UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarterly Period Ended December 1, 2001 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Transition Period From To Commission File Number 1-5742 RITE AID CORPORATION (Exact name of registrant as specified in its charter) Delaware 23-1614034 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 30 Hunter Lane, 17011 Camp Hill, Pennsylvania (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (717) 761-2633 (Former name, former address and former fiscal year, if changed since last report) Not Applicable 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, and (2) has been subject to such filing requirements for the past 90 days. X Yes No Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. The registrant had 515,085,296 shares of its $1.00 par value common stock outstanding as of December 29, 2001. RITE AID CORPORATION TABLE OF CONTENTS Page Cautionary Statement Regarding Forward Looking Statements 1 PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements: Condensed Consolidated Balance Sheets as of December 1, 2001 and March 3, 2001 2 Condensed Consolidated Statements of Operations for the Thirteen Week Periods Ended December 1, 2001 and November 25, 2000 3 Condensed Consolidated Statements of Operations for the Thirty-Nine Week Periods Ended December 1, 2001 and November 25, 2000 4 Condensed Consolidated Statement of Stockholders' Equity (Deficit) for the Thirty-Nine Week Period Ended December 1, 2001 5 Condensed Consolidated Statements of Cash Flows for the Thirty-Nine Week Periods Ended December 1, 2001 and November 25, 2000 6 Notes to Condensed Consolidated Financial Statements 8 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 29 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings 30 ITEM 2. Changes in Securities and Use of Proceeds 30 ITEM 3. Defaults Upon Senior Securities 30 ITEM 4. Submission of Matters to a Vote of Security Holders 30 ITEM 5. Other Information 30 ITEM 6. Exhibits and Reports on Form 8-K 31 CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS This report includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are identified by terms and phrases such as "anticipate," "believe," "intend," "estimate," "expect," "continue," "should," "could," "may," "plan," "project," "predict," "will" and similar expressions and include references to assumptions and relate to our future prospects, developments and business strategies. Factors that could cause actual results to differ materially from those expressed or implied in such forward-looking statements include, but are not limited to: o our high level of indebtedness; o our ability to make interest and principal payments on our debt and satisfy the other covenants contained in our credit facilities and other debt agreements; o our ability to improve the operating performance of our existing stores, and, in particular, our new and relocated stores in accordance with our management's long term strategy; o the outcomes of pending lawsuits and governmental investigations, both civil and criminal, involving our financial reporting and other matters; o competitive pricing pressures and continued consolidation of the drugstore industry; o third-party prescription reimbursement levels and regulatory changes governing pharmacy practices; o general economic conditions, inflation and interest rate movements; o merchandise supply constraints or disruptions; o access to capital; and o our ability to further develop, implement and maintain reliable and adequate internal accounting systems and controls. We undertake no obligation to revise the forward-looking statements included in this report to reflect any future events or circumstances. Our actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. Factors that could cause or contribute to such differences are discussed in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations---Overview and Factors Affecting Our Future Prospects" included in this quarterly report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended March 3, 2001 ("the Fiscal 2001 10-K"), which was filed with the Securities and Exchange Commission (the "SEC") on May 21, 2001 and is available on the SEC's website at www.sec.gov. 1 PART I. FINANCIAL INFORMATION Item 1. Financial Statements RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share amounts) (unaudited) December 1, March 3, 2001 2001 --------------- --------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 94,272 $ 92,290 Accounts receivable, net 593,606 503,527 Inventories, net 2,528,870 2,444,525 Investment in AdvancePCS -- 491,198 Prepaid expenses and other current assets 93,481 85,292 --------------- --------------- Total current assets 3,310,229 3,616,832 PROPERTY, PLANT AND EQUIPMENT, NET 2,253,554 3,041,008 GOODWILL AND OTHER INTANGIBLES, NET 986,179 1,067,339 OTHER ASSETS 183,394 188,732 --------------- --------------- Total assets $ 6,733,356 $ 7,913,911 =============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) CURRENT LIABILITIES: Short-term debt and current maturities of convertible notes, long-term debt and lease financing obligations $ 220,695 $ 36,956 Accounts payable 839,614 896,390 Sales and other taxes payable 43,898 31,562 Accrued salaries, wages and other current liabilities 823,519 696,047 --------------- --------------- Total current liabilities 1,927,726 1,660,955 CONVERTIBLE NOTES 242,625 357,324 LONG-TERM DEBT, LESS CURRENT MATURITIES 3,287,550 4,428,871 LEASE FINANCING OBLIGATIONS, LESS CURRENT MATURITIES 208,558 1,071,397 OTHER NONCURRENT LIABILITIES 742,632 730,342 --------------- --------------- Total liabilities 6,409,091 8,248,889 COMMITMENTS AND CONTINGENCIES -- -- REDEEMABLE PREFERRED STOCK 19,536 19,457 STOCKHOLDERS' EQUITY (DEFICIT): Preferred stock, par value $100 per share 354,221 333,974 Common stock, par value $1 per share 516,226 348,055 Additional paid-in capital 3,161,005 2,065,301 Accumulated deficit (3,746,923) (3,171,956) Stock-based and deferred compensation 20,822 19,782 Accumulated other comprehensive (loss) income (622) 50,409 --------------- --------------- Total stockholders' equity (deficit) 304,729 (354,435) --------------- --------------- Total liabilities and stockholders' equity (deficit) $ 6,733,356 $ 7,913,911 =============== =============== See accompanying notes to condensed consolidated financial statements. 2 RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share amounts) (unaudited) Thirteen Week Period Ended ----------------------------------- December 1, November 25, 2001 2000 --------------- --------------- REVENUES $ 3,732,079 $ 3,531,691 COSTS AND EXPENSES: Cost of goods sold, including occupancy costs 2,923,759 2,713,988 Selling, general and administrative expenses 801,453 810,900 Goodwill amortization 5,200 5,058 Store closing and impairment charges 18,652 95,571 Interest expense 82,515 146,122 Interest rate swap contracts 10,382 -- (Gain) loss on debt and lease conversions and modifications, net (56) 8,306 Share of loss from equity investment 1,697 6,484 Loss (gain) on sale of assets and investments, net 694 (13,491) --------------- --------------- 3,844,296 3,772,938 --------------- --------------- Loss from continuing operations before income taxes (112,217) (241,247) INCOME TAX EXPENSE 546 -- --------------- --------------- Loss from continuing operations (112,763) (241,247) DISCONTINUED OPERATIONS, reduction of loss on disposal of the PBM segment (net of income tax expense of $0) -- 135,534 --------------- --------------- NET LOSS $ (112,763) $ (105,713) =============== =============== BASIC AND DILUTED (LOSS) PER SHARE: Loss from continuing operations $ (0.23) $ (0.74) Reduction of loss from discontinued operations -- .40 --------------- --------------- Net loss per share $ (0.23) $ (0.34) =============== =============== See accompanying notes to condensed consolidated financial statements. 3 RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share amounts) (unaudited) Thirty-Nine Week Period Ended ----------------------------------- December 1, November 25, 2001 2000 --------------- --------------- REVENUES $ 11,133,286 $ 10,413,346 COSTS AND EXPENSES: Cost of goods sold, including occupancy costs 8,636,889 8,005,474 Selling, general and administrative expenses 2,469,452 2,491,090 Goodwill amortization 15,823 16,759 Store closing and impairment charges 40,393 199,742 Interest expense 313,581 499,871 Interest rate swap contracts 41,429 -- Loss on debt and lease conversions and modifications, net 154,539 92,095 Share of loss from equity investment 12,092 30,554 (Gain) loss on sale of assets and investments, net (50,761) 3,035 --------------- --------------- 11,633,437 11,338,620 --------------- --------------- Loss from continuing operations before income taxes (500,151) (925,274) INCOME TAX EXPENSE 3,046 144,382 --------------- --------------- Loss from continuing operations before extraordinary item (503,197) (1,069,656) DISCONTINUED OPERATIONS: Income from discontinued operations (net of income tax expense of $13,846) -- 11,335 Estimated loss on disposal of the PBM segment (net of income tax benefit of $734) -- (199,229) --------------- --------------- Net loss before extraordinary item (503,197) (1,257,550) EXTRAORDINARY ITEM, loss on early extinguishment of debt (net of income taxes of $0) 66,589 -- --------------- --------------- NET LOSS $ (569,786) $ (1,257,550) =============== =============== BASIC AND DILUTED (LOSS) PER SHARE: Loss from continuing operations $ (1.15) $ (4.12) Loss from discontinued operations -- (0.62) Loss from extraordinary item (0.14) -- --------------- --------------- Net loss per share $ (1.29) $ (4.74) =============== =============== See accompanying notes to condensed consolidated financial statements. 4 RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT) For the Thirty-Nine Week Period Ended December 1, 2001 (Dollars and share information in thousands) (unaudited) Preferred Stock Common Stock Additional ----------------------------------- ----------------------------------- Paid-in Shares Issued Shares Issued Capital --------------- --------------- --------------- --------------- --------------- BALANCE MARCH 3, 2001 3,340 $ 333,974 348,055 $ 348,055 $ 2,065,301 Net loss Other comprehensive loss: Sale of investment in AdvancePCS Cash flow hedge transition liability adjustment Cash flow hedge market value adjustment Elimination of cash flow hedge accounting Comprehensive loss Bond conversions 86,386 86,386 649,797 Issuance of common stock 80,083 80,083 448,321 Issuance of common stock warrants 982 982 8,018 Preferred stock conversion reset (5,181) 5,181 Accretion of convertible preferred stock 5,181 Deferred compensation plans 88 88 659 Stock options exercised 420 420 1,761 Issuance of common stock for services 241 241 1,556 Stock forfeitures (29) (29) (53) Dividends on preferred stock 202 20,247 (20,247) Increase resulting from sale of stock by equity method investee 711 --------------- --------------- --------------- --------------- --------------- BALANCE DECEMBER 1, 2001 3,542 $ 354,221 516,226 $ 516,226 $ 3,161,005 =============== =============== =============== =============== =============== Stock-Based Accumulated and Other Accumulated Deferred Comprehensive Deficit Compensation Income/(Loss) Total --------------- --------------- --------------- --------------- BALANCE MARCH 3, 2001 $ (3,171,956) $ 19,782 $ 50,409 $ (354,435) Net loss (569,786) (569,786) Other comprehensive loss: Sale of investment in AdvancePCS (51,031) (51,031) Cash flow hedge transition liability adjustment (29,010) (29,010) Cash flow hedge market value adjustment (2,037) (2,037) Elimination of cash flow hedge accounting 31,047 31,047 --------------- Comprehensive loss (620,817) Bond conversions 736,183 Issuance of common stock 528,404 Issuance of common stock warrants 9,000 Preferred stock conversion reset -- Accretion of convertible preferred stock (5,181) -- Deferred compensation plans 976 1,723 Stock options exercised 2,181 Issuance of common stock for services 1,797 Stock forfeitures 64 (18) Dividends on preferred stock -- Increase resulting from sale of stock by equity method investee 711 --------------- --------------- --------------- --------------- BALANCE DECEMBER 1, 2001 $ (3,746,923) $ 20,822 $ (622) $ 304,729 =============== =============== =============== =============== See accompanying notes to condensed consolidated financial statements. 