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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT
OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 26, 1998. COMMISSION FILE NUMBER
333-41239
DUANE READE INC.
(Exact name of registrant as specified in its charter)
DELAWARE 04-3164702
(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
DRI I Inc.* Delaware 04-3166107
Duane Reade* New York 11-2731721
* Guarantors with respect to the Company's 9 1/4% Senior Subordinated Notes
due 2008
440 NINTH AVENUE 10001
NEW YORK, NEW YORK (Zip Code)
(Address of principal executive
offices)
(212) 273-5700
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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Common Stock, $.01 par value per share New York Stock Exchange, Inc.
9 1/4% Senior Subordinated Notes due 2008 None.
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: NONE.
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
The only class of voting securities of Duane Reade Inc. is its Common Stock,
par value $.01 per share (the "Common Stock"). On March 19, 1999, the aggregate
market value of the voting stock held by non-affiliates of the registrant was
approximately $233 million.
The number of shares of the Common Stock outstanding as of March 19, 1999:
17,113,835
DOCUMENTS INCORPORATED BY REFERENCE
DOCUMENT PART OF FORM 10-K
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Portions of the Proxy Statement for the Annual Meeting Part III
of Stockholders to be held May 6, 1999
Certain exhibits as listed on the Exhibit Index and filed with registrant's
registration statements on Form S-1 (Nos. 333-41239 and 333-43313) under the
Securities Act of 1933, as amended, are incorporated by reference into Part IV
of this Form 10-K.
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INDEX
PAGE
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PART I
ITEM 1 Business.................................................................................... 3
ITEM 2. Properties.................................................................................. 9
ITEM 3. Legal Proceedings........................................................................... 9
ITEM 4. Submission of Matters to a Vote of Security Holders......................................... 10
PART II
ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters....................... 11
ITEM 6. Selected Financial Data..................................................................... 12
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations....... 14
ITEM 7A. Market Risk................................................................................. 20
ITEM 8. Financial Statements and Supplementary Data................................................. 21
ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure........ 42
PART III
ITEM 10. Directors and Executive Officers of the Registrant.......................................... 43
ITEM 11. Executive Compensation...................................................................... 43
ITEM 12. Security Ownership of Certain Beneficial Owners and Management.............................. 43
ITEM 13. Certain Relationships and Related Transactions.............................................. 43
PART IV
ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K............................ 43
SIGNATURES................................................................................................ 46
2
PART I
ITEM 1. BUSINESS.
GENERAL
Duane Reade is the largest drugstore chain in metropolitan New York, based
on sales volume, with 75 of its 128 stores located in Manhattan's high-traffic
business and residential districts. Since opening its first store in 1960, the
Company has successfully executed a marketing and operating strategy tailored to
the unique characteristics of New York, the largest and most densely populated
market in the United States. For the fiscal year ended December 26, 1998, the
Company had sales of $587.4 million and EBITDA (earnings before interest, income
taxes, depreciation, amortization, extraordinary charge, nonrecurring charges
and other non-cash items) of $62.0 million, increases of 36.7% and 44.0%,
respectively, over the 1997 fiscal year. For the fiscal year ended December 26,
1998, the Company had a net loss of $4.8 million. For the fiscal year ended
December 27, 1997, the Company had a net loss of $14.7 million.
The Company enjoys strong brand name recognition in metropolitan New York,
which it believes results from the Company's many locations in high-traffic
areas of Manhattan. The Company has developed an operating strategy designed to
capitalize on the unique characteristics of the metropolitan New York market,
which include high-traffic volume, complex distribution logistics and high costs
of occupancy, media advertising and personnel. The key elements of the Company's
operating strategy are (i) everyday low price format and broad product offering,
(ii) low cost operating structure supported by its high volume stores and low
advertising and distribution costs and (iii) ability to design and operate its
stores in a wide variety of sizes and layouts.
The Company believes that its everyday low price format and broad product
offerings provide value and convenience for its customers and build customer
loyalty. The Company's everyday low price format results in prices that the
Company believes are lower, on average, than the prices offered by its
competitors.
The Company is able to keep its operating costs relatively low due to its
high per store sales volume, relatively low warehouse and distribution costs and
relatively low advertising expenditures. The Company's high volume stores allow
it to effectively leverage occupancy costs, payroll and other store operating
expenses. The Company's distribution facility is centrally located and, combined
with the rapid turnover of inventory in Duane Reade's stores, results in
relatively low warehouse and distribution costs.
The Company has demonstrated its ability to successfully operate stores
using a wide variety of store configurations and sizes, which the Company
believes is necessary to succeed in the metro New York City market. For example,
the size of the Company's stores ranges from 2,600 to 22,000 square feet, and it
operates 34 bi-level stores. The Company believes that its flexibility in
configuring stores provides it with a competitive advantage in securing
locations for its new stores, as many of its competitors target more
standardized spaces for their stores, which are more difficult to find in
metropolitan New York. In addition, the Company's management team has extensive
experience and knowledge of the New York real estate market, allowing it to
pursue attractive real estate opportunities.
The Company was founded in 1960, and in June 1997, investment funds
affiliated with DLJ Merchant Banking Partners II, L.P. (the "DLJ Entities")
acquired approximately 91.5% of the outstanding capital stock of the Company. On
February 10, 1998, the Company successfully completed its initial public
offering, which raised approximately $102 million in new equity to the Company.
Upon consummation of the initial public offering (in which the DLJ Entities and
certain other selling securityholders participated), the DLJ Entities owned
approximately 48.9% of the Company's issued and outstanding common stock. In
addition, in 1998 Duane Reade approximately doubled its size, from 67 stores to
128 stores by opening 33 new stores and acquiring 38 stores from the Rock Bottom
chain, 28 of which the Company will continue to
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operate. The Company purchased substantially all of the operating assets
(including inventory and store leases) from Rock Bottom Stores, Inc. in
September 1998 (the "Rock Bottom Acquisition") and has essentially completed its
integration of Rock Bottom stores into the Duane Reade chain, including
remodeling these stores to reflect the Duane Reade merchandising concept. In
addition, the Company opened a new warehouse and distribution facility in 1998,
which doubled the Company's warehousing capacity by providing the Company with
450,000 square feet of space.
COMPANY OPERATIONS
MERCHANDISING. Duane Reade's overall merchandising strategy is to provide
the broadest selection of branded and private label drugstore products available
in Manhattan and to sell them at everyday low prices. To further enhance
customer service and loyalty, the Company attempts to maintain a consistent in-
stock position in all merchandise categories. In addition to prescription and
over-the-counter ("OTC") drugs, the Company offers health and beauty aids, food
and beverage items, tobacco products, cosmetics, housewares, hosiery, greeting
cards, photofinishing, photo supplies, seasonal merchandise and other products.
Health and beauty care products, including OTC drugs, represent the largest of
the Company's product categories. Duane Reade drugstores offer a wide variety of
brand name and private label products, including oral, skin and hair care
products, bath supplies, vitamins and nutritional supplements, feminine hygiene
products, family planning products and baby care products. Popular brands of
health and beauty aids are given ample shelf space, and large sizes are offered,
which the Company believes appeals to the value consciousness of many Manhattan
consumers. Convenience items such as candy, snacks and seasonal goods are
positioned near the check out registers to provide optimum convenience and
stimulate impulse purchases for the customers while allowing the store employees
to monitor those product categories that are particularly susceptible to
inventory shrink.
In addition to the wide array of brand products offered in its stores, the
Company offers its own private label products. Private label products provide
customers with high-quality, lower priced alternatives to name brand products
while generating higher gross profit margins than name brand products. These
offerings also enhance Duane Reade's reputation as a value-oriented store. The
Company currently offers approximately 500 private label products. In 1998,
these private label products accounted for approximately 5.3% of non-pharmacy
sales. The Company believes that its strong brand image, reputation for quality
and reliability in the New York City market, and its economies of scale in
purchasing allow it to aggressively promote private label goods.
