inc.
Memphis, TN 38118
We hereby consent to the incorporation by reference in the Registration
Statements on Form S-3 (No. 33-68479 and No. 333-83918) and on Form S-8 (No.
33-48380, No. 33-67606 and No. 333-103904) of Fred's, Inc. of our reports dated
April 15, 2005, relating to the consolidated financial statements and financial
statement schedules, and the effectiveness of Fred's, Inc.'s internal control
over financial reporting, which appears in this Form 10-K for the year ended
January 29, 2005. Our report dated April 15, 2005 on management's assessment of
the effectiveness of internal control over financial reporting and the
effectiveness of internal control over financial reporting as of January 29,
2005, expresses our opinion that the Company did not maintain effective internal
control over financial reporting as of January 29, 2005 because of the effect of
material weaknesses on the achievement of the objectives of the control
criteria.
/s/ BDO Seidman, LLP
Memphis, Tennessee
April 28, 2005
60
Exhibit 23.2
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We consent to the incorporation by reference in the Registration Statements
(Form S-8 Nos. 33-48380, 33-67606, 333-103904, and Form S-3 Nos. 333-68478 and
333-83918) of Fred's, Inc. of our report dated April 5, 2004, except for Note 2
as to which the date is April 28, 2005, with respect to the consolidated
financial statements of Fred's, Inc. included in this Annual Report (Form 10-K)
for the year ended January 29, 2005.
Our audit also included the financial statement schedule of Fred's, Inc. listed
in Item 15(a) for the years ended January 31, 2004 and February 1, 2003. This
schedule is the responsibility of the Company's management. Our responsibility
is to express an opinion based on our audits. In our opinion, the financial
statement schedule referred to above, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein for the years ended January 31, 2004 and
February 1, 2003.
/s/ Ernst & Young LLP
Memphis, Tennessee
April 28, 2005
61
Schedule II - Valuation and Qualifying Accounts
Balance at Charged to Balance at
Beginning Costs and Deductions End
of Period Expenses Write-offs of Period
Allowance for doubtful Accounts (in thousands):
Year ended February 1, 2003 $657 $318 $ - $975
Year ended January 31, 2004 $975 $462 $ - $1,437
Year ended January 29, 2005 $1,437 $ - $ 808 $629
62
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, on this 28th day of
April, 2005.
FRED'S, INC.
By: /s/ Michael J. Hayes
--------------------------------
Michael J. Hayes, Chief Executive
Officer
By: /s/ Jerry A. Shore
--------------------------------
Jerry A. Shore, Executive Vice
President and Chief Financial Officer
(Principal Accounting and Financial
Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities indicated on this 28th day of April, 2005.
Signature Title
--------- -----
/s/ Michael J. Hayes Director, Chairman of the Board,
-------------------- Chief Executive Officer
Michael J. Hayes
/s/ Roger T. Knox Director
--------------------
Roger T. Knox
/s/ John R. Eisenman Director
--------------------
John R. Eisenman
/s/ John D. Reier President and Director
--------------------
John D. Reier
/s/ Thomas H. Tashjian Director
-----------------------
Thomas H. Tashjian
63
Exhibit 31.1
CERTIFICATION OF CHIEF EXECUTIVE OFFICER
I, Michael J. Hayes, certify that:
1. I have reviewed this annual report on Form 10-K of Fred's, Inc.;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designated under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during
the period in which this report is being prepared;
b) Designated such internal control over financial reporting, or
caused such internal control over financial reporting to be
designed under our supervision, to provide reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in
accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant's board of directors:
a) All significant deficiencies and material weaknesses in the
design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the registrant's
ability to record, process, summarize and report financial
information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: April 28, 2005 /s/ Michael J. Hayes
-------------------------------------
Michael J. Hayes
Chief Executive Officer
64
Exhibit 31.2
CERTIFICATION OF CHIEF FINANCIAL OFFICER
I, Jerry A. Shore, certify that:
1. I have reviewed this annual report on Form 10-K of Fred's, Inc.
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal
control over financial reporting (as defined in Exchange Act Rules
13a-15(f) and 15d-15(f) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designated under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made
known to us by others within those entities, particularly during
the period in which this report is being prepared;
b) Designated such internal control over financial reporting, or
caused such internal control over financial reporting to be
designed under our supervision, to provide reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in
accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure
controls and procedures and presented in this report our
conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this
report based on such evaluation; and
d) Disclosed in this report any changes in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant's board of directors:
a) All significant deficiencies and material weaknesses in the
design or operation of internal control over financial reporting
which are reasonably likely to adversely affect the registrant's
ability to record, process, summarize and report financial
information; and
b) Any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal control over financial reporting.
Date: April 28, 2005 /s/ Jerry A. Shore
---------------------------------
Jerry A. Shore
Executive Vice President and
Chief Financial Officer
65
Exhibit 32
CERTIFICATION OF CHIEF EXECUTIVE OFFICER AND CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 18 U.S.C. SECTION 1350
In connection with this annual report on Form 10-K of Fred's, Inc. each of the
undersigned, Michael J. Hayes and Jerry A Shore, certifies, pursuant to Section
18 U.S.C. Section 1350, that:
1. The report fully complies with the requirements of Section 13(a) or
15(d) of the Securities Exchange Act of 1934; and
2. The information contained in this report fairly presents, in all
material respects, the financial condition and results of
operations of Fred's, Inc.
Date: April 28, 2005 /s/ Michael J. Hayes
----------------------------------------
Michael J. Hayes
Chief Executive Officer
/s/ Jerry A. Shore
----------------------------------------
Jerry A Shore
Executive Vice President and
Chief Financial Officer
66
EXHIBIT 21.1
FRED'S, INC.
SUBSIDIARIES OF REGISTRANT
Fred's, Inc. has the following subsidiaries, all of which are 100% owned:
Fred's Stores of Tennessee, Inc.
Fred's Capital Management Company, Inc.
National Equipment Management and Leasing, Inc.
Fred's Capital Finance, Inc.
Insurance Value Protection Group, LTD
67