5 RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (unaudited) Thirty-Nine Week Period Ended ----------------------------------- December 1, November 25, 2001 2000 --------------- --------------- OPERATING ACTIVITIES: Net loss $ (569,786) $ (1,257,550) Extraordinary loss 66,589 -- Income from discontinued operations -- (11,335) Loss on disposal of discontinued operations -- 199,229 --------------- --------------- Loss from continuing operations (503,197) (1,069,656) Adjustments to reconcile to net cash used in operations: Depreciation and amortization 266,913 278,004 Store closing and impairment charges 40,393 199,742 Non-cash stock charge 2,800 9,659 Interest rate swap contracts 41,429 -- Loss on debt and lease conversions and modifications, net 154,539 92,095 Gain on sale of assets and investments, net (50,761) (6,576) Changes in operating assets and liabilities (261,938) (271,251) --------------- --------------- NET CASH USED IN CONTINUING OPERATIONS (309,822) (767,983) --------------- --------------- NET CASH PROVIDED BY DISCONTINUED OPERATIONS -- 8,881 --------------- --------------- INVESTING ACTIVITIES: Expenditures for property, plant and equipment (146,476) (78,923) Proceeds from the repayment/sale of AdvancePCS securities 484,214 -- Intangible assets acquired (9,103) (5,200) Proceeds from sale of assets 19,400 92,774 Proceeds from sale of discontinued operations -- 675,000 --------------- --------------- NET CASH PROVIDED BY INVESTING ACTIVITIES 348,035 683,651 --------------- --------------- FINANCING ACTIVITIES: Net proceeds from bank loans -- 3,204,038 Principal payments on long-term debt (2,113,237) (2,924,295) Proceeds from the issuance of the senior credit facility 1,378,462 -- Proceeds from the issuance of convertible bonds 242,500 -- Net (payments) of commercial paper borrowings -- (192,000) Deferred financing costs paid (74,522) (73,071) Proceeds from issuance of stock 530,566 -- Other financing activities, net -- (1,492) --------------- --------------- NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (36,231) 13,180 --------------- --------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 1,982 (62,271) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 92,290 179,757 --------------- --------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 94,272 $ 117,486 =============== =============== (Continued) 6 RITE AID CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) (Dollars in thousands) (unaudited) Thirty-Nine Week Period Ended ----------------------------------- December 1, November 25, 2001 2000 --------------- --------------- SUPPLEMENTARY CASH FLOW DATA: Cash paid: Interest (net of capitalized amounts of $612 and $1,555) $ 314,490 $ 386,526 =============== =============== Income tax refunds (payments) $ (1,108) $ 87,032 =============== =============== Non-cash investing and financing activities: Conversion of debt to common stock $ 588,711 $ 554,832 =============== =============== Conversion of debt to debt $ 152,025 $ -- =============== =============== Non-cash consideration received for sale of discontinued operations $ -- $ 431,000 =============== =============== Components of conversion of leases from capital to operating: Reduction in leased assets, net $ 704,191 -- =============== =============== Reduction in lease financing obligations $ 850,792 -- =============== =============== Increase in deferred gain $ 168,483 -- =============== =============== See accompanying notes to condensed consolidated financial statements. 7 RITE AID CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS For the Thirteen and Thirty-Nine Week Periods Ended December 1, 2001 and November 25, 2000 (Dollars and share information in thousands, except per share amounts) (unaudited) 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X and therefore do not include all of the information and footnotes required by generally accepted accounting principles for complete annual financial statements. The accompanying financial information reflects all adjustments (consisting primarily of normal recurring adjustments except as described in these notes), which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods. The results of operations for the thirteen and thirty-nine week periods ended December 1, 2001 are not necessarily indicative of the results to be expected for the full year. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's fiscal 2001 Annual Report on Form 10-K filed with the SEC. Certain reclassifications have been made to prior years' amounts to conform to current year classifications. 2. Loss Per Share Following is a summary of the components of the numerator and denominator of the basic loss per share computation: Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Numerator for earnings per share: Loss from continuing operations $ (112,763) $ (241,247) $ (503,197) $ (1,069,656) Preferred stock beneficial conversion and reset -- -- (5,181) (160,915) Cumulative preferred stock dividends (6,879) (6,815) (20,247) (20,237) --------------- --------------- --------------- --------------- Net loss from continuing operations attributable to common stockholders (119,642) (248,062) (528,625) (1,250,808) Total income (loss) from discontinued operations -- 135,534 -- (187,894) Extraordinary item, loss on early extinguishment of debt -- -- (66,589) -- --------------- --------------- --------------- --------------- Net loss attributable to common stockholders $ (119,642) $ (112,528) $ (595,214) $ (1,438,702) =============== =============== =============== =============== Denominator: Basic weighted average shares 516,086 333,529 460,289 303,247 =============== =============== =============== =============== Fully diluted loss per share is not presented as the Company incurred losses for the thirteen and thirty-nine week periods ended December 1, 2001 and November 25, 2000, and the amount would be antidilutive. At December 1, 2001, an aggregate of 189,758 potential common shares related to stock options, convertible notes, preferred stock, warrants and shares committed to be issued in connection with the settlement of certain litigation, have been excluded from the computation of diluted earnings per share. 8 3. Business Segments The Company operated in a single business segment during the thirty-nine week period ended December 1, 2001, the Retail Drug segment. This segment consists of the operation of retail drugstores across the United States. The drugstores' primary business is pharmacy services, with prescription drugs accounting for approximately 61.7% and 60.0% of total segment sales for the thirty-nine week periods ended December 1, 2001 and November 25, 2000, respectively. In addition, the Company's drugstores offer a full selection of health and personal care products, seasonal merchandise and a large private label product line. The Company operated in two business segments in the thirty-nine week period ended November 25, 2000, the Retail Drug segment and the pharmacy benefit management ("PBM") segment. Through its PBM segment, which consisted primarily of PCS Health Systems, Inc. ("PCS"), the Company offered pharmacy benefit management, mail-order pharmacy services, marketing prescription plans and other managed health care services to employers, health plans and their members and government-sponsored employee benefit programs. The Company sold its PBM segment to Advance Paradigm Inc. (now known as "AdvancePCS"). As a result, the PBM segment has been reclassified and is accounted for as a discontinued operation in the accompanying fiscal 2001 financial statements. The Company's continuing operations consist solely of the Retail Drug segment. 4. Discontinued Operations On October 2, 2000, the Company sold its wholly owned subsidiary, PCS, to AdvancePCS. The proceeds from the sale of PCS consisted of $710,557 in cash, $200,000 in principal amount of AdvancePCS's unsecured 11% senior subordinated notes and equity securities of AdvancePCS. During March 2001, the Company sold the AdvancePCS equity securities for $284,214 resulting in a gain of $53,214, which was recognized during the thirteen week period ended June 2, 2001. The recognition resulted in a reduction of other comprehensive income of $51,031, which represented the appreciation in the market value of the equity securities from date of acquisition of the securities through March 3, 2001. Additionally, AdvancePCS repurchased the unsecured 11% senior subordinated notes for $200,000 plus accrued interest. PCS is reported as a discontinued operation for the thirteen and thirty-nine week periods ended November 25, 2000, and the operating results of PCS are reflected separately from the results of continuing operations. As a result of the sale, the Company recorded an increase to the tax valuation allowance and income tax expense of $146,917 in the thirty-nine week period ended November 25, 2000. 5. Store Closing and Impairment Charges Store closing and impairment charges consist of: Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Impairment charges $ 8,060 $ 44,518 $ 24,613 $ 70,342 Store and equipment lease exit charges 10,590 22,601 15,437 23,703 Impairment of other assets 2 28,452 343 105,697 --------------- --------------- --------------- --------------- $ 18,652 $ 95,571 $ 40,393 $ 199,742 =============== =============== =============== =============== 9 Impairment Charges Impairment charges include non-cash charges of $8,060 and $44,518 for the thirteen week periods ended December 1, 2001 and November 25, 2000, respectively, for the impairment of long-lived assets (including allocable goodwill) at 23 and 142 stores, respectively. Impairment charges include non-cash charges of $20,413 and $70,342 for the thirty-nine week periods ended December 1, 2001 and November 25, 2000, respectively, for the impairment of long-lived assets (including allocable goodwill) at 53 and 244 stores, respectively. These amounts include the write-down of long-lived assets at stores that were assessed for impairment because of management's intention to relocate or close the store. Also included in impairment charges for the thirty-nine weeks ended December 1, 2001 are approximately $4,200 of costs related to software. The Company has an investment in the common stock of drugstore.com, which is accounted for under the equity method. The initial investment was valued based upon the initial public offering price of drugstore.com. During the thirty-nine weeks ended November 25, 2000, the Company recorded an impairment of its investment in drugstore.com's stock of $105,697 that the Company believes to be other-than-temporary. As of December 1, 2001, the Company has no remaining recorded value for its investment in drugstore.com's common stock. Store and Equipment Lease Exit Costs Costs incurred to close a store, which principally consist of lease termination costs, are recorded at the time management commits to closing the store, which is the date that the closure is formally approved by senior management, or in the case of a store to be relocated, the date the new property is leased or purchased. The Company calculates its liability for closed stores on a store-by-store basis. The calculation includes the future minimum lease payments and related ancillary costs from the date of closure to the end of the remaining lease term, net of estimated cost recoveries that may be achieved through subletting properties or through favorable lease terminations. This liability is discounted using a risk-free rate of interest. The Company evaluates these assumptions at each interim period and adjusts the liability accordingly. During the thirteen week periods ended December 1, 2001 and November 25, 2000 the Company recorded a provision for 9 and 72 stores, respectively, that were designated for closure. During the thirty-nine week periods ended December 1, 2001 and November 25, 2000, the Company recorded a provision for 42 and 106 stores, respectively, that were designated for closure. Also included in this line are charges of approximately $1,300 incurred in the thirty-nine weeks ended December 1, 2001, related to the early termination of an equipment lease. The reserve for store and equipment lease exit costs includes the following activity: Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Balance --- beginning of period $ 219,825 $ 200,057 $ 233,008 $ 212,812 Provision for present value of noncancellable lease payments of stores designated to be closed 7,690 45,331 27,927 73,639 Changes in assumptions about future sublease income, terminations, and changes in interest rates 2,953 (21,764) (7,140) (41,639) Reversals of reserves for stores that management has determined will remain open (53) (966) (6,678) (8,298) Interest accretion 2,042 2,760 6,725 8,751 Cash payments, net of sublease income (12,639) (14,643) (34,024) (34,490) --------------- --------------- --------------- --------------- Balance --- end of period $ 219,818 $ 210,775 $ 219,818 $ 210,775 =============== =============== =============== =============== 10 6. Indebtedness, Credit Agreements and Lease Financing Obligations Following is a summary of indebtedness and lease financing obligations at December 1, 2001 and March 3, 2001: December 1, 2001 March 3, 2001 ---------------- --------------- Secured Debt: Senior secured credit facility ("SCF") $ 1,378,462 $ -- Senior facility -- 682,000 Revolving Credit Facility due 2002 ("RCF") -- 730,268 Term loan due 2002 ("PCS") -- 591,391 Exchange debt -- 216,126 10.5% senior secured notes due 2002 21,879 467,500 12.5% senior secured notes due 2006 143,739 -- Other 11,942 12,447 --------------- --------------- 1,556,022 2,699,732 Lease Financing Obligations 223,879 1,100,000 Unsecured Debt: 6.7% notes due 2001 7,342 7,342 5.25% convertible subordinated notes due 2002 152,010 357,324 6.0% dealer remarketable securities due 2003 85,050 187,650 6.0% fixed-rate senior notes due 2005 194,500 194,500 7.625% senior notes due 2005 198,000 198,000 4.75% convertible notes due 2006 242,625 -- 7.125% notes due 2007 350,000 350,000 6.125% fixed-rate senior notes due 2008 150,000 150,000 11.25% notes due 2008 150,000 -- 6.875% senior debentures due 2013 200,000 200,000 7.7% notes due 2027 300,000 300,000 6.875% fixed-rate senior notes due 2028 150,000 150,000 --------------- --------------- 2,179,527 2,094,816 --------------- --------------- Total debt 3,959,428 5,894,548 Short-term debt and current maturities of convertible notes, long-term debt and lease financing obligations (220,695) (36,956) --------------- --------------- Long-term debt and lease financing obligations, less current maturities $ 3,738,733 $ 5,857,592 =============== =============== Refinancing Transactions On June 27, 2001, the Company completed a major financial restructuring that extended the maturity dates of the majority of its debt to 2005 or beyond, provided additional equity and converted a portion of its debt to equity. These transactions are described below: New Senior Secured Credit Facility: The Company entered into a new $1,900,000 senior secured credit facility with a syndicate of banks led by Citicorp USA, Inc. as senior agent. The new facility matures on June 27, 2005 unless more than $20,000 of the 7.625% senior notes due April 15, 2005 are outstanding on December 31, 2004, in which event the maturity date is March 15, 2005. The new facility consists of a $1,400,000 term loan facility and a $500,000 revolving credit facility. The term loan was used to repay the outstanding balances of the old senior facility, PCS facility, RCF facility, the Exchange Debt and all but $21,879 of the 10.5% senior secured notes due September 2002. The revolving facility is available for working capital requirements, capital expenditures and general corporate purposes. Borrowings under the facilities generally bear interest either at LIBOR plus 3.5%, if the Company chooses to make LIBOR borrowings, or at Citibank's base rate plus 2.5%. The Company is required to pay fees of 0.50% per annum on the daily unused amount of the revolving facility. Amortization payments of $5,000 related to the term loan begin March 4, 2002, increasing to $7,500 for the quarters ending May 31, 2002 through August 31, 2003 and $15,000 for the quarters ending November 30, 2003 through February 26, 2005. 