The Company also offers same-day photofinishing services in all of its
stores and has installed one-hour photofinishing in twenty stores. Management
believes that photofinishing services contribute significantly to sales of other
merchandise categories because of customer traffic increases that result from
the customer visiting a store twice, in order to drop off film and pick up the
processed photos.
PHARMACY. The Company believes that its pharmacy business will continue to
contribute significantly to the Company's growth. Management also believes that
a larger and stronger pharmacy business will enhance customer loyalty and
generate incremental customer traffic, which is expected to increase sales of
Duane Reade's wide variety of OTC drugs and other non-pharmacy merchandise.
Duane Reade's prescription drug sales (as reflected by same store pharmacy
sales) grew by 21.5% in 1998 compared to 1997. Sales of prescription drugs
represented 28.3% of total sales in 1998 compared to 25.1% of total sales in
1997. Although the average number of prescriptions filled by Duane Reade per
store per week has increased from 640 in 1994 to 970 during the fourth quarter
of 1998, the Company's average remains well below the industry chain store
average of approximately 1,100, providing significant opportunity for continued
pharmacy growth. The Company believes that the average number of prescriptions
filled per week by it lags behind the industry average because of (i) the
historically low penetration of Third Party Plans (as defined) in the New York
City area and (ii) the Company's concentration of stores in business
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areas, rather than residential areas. The Company believes continued pharmacy
growth will also increase overall customer traffic and benefit its non-pharmacy
sales.
The Company believes that its extensive network of conveniently located
stores, strong local market position, pricing policies and reputation for high
quality health care products and services provide it with a competitive
advantage in attracting pharmacy business from individual customers as well as
managed care organizations, insurance companies, employers and other third party
payors (collectively, "Third Party Plans"). The percentage of the Company's
total prescription drug sales attributable to Third Party Plans increased to
approximately 78% in 1998 from approximately 74% in 1997. Although gross margins
on sales to Third Party Plans are generally lower than other prescription drug
sales because of the highly competitive nature of pricing for this business and
the purchasing power of Third Party Plans, management believes that the lower
gross profit margins are offset by the higher volume of pharmacy sales to Third
Party Plan customers allowing the Company to leverage other fixed store
operating expenses. In addition, the Company believes that Third Party Plans
generate additional general merchandise sales by increasing customer traffic in
the stores. As of December 26, 1998, the Company had contracts with over 200
Third Party Plans, including every major Third Party Plan in the Company market
areas.
Another important component of the Company's pharmacy growth strategy is the
continued acquisition of prescription files from independent pharmacies in
market areas currently served by existing Company stores. In 1998, the Company
purchased the prescription files of 24 independent pharmacies for an aggregate
total of $7.3 million which generated approximately $50 million in revenues on
an annualized basis. Independent pharmacists tend to have a higher proportion of
customers that are not Third Party Plans, which provide the Company with
incremental revenue and higher margin contribution. When appropriate, the
Company will retain the services of the pharmacist, whose personal relationship
with the customers generally maximizes the retention rate of the purchased file.
Since 1995, the Company has experienced an estimated 80% customer retention rate
with respect to prescription files acquired. Given the large number of
independent pharmacies in metropolitan New York, the Company believes that these
stores will provide additional acquisition opportunities in the future.
The Company's pharmacies employ computer systems that link all of the
Company's pharmacies and enable them to provide customers with a broad range of
services. The Company's pharmacy computer network profiles customer medical and
other relevant information, supplies customers with information concerning their
drug purchases for income tax and insurance purposes and prepares prescription
labels and receipts. The computer network also expedites transactions with Third
Party Plans by electronically transmitting prescription information directly to
the Third Party Plan and providing on-line adjudication, which confirms at the
time of sale customer eligibility, prescription coverage and pricing and
co-payment requirements and automatically bills the respective plan. On-line
adjudication reduces losses from rejected claims and eliminates a portion of the
Company's paperwork for billing and collection of receivables and costs
associated therewith.
STORE OPERATIONS. Duane Reade stores range in size from 2,600 to 22,000
square feet, with an average of 6,719 square feet for the Duane Reade stores and
11,396 square feet for the stores acquired through the Rock Bottom Acquisition.
The Company's stores are designed to facilitate customer movement and to
minimize inventory shrink. The Company believes that its wide, straight aisles
and well-stocked shelves allow customers to find merchandise easily and allow
the store's employees (managers, security guards, cashiers and stock clerks) to
effectively monitor customer behavior. The Company attempts to group merchandise
logically in order to enable customers to locate items quickly and to stimulate
impulse purchases.
The Company establishes each store's hours of operation in an attempt to
best serve customer traffic patterns and purchase habits and to optimize store
labor productivity. Stores in Manhattan's business districts are generally open
five days a week. In residential and appropriate business/shopping districts,
stores are open six or seven days a week with a heavy emphasis on convenient,
early morning and late
5
evening openings. In 1998, the Company had nine stores which were open 24 hours
a day, 365 days a year. The Company intends to continue to identify stores in
which extended operating hours would improve customer service and convenience
and contribute to the Company's profitability. Each store is supervised by one
store manager and one or more assistant store managers. Stores are supplied by
deliveries from the Company's warehouse in Queens an average of three times a
week, allowing the stores to maintain a high in-stock position, maximize store
selling space and minimize inventory required to be held on hand.
The Company attempts to mitigate inventory shrink through (i) the employment
of full time security guards in each store, (ii) use of a state-of-the-art
Electronic Article Surveillance ("EAS") system that detects unremoved EAS tags
on valuable or easily concealed merchandise and (iii) merchandise delivery and
stocking during non-peak hours. Additionally, all store and warehouse employees
are trained to monitor inventory shrink, and the Company uses outside consulting
services to monitor employee behavior. The Company has a full-time team of loss
prevention professionals and utilizes an anonymous call-in line to allow
employees to report instances of theft. The Company also has ongoing audits of
warehouse picking and receiving and an anonymous reward line for the reporting
of theft. The Company believes that these programs have enabled it to control
inventory shrink and will enable it to continue to do so.
PURCHASING AND DISTRIBUTION. The Company purchases approximately 72% of its
merchandise directly from manufacturers. The Company distributes approximately
82% of its merchandise through the Company's warehouse and receives
direct-to-store deliveries for approximately 18% of its purchases. Direct-to-
store deliveries are made for pharmaceuticals, greeting cards, photofinishing,
convenience foods and beverages. The Company purchases from over 1,000 vendors.
The Company believes that there are ample sources of supply for the merchandise
currently sold in its stores. The Company manages its purchasing through a
combination of forward buying, national buying and vendor discount ("deal")
buying in ways in which it believes maximizes its buying power. For example, the
Company uses a computerized forecasting and investment program that is designed
to determine optimal forward buying quantities before an announced or
anticipated price increase has been implemented. By forward buying, the Company
stocks up on regularly carried items when manufacturers temporarily reduce the
cost of goods or when a price increase has been announced or is anticipated.
The Company currently operates one warehouse, which is located in Maspeth,
Queens. The warehouse contains approximately 450,000 square feet devoted to
inventory. The Company believes that the close proximity of the warehouse to the
stores allows the Company to supply the stores frequently, thereby minimizing
inventory and maximizing distribution economies. The Company also owns a fleet
of trucks and vans, which it uses for deliveries from the warehouse to the
stores.
ADVERTISING AND PROMOTION
The Company regularly promotes key items at reduced retail prices during
four-week promotional periods. Store windows and in-store signs are utilized to
communicate savings and value to shoppers. Additionally, over 40 million bags
with the highly recognizable Duane Reade logo are used by its customers each
year, helping to promote the Company's name throughout metropolitan New York.
The Company also utilizes full color circulars to announce new stores and
heavily circulates them in local areas to attract customers. Typically, a new
store sells one to two times its regular volume during a grand opening
promotion, which generally lasts two to three weeks. The Company generally does
not rely heavily on the use of print or broadcast media to promote its stores.
Rather, because of its many high-traffic locations, the Company typically relies
on in-window displays as its primary method of advertising. In 1997, the Company
began using radio advertising. The radio advertising focuses on the Company's
pharmacy business, highlighting services enhanced by the modern pharmacy
computer system, pharmacist accessibility and enhanced convenience.