11 Substantially all of Rite Aid Corporation's wholly owned subsidiaries guarantee the obligations under the senior secured credit facility. The subsidiary guarantees are secured by a first priority lien on the inventory, accounts receivable, prescription files, intellectual property and certain real estate assets of the subsidiary guarantors. Rite Aid Corporation is a holding company with no direct operations and is dependent upon dividends and other payments from its subsidiaries to service payments due under the senior credit facility. Rite Aid Corporation's direct obligations under the senior credit facility are unsecured. The senior secured credit facility contains customary covenants, which place restrictions on the assumption of debt, the payment of dividends, mergers, liens and sale and leaseback transactions. The senior secured credit facility has been amended to allow the Company, at its option, to issue up to $643,000 of unsecured debt that is not guaranteed by any subsidiaries of the Company, reduced by the following debt to the extent incurred: (i) $150,000 of financing transactions of existing owned real estate; (ii) $393,000 of additional debt secured by the facility's collateral on a second priority basis; and (iii) $100,000 of financing transactions for property or assets acquired after June 27, 2001. The $643,000 of permitted debt, whether secured or unsecured, is reduced by the aggregate outstanding, undefeased balances of the 5.25% convertible subordinated notes, the 6.0% dealer remarketable securities and the 4.75% convertible notes. As of December 1, 2001, the Company had outstanding principal balances of $152,010, $85,050 and $250,000 of the 5.25% convertible subordinated notes, 6.0% dealer remarketable securities and 4.75% convertible notes, respectively. The senior secured credit facility requires the Company to meet various financial ratios and limits capital expenditures. Beginning with the nine months ending December 1, 2001, the covenants require the Company to maintain a maximum leverage ratio of 8.25:1 decreasing to 3.5:1 for the twelve months ending May 31, 2005. The Company must also maintain a minimum interest coverage ratio of 1.25:1 for the nine months ending December 1, 2001, increasing to 2.8:1 for the twelve months ending May 31, 2005 and a minimum fixed charge coverage ratio of 0.9:1 for the nine months ending December 1, 2001 increasing to 1.25:1 for the twelve months ending May 31, 2005. Capital expenditures are limited to $200,000 annually beginning with the twelve months ending March 2, 2002. These expenditure limits are subject to upward adjustment based upon availability of excess liquidity as defined in the Company's senior secured credit facility. As of December 1, 2001, the Company is in compliance with these covenants. The senior secured credit facility provides for customary events of default, including nonpayment, misrepresentation, breach of covenants and bankruptcy. It is also an event of default if any event occurs that enables, or which with the giving of notice or the lapse of time would enable, the holder of the Company's debt to accelerate the maturity of debt having a principal amount of $25,000 or more. The Company's ability to borrow under the senior secured credit facility is based on a specified borrowing base consisting of eligible accounts receivable and inventory. At December 1, 2001, the term loan was fully drawn except for $21,538, which is available and may be drawn to pay the remaining outstanding 10.5% senior secured notes when they mature on September 15, 2002. At December 1, 2001, the Company had no outstanding draws on the revolving credit facility and the Company had additional available borrowing capacity of $417,560, net of outstanding letters of credit of $82,440. High Yield Notes: The Company issued $150,000 of 11.25% senior notes due July 2008 in a private placement offering. These notes are unsecured and are effectively subordinate to the secured debt of the Company. Among the transactions permitted by the 11.25% senior notes to increase debt are transactions to finance existing owned real estate not to exceed an aggregate $150,000 and $400,000 of other debt. The 11.25% senior notes also allow $600,000 of additional permitted debt, which includes increasing the senior secured facility. As a result of the issuance by the Company of $250,000 of 4.75% convertible notes in November 2001, the amount of additional other debt permitted by the 11.25% senior notes decreased from $400,000 to $150,000, although the Company may reclassify this debt to other permitted debt at any time. 12 Debt for Debt Exchange: The Company exchanged $152,025 of its existing 10.5% senior secured notes due 2002 for an equal amount of 12.5% senior notes due September 2006. In addition, holders of these notes received warrants to purchase 3,000 shares of Company common stock at $6.00 per share. On June 29, 2001, the warrant holders exercised these warrants, on a cashless basis, and as a result approximately 982 shares of common stock were issued. Tender Offer: On May 24, 2001, the Company commenced a tender offer for the 10.50% senior secured notes due 2002 at a price of 103.25% of the principal amount of the notes. The tender offer was closed on June 27, 2001, at which time $174,462 principal amount of the notes was tendered. The Company incurred a tender offer premium of $5,670 as a result of the transaction, which is included as a component of the extraordinary loss. The Company used proceeds from the new senior secured credit facility to pay for the notes tendered. Debt for Equity Exchanges and Sales of Capital Stock: The Company has completed the following debt for equity exchanges during the thirty-nine weeks ended December 1, 2001. Debt Exchanged Carrying Common Additional Amount Stock Paid-In Exchanged Capital --------------- --------------- --------------- PCS facility $ 14,478 $ 1,769 $ 13,867 RCF facility 169,906 26,370 158,388 5.25% convertible subordinated notes 205,308 29,750 307,686 6.00% dealer remarketable securities 79,885 12,382 55,633 10.50% notes due 2002 119,134 16,115 114,223 --------------- --------------- --------------- $ 588,711 $ 86,386 $ 649,797 =============== =============== =============== In addition to the debt for equity exchange transactions listed above, the Company sold approximately 80,083 shares of its common stock for net proceeds of $528,404, which resulted in an increase to common stock of $80,083, and additional paid in capital of $448,321. The Company issued approximately 2,122 shares of its Series C Convertible Preferred Stock in connection with the debt for equity exchanges. The Series C Convertible Preferred Stock converted into 21,217 shares of common stock on July 30, 2001, at which time the Series C Convertible Preferred Stock was retired. As a result of the above exchanges, the Company recognized an aggregate loss of $151,907 for the thirty-nine week period ended December 1, 2001. The amount of this loss related to the exchange of debt convertible into the Company's common stock is $132,713, and is classified as a component of operations. The remaining loss of $19,194 is classified as a component of the extraordinary loss. Lease Obligations: The Company surrendered certain renewal options contained in certain real estate leases on property previously sold and leased back to the Company and as a result these leases which were previously afforded sale and leaseback accounting treatment and have been reclassified as operating leases. This action resulted in a reduction of outstanding capital lease obligations of $850,792. Accordingly, the Company recognized a loss on lease modifications of $21,882 in the thirty-nine weeks ended December 1, 2001, and recorded a net deferred gain of $168,483, which will be amortized over the remaining noncancellable lease terms. In addition, the Company repaid certain obligations totaling $16,467 related to leasehold improvements. Synthetic Leases: The Company terminated existing synthetic lease agreements for certain land, buildings, equipment and aircraft, which were accounted for as operating leases. A wholly owned subsidiary of the Company purchased the equipment for $82,604, and is leasing the land, buildings and aircraft from different parties. The obligations under the new synthetic lease for the land and buildings are secured by a first priority lien on the equipment at the leased buildings owned by the Company's subsidiary. The Company has guaranteed certain of the obligations of the subsidiary. The Company accounted for these new leases as operating leases. 13 Guarantees: Substantially all of Rite Aid Corporation's wholly-owned subsidiaries guarantee the obligations under the new senior secured credit facility. These subsidiary guarantees are secured primarily by a first priority lien on the inventory, accounts receivable, prescription files, intellectual property and some real estate assets of the subsidiary guarantors. Rite Aid Corporation is a holding company with no direct operations and is dependent upon dividends and other payments from its subsidiaries to service payments due under the senior credit facility. Rite Aid Corporation's direct obligations under the senior credit facility are unsecured. The $21,879 aggregate principal amount of outstanding 10.5% senior secured notes are guaranteed by substantially all of the Company's wholly-owned subsidiaries, which are secured on a shared first priority basis with the new credit facility. The 12.5% senior secured notes due 2006 are guaranteed by substantially all of the Company's wholly-owned subsidiaries, and are secured on a second priority basis by the same collateral as the new senior secured credit facility. Interest Rate Swap Contracts: In June 2000, the Company entered into an interest rate swap contract that fixes the LIBOR component of $500,000 of the Company's variable rate debt at 7.083% for a two-year period. In July 2000, the Company entered into an additional interest rate swap that fixes the LIBOR component of an additional $500,000 of variable rate debt at 6.946% for a two-year period. On March 4, 2001, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended by SFAS No. 138. In connection with the adoption of the new statement, the Company recorded $29,010 in Other Comprehensive Income ("OCI") as a cumulative change in accounting for derivatives designated as cash flow type hedges prior to adopting SFAS 133. The Company enters into interest rate swap agreements to hedge the exposure to increasing rates with respect to its variable rate debt. These interest rate swap agreements were accounted for as cash flow hedges upon the initial adoption of SFAS 133. As a result of the June 27, 2001 refinancing, the Company's interest rate swaps no longer qualify for hedge accounting treatment and therefore, the changes in fair value of these interest rate swap contracts is required to be recorded as a component of net loss. Accordingly, the Company recognized a charge of $31,047 representing the amount that the Company would have to pay the counter party to terminate these contracts as of that date. Subsequent changes in the market value of the interest rate swaps of $10,382, inclusive of cash payments, have been recorded on the income statement for the thirteen weeks ended December 1, 2001. This amount represents an adjustment to the aggregate expense projected to be recognized by the Company relating to the swaps. This adjustment is due to a reduction in market interest rates over the thirteen week period ended December 1, 2001. The termination liability was $31,276 as of December 1, 2001. Other: As a result of the above transactions, the Company has recorded an extraordinary loss on early extinguishment of debt of $66,589 (including $40,735 of deferred debt issue costs written-off), loss on debt and lease conversions and modifications of $21,882 and deferred debt issue costs of $73,972. Other Transactions Convertible Notes: The Company issued $250,000 of 4.75% convertible notes due December 2006 in November 2001. These notes were issued at a 3% discount resulting in cash proceeds of $242,500. These notes are unsecured and are effectively subordinate to the secured debt of the Company. The notes are convertible, at the option of the holder, into shares of the Company's common stock at a conversion price of $6.50 per share, subject to adjustments to prevent dilution, at any time. Repurchase of Debt: The Company repurchased $22,715 of its 6.0% dealer remarketable securities due 2003 during the thirteen weeks ended December 1, 2001. Exchange: The Company is party to an agreement to exchange approximately 3,000 shares of its common stock for $21,300 aggregate liquidation preference of one of its subsidiary's 7% redeemable preferred stock. The number of shares of common stock to be issued will be based upon the average trading price of the common stock over a period of time to be determined. The transaction has not been consummated as of December 1, 2001. The redeemable preferred stock has a carrying value of $19,536 ($21,300 less unamortized discount of $1,764) as of December 1, 2001. Other: In March 2001, the Company sold its investment in AdvancePCS. Proceeds received from the sale were used to pay down $437,508 of borrowings under the PCS facility, and $46,596 of borrowings under the Exchange Debt. 14 The aggregate annual principal payments of long-term debt and capital lease obligations for the remainder of fiscal 2002 and for the four succeeding fiscal years are as follows: 2002, $10,023; 2003, $223,849; 2004, $143,616; 2005, $84,967; 2006, $1,653,621 and $1,859,013 in 2007 and thereafter. The aggregate annual minimum lease payments of operating leases for the remainder of fiscal 2002 and for the four succeeding fiscal years are as follows: 2002, $148,454; 2003, $586,591; 2004, $555,138; 2005, $521,569; 2006, $478,937 and $4,554,939 in 2007 and thereafter. 7. Stockholders' Equity (Deficit) On June 27, 2001, the stockholders approved an amendment to the Company's Restated Certificate of Incorporation to increase the number of authorized shares of common stock, $1.00 par value, from 600,000 to 1,000,000. On October 5, 2001, the Company exchanged all outstanding shares of Series B cumulative pay-in-kind preferred (Series B preferred stock) for an equal number of shares of 8% Series D cumulative pay-in-kind preferred stock (Series D preferred stock). The Series D preferred stock differs from the Series B preferred stock only in that the consent of holders of the Series D preferred stock is not required in order for the Company to issue shares of the Company's capital stock that are on parity with the Series D preferred stock with respect to dividends and distributions upon our liquidation, distribution or winding up. During the thirty-nine week period ended December 1, 2001, the Company issued, as a dividend, 202 shares of 8% Series D preferred stock at $100 per share, which is the liquidation preference. The Series D Preferred Stock is convertible into shares of the Company's common stock at a conversion price of $5.50 per share, subject to adjustments to prevent dilution. In November 2000, the Company reduced the exercise price of approximately 16,684 stock options issued after December 4, 1999 to $2.75 per share, which represents the fair market value of a share of common stock on the date of the repricing. In connection with the repricing, the Company recognizes compensation expense for these options using variable plan accounting. Under variable plan accounting, the Company recognizes compensation expense over the option vesting period. In addition, subsequent changes in the market value of the Company's common stock during the option period, or until exercised, will generate changes in the compensation expense recognized on the repriced options. The Company recognized a reduction of expense of $39,847 and $2,719 during the thirteen and thirty-nine week periods ended December 1, 2001, respectively, related to the repriced options. As of December 1, 2001, the stock-based and deferred compensation component of stockholders' equity is comprised of $31,026 related to the repriced options offset by $10,204 of deferred compensation. During fiscal 2002, in connection with the vesting of certain restricted shares of common stock, the Company made loans totaling approximately $5,900 to executive officers to provide them with funds to pay federal and state income taxes due upon the vesting. The loans bore interest and were secured on a non-recourse basis by the vested shares. On December 10, 2001, the executive officers repaid these loans utilizing the 1,140 shares securing those loans. This will result in a charge of $1,315 during the fourth quarter of fiscal 2002. During the thirteen week period ended December 1, 2001, the Company finalized an agreement with a service provider whereby the provider would receive shares of Company common stock in exchange for certain services. In connection with this agreement, the Company issued 241 shares of its common stock and recognized $1,797 of stock based compensation expense during the thirteen weeks ended December 1, 2001. 8. Commitments and Contingencies The Company is party to numerous legal proceedings, as described below. Federal investigations There are currently pending federal governmental investigations, both civil and criminal, by the SEC and the United States Attorney, involving the Company's financial reporting and other matters. Management is cooperating fully with the SEC and the United States Attorney. Settlement discussions have begun with the United States Attorney for the Middle District of Pennsylvania. The United States Attorney has proposed that the government would not institute any criminal proceeding against the Company if the Company enters into a consent judgement providing for a civil penalty payable over a period of years. The amount of the civil penalty has not been agreed to and there can be no assurance that a settlement will be reached or that the amount of such penalty will not have a material adverse effect on the Company's financial condition and results of operations. 15 The U.S. Department of Labor has commenced an investigation of matters relating to the Company's employee benefit plans, including the Company's principal 401(k) plan, which permitted employees to purchase the Company's common stock. Purchases of the Company's common stock under the plan were suspended in October 1999. In January 2001, the Company appointed an independent trustee to represent the interests of these plans in relation to the Company and to investigate possible claims the plans may have against the Company. Both the independent trustee and the Department of Labor have asserted that the plans may have claims against the Company. The investigations, with which the Company is cooperating fully, are ongoing and the Company cannot predict their outcomes. In addition, a purported class action lawsuit on behalf of the plans and their participants has been filed by a participant in the plans in the United States District Court for the Eastern District of Pennsylvania. These investigations and settlement discussions are ongoing and the Company cannot predict their outcomes. If the Company were convicted of any crime, certain licenses and government contracts such as Medicaid plan reimbursement agreements that are material to operations may be revoked, which would have a material adverse effect on the Company's results of operations and financial condition. In addition, substantial penalties, damages or other monetary remedies assessed against the Company, including a settlement, could also have a material adverse effect on the Company's results of operations, financial condition or cash flows. Stockholder litigation The Company, certain directors, its former chief executive officer Martin Grass, its former president Timothy Noonan, its former chief financial officer Frank Bergonzi, and its former auditor KPMG LLP, have been sued in a number of actions, most of which purport to be class actions, brought on behalf of stockholders who purchased the Company's securities on the open market between May 2, 1997 and November 10, 1999. Most of the complaints asserted claims under Sections 10 and 20 of the Securities Exchange Act of 1934, based upon the allegation that the Company's financial statements for fiscal 1997, fiscal 1998 and fiscal 1999 fraudulently misrepresented the Company's financial position and results of operation for those periods. All of these cases have been consolidated in the U.S. District Court for the Eastern District of Pennsylvania. On November 9, 2000, the Company announced that it had reached an agreement to settle the consolidated securities class action lawsuits pending there and in the Delaware Court of Chancery. Under the agreement, the Company will pay $45,000 in cash, which will be fully funded by the Company's officers' and directors' liability insurance, and issue shares of common stock in 2002. The shares will be valued over the 10 day trading period which began January 11, 2002. If the value determined is at least $7.75 per share, the Company will issue 20,000 shares. If the value determined is less than $7.75 per share, the Company has the option to deliver any combination of common stock, cash and short-term notes, with a total value of $155,000. As additional consideration for the settlement, the Company has assigned to the plaintiffs all of the Company's claims against the above named executives and KPMG LLP. On August 16, 2001, the district court approved the settlement. Certain of the nonsettling defendants have appealed the order. The Company cannot predict the outcome of that appeal. If the settlement does not become final, this litigation could result in a material adverse effect on the Company's results of operations, financial condition or cash flows. Several members of the class have elected to "opt-out" of the class and, as a result, approval of the settlement becomes final and they will be free to individually pursue their claims. Management believes that their claims, individually and in the aggregate, are not material. A purported class action has been instituted by a stockholder against the Company in Delaware state court on behalf of stockholders who purchased shares of the Company's common stock prior to May 2, 1997, and who continued to hold them after November 10, 1999, alleging claims similar to the claims alleged in the consolidated securities class action lawsuits described above. The amount of damages sought was not specified and may be material. The Company has filed a motion to dismiss this claim which is pending before the court. These claims are ongoing and the Company cannot predict their outcome. An unfavorable outcome could result in a material adverse effect on the Company's results of operations, financial condition or cash flows. 16 Drug pricing and reimbursement matters On October 5, 2000, the Company settled, for an immaterial amount, and without admitting any violation of the law, the lawsuit filed by the Florida Attorney General alleging that the Company's non-uniform pricing policy for cash prescription purchases was unlawful under Florida law. The filing of the complaint by the Florida Attorney General, and the Company's press release issued in conjunction therewith, precipitated investigations by the Attorneys General of certain other states (all of which have been closed without any significant cost to the Company) and the filing of several purported federal and state class actions, all of which (other than one pending in New York that was filed on October 5, 1999 and which the Company believes is without merit and immaterial in amount) have been dismissed. A motion to dismiss the action in New York is currently pending. On May 30, 2001, a complaint filed in New Jersey in which the plaintiff made similar allegations and which the trial court dismissed for failing to state a claim upon which relief could be based was reinstated by the appellate court. The Company is being investigated by multiple state attorneys general for its reimbursement practices relating to partially-filled prescriptions and fully-filled prescriptions that are not picked up by ordering customers. The Company is supplying similar information with respect to these matters to the Department of Justice. The Company believes that these investigations are similar to investigations which were, and are being, undertaken with respect to the practices of others in the retail drug industry. The Company also believes that its existing policies and procedures fully comply with the requirements of applicable law and intend to fully cooperate with these investigations. The Company cannot, however, predict their outcomes at this time. An individual acting on behalf of the United States of America, has filed a lawsuit in the United Stated District Court for the Eastern District of Pennsylvania under the Federal False Claims Act alleging that the Company defrauded federal healthcare plans by failing to appropriately issue refunds for partially filled prescriptions and prescriptions which were not picked up by customers. The Department of Justice has advised the court that it intends to join this lawsuit, as is its right under the law; its investigation is continuing. The Company has filed a motion to dismiss the complaint for failure to state a claim. The Company has reached an agreement to settle these investigations and the lawsuit filed by the private individual for $7,225, which is subject to court approval. The Company has reserved $7,225 against this potential liability. These claims are ongoing and the Company cannot predict their outcome. If any of these cases result in a substantial monetary judgement against the Company or is settled on unfavorable terms, the Company's results of operations, financial position and cash flows could be materially adversely affected. Other The Company, together with a significant number of major U.S. retailers, have been sued by the Lemelson Foundation in a complaint which alleges that portions of the technology included in the Company's point-of-sale system infringe upon a patent held by the plaintiffs. The amount of damages sought is unspecified and may be material. The Company cannot predict the outcome of this litigation or whether it could result in a material adverse effect on the Company's results of operations, financial conditions or cash flows. The Company is subject from time to time to lawsuits arising in the ordinary course of business. In the opinion of the Company's management, these matters are adequately covered by insurance or, if not so covered, are without merit or are of such nature or involve amounts that would not have a material adverse effect on the Company's results of operations, financial condition, or cash flows if decided adversely. 