6
MANAGEMENT INFORMATION SYSTEMS
The Company currently has modern pharmacy and inventory management
information systems. The pharmacy system (PDX) has reduced the processing time
for electronic reimbursement approval for prescriptions from Third Party Plan
providers from 50 seconds to 7 seconds, and the inventory management systems
(JDA merchandising and E3 replenishment) have allowed the Company to increase
turns in the warehouse. The Company utilizes point of sale (POS) systems in its
stores. These systems allow the Company to better control pricing, inventory and
shrink, while maximizing the benefits derived from the other parts of its
systems installation program. POS also provides sales analysis that enables the
Company to improve labor scheduling, and helps optimize planogram design by
allowing detailed analysis of stock-keeping unit sales.
The Company is implementing a program to ensure that the Company computer
systems and applications (IT Systems) and non-IT Systems will function properly
beyond 1999. This program includes inventorying year 2000 items; assigning
priorities to the identified items; assessing year 2000 compliance of items
determined to be material to the Company; remediating or replacing material
items that are not year 2000 compliant; and determining contingency plans that
may be required.
The Company has completed inventorying and prioritizing year 2000 compliance
of its IT Systems and is commencing these phases for its non-IT systems, which
will include surveying significant third party vendors. The Company is upgrading
its software and expects this phase to be completed by June 30, 1999.
The Company is utilizing both internal and external resources to address
year 2000 issues and believes that the cost of such modifications will
approximate $600,000. Approximately $250,000 of this includes system upgrades
that had been previously identified for operational enhancements.
Although management expects to complete the upgrading of all of its software
by mid-1999, the Company will develop a year 2000 contingency plan before
mid-1999 if it appears that the Company will not achieve full year 2000
compliance. Management regularly monitors the status of the year 2000 compliance
process.
The failure to correct a material year 2000 problem could result in an
interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, financial condition and liquidity. No assurances,
however, can be given that the Company will be able to identify and address all
year 2000 issues due to their complexity as well as the Company's dependence on
the technical skills of employees and independent contractors and on the
representations and preparedness of third parties with which the Company does
business. Although the Company believes that its efforts are designed to
appropriately identify and address year 2000 issues that are subject to the
Company's reasonable control, there can be no assurance that year 2000 issues
will not have a material adverse effect on the Company's business, financial
condition or results of operations.
COMPETITION
The Company's stores compete on the basis of, among other things,
convenience of location and store layout, product mix, selection, customer
service and price. The New York City drugstore market is highly fragmented due
to the complexities and costs of doing business in the most densely populated
area of the country. The diverse labor pool, local customer needs and complex
real estate market in New York City all favor regional chains and independents
that are familiar with the market. Duane Reade's store format is tailored to
meet all of these requirements and has proven successful in both the business
and residential neighborhoods of Manhattan.
Because of the difficulties of operating in densely populated areas, the New
York City drugstore market remains somewhat under-penetrated by national chains
as compared to the rest of the country. Nationwide, approximately 75% of the
drugstore market is controlled by chains, while in New York City that number is
approximately 50%. There can be no assurance that such underpenetration will
continue.
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Duane Reade believes that it has significant competitive advantages over
independent drugstores in New York City, including purchasing economies of
scale, a centrally located warehouse that minimizes store inventory and
maximizes selling space, a full line of in stock, brand name merchandise and a
convenient store format. Major chain competitors in the New York City market
include Rite-Aid, Genovese and CVS.
GOVERNMENT REGULATION
Duane Reade's stores and its distribution facility are registered with the
federal U.S. Drug Enforcement Agency and are subject to various state and local
licensing requirements. Each of Duane Reade's pharmacies and pharmacists located
in New York are licensed by the State of New York. The pharmacy and pharmacists
employed at Duane Reade's stores in Newark and Bayonne, New Jersey are licensed
by the State of New Jersey. In addition, Duane Reade has been granted cigarette
tax stamping licenses from the State of New York and from the City of New York
which permit Duane Reade to buy cigarettes directly from the manufacturers and
stamp the cigarettes themselves. Duane Reade's stores possess cigarette tax
retail dealers licenses issued by the State of New York, the City of New York
and the State of New Jersey.
EMPLOYEES
As of December 26, 1998, Duane Reade had approximately 3,500 employees,
almost all of whom were full-time. Approximately 2,300 of the Company's 3,500
employees are represented by unions. Non-union employees include employees at
corporate headquarters, employees at Duane Reade's personnel office and store
management. The distribution facility employees are represented by the
International Brotherhood of Teamsters, Chauffeurs and Warehousemen and Helpers
of America, Local 815. The Company's three year contract with this union expires
on August 31, 1999. Store employees are represented by the Allied Trade Council
and as a result of the Rock Bottom Acquisition, certain stores are represented
by the National Health and Human Services Employees Union AFL-CIO, Local 1199
("Local 1199") and Local 34A New York Joint Board. The Company's three year
contract with the Allied Trade Council expires August 31, 2001. The contract
with Local 34A New York Joint Board expires September 21, 2002. The Company is
currently in negotiation with Local 1199 and expects to have a completed
contract within the next several months. The sixteen stores represented by Local
1199 have been operating uninterrupted without a contract since the Rock Bottom
Acquisition. Duane Reade believes that its relations with its employees are
good.
TRADEMARKS
The name "Duane Reade" and the "DR" logo are registered trademarks. The
Company believes that it has developed strong brand awareness within the New
York City area. As a result, the Company regards the Duane Reade logo as a
valuable asset.
In addition, in connection with the Rock Bottom Acquisition, Duane Reade
acquired the "Rock Bottom" name, the "Rock Bottom" logo and "RXCELLENT SERVICE
and Design," each of which were registered trademarks.
THE FOREGOING INFORMATION CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS THAT
INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES. A NUMBER OF FACTORS COULD CAUSE
ACTUAL RESULTS, PERFORMANCE, ACHIEVEMENTS OF THE COMPANY, OR INDUSTRY RESULTS TO
BE MATERIALLY DIFFERENT FROM ANY FUTURE RESULTS, PERFORMANCE OR ACHIEVEMENTS
EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. THESE FACTORS INCLUDE,
BUT ARE NOT LIMITED TO, THE COMPETITIVE ENVIRONMENT IN THE DRUGSTORE INDUSTRY IN
GENERAL AND IN THE COMPANY'S SPECIFIC MARKET AREA; INFLATION; CHANGES IN COSTS
OF GOODS AND SERVICES; ECONOMIC CONDITIONS IN GENERAL AND IN THE COMPANY'S
SPECIFIC MARKET AREAS; DEMOGRAPHIC CHANGES; CHANGES IN PREVAILING INTEREST RATES
AND THE AVAILABILITY OF AND TERMS OF FINANCING TO FUND THE ANTICIPATED GROWTH OF
THE COMPANY'S BUSINESS; LIABILITY AND OTHER CLAIMS ASSERTED AGAINST THE COMPANY;
CHANGES IN OPERATING STRATEGY OR DEVELOPMENT PLANS; THE ABILITY TO ATTRACT AND
RETAIN QUALIFIED PERSONNEL; THE
8
SIGNIFICANT INDEBTEDNESS OF THE COMPANY; LABOR DISTURBANCES; CHANGES IN THE
COMPANY'S ACQUISITION AND CAPITAL EXPENDITURE PLANS; AND OTHER FACTORS
REFERENCED HEREIN. IN ADDITION, SUCH FORWARD-LOOKING STATEMENTS ARE NECESSARILY
DEPENDENT UPON ASSUMPTIONS, ESTIMATES AND DATES THAT MAY BE INCORRECT OR
IMPRECISE AND INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES AND OTHER FACTORS.
ACCORDINGLY, ANY FORWARD-LOOKING STATEMENTS INCLUDED HEREIN DO NOT PURPORT TO BE
PREDICTIONS OF FUTURE EVENTS OR CIRCUMSTANCES AND MAY NOT BE REALIZED.
FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY, AMONG OTHER THINGS, THE USE OF
FORWARD-LOOKING TERMINOLOGY SUCH AS "BELIEVES," "EXPECTS," "MAY," "WILL,"
"SHOULD," "SEEKS," "PRO FORMA," "ANTICIPATES," "INTENDS" OR THE NEGATIVE OF ANY
THEREOF, OR OTHER VARIATIONS THEREON OR COMPARABLE TERMINOLOGY, OR BY
DISCUSSIONS OF STRATEGY OR INTENTIONS. GIVEN THESE UNCERTAINTIES, PROSPECTIVE
INVESTORS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH FORWARD-LOOKING
STATEMENTS. THE COMPANY DISCLAIMS ANY OBLIGATIONS TO UPDATE ANY SUCH FACTORS OR
TO PUBLICLY ANNOUNCE THE RESULTS OF ANY REVISIONS TO ANY OF THE FORWARD-LOOKING
STATEMENTS CONTAINED HEREIN TO REFLECT FUTURE EVENTS OR DEVELOPMENTS.
ITEM 2. PROPERTIES.
As of December 26, 1998, the Company is operating stores in the following
locations:
NO. OF STORES
-------------------
Manhattan, NY................................................................................... 75
Brooklyn, NY.................................................................................... 16
Queens, NY...................................................................................... 11
Bronx, NY....................................................................................... 6
Staten Island, NY............................................................................... 3
Nassau/Suffolk County, NY....................................................................... 10
Westchester County, NY.......................................................................... 5
New Jersey...................................................................................... 2
---
Total:.......................................................................................... 128
Store leases are generally for 15 year terms. The average year of expiration
for stores operating as of December 26, 1998 is 2008. Lease rates are generally
subject only to increases based on inflation, real estate tax increases or
maintenance cost increases. The following table sets forth the lease expiration
dates of the Company's leased stores over each of the next five years and
thereafter. Of the stores with leases expiring in the next five years, fourteen
have renewal options.
YEAR
-------------
1999.................................................................................................. 1
2000.................................................................................................. 5
2001.................................................................................................. 1
2002.................................................................................................. 10
2003.................................................................................................. 6
Thereafter............................................................................................ 105
The Company leases space for its corporate headquarters, which is located in
Manhattan, New York.
The Company leases a 450,000 square foot warehouse in Maspeth, Queens, New
York under a lease which expires 2017. The Company also owns a 150,000 square
foot warehouse which is no longer used by the Company and is under contract for
sale in 1999.
ITEM 3. LEGAL PROCEEDINGS.
The Company is a party to certain legal actions arising in the ordinary
course of business. Based on information presently available to the Company, the
Company believes that it has adequate legal defenses
9
or insurance coverage for these actions and that the ultimate outcome of these
actions will not have a material adverse effect on the Company.
In addition, the Company is currently party to legal actions arising out of
disputes over the purchase price with respect to the Rock Bottom Acquisition.
The disputed amounts are not material to the Company, and the Company believes
that the ultimate outcome of these actions will not have a material adverse
effect on the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
During the fourth quarter of fiscal 1998, the Company did not submit any
matters to a vote of the Company's security holders.
10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
MARKET PRICE RANGE OF COMMON STOCK
YEAR ENDED DECEMBER
26, 1998
---------------------
QUARTER ENDED HIGH LOW
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March 28, 1998............................................................................. $ 26.125 $ 20.50
June 27, 1998.............................................................................. 31.00 21.3125
September 26, 1998......................................................................... 44.75 27.125
December 26, 1998.......................................................................... 45.00 31.75
Duane Reade's common stock is listed on the New York Stock Exchange under
the symbol: "DRD." At March 19, 1999 there were 76 registered shareholders of
the Common Stock compared with 85 registered shareholders at March 23, 1998. The
Company's common stock was not publicly traded in 1997, and the Company paid no
dividends in 1997 or 1998. The Company does not currently anticipate paying cash
dividends in the future.
11
ITEM 6 SELECTED FINANCIAL DATA
IN THOUSANDS, EXCEPT PER SHARE AMOUNTS, PERCENTAGES AND STORE DATA
FISCAL YEAR 1998 1997 1996 1995 1994
- ----------------------------------------------------- ---------- ---------- ---------- ---------- ----------
BALANCE SHEET DATA (AT END OF PERIOD)
Working capital...................................... $ 90,000 $ 37,494 $ 9,917 $ 13,699 $ 20,152
Total assets......................................... 428,140 249,521 222,476 235,860 229,699
Total debt and capital lease obligations............. 310,969 278,085 245,657 244,104 228,764
Stockholders' equity (deficiency).................... 22,789 (74,109) (59,396) (41,196) (23,170)
STATEMENT OF OPERATIONS DATA
Net sales............................................ $ 587,432 $ 429,816 $ 381,466 $ 336,922 $ 281,103
Cost of sales........................................ 431,025 322,340 288,505 259,827 209,678
---------- ---------- ---------- ---------- ----------
Gross profit......................................... 156,407 107,476 92,961 77,095 71,425
Selling, general & administrative expenses........... 94,577 65,414 59,048 50,326 39,741
Amortization......................................... 7,121 5,303 16,217 11,579 18,238
Depreciation......................................... 7,037 3,507 3,015 1,929 1,184
Store pre-opening expenses........................... 3,273 767 139 1,095 1,220
Nonrecurring charges(1).............................. -- 12,726 -- -- --
---------- ---------- ---------- ---------- ----------
Operating income..................................... 44,399 19,759 14,542 12,166 11,042
Interest expense, net................................ 25,612 34,473 32,396 30,224 27,480
---------- ---------- ---------- ---------- ----------
Income (loss) before taxes........................... 18,787 (14,714) (17,854) (18,058) (16,438)
Income taxes......................................... -- -- -- -- --
---------- ---------- ---------- ---------- ----------
Income (loss) before extraordinary charge............ 18,787 (14,714) (17,854) (18,058) (16,438)
Extraordinary charge(2).............................. (23,600) -- -- -- --
---------- ---------- ---------- ---------- ----------
Net loss............................................. $ (4,813) $ (14,714) $ (17,854) $ (18,058) $ (16,438)
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Per common share--basic:
Income (loss) before extraordinary charge.......... $ 1.16 $ (1.45) $ (1.77) $ (1.77) $ (1.62)
Extraordinary charge............................... (1.46) -- -- -- --
---------- ---------- ---------- ---------- ----------
Net loss........................................... $ (0.30) $ (1.45) $ (1.77) $ (1.77) $ (1.62)
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Weighted average common shares
outstanding...................................... 16,198 10,161 10,103 10,178 10,161
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Per common share--diluted:
Income (loss) before extraordinary charge.......... $ 1.07 $ (1.45) $ (1.77) $ (1.77) $ (1.62)
Extraordinary charge............................... (1.34) -- -- -- --
---------- ---------- ---------- ---------- ----------
Net loss........................................... $ (0.27) $ (1.45) $ (1.77) $ (1.77) $ (1.62)
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
Weighted average common shares
outstanding...................................... 17,508 10,161 10,103 10,178 10,161
---------- ---------- ---------- ---------- ----------
---------- ---------- ---------- ---------- ----------
12
FISCAL YEAR 1998 1997 1996 1995 1994
- ----------------------------------------------------- ---------- ---------- ---------- ---------- ----------
OPERATING AND OTHER DATA
EBITDA(3)............................................ $ 62,016 $ 43,056 $ 35,300 $ 27,443 $ 31,188
EBITDA as a percentage of sales...................... 10.6% 10.0% 9.3% 8.2% 11.1%
Number of stores at end of period.................... 128 67 60 59 51
Same store sales growth(4)........................... 6.5% 7.6% 8.3% (3.5)% 1.6%
Pharmacy same store sales growth..................... 21.5% 24.6% 25.5% 7.0% 14.2%
Average store size (square feet) at end of period:
Duane Reade........................................ 6,719 6,910 6,733 6,712 6,596
Rock Bottom........................................ 11,396 -- -- -- --
Sales per square foot................................ $ 1,040 $ 1,010 $ 956 $ 898 $ 970
Pharmacy sales as a % of net sales................... 28.3% 25.1% 21.8% 19.0% 17.6%
Third-Party Plan sales as a % of pharmacy sales...... 77.9% 74.2% 64.4% 58.2% 45.7%
Capital expenditures................................. $ 33,266 $ 9,360 $ 3,539 $ 6,868 $ 9,947
- ------------------------
(1) Refer to Note 18 of Consolidated Financial Statements.