9. Subsequent Events In December 2001, the Company entered into an agreement with another operator of retail drugstores under which the Company will exchange certain of its prescription files, fixed assets and inventory for certain prescription files, fixed assets and inventory owned by the other retailer. The party which transfers assets having a lesser aggregate value will make a cash payment to the other party in an amount necessary to equalize the value. The Company will account for this transaction as an exchange of non-monetary assets, and therefore, will record the assets received at the cost basis of the assets relinquished. In connection with this transaction, the Company plans to close 36 stores which held prescription files that are being transferred to other stores. The Company expects to incur a fourth quarter charge of approximately $40,000 related to these closings, which consists primarily of lease termination costs. 17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview We operate 3,583 retail drugstores in 29 states and in the District of Columbia. We sell prescription drugs, which accounted for approximately 61.7% of our total sales during the first three quarters of 2002, and other products, which we refer to as front-end products, including non-prescription medications, health and beauty aids and personal care items, cosmetics, photo processing and convenience items. Until October 2, 2000, we operated a pharmacy benefit management services business. From the beginning of fiscal 1997 until December 1999, we were engaged in an aggressive expansion program. During that period, we purchased 1,554 stores, relocated 866 stores, opened 445 new stores, remodeled 308 stores and acquired PCS. These activities had a significant negative impact on our operating results, severely strained our liquidity and increased our indebtedness to $6.6 billion as of February 26, 2000. In October 1999, we announced that we had identified accounting irregularities and our former chairman and chief executive officer resigned. In November 1999, our former auditors resigned and withdrew their previously issued opinions on our financial statements for the fiscal years 1998 and 1999. Thereafter, the SEC and the U.S. Attorney for the Middle District of Pennsylvania began investigations into our affairs. In addition, the complaint in a securities class action lawsuit, which had been filed in March 1999, was amended to include allegations based upon the accounting irregularities we disclosed. In December 1999, a new senior management team was hired. At the time of their arrival, the new management team faced a series of immediate challenges. These included: o Deteriorating Store Operations. We experienced substantial operational difficulties during fiscal 2000. The principal problem was a decline in customer traffic and revenues due to inventory shortages, reduced advertising and uncompetitive prices on front-end products. By November 1999, our out-of-stock level had reached 29% and many popular products were not available in our stores. This situation resulted from liquidity constraints and concerns, tighter vendor credit terms and a delay in the opening of our distribution center in Perryman, MD, which caused delays in the shipment of seasonal merchandise. During fiscal 2000, we also suspended our practice of circulating regular newspaper advertising supplements. This disrupted customer traffic and adversely affected revenues. In order to offset the effects of these actions, former management raised the prices of front-end products above competitive levels. Customers rejected the higher prices and revenues continued to decline. o Inability to Access Capital Markets. From March 1995 through February 2000, we substantially increased our level of debt and placed a significant strain on our short-term liquidity. The problems were exacerbated by our inability to complete a planned public offering of equity securities to repay the $1.3 billion short-term credit facility due in October 1999, which had been established to support the commercial paper issuances used to acquire PCS. By June 1999, we had issued the maximum amount of commercial paper that was permitted under our credit facilities. In September 1999, we informed our banks that we anticipated being in default on various covenants under both our $1.3 billion PCS credit facility and our $1.0 billion general credit facility and in October 1999, Standard & Poor's and Moody's downgraded our credit rating. Following these events, we lost access to the commercial paper market. In response to the situation we faced, we completed the following: o Reduced our indebtedness from $6.6 billion on February 26, 2000 to $4.0 billion on December 1, 2001; o Improved our front-end same store sales growth from a negative 2.2% in fiscal 2000 to a positive 3.6% during the first three quarters of fiscal 2002 by improving store conditions and product pricing and launching a competitive marketing program; 18 o Restated our financial statements for fiscal 1998 and fiscal 1999, engaged new auditors to audit our financial statements for fiscal 1998, fiscal 1999 and fiscal 2000, and resumed normal financial reporting; o Significantly reduced the amount of our indebtedness maturing prior to March 2005; o Settled, subject to appeal, the securities class action and related lawsuits for $45.0 million to be funded with insurance proceeds and $155.0 million of common stock, cash and/or notes to be issued and paid in January 2002; o Began implementing an initiative to improve all aspects of our supply chain, including buying practices, category management systems and other inventory issues; o Continued developing and implementing a comprehensive plan, which is ongoing, to address problems with our accounting systems and controls, and also resumed normal financial reporting; and o Completed the refinancing of our indebtedness. See "--Liquidity and Capital Resources--Refinancing" for further details. Recent Actions Affecting Operating Results. During fiscal 2001 and the first three quarters of fiscal 2002, we took a number of actions which had the short-term effect of significantly reducing our operating results but which management believes were nevertheless necessary. Actions taken in fiscal 2001 were: (i) the sale of PCS, which resulted in our recognizing a loss of $168.8 million and an increase in income tax expense of $146.9 million; (ii) the exchange of approximately $597.3 million of our debt for shares of our common stock, which resulted in an a net loss of $100.6 million; (iii) our decision to close or relocate certain stores, which resulted in an approximately $149.2 million charge included in the $388.1 million recorded charges for store closures and impairment; and (iv) the restatement and audit of our fiscal 1998 and fiscal 1999 financial statements and the related investigation conducted by our audit committee of prior accounting irregularities, which resulted in our incurring and recording $82.1 million of accounting and legal expense. In the first three quarters of fiscal 2002, the actions taken were (i) completion of the Refinancing, which extended the maturity of the majority of our debt, converted a portion of our debt to equity, and reclassified capital leases to operating leases, resulting in aggregate losses of $252.2 million and (ii) our decision to close or relocate certain stores, which resulted in a charge of $40.4 million. We anticipate taking actions in the future similar to some of those described above that may have a material negative impact upon our operating results for the period in which we take those actions or subsequent periods. Maturing Store Base. Since the beginning of fiscal 1997, we built 473 new stores, relocated 956 stores, remodeled 462 stores and closed 1,211 stores. These new, relocated and remodeled stores represented approximately 50% of our total stores at December 1, 2001. The new and relocated stores opened in recent years are generally larger, freestanding stores with higher operating expenses than our older stores. New stores generally do not become profitable until a critical mass of customers is developed. Relocated stores also must attract additional customers to achieve comparable profitability to the store that was replaced. We believe that the period of time required for a new store to achieve profitable operations is generally two to four years. This period can vary significantly based on the location of a particular store and on other factors, including the investments made in purchasing prescription files for the location and advertising. Our recent liquidity constraints have limited our ability to purchase prescription files and make other investments to promote the development of our new and relocated stores. We believe that our relatively high percentage of new and relocated stores is a significant factor in our recent operating results. However, we believe that as these newer stores mature they should gain the critical mass of customers needed for profitable operations. This continuing maturation should positively affect our operating performance in future periods. If we are not able to improve the performance of these new and relocated stores, it will adversely affect our ability to restore the profitability of our operations. Substantial Accounting, Legal and Investigation Expenses. We have incurred substantial expenses in connection with the process of reviewing and reconciling our books and records, restating our fiscal 1998 and fiscal 1999 statements, investigating our prior accounting practices and preparing our financial statements. Included in these expenses are the costs of the Deloitte & Touche LLP audits, the investigation by the law firm of Swidler, Berlin, Shereff, Friedman, LLP assisted by Deloitte & Touche LLP, conducted for our audit committee concerning the accounting irregularities which led to the restatement of our financial statements for fiscal 1998 and fiscal 1999 and the costs of retaining Arthur Andersen LLP to assist management in reviewing and reconciling our books and records. We incurred $82.1 million in fiscal 2001, $14.5 million in the first three quarters of fiscal 2002, and we expect to incur $2.0 million to $5.0 million in the remainder of fiscal 2002. We anticipate that we will continue to incur significant legal and other expenses in connection with the ongoing litigation and investigations to which we are subject. 19 Dilutive Equity Issuances. At December 1, 2001, 516.2 million shares of common stock were outstanding and additional 189.8 million shares of common stock were issuable related to outstanding stock options, convertible notes, preferred stock, warrants and shares committed to be issued in connection with the settlement of certain litigation. During the first three quarters of fiscal 2002, we issued 86.4 million shares of common stock in exchange for $588.7 million of indebtedness. See "--Liquidity and Capital Resources--Refinancing" for further details. Included in the issuable shares are 38.5 million shares issuable upon the conversion of the 4.75% convertible notes due 2006. In light of our substantial leverage and liquidity constraints, we will continue to consider opportunities to use our equity securities to discharge debt or other obligations that may arise. Such issuances may have a dilutive effect on the outstanding shares of common stock. Accounting Systems. Following its review of our books and records in connection with our fiscal 2000 audit, management concluded that further steps were needed to establish and maintain the adequacy of our internal accounting systems and controls. In connection with the audit of our financial statements, Deloitte & Touche LLP advised us that it believed there were numerous "reportable conditions" under the standards established by the American Institute of Certified Public Accountants which relate to our accounting systems and controls that could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. We are further developing and implementing comprehensive, adequate and reliable accounting systems and controls which address the reportable conditions identified by Deloitte & Touche LLP. Sale of PCS. On October 2, 2000, we sold PCS, our PBM segment, to Advance Paradigm (now AdvancePCS). The selling price of PCS consisted of $710.5 million in cash, $200.0 million in principal amount of Advance PCS's 11% promissory notes and AdvancePCS equity securities. Accordingly, the PBM segment is reported as a discontinued operation for all periods presented in the accompanying financial statements, and the operating income of the PBM segment through October 2, 2000, the date of sale, is reflected separately from the income from continuing operations. The loss on disposal of the PBM segment was $168.8 million. Additionally, we recorded an increase to the tax valuation allowance and income tax expense of $146.9 million in the first quarter of fiscal 2001 in continuing operations. Working Capital. We generally finance our inventory and capital expenditure requirements with internally generated funds and borrowings. We expect to use borrowings to finance inventories and to support our continued growth. Approximately 75% of our front-end sales are in cash. Third-party insurance programs, which typically settle in fewer than 30 days, accounted for 90.3% and 92.0% of our pharmacy revenues and 53.7% and 56.9% of our revenues in fiscal 2001 and the first three quarters of fiscal 2002, respectively. Seasonality. We experience seasonal fluctuations in our results of operations in the fourth fiscal quarter as the result of the seasonal nature of Christmas and the flu season. We also tailor certain front-end merchandise to capitalize on holidays and seasons. This leads to an increase in revenues during our fourth quarter. Industry Trends. It is anticipated that pharmacy sales in the United States will increase 75% over the next five years. This anticipated growth is expected to be driven by the "baby boom" generation entering their fifties, the increasing life expectancy of the American population, the introduction of several new drugs and inflation. The retail drugstore industry is highly fragmented and has been experiencing consolidation. We believe that the continued consolidation of the drugstore industry will further increase competitive pressures in the industry. We expect to continue to compete on the basis of price and convenience, particularly in front-end products and therefore will continue to focus on programs designed to improve our image with customers. Prescription drug sales continue to represent a greater portion of our new business due to the general aging of the population, the use of pharmaceuticals to treat a growing number of healthcare problems, and the introduction of a number of successful new prescription drugs. In fiscal 2001 and the first three quarters of fiscal 2002, we were reimbursed by third-party payors for approximately 90.3% and 92.0%, respectively, of all of the prescription drugs that we sold. If third-party payors reduce their reimbursement levels or if Medicare covers prescription drugs at reimbursement levels lower than our current retail prices, our margins on these sales would be reduced and the profitability of our business could be adversely affected. 20 Results of Operations Revenues and Other Operating Data Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Revenues $ 3,732,079 $ 3,531,691 $ 11,133,286 $ 10,413,346 Revenue growth 5.7% 7.7% 6.9% 5.9% Same store sales growth 6.9% 10.0% 8.3% 8.5% Pharmacy sales growth 8.5% 9.1% 9.6% 8.0% Same store pharmacy sales growth 10.6% 11.0% 11.4% 10.3% Pharmacy as a % of total sales 62.5% 60.3% 61.7% 60.0% Third party sales as a % of total pharmacy sales 92.2% 90.7% 92.0% 90.1% Front-end sales growth (decline) (0.8)% 5.5% 1.9% 3.2% Same store front end sales growth 1.2% 8.4% 3.6% 5.9% Front end sales as a % of total sales 37.5% 39.7% 38.2% 40.0% Store data: Total stores (beginning of period) 3,594 3,767 3,648 3,802 New stores 4 -- 7 5 Closed stores (15) (25) (72) (65) Store acquisitions, net -- -- -- -- Total stores (end of period) 3,583 3,742 3,583 3,742 Relocated stores 3 14 11 57 Revenues The 5.7% and 6.9% growth in revenues for the thirteen and thirty-nine week periods ended December 1, 2001 were driven predominately by pharmacy sales growth of 8.5% and 9.6%, respectively. Same store sales growth for the thirteen and thirty-nine week periods ended December 1, 2001 was 6.9% and 8.3%, respectively. As the prior fiscal year was a 53 week year, same store sales for the thirteen and thirty-nine week periods ended December 1, 2001 are calculated by comparing that period with the thirteen and thirty-nine week periods ended December 2, 2000. For the thirteen and thirty-nine week periods ended December 1, 2001, pharmacy sales led revenue growth with same-store sales increases of 10.6% and 11.4%, respectively. Pharmacy same store sales increases are due to an increase in both prescriptions filled and sales price per prescription. Factors contributing to pharmacy same store sales increases include inflation, our ability to attract and retain managed care customers, our reduced cash pricing, our increased focus on pharmacy initiatives such as will call and predictive refill, and favorable industry trends. These trends include an aging American population with many "baby boomers" now in their fifties and consuming a greater number of prescription drugs. The use of pharmaceuticals as the treatment of choice for a growing number of healthcare problems and the introduction of a number of successful new prescription drugs also contributes to the growing demand for pharmaceutical products. Front-end sales, which includes all non-prescription sales such as seasonal merchandise, convenience items and food had same store sales growth of 1.2% and 3.6% in the thirteen and thirty-nine week periods ended December 1, 2001, respectively. The same store sales increase was primarily a result of increased sales volume due to lowering prices on key items, distributing a nationwide weekly advertising circular, expanding certain product categories and improving general store conditions. 21 Costs and Expenses Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Cost of goods sold $ 2,923,759 $ 2,713,988 $ 8,636,889 $ 8,005,474 Gross profit 808,320 817,703 2,496,397 2,407,872 Gross margin 21.7% 23.2% 22.4% 23.1% Selling, general and administrative expenses 801,453 810,900 2,469,452 2,491,090 Selling, general and administrative expenses as a percentage of revenues 21.5% 22.9% 22.2% 23.9% Goodwill amortization 5,200 5,058 15,823 16,759 Store closing and impairment charges 18,652 95,571 40,393 199,742 Interest expense 82,515 146,122 313,581 499,871 Interest rate swap contracts 10,382 -- 41,429 -- (Gain) loss on debt and lease conversions and modifications, net (56) 8,306 154,539 92,095 Share of loss from equity investment 1,697 6,484 12,092 30,554 (Gain) loss on sale of assets and investments, net 694 (13,491) (50,761) 3,035 Cost of Goods Sold Gross margin was 21.7% for the thirteen week period ended December 1, 2001 compared to 23.2% for the thirteen week period ended November 25, 2000. Gross margin was negatively impacted by the continuing trend of inflation, increased third party reimbursed prescription sales as a percent of total prescription sales and lower cash prices on pharmacy sales. The increase in third party prescription sales had a negative impact on gross margin rates because they are paid by a person or entity other than the recipient of the prescribed pharmaceutical, and are generally subject to lower negotiated reimbursement rates in conjunction with a pharmacy benefit plan. Third party sales as a percentage of total pharmacy sales were 92.2% for the thirteen week period ended December 1, 2001 compared to 90.7% for the thirteen week period ended November 25, 2000, respectively. In addition, the reclassification of certain leases from capital to operating in the refinancing caused an increase in occupancy costs in the thirteen weeks ended December 1, 2001. Gross margin was 22.4% for the thirty-nine week period ended December 1, 2001, compared to 23.1% for the thirty-nine week period ended November 25, 2000. Gross margin was negatively impacted by the continuing trend of increased third party reimbursed prescription sales as a percent of total prescription sales, higher shrink costs, and lower cash prices on pharmacy sales. In addition, the reclassification of certain leases from capital to operating in the refinancing caused an increase in occupancy costs. We use the last-in, first-out (LIFO) method of inventory valuation, which is determined annually when inflation rates and inventory levels are finalized. Therefore, LIFO costs for interim period financial statements are estimated. Cost of sales includes a LIFO provision of $15.0 and $45.0 million for the thirteen and thirty-nine week periods ended December 1, 2001 versus $10.8 million and $22.4 million for the thirteen and thirty-nine week periods ended November 25, 2000. 22 Selling, General and Administrative Expenses The selling, general and administrative expense ("SG&A") for the thirteen week period ended December 1, 2001 includes $5.5 million of expenses incurred in connection with our defense of shareholder litigation and assisting with various governmental investigations. Offsetting this amount is $39.4 million of non-cash income related to variable plan accounting on certain management stock options, restricted stock grants and stock appreciation rights. Excluding these items, SG&A as a percentage of revenues was 22.4% for the thirteen week period ended December 1, 2001. SG&A for the thirteen week period ended November 25, 2000, includes $21.9 million of costs incurred with the restatement of our historical financial statements primarily offset by a $20.0 million increase in estimated insurance recovery related to the settlement of the stockholder's class action lawsuit. Excluding these items, SG&A as a percentage of revenue remained 22.9% for the thirteen week period ended November 25, 2000. SG&A exclusive of these items in the thirteen week period of the current fiscal year of 22.4% is slightly favorable to the adjusted 22.9% of the prior year's comparable period because of decreased labor charges and better leveraging of our fixed costs resulting from our higher sales volume. SG&A for the thirty-nine week period ended December 1, 2001 includes $14.5 million of expenses incurred in connection with our defense of shareholder litigation and assisting with various governmental investigations. Also included in the SG&A expense for the thirty-nine week period ended December 1, 2001, is a net expense of $2.9 million for the accrual of anticipated loss on certain legal matters and $2.9 million of non-cash expense related to variable plan accounting on certain management stock options, restricted stock grants and stock appreciation rights. Offsetting these amounts are receipts of $41.3 million for the settlement of litigation with certain drug manufacturers. Excluding these items, SG&A as a percentage of revenues was 22.4% for the thirty-nine week period ended December 1, 2001. SG&A for the thirty-nine week period ended November 25, 2000 includes $73.4 million of costs incurred with the restatement of our historical financial statements, offset by a receipt of $12.3 million related to the partial settlement of litigation with certain drug manufacturers and a $20.0 million increase in estimated insurance recovery related to the settlement of the shareholder's class action lawsuit. Excluding these items, SG&A as a percentage of revenue was 23.5% for the thirty-nine week period ended November 25, 2000. SG&A exclusive of these items in the period of the current fiscal year of 22.4% compares favorably to the adjusted 23.5% of the prior year's comparable period because of decreased labor charges, decreased depreciation and amortization and occupancy charges resulting from a reduced store count, and better leveraging of our fixed costs resulting from our higher sales volume. 23 Store Closing and Impairment Charges Store closing and impairment charges consist of: Thirteen Week Period Ended Thirty-Nine Week Period Ended ----------------------------------- ----------------------------------- December 1, November 25, December 1, November 25, 2001 2000 2001 2000 --------------- --------------- --------------- --------------- Impairment charges $ 8,060 $ 44,518 $ 24,613 $ 70,342 Store and equipment lease exit charges 10,590 22,601 15,437 23,703 Impairment of other assets 2 28,452 343 105,697 --------------- --------------- --------------- --------------- $ 18,652 $ 95,571 $ 40,393 $ 199,742 =============== =============== =============== =============== Impairment Charges. Impairment charges include non-cash charges of $8.1 million and $44.5 million for the thirteen week periods ended December 1, 2001 and November 25, 2000, respectively, for the impairment of long-lived assets (including allocable goodwill) at 23 and 142 stores, respectively. Impairment charges include non-cash charges of $20.4 million and $70.3 million for the thirty-nine week periods ended December 1, 2001 and November 25, 2000, respectively, for the impairment of long-lived assets (including allocable goodwill) at 53 and 244 stores, respectively. These amounts include the write-down of long-lived assets at stores that were assessed for impairment because of management's intention to relocate or close the store. Included in impairment charges for the thirty-nine week period ended December 1, 2001 are $4.2 million of costs related to software. We have an investment in the common stock of drugstore.com, which is accounted for under the equity method. The initial investment was valued based upon the initial public offering price of drugstore.com. During the thirty nine week period ended November 25, 2000, we recorded a write-down of $105.7 million of our investment in drugstore.com. This write-down was based on a decline in the market price of drugstore.com's stock that we believe is other than temporary. As of December 1, 2001, we have no remaining recorded value for our investment in drugstore.com's common stock. Store and Equipment Lease Exit Costs. Charges incurred to close a store, which principally consist of lease termination costs, are recorded at the time management commits to closing the store, which is the date that the closure is formally approved by senior management, or in the case of a store to be relocated, the date the new property is leased or purchased. We calculate our liability for closed stores on a store-by-store basis. The calculation includes the future minimum lease payments and related ancillary costs from the date of closure to the end of the remaining lease term, net of estimated cost recoveries that may be achieved through subletting properties or through favorable lease terminations. This liability is discounted using a risk-free rate of interest. We evaluate these assumptions each quarter and adjust the liability accordingly. During the thirteen week periods ended December 1, 2001 and November 25, 2000 we recorded a provision for 9 and 72 stores, respectively, that were designated for closure. During the thirty-nine week periods ended December 1, 2001 and November 25, 2000, we recorded a provision for 42 and 106 stores, respectively, that were designated for closure. Also included in this line are charges of $1.3 million incurred in the thirty-nine weeks ended December 1, 2001, related to the early termination of an equipment lease. In December 2001, we entered into an agreement with another operator of drugstores under which we will exchange certain of our prescription files, fixed assets and inventory for certain prescription files, fixed assets and inventory owned by the other retailer. In connection with this transaction, we plan to close 36 stores which held prescription files that are being transferred to other stores. We expect to incur a fourth quarter charge of approximately $40.0 million related to these closings, which consists primarily of lease termination costs. 