(2) Refer to Note 17 of the Consolidated Financial Statements.
(3) As used herein, "EBITDA" means earnings before interest, income taxes,
depreciation, amortization, extraordinary charge, nonrecurring charges and
other non-cash items (primarily deferred rents). Management believes that
EBITDA, as presented, represents a useful measure of assessing the
performance of the Company's ongoing operating activities as it reflects the
earnings trends of the Company without the impact of certain non-cash
charges. Targets and positive trends in EBITDA are used as the performance
measure for determining management's bonus compensation; EBITDA is also
utilized by the Company's creditors in assessing debt covenant compliance.
The Company understands that, while EBITDA is frequently used by security
analysis in the evaluation of companies, it is not necessarily comparable to
other similarly titled captions of other companies due to potential
inconsistencies in the method of calculation. EBITDA is not intended as an
alternative to cash flow from operating activities as a measure of
liquidity, nor an alternative to net income as an indicator of the Company's
operating performance nor any other measure of performance in conformity
with GAAP.
A reconciliation of net loss to EBITDA for each period included above is set
forth below (dollars in thousands):
FISCAL YEAR 1998 1997 1996 1995 1994
- ---------------------------------------------- --------- ---------- ---------- --------- ----------
Net loss...................................... $ (4,813) $ (14,714) $ (17,854) $ 18,058) $ (16,438)
Interest expense, net......................... 25,612 34,473 32,396 30,224 27,480
Amortization.................................. 7,121 5,303 16,217 11,579 18,238
Depreciation.................................. 7,037 3,507 3,015 1,929 1,184
Extraordinary charge.......................... 23,600 -- -- -- --
Nonrecurring charges.......................... -- 12,726 -- -- --
Other non-cash items.......................... 3,459 1,761 1,526 1,769 724
--------- ---------- ---------- --------- ----------
EBITDA........................................ $ 62,016 $ 43,056 $ 35,300 $ 27,443 $ 31,188
--------- ---------- ---------- --------- ----------
--------- ---------- ---------- --------- ----------
(4) Same store sales figures include stores that have been in operation for at
least 13 months.
13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following should be read in connection with the consolidated financial
statements of the Company and the notes thereto included elsewhere in this
report.
GENERAL
The Company generates revenues primarily through sales of OTC drugs and
prescription pharmaceutical products, health and beauty aids, food and beverage
items, tobacco products, cosmetics, housewares, hosiery, greeting cards,
photofinishing, photo supplies and seasonal merchandise. Health and beauty
products, including OTC drugs, represent the largest of the Company's product
categories. The Company's primary costs and expenses consist of (i) inventory
costs, (ii) labor expenses and (iii) occupancy costs.
The Company had sales per square foot of $1,010 and $1,040 in fiscal 1997
and fiscal 1998, respectively. The Company believes that sales per square foot
is a useful measure of comparing the Company's performance to that of its
competitors because it is a measure of a store's sales productivity. The Company
currently expects that its sales per square foot may decline as it continues
with its plan to increase new store openings during 1999. The opening of such
additional stores may result in a decline in sales per square foot principally
because (i) the average square footage for new stores will often be greater than
that of the existing store base and (ii) new stores generally take some time to
reach a mature level of sales. The Company believes that its competitors in the
industry experience increases and decreases in sales per square foot for similar
reasons. Over the next two years, the Company plans to open approximately 30 to
40 stores, primarily in New York City.
The Company includes stores that have been in operation for at least 13
months for purposes of calculating comparable store sales figures.
In June 1997, DLJ Merchant Banking Partners II, L.P. ("DLJMBPII") and
certain of its affiliates acquired approximately 91.5% of the outstanding
capital stock of the Company from Bain Capital and certain other selling
securityholders. Upon consummation of such purchase, the Company reclassified
all of its outstanding capital stock (then consisting of four classes) into one
class of common stock, $0.01 par value per share. In February 1998, the Company
successfully completed an initial public offering (the "Offering") of its common
stock.
The Company's primary assets are its ownership of 99% of the outstanding
partnership interest of Duane Reade, a New York general partnership ("Duane
Reade") and ownership of all of the outstanding common stock of DRI I Inc.
("DRI"). DRI owns the remaining 1% partnership interest in Duane Reade.
Substantially all of the operations of the Company are conducted through Duane
Reade.
14
RESULTS OF OPERATIONS
The following sets forth the results of operations as a percentage of sales
for the periods indicated.
FISCAL YEAR
-------------------------------
1998 1997 1996
--------- --------- ---------
Net Sales........................................................................... 100.0% 100.0% 100.0%
Cost of Sales....................................................................... 73.4 75.0 75.6
--------- --------- ---------
Gross profit........................................................................ 26.6 25.0 24.4
Selling, general and administrative expenses........................................ 16.1 15.2 15.5
Amortization........................................................................ 1.3 1.2 4.3
Depreciation........................................................................ 1.2 0.8 0.8
Store pre-opening expenses.......................................................... 0.6 0.2 0.0
Nonrecurring charges................................................................ -- 3.0 --
--------- --------- ---------
Operating income.................................................................... 7.6 4.6 3.8
Net interest expense................................................................ 4.4 8.0 8.5
--------- --------- ---------
Income (loss) before extraordinary charge........................................... 3.2 (3.4) (4.7)
Extraordinary charge................................................................ (4.0) -- --
--------- --------- ---------
Net loss............................................................................ (0.8)% (3.4)% (4.7)%
--------- --------- ---------
--------- --------- ---------
FISCAL 1998 COMPARED TO FISCAL 1997
Net sales in 1998 were $587.4 million, an increase of 36.7% over 1997 net
sales of $429.8 million. The increase was due to increased comparable store
sales of 6.5% and the inclusion of seven stores opened during 1997 for the
entire 1998 period, 33 new stores opened in 1998, and 28 stores purchased in the
Rock Bottom Acquisition. The increase in comparable store sales was primarily
attributable to increased pharmacy sales, which increased to 28.3% of total
sales in 1998 compared to 25.1% of total sales in 1997.
Cost of sales as a percentage of net sales decreased to 73.4% for 1998 from
75.0% for 1997, resulting in an increase in gross profit margin to 26.6% for
1998 from 25.0% for 1997. The increase in gross margin resulted principally from
contribution from higher margin merchandise such as greeting cards, photo
finishing, cosmetics, vitamins, generic drugs and private label products.
Selling, general and administrative expenses were $94.6 million or 16.1% of
net sales and $65.4 million or 15.2% of net sales in 1998 and 1997,
respectively. The percentage increase in 1998 compared to 1997 resulted
principally from higher selling expenses related to higher store salaries as a
percentage of net sales and increases in other store-related expenses
(principally attributable to new stores during the early months of operation) as
well as approximately $1.4 million of nonrecurring transition costs related to
the integration of the Rock Bottom stores during the fourth quarter of 1998.
Transition costs related to the Rock Botton Acquisition include redundant costs
incurred related to the occupancy costs of an additional warehouse, the costs
related to maintaining duplicate warehouse and point of sale systems,
administrative payroll costs for positions during the integration period and
expenses incurred to convert the stores to the Duane Reade format.
Amortization of goodwill and other intangibles in 1998 and 1997 was $7.1
million and $5.3 million, respectively. The increase in amortization resulted
principally from the amortization of goodwill and identifiable intangibles
related to the Rock Bottom stores as well as increases in the amortization of
customer lists and lease acquisition costs for pharmacy acquisitions during
1998.