24 Interest Expense Interest expense was $82.5 and $313.6 million for the thirteen and thirty-nine week periods ended December 1, 2001, compared to $146.1 and $499.9 million in the thirteen and thirty-nine week periods ended November 25, 2000. Interest expense for the thirteen and thirty nine week periods ended November 25, 2000 was favorably impacted by a reversal (resulting from the settlement of a contract) of $20.0 million of previously amortized cost of issuance related to financing effected in October 1999. The decrease was due to the reduction of debt resulting from the sale of PCS, debt for equity exchanges and the June 2001 refinancing. The weighted average interest rates, excluding capital leases, on our indebtedness for the thirteen week periods ended December 1, 2001 and November 25, 2000 were 8.1% and 8.6%, respectively. Interest Rate Swap Contracts We entered into interest rate swap contracts to hedge the exposure to increasing rates with respect to our variable rate debt. As a result of the June 2001 refinancing, the interest rate swap contracts no longer qualify for hedge accounting treatment and therefore, the changes in fair value of these interest rate swap contracts is required to be recorded as a component of net loss. Accordingly, we recognized a charge of $31.0 million representing the amount that we would have to pay the counter party to terminate the contracts as of that date. Subsequent changes in the market value of the interest rate swaps of $10.4 million, inclusive of cash payments, has been recorded on the income statement for the thirteen weeks ended December 1, 2001. This amount represents an adjustment to the aggregate expense projected to be recognized relating to the swaps. This adjustment is due to a reduction in market interest rates over the thirteen weeks ended December 1, 2001. Our termination liability is $31.3 million as of December 1, 2001. Income Taxes The Federal tax benefit for the thirteen and thirty-nine week periods ended December 1, 2001 and November 25, 2000 is fully offset by a valuation allowance based on management's determination that, based on available evidence, it is more likely than not that certain of the deferred tax assets will not be realized. The state tax provision reflects taxable income in certain states which do not allow combined or consolidated returns which would have benefited from the groups' loss. The income tax provision for the thirteen and thirty-nine week periods ended November 25, 2000 reflects the effect of the decision to sell PCS and to discontinue the operations of our PBM segment. It is foreseeable that an "ownership change" for statutory purposes will occur during fiscal 2002 as a result of our refinancing efforts, including issuances of equity and exchanges of debt for equity. An "ownership change" would result in a limitation imposed on the future use of net operating losses and any net unrealized built-in losses incurred or existing prior to the "ownership change". Other Significant Charges The net loss from continuing operations for the thirteen week periods ended December 1, 2001 and November 25, 2000 was $112.8 million and $241.2 million, respectively. The net loss from continuing operations for the thirty-nine week periods ended December 1, 2001 and November 25, 2000 was $503.2 million and $1,069.7 million, respectively. In addition to the matters discussed above, our results in the thirteen and thirty-nine week periods ended December 1, 2001 and November 25, 2000 have been affected by other charges. In the thirteen week periods ended December 1, 2001 and November 25, 2000, we recorded $1.7 million and $6.5 million representing our share of drugstore.com losses. We also recorded a loss of $8.3 million on debt and lease conversions and modifications in the thirteen week period ended November 25, 2000. In the thirty-nine week periods ended December 1, 2001 and November 25, 2000, we recorded pre-tax losses of $154.5 million and $92.1 million on debt and lease conversions and modifications and losses of $12.1 million and $30.6 million representing our share of drugstore.com losses. In addition, we recorded an extraordinary loss of $66.6 million in the thirty-nine week period ended December 1, 2001, related to early extinguishment of debt in the refinancing. We also recorded a gain of $53.2 million in the thirty-nine week period ended December 1, 2001 resulting from the sale of AdvancePCS securities. Additionally, for the thirteen and thirty-nine week periods ended November 25, 2000, we recorded a reduction of loss (loss) net of income taxes of $135.5 million and ($199.2) million on the disposal of the PBM segment, respectively. As a result of the decision to dispose of the PBM segment, we recognized an increase in the income tax valuation allowance of $146.9 million for the thirty-nine week period ended November 25, 2000. 25 Liquidity and Capital Resources We have two primary sources of liquidity: (i) cash provided by operations and (ii) the revolving credit facility under our new senior secured credit facility. The senior secured credit facility also allows us, at our option, to issue up to $643.0 million of unsecured debt that is not guaranteed by any of our subsidiaries, reduced by the following debt to the extent incurred: (i) $150.0 million of financing transactions of existing owned real estate; (ii) $393.0 million of additional debt secured by the facility's collateral on a second priority basis; and (iii) $100.0 million of financing transactions for property or assets acquired after June 27, 2001. The $643.0 million of permitted debt, whether secured or unsecured, is reduced by the aggregate outstanding, undefeased balances of the 5.25% convertible subordinated notes, the 6.0% dealer remarketable securities and the 4.75% convertible notes (see "Other Transactions" below). As of December 1, 2001, we had outstanding principal balances of $152.0 million, $85.1 million and $250.0 million of the 5.25% convertible subordinated notes, 6.0% dealer remarketable securities and 4.75% convertible notes, respectively. Our 11.25% senior notes due July 2008 also permit $150.0 million of real estate financing, $400.0 million of additional other debt and $600.0 million of additional permitted debt, which includes allowing us to increase our senior secured credit facility. The issuance of 4.75% convertible notes reduced additional other debt permitted by our 11.25% senior notes due 2008 to $150.0 million, although we may reclassify this debt to other permitted debt at any time. During the thirty-nine week period ended December 1, 2001, operations did not provide sufficient cash to fund our working capital needs. Our principal uses of cash are to provide working capital for operations, service our obligations to pay interest and principal on debt, and to provide funds for capital expenditures. Refinancing On June 27, 2001, we completed a major refinancing that extended the maturity dates of the majority of our debt to 2005 or beyond, provided additional equity, converted a portion of our debt for equity and reclassified capital leases to operating leases. The components of the refinancing are described in detail in the footnotes to the consolidated financial statements. Major components of the refinancing are summarized below: New Secured Credit Facility: We entered into a new $1.9 billion syndicated senior secured credit facility with a syndicate of banks led by Citicorp USA, Inc. as senior agent. The new facility matures on June 27, 2005 unless more than $20.0 million of our 7.625% senior notes due April 15, 2005 are outstanding on December 31, 2004, in which event the maturity date is March 15, 2005. The new facility consists of a $1.4 billion term loan facility and a $500.0 million revolving credit facility. The term loan was used to prepay various outstanding debt balances. Our ability to borrow under the senior secured credit facility is based on a specified borrowing base consisting of eligible accounts receivable and inventory. On December 1, 2001, the term loan was fully drawn except for $21.5 million, which is available and may be drawn to pay for the remaining outstanding 10.5% senior secured notes when they mature on September 15, 2002. At December 1, 2001, we had $417.6 million in additional available borrowing capacity under the revolving credit facility net of outstanding letters of credit of $82.4 million. High Yield Notes: We issued $150.0 million of 11.25% senior notes due July 2008 in a private placement offering. These notes are unsecured and are effectively subordinate to our secured debt. Debt for Debt Exchange: We exchanged $152.0 million of our existing 10.50% senior secured notes for an equal principal amount of 12.50% senior secured notes due September 15, 2006. The 12.50% notes are secured by a second priority lien on the collateral of the senior secured credit facility. In addition, holders of these notes received warrants to purchase 3.0 million shares of our common stock at $6.00 per share. On June 29, 2001, the warrant holders elected to exercise these warrants, on a cashless basis, and as a result 1.0 million shares of common stock were issued. Tender Offer: On May 24, 2001, we commenced a tender offer for the 10.50% senior secured notes due 2002 at a price of 103.25% of the principal amount. The tender offer was closed on June 27, 2001, at which time $174.5 million principal was tendered. We incurred a tender offer premium of $5.7 million as a result of the transaction. We used proceeds from the new senior secured credit facility to pay for the tender offer. Debt for Equity Exchanges: We completed exchanges of $588.7 million of debt for 86.4 million shares of common stock. 26 Sales of Common Stock: We issued 80.1 million shares of our common stock for net proceeds of $528.4 million. Lease Obligations: We relinquished certain renewal options which had been available under the terms of certain real estate leases on property previously sold and leased back, reclassified the related leases as operating leases thereby reducing outstanding capital lease obligations by $850.8 million. Impact on Results of Operations for Fiscal 2002: As a result of the refinancing, we: i) recorded an extraordinary loss on early extinguishment of debt of $66.6 million; ii) recognized a loss of $21.9 million related to debt and lease conversions and modifications; and iii) recognized a charge of $31.0 million related to our interest rate swap agreements. On a prospective annual basis, the refinancing will reduce depreciation and amortization expense by approximately $4.0 million but increase rent expense by approximately $57.0 million. Interest expense is also expected to decrease due to the refinancing, debt for equity exchanges affected prior to June 3, 2001, and the repayment of debt related to the sale of the AdvancePCS investments. Prospective annual interest expense is estimated to be $350.0 million to $370.0 million of which $300.0 million to $320.0 million is cash interest. Other Transactions Convertible Notes: In November 2001, we issued $250.0 million of 4.75% convertible notes due December 2006. These notes were issued at a 3% discount resulting in cash proceeds of $242.5 million. These notes are unsecured and are effectively subordinate to our secured debt. The notes are convertible, at the option of the holder, into shares of our common stock at a conversion price of $6.50 per share, subject to adjustments to prevent dilution, at any time. Repurchase and Debt: We repurchased $22.7 million of our 6.0% dealer remarketable securities due 2003 during the thirteen weeks ended December 1, 2001. Net Cash Provided by/Used in Operating, Investing and Financing Activities Cash Flows Our operating activities used $309.8 million of cash in the thirty-nine week period ended December 1, 2001 and $768.0 million of cash in the thirty-nine week period ended November 25, 2000. Operating cash flow was negatively impacted by $314.5 million in interest payments. Cash provided by investing activities was $348.0 million for the thirty-nine week period ended December 1, 2001, due primarily to the sale of the securities we received in our sale of AdvancePCS. Cash provided by investing activities was $683.7 million for the thirty-nine week period ended November 25, 2000, due primarily to proceeds from the sale of discontinued operations. Cash used for capital expenditures amounted to $146.5 million for the thirty nine-week period ended December 1, 2001, see "Capital Expenditures" section below for more detail. Cash (used in) provided by financing activities was $(36.2) million and $13.1 million for the thirty-nine week periods ended December 1, 2001 and November 25, 2000, respectively. Proceeds from the issuance of the new senior credit facility, issuance of common stock, and the sale of our AdvancePCS securities were all used to pay down a significant portion of our debt, which significantly impacted cash used in financing activities in the thirty-nine week period ended December 1, 2001. Partially offsetting the cash used in financing activities for the thirty-nine week period ended December 1, 2001 were proceeds of $242.5 million from the issuance of convertible notes. Working Capital Working capital was $1,382.5 million at December 1, 2001, compared to $1,955.9 million at March 3, 2001. The decrease in working capital is primarily due to the sale of the securities we received in our sale of AdvancePCS, proceeds of which were used to pay down long-term debt, as well as the increase in current maturities of long-term debt. Net working capital was also impacted by the reclassification of the previously classified non-current portion of the liability relating to the stockholder litigation settlement as a current liability. 