The increase in depreciation from $3.5 million in 1997 to $7.0 million in
1998 resulted principally from depreciation on the 33 stores opened during 1998,
a full year of depreciation expense in 1998 on the seven stores opened during
1997 compared to a partial year of depreciation expense in 1997 and depreciation
expense on the 28 Rock Bottom stores.
15
Store pre-opening expenses increased from $767,000 in 1997 to $3.3 million
in 1998 due to the opening of 33 new stores in 1998 compared to seven in 1997.
Net interest expense decreased 25.7% to $25.6 million in 1998 from $34.5
million in 1997. The decrease in interest expense was principally due to the
impact of the debt refinancing completed during February 1998 in connection with
the Refinancing Plan (as defined) which resulted in lower overall debt levels
and a reduction of interest rates.
The Company's income before extraordinary charge increased by $33.5 million
to $18.8 million for 1998 from a net loss of $14.7 million for 1997 as a result
of the $12.7 million nonrecurring charges in the prior year period; decreased
interest expense; and increased sales and gross profit margin, partially offset
by increased selling, general and administrative expenses; store pre-opening
expenses; depreciation and amortization. Including the extraordinary charge
related to the early extinguishment of debt, the net loss for 1998 was $4.8
million.
FISCAL 1997 COMPARED TO FISCAL 1996
Net sales in 1997 were $429.8 million, an increase of 12.7% over 1996 net
sales of $381.5 million. The increase was attributable to increased comparable
store sales of 7.6% and the inclusion of one new store opened during 1996 for
the entire 1997 period and seven new stores opened in 1997.
Cost of sales as a percentage of net sales decreased to 75.0% for 1997 from
75.6% for 1996, resulting in an increase in gross profit margin to 25.0% for
1997 from 24.4% during 1996. The increase in gross margin resulted from a number
of factors including (i) increased contribution from the sale of higher margin
merchandise such as cosmetics, vitamins, general merchandise, generic drugs and
private label products, (ii) higher promotional allowances received from venders
and (iii) occupancy costs that increased at a lesser rate than the rate at which
sales increased.
Selling, general and administrative expenses were $65.4 million or 15.2% of
net sales and $59.0 million or 15.5% of net sales in 1997 and 1996,
respectively. The percentage decrease in 1997 compared to 1996 resulted
principally from lower general and administrative expense as a percentage of net
sales including the elimination of agreements requiring the annual payment of
$1.0 million in management fees to Bain Capital, partially offset by higher
selling expenses related to higher store salaries as a percentage of net sales
(principally from new stores during the early months of operation).
Amortization of goodwill and other intangibles in 1997 and 1996 was $5.3
million and $16.2 million, respectively. The decrease in amortization is
principally a result of the completion in 1996 of amortization of covenants not
to compete and the related write-off of the balance of such amounts during the
fourth quarter of 1996.
Depreciation was $3.5 million and $3.0 million in 1997 and 1996,
respectively.
Store pre-opening expenses increased to $0.8 million in 1997 from $0.1 in
1996 due to the opening of seven new store locations in 1997 compared to one in
1996.
Net interest expense was $34.5 million in 1997 compared to $32.4 million in
1996. The increase in interest expense was principally due to (i) higher
non-cash accretion of the 15% Senior Subordinated Zero Coupon Notes due 2004
(the "Zero Coupon Notes"), (ii) interest related to financing of third party
accounts receivable and (iii) increased interest on borrowings under the
revolving credit facility, partially offset by (a) reduced interest on term loan
borrowings caused by the decrease in average balance from $72.0 million for 1996
to $67.4 million for 1997 and a decrease in the average interest rate from 9.1%
to 8.7% and (b) reduced interest on capital lease obligations.
The net loss for the Company decreased by $3.2 million from $17.9 million in
1996 to $14.7 million in 1997 primarily as a result of an increase in sales and
gross profit margin and a reduction in amortization expense, partially offset by
nonrecurring charges (see Note 18 of Notes to Consolidated Financial
Statements). The Company's EBITDA improved by $7.8 million or 22.0% to $43.1
million in 1997
16
compared to $35.3 million in 1996. EBITDA as a percentage of sales increased to
10.0% in 1997 from 9.3% in 1996.
LIQUIDITY AND CAPITAL RESOURCES
In February 1998, the Company successfully completed the Offering, which was
part of a plan to refinance all of the Company's then existing indebtedness (the
"Refinancing Plan") in order to enhance the Company's financial flexibility to
pursue growth opportunities and implement capital improvements. The Refinancing
Plan resulted in a reduction in the Company's overall indebtedness, a
simplification of the Company's capital structure and access to additional
borrowings. The principal components of the Refinancing Plan were: (i) the sale
by the Company of 6.7 million shares of common stock for net proceeds of
approximately $102 million; (ii) the execution of a new secured credit agreement
(the "Existing Credit Agreement"), which provided for borrowings up to
approximately $160 million ($130 million of term loans and up to $30 million of
revolving loans); (iii) the issuance of $80 million aggregate principal amount
of the Company's 9 1/4% Senior Subordinated Notes due 2008 (the "Senior Notes")
for net proceeds of approximately $77 million; (iv) the repayment of all
outstanding borrowings under the Company's former credit agreement, the
outstanding principal amount of which was $89.8 million as of December 27, 1997;
(v) the redemption of the Company's outstanding Zero Coupon Notes; (vi) the
redemption of the Company's outstanding 12% Senior Notes due 2002.
On August 14, 1998, in connection with the Rock Bottom Acquisition, the
Existing Credit Agreement was amended to allow for increased term loan
borrowings of $10 million. On September 11, 1998, also in connection with the
Rock Bottom Acquisition, the Existing Credit Agreement was amended and restated
to increase available term loan borrowings by $70 million, bringing the total
permitted borrowings under the Existing Credit Agreement to $240 million ($210
of term loans and up to $30 million of revolving loans).
Working capital was $90.0 million and $37.5 million as of December 26, 1998
and December 27, 1997, respectively. The increase is primarily due to increases
in inventory related to the Rock Bottom Acquisition, the opening of 33
additional stores during 1998 and the Company's increase in its investments in
forward-buy inventory. In addition, accounts receivable increased due to
additional volume as well as an increase in third party pharmacy receivables due
to the Company's decision to no longer factor these receivables.
The Company's EBITDA increased by $19.0 million or 44.0% to $62.0 million in
1998 compared to 1997. EBITDA as a percentage of sales increased to 10.6% in
1998 from 10.0% in 1997.
For the fiscal year ended December 26, 1998, net cash used in operating
activities was $7.9 million, compared to $3.8 million for the fiscal year ended
December 27, 1997. The primary reason for this use of cash was an increase in
inventory and vendor receivables previously discussed. The Company believes that
the activities have not and will not materially adversely affect its liquidity.
For the fiscal year ended December 26, 1998, net cash used in investing
activities was $98.2 million, compared to $8.3 million for the fiscal year ended
December 27, 1997. The increase reflects the Rock Bottom Acquisition and capital
expenditures in 1998 related to store openings and remodeling.
For the fiscal year ended December 26, 1998, net cash provided by financing
activities was $106.6 million, compared to $12.1 million for the fiscal year
ended December 27, 1997. This increase primarily resulted from proceeds from the
Offering, new term loan financing, proceeds from the issuance of the Senior
Notes, the borrowing of $80 million to finance the Rock Bottom Acquisition and
related supporting inventory, and the revolving credit facility borrowing, net
of repayments for capital lease obligations.
During the third quarter, the Company completed the transfer of its
warehouse operations to the distribution center in Maspeth, New York. This new
facility, which has doubled the Company's distribution capacity, is located one
mile away from the Company's former center. The Company's capital requirements
17
primarily result from opening and stocking new stores and from the continuing
development of management information systems. The Company believes that there
are significant opportunities to open additional stores, and currently plans to
open approximately 30 to 40 stores during the next two years. The Company
expects to spend approximately $20 million in 1999 on capital expenditures
primarily for new and replacement stores. Working capital is also required to
support inventory for the Company's existing stores. Historically, the Company
has been able to lease its store locations.