27 Capital Expenditures We plan capital expenditures of approximately $100.0 million to $110.0 million during fiscal 2002, consisting of $45.0 million to $50.0 million related to new store construction, store relocation and other store construction projects, and an additional $55.0 million to $60.0 million which will be dedicated to other store improvement activities and the purchase of prescription files from independent pharmacists. In addition, as part of the June 27, 2001 refinancing, we expended $82.6 million related to the termination of an operating lease and the corresponding purchase of equipment. We expect that these capital expenditures will be financed primarily with cash flow from operations and borrowings under the revolving credit facility available under our senior secured facility. During the thirty-nine week period ended December 1, 2001, we spent $155.6 million on capital expenditures, consisting of $38.0 million related to new store construction, store relocation and other store construction projects. An additional $35.0 million was related to other store improvement activities and the purchase of prescription files from independent pharmacists and $82.6 million in conjunction with the refinancing. Future Liquidity We are highly leveraged. Our high level of indebtedness: (a) limits our ability to obtain additional financing; (b) limits our flexibility in planning for, or reacting to, changes in our business and the industry; (c) places us at a competitive disadvantage relative to our competitors with less debt; (d) renders us more vulnerable to general adverse economic and industry conditions; and (e) requires us to dedicate a substantial portion of our cash flow to service our debt. Based upon current levels of operations and planned improvements in our operating performance, management believes that cash flow from operations together with available borrowing under the senior secured credit facility and our other sources of liquidity will be adequate to meet our anticipated annual requirements for working capital, debt service and capital expenditures for the next twelve months. We will continue to assess our liquidity position and potential sources of supplemental liquidity in light of our operating performance and other relevant circumstances. Should we determine, at any time, that it is necessary to seek additional short-term liquidity, we will evaluate our alternatives and take appropriate steps to obtain sufficient additional funds. Obtaining any such supplemental liquidity through the increase of indebtedness or asset sales may require the consent of the lenders under one or more of our debt agreements. There can be no assurance that any such supplemental funding, if sought, could be obtained or that our lenders would provide the necessary consents, if required. Our inability to obtain any necessary consent or relief could have a material adverse effect on us. Recent Accounting Pronouncements In June 2001, the FASB issued two new pronouncements: SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS 141 is effective as follows: (a) use of the pooling-of-interest method is prohibited for business combinations initiated after June 30, 2001; and (b) the provisions of SFAS 141 also apply to all business combinations accounted for by the purchase method that are completed after June 30, 2001 (that is, the date of the acquisition is July 2001 or later). SFAS 142 is effective for the fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized in an entity's statement of financial position at that date, regardless of when those assets were initially recognized. We are currently evaluating the provisions of SFAS 142 and have not adopted such provisions in our December 1, 2001 condensed consolidated financial statements. At December 1, 2001, unamortized goodwill was $723.0 million. In August 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS 144 retains the requirements of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," to recognize an impairment loss if the carrying amount of a long-lived asset is not recoverable from its undiscounted cash flows and to measure an impairment loss as the difference between the carrying amount and fair value of the asset. SFAS 144 modifies SFAS 121 in that it eliminates the requirement to allocate goodwill to long-lived assets to be tested for impairment. SFAS 144 also modifies APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," to require discounted operations presentation in the income statement for a component of an entity that is to be disposed. SFAS 144 is effective for fiscal years beginning after December 15, 2001, and early adoption is encouraged. We are currently evaluating the provisions of SFAS 144 and have not adopted such provisions in our December 1, 2001 condensed consolidated financial statements. 28 Factors Affecting Our Future Prospects For a discussion of risks related to our financial condition, operations and industry, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations--Factors Affecting Our Future Prospects" in our Form 10-K for the 2001 fiscal year, filed with the SEC on May 21, 2001. Item 3. Quantitative and Qualitative Disclosures About Market Risk Our future earnings, cash flow and fair values relevant to financial instruments are dependent upon prevalent market rates. Market risk is the risk of loss from adverse changes in market prices and interest rates. The major market risk exposure is changing interest rates. Increases in interest rates would increase our interest expense. Since the end of fiscal 2001, our primary risk exposure has not changed. Our company enters into debt obligations to support capital expenditures, acquisitions, working capital needs and general corporate purposes. Our policy is to manage interest rates through the use of a combination of variable-rate credit facilities, fixed-rate long-term obligations and derivative transactions. The table below provides information about our financial instruments that are sensitive to changes in interest rates. The table presents principal payments and the related weighted average interest rates by expected maturity dates as of December 1, 2001. Fiscal Year --------------- 2002 2003 2004 2005 2006 --------------- --------------- --------------- --------------- --------------- (dollars in thousands) Long-term debt, including current portion Fixed rate $ 7,942 $ 205,441 $ 123,472 $ 62,528 $ 1,267,937 Average Interest Rate 6.80% 6.60% 7.39% 10.55% 9.37% Variable Rate -- -- -- -- 378,462 Average Interest Rates -- -- -- -- 7.19% Interest Rate Swaps -- -- -- -- -- Fair Value at Thereafter Total December 1, 2001 --------------- --------------- ---------------- Long-term debt, including current portion Fixed rate $ 1,705,428 $ 3,372,748 $ 2,999,077 Average Interest Rate 7.57% 8.22% Variable Rate -- $ 378,462 $ 378,462 Average Interest Rates -- 7.19% Interest Rate Swaps -- -- $ (31,276) In June 2000, we refinanced certain variable and fixed-rate obligations maturing in fiscal years 2001 and 2002 and entered into an interest rate swap that fixes the LIBOR component of $500.0 million of our variable-rate debt at 7.083% for a two-year period. In July 2000, we entered into an additional interest rate swap that fixes the LIBOR component of an additional $500.0 million of variable rate debt at 6.946% for a two year period. The variable rate debt that had interest rates fixed by the two interest rate swaps were included with fixed rate debt in the above table. As of December 1, 2001, 10.1% of our total debt is exposed to fluctuations in variable interest rates. Our ability to satisfy interest payment obligations on our outstanding debt will depend largely on our future performance, which, in turn, is subject to prevailing economic conditions and to financial, business and other factors beyond our control. If we do not have sufficient cash flow to service our interest payment obligations on our outstanding indebtedness and if we cannot borrow or obtain equity financing to satisfy those obligations, our business and results of operations will be materially adversely affected. We cannot assure you that any such borrowing or equity financing could be successfully completed. As of December 28, 2001, we had one credit facility: the $1.9 billion syndicated senior secured credit facility. The ratings on this facility were BB- by Standard & Poor's and B1 by Moody's. The interest rates on the variable rate borrowings on this facility are LIBOR plus 3.50%. 29 PART II. OTHER INFORMATION Item 1. Legal Proceedings On December 24, 2001, the time for appeal of the judgement in the store management overtime litigation expired and the judgement became final. Item 2. Changes in Securities and Use of Proceeds (a) none (b) none (c) We sold the following equity securities during the period covered by this report that were not registered under the Securities Act: o On November 19, 2001, we issued and sold to a group of institutional investors $250.0 million aggregate principal amount of new 4.75% Convertible Notes Due December 1, 2006. We issued the 4.75% notes to the initial purchasers at a 3% discount. The 4.75% convertible notes are convertible into shares of our common stock at any time, unless we previously have redeemed or repurchased the 4.75% convertible notes or unless the 4.75% convertible notes previously have matured. Holders of the 4.75% convertible notes called for redemption or repurchase are entitled to convert their notes to and including, but not after, the close of business on the date fixed for redemption or repurchase, as the case may be. The 4.75% convertible notes were issued in a transaction exempt from registration in reliance on Rule 144A of the Securities Act. o On October 5, 2001, the holder of all 3,495,990 outstanding shares of Series B preferred stock exchanged those shares for 3,495,990 shares of our Series D preferred stock. The Series D preferred stock was issued in a privately negotiated transaction exempt from registration under Section 3(a)(9) under the Securities Act. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. 30 Item 6. Exhibits and Reports on Form 8-K (a) The following exhibits are filed as part of this report. Exhibit Numbers Description Incorporation by Reference to - ------- ----------- ----------------------------- 3.1 Restated Certificate of Incorporation dated December 12, 1996 Exhibit 3(i) to Form 8-K filed on November 2, 1999 3.2 Certificate of Amendment to the Restated Certificate of Exhibit 3(ii) to Form 8-K filed on November 2, 1999 Incorporation dated October 25, 1999 3.3 Series C Preferred Stock Certificate of Designation dated June Exhibit 3.3 to Form S-1 filed on July 12, 2001 26, 2001 3.4 Certificate of Amendment to Restated Certificate of Exhibit 3.4 to Form S-1 filed on July 12, 2001 Incorporation dated June 27, 2001 3.5 8% Series D Cumulative Convertible Pay-in-Kind Preferred Stock Exhibit 3.5 to the 10-Q filed on October 12, 2001 Certificate of Designation dated October 3, 2001. 3.6 By-laws, as amended on November 8, 2000 Exhibit 3.1 to Form 8-K filed on November 13, 2000 4.1 Indenture, dated as of June 27, 2001, between Rite Aid Exhibit 4.7 to Form S-1 filed on July 12, 2001 Corporation, as issuer and State Street Bank and Trust Company, as trustee, related to the Company's 12.50% Senior Secured Notes due 2006. 4.2 Indenture, dated as of June 27, 2001 between Rite Aid Exhibit 4.8 to Form S-1 filed on July 12, 2001 Corporation, as issuer and BNY Midwest Trust Company, as trustee, related to the Company's 11 3/4% Senior Notes due 2008 4.3 Indenture, dated as of November 19, 2001, between Rite Aid Filed herewith Corporation as issuer, and BNY Midwest Trust Company, as trustee, related to the Company's 4.75% Convertible Notes due December 1, 2006. 4.4 Registration Rights Agreement, dated as of November 19, 2001, Filed herewith between Rite Aid Corporation, as issuer, and Salomon Smith Barney, Inc. and J.P. Morgan Securities Inc., as the initial purchasers related to the Company's 4.75% Convertible Notes due December 1, 2006. 10.1 Exchange Agreement, dated as of October 3, 2001, by and among Exhibit 10.60 to Form 10-Q filed on October 12, 2001. Rite Aid Corporation and Green Equity Investors III, L.P. 31 10.2 Amendment Number 1 to the Registration Rights Agreement dated Exhibit 10.61 to Form 10-Q filed on October 12, 2001. as of October 27, 1999, dated as of October 3, 2001, by and among Rite Aid Corporation and Green Equity Investors III, L.P. 10.3 Amendment Number 1 to the Senior Credit Agreement dated June Exhibit 10.62 to Form 10-Q filed on October 12, 2001. 27, 2001, dated as of September 19, 2001, among Rite Aid Corporation, the Banks (as defined therein), Citicorp USA, Inc., as a Swingline Bank, as an Issuing Bank and as administrative agent for the Banks, Citicorp USA, Inc., as collateral agent for the Banks and The Chase Manhattan Bank, Credit Suisse First Boston and Fleet Retail Finance, Inc., as syndication agents. 10.4 Purchase Agreement dated as of November 13, 2001 between Rite Filed herewith Aid Corporation, as issuer, and Salomon Smith Barney, Inc. and J.P. Morgan Securities Inc., as representatives of the Initial Purchasers of the Company's 4.75% Convertible Notes due 2006 11 Statements re Computation of Loss Per Share (See Note 2 to the condensed consolidated financial statements) - ------ (b) Rite Aid Corporation has filed the following Current Reports on Form 8-K in the thirteen week period ended December 1, 2001: None SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: January 15, 2002 RITE AID CORPORATION By: /s/ ELLIOT S. GERSON Elliot S. Gerson Senior Executive Vice President and General Counsel Date: January 15, 2002 By: /s/ JOHN T. STANDLEY John T. Standley Senior Executive Vice President and Chief Financial Officer 32