Leases for seven of the Company's stores that generated approximately 6.3%
of the Company's net sales for the fiscal year ended December 26, 1998 are
scheduled to expire before the end of the year 2001. The Company believes that
it will be able to renew such leases on economically favorable terms or,
alternatively, find other economically attractive locations to lease.
As of December 26, 1998, approximately 2,300 of the Company's approximately
3,500 employees were represented by various labor unions and were covered by
collective bargaining agreements. Pursuant to the terms of such collectively
bargaining agreements, the Company is required to pay certain annual increases
in salary and benefits to such employees. The Company does not believe that such
increases will have a material impact on the Company's liquidity or results of
operations.
The Company records significant accounts receivable related to pharmacy
sales in connection with third party plans. In the past, the Company had a
non-recourse factoring arrangement with an independent third party, Pharmacy
Fund, Inc. ("Pharmacy Fund") under which the Company sold it accounts receivable
associated with the third party plans. On September 8, 1998, Pharmacy Fund
declared bankruptcy and no longer purchases the Company's third party plan
receivables. The Company believes that it will not suffer any loss from the
bankruptcy. The Company plans to collect its own receivables for the foreseeable
future.
The Company believes that, based on current levels of operations and
anticipated growth, cash flow from operations, together with other available
sources of funds, including borrowings under the Existing Credit Agreement, will
be adequate for at least the next two years to make required payments of
principal and interest on the Company's indebtedness, to fund anticipated
capital expenditures and working capital requirements and to comply with the
terms of its debt agreements. As of December 26, 1998, the Company had borrowed
approximately $16.5 million under the revolving portion of its bank credit
facility and had approximately $13.0 million of remaining availability. The
ability of the Company to meet its debt service obligations and reduce its total
debt will be dependent upon the future performance of the Company and its
subsidiaries which, in turn, will be subject to general economic, financial,
business, competitive, legislative, regulatory and other conditions, many of
which are beyond the Company's control. In addition, there can be no assurance
that the Company's operating results, cash flow and capital resources will be
sufficient for repayment of its indebtedness in the future. Substantially all of
the Company's borrowings under the Existing Credit Agreement bear interest at
floating rates; therefore, the Company's financial condition will be affected by
the changes in prevailing interest rates. The Company has entered into interest
rate protection agreements to minimize the impact from a rise in interest rates.
TAX BENEFITS FROM NET OPERATING LOSSES
At December 26, 1998, the Company had net operating loss carryforwards
("NOLs") of approximately $107 million, which are due to expire in the years
2007 through 2018. These NOLs may be used to offset future taxable income
through 2018 and thereby reduce or eliminate the Company's federal income taxes
otherwise payable. The Internal Revenue Code of 1986, as amended (the "Code"),
imposes significant limitations on the utilization of NOLs in the event of an
"ownership change," as defined in Section 382 of the Code (the "Section 382
Limitation"). The Section 382 Limitation is an annual limitation on the amount
of pre-ownership change NOLs that a corporation may use to offset its
post-ownership change income. The Section 382 Limitation is calculated by
multiplying the value of a corporation's stock immediately before an ownership
change by the long-term tax-exempt rate (as published by the Internal Revenue
Service). Generally, an ownership change occurs with respect to a corporation if
the aggregate increase in the percentage of stock ownership (by value) of that
corporation by one or more 5%
18
shareholders (including certain groups of shareholders who in the aggregate own
at least 5% of that corporation's stock) exceeds 50 percentage points over a
three-year testing period. The Recapitalization caused the Company to experience
an ownership change. As a result, the Company currently is subject to an annual
Section 382 Limitation of approximately $5.1 million on the amount of NOLs
generated prior to the Recapitalization that the Company may utilize to offset
future taxable income. NOLs generated by the Company since the Recapitalization
(approximately $37 million) are not subject to the Section 382 Limitation and
may be used to offset future taxable income. There can be no assurance that any
NOLs will be able to be used by the Company to offset future taxable income or
that such NOLs will not become subject to limitation due to future ownership
changes.
YEAR 2000 UPDATE
The Company is implementing a program to ensure that the Company computer
systems and applications (IT Systems) and non-IT Systems will function properly
beyond 1999. This program includes inventorying year 2000 items; assigning
priorities to the identified items; assessing year 2000 compliance of items
determined to be material to the Company; remediating or preplacing material
items that are not year 2000 compliant; and determining contingency plans that
may be required.
The Company has completed inventorying and prioritizing year 2000 compliance
of its IT Systems and is commencing these phases for its non-IT Systems, which
will include surveying significant third party vendors. The Company is upgrading
its software and expects this phase to be completed by June 30, 1999.
The Company is using both internal and external resources to address year
2000 issues and believes that the cost of such modifications will approximate
$600,000. Approximately $250,000 of this includes system upgrades that had been
previously identified for operational enhancements.
Although management expects to complete the upgrading of all of its software
by mid-1999, the Company will develop a year 2000 contingency plan before
mid-1999 if it appears that the Company will not achieve full year 2000
compliance. Management regularly monitors the status of the year 2000 compliance
process.
The failure to correct a material year 2000 problem could result in an
interruption in, or failure of, certain normal business activities or
operations. Such failures could materially and adversely affect the Company's
results of operations, financial condition and liquidity. No assurances,
however, can be given that the Company will be able to identify and address all
year 2000 issues due to their complexity as well as the Company's dependence on
the technical skills of employees and independent contractors and on the
representations and preparedness of third parties with which the Company does
business. Although the Company believes that its efforts are designed to
appropriately identify and address year 2000 issues that are subject to the
Company's reasonable control, there can be no assurance that year 2000 issues
will not have a material adverse effect on the Company's business, financial
condition or results of operations.
SEASONALITY
In general, sales of drugstores items such as prescription drugs, OTC drugs
and health and beauty care products exhibit limited seasonality in the
aggregate, but do vary by product category. Quarterly results are primarily
affected by the timing of new store openings and the sale of seasonal products.
In view of the Company's recent expansion of seasonal merchandising, the Company
expects slightly greater revenue sensitivity relating to seasonality in the
future.
INFLATION
The Company believes that inflation has not had a material impact on results
of operations for the Company during the three years ended December 26, 1998.
19
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
FASB Statement No. 133 "Accounting for Derivative Instruments and Hedging
Activities" requires that derivative instruments such as options, forward
contracts and swaps be recorded as assets and liabilities at fair value and
provides guidance for recognition of changes in fair value depending on the
reason for holding the derivative. The Company does not presently have
significant transactions involving derivative instruments, but may do so in the
future. The Company is required to adopt Statement No. 133 for the first quarter
of 2000 and may adopt it earlier.
ITEM 7A. MARKET RISK
The financial results of the Company are subject to risk from interest rate
fluctuations on debt which carries variable interest rates. Variable rate debt
outstanding (under the Existing Credit Agreement) was approximately $225 million
at December 26, 1998, which is somewhat lower than the Company expects its
outstanding variable rate debt to be during the next twelve months. The
anticipated outstanding balances, however, are not expected to be materially
greater than at December 26, 1998. Based on the December 26, 1998 outstanding
balances, a 0.50% change in interest rates would affect annual results of
operations by approximately $1.1 million. The Company also has $80 million of
Senior Notes outstanding at December 26, 1998. These notes, which bear interest
at a fixed 9 1/4%, are not subject to risk from interest rate fluctuations.
The principal objective of the Company's investment management activities is
to maintain acceptable levels of interest rate and liquidity risk and to
facilitate the funding needs of the Company. As part of its investment
management, the Company may use derivative financial products such as interest
rate hedges and interest rate swaps. During the year ended December 27, 1997
there were no derivative positions. During the year ended December 26, 1998, in
connection with the Existing Credit Agreement requirements, the Company entered
into an interest rate protection agreement.
20
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA
Report of Independent Accountants
TO THE BOARD OF DIRECTORS AND
STOCKHOLDERS OF DUANE READE INC.
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity (deficiency) and
of cash flows present fairly, in all material respects, the financial position
of Duane Reade Inc. and its subsidiaries (the "Company") at December 26, 1998
and December 27, 1997 and the results of their operations and their cash flows
for each of the 52 week periods ended December 26, 1998, December 27, 1997 and
December 28, 1996 in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
[LOGO]
PricewaterhouseCoopers LLP
New York, NY
February 8, 1999
21
DUANE READE INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FOR THE 52 WEEKS ENDED
----------------------------------------
DECEMBER 26, DECEMBER 27, DECEMBER 28,
1998 1997 1996
------------ ------------ ------------
Net sales............................................................. $ 587,432 $ 429,816 $ 381,466
Cost of sales......................................................... 431,025 322,340 288,505
------------ ------------ ------------
Gross profit.......................................................... 156,407 107,476 92,961
Selling, general and administrative expenses.......................... 94,577 65,414 59,048
Amortization.......................................................... 7,121 5,303 16,217
Depreciation.......................................................... 7,037 3,507 3,015
Store pre-opening expenses............................................ 3,273 767 139
Nonrecurring charges.................................................. -- 12,726 --
------------ ------------ ------------
112,008 87,717 78,419
------------ ------------ ------------
Operating income...................................................... 44,399 19,759 14,542
Interest expense, net................................................. 25,612 34,473 32,396
------------ ------------ ------------
Income (loss) before income taxes..................................... 18,787 (14,714) (17,854)
Income taxes.......................................................... -- -- --
------------ ------------ ------------
Income (loss) before extraordinary charge............................. 18,787 (14,714) (17,854)
Extraordinary charge.................................................. (23,600) -- --
------------ ------------ ------------
Net loss.............................................................. $ (4,813) $ (14,714) $ (17,854)
------------ ------------ ------------
------------ ------------ ------------
Per common share--basic:
Income (loss) before extraordinary charge........................... $ 1.16 $ (1.45) $ (1.77)
Extraordinary charge................................................ (1.46) -- --
------------ ------------ ------------
Net loss............................................................ $ (0.30) $ (1.45) $ (1.77)
------------ ------------ ------------
------------ ------------ ------------
Weighted average common shares outstanding............................ 16,198 10,161 10,103
------------ ------------ ------------
------------ ------------ ------------
Per common share--diluted:
Income (loss) before extraordinary charge........................... $ 1.07 $ (1.45) $ (1.77)
Extraordinary charge................................................ (1.34) -- --
------------ ------------ ------------
Net loss............................................................ $ (0.27) $ (1.45) $ (1.77)
------------ ------------ ------------
------------ ------------ ------------
Weighted average common shares outstanding............................ 17,508 10,161 10,103
------------ ------------ ------------
------------ ------------ ------------
The accompanying notes are an integral part of these financial statements.
22
DUANE READE INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 26, December 27,
1998 1997
------------ -------------
ASSETS
Current assets
Cash.............................................................................. $ 869 $ 261
Receivables....................................................................... 25,547 9,592
Inventories....................................................................... 134,313 66,665
Property held for sale............................................................ 11,527 --
Prepaid expenses and other current assets......................................... 4,774 2,556
------------ -------------
TOTAL CURRENT ASSETS............................................................ 177,030 79,074
Property and equipment--net......................................................... 71,974 32,557
Goodwill, net of accumulated amortization $21,954 and $18,264....................... 144,946 120,890
Other assets........................................................................ 34,190 17,000
------------ -------------
TOTAL ASSETS.................................................................... $ 428,140 $ 249,521
------------ -------------
------------ -------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
Current liabilities
Accounts payable.................................................................. $ 50,028 $ 23,510
Accrued interest.................................................................. 3,636 4,634
Other accrued expenses............................................................ 25,677 10,873
Current portion of long-term debt................................................. 5,600 660
Current portion of capital lease obligations...................................... 2,089 1,903
------------ -------------
TOTAL CURRENT LIABILITIES....................................................... 87,030 41,580
Long-term debt...................................................................... 299,350 271,596
Capital lease obligations, less current portion..................................... 3,930 3,926
Other non-current liabilities....................................................... 15,041 6,528
------------ -------------
TOTAL LIABILITIES............................................................... 405,351 323,630
------------ -------------
Commitments and Contingencies (Note 14)
Stockholders' equity (deficiency)
Preferred stock, $0.01 par; authorized 5,000,000 shares; issued and outstanding:
none............................................................................ -- --
Common stock, $0.01 par; authorized 30,000,000 shares; issued and outstanding:
16,985,557 and 10,260,577 shares................................................ 170 103
Paid-in capital................................................................... 126,207 24,563
Accumulated deficit............................................................... (103,588) (98,775)
------------ -------------
TOTAL STOCKHOLDERS' EQUITY (DEFICIENCY)......................................... 22,789 (74,109)
------------ -------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)......................... $ 428,140 $ 249,521
------------ -------------
------------ -------------
The accompanying notes are an integral part of these financial statements.
23
DUANE READE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
FOR THE 52 WEEKS ENDED
----------------------------------------
DECEMBER 26, DECEMBER 27, DECEMBER 28,
1998 1997 1996
------------ ------------ ------------
Cash flows from operating activities:
Net loss............................................................ $ (4,813) $ (14,714) $ (17,854)
Adjustments to reconcile net loss to net cashprovided by operating
activities:
Depreciation and amortization of property and equipment........... 7,037 3,507 3,015
Amortization of goodwill and other intangibles.................... 8,475 9,542 18,897
Accretion of principal of zero coupon debt........................ 1,659 13,081 11,249
Extraordinary charge.............................................. 23,600 -- --
Other............................................................. 3,459 1,761 1,526
Changes in operating assets and liabilities (net of effect of
acquisition):
Receivables......................................................... (15,955) (2,421) (1,431)
Inventories......................................................... (44,976) (18,751) (4,767)
Accounts payable.................................................... 22,288 3,495 (412)
Prepaid and accrued expenses........................................ 4,624 2,086 2,321
Increase in other (liabilities) assets--net........................... (13,262) (1,392) 51
------------ ------------ ------------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES................. (7,864) (3,806) 12,595
------------ ------------ ------------
Cash flows from investing activities:
Purchase of Rock Bottom assets...................................... $ (64,906) $ -- $ --
Proceeds from sales of capital assets............................... -- 1,075 --
Capital expenditures................................................ (33,266) (9,360) (3,539)
Sale of government securities--net.................................. -- -- 44
------------ ------------ ------------
NET CASH USED IN INVESTING ACTIVITIES............................... (98,172) (8,285) (3,495)
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from common stock offering--net............................ $ 101,606 $ -- $ --
Proceeds from new term loan......................................... 210,000 65,475 --
Proceeds from new senior subordinated notes......................... 80,000 -- --
Repayments of old term loan......................................... (65,310) (69,475) (5,625)
Net borrowings (repayments)--old revolving credit facility.......... (24,500) (2,500) (1,500)
Repayment of old senior subordinated notes.......................... (89,893) (107) --
Repayment of zero coupon debt....................................... (99,346) (9) --
Premiums paid on early extinguishment of debt....................... (11,496) -- --
Fees and expenses related to early extinguishment of debt........... (478) -- --
Repayments of new term loan......................................... (1,550) (165) --
Borrowings from new revolving credit facility....................... 16,500 24,500 --
Deferred financing costs............................................ (6,961) (3,079) (952)
Proceeds from issuance of stock..................................... 105 1 --
Repurchase of stock................................................. -- -- (95)
Repayments of capital lease obligations............................. (2,033) (2,505) (2,845)
------------ ------------ ------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES................. 106,644 12,136 (11,017)
------------ ------------ ------------
Net increase (decrease) in cash....................................... 608 45 (1,917)
Cash at beginning of year............................................. 261 216 2,133
------------ ------------ ------------
CASH AT END OF YEAR................................................... $ 869 $ 261 $ 216
------------ ------------ ------------
Supplementary disclosures of cash flow information:
Cash paid for interest................................................ $ 76,688(1) $ 17,601 $ 18,391
------------ ------------ ------------
------------ ------------ ------------
(1) Includes $52,741 of accretion of Zero Coupon Notes from September 1992
through February 1998, which was repaid in connection with the Company's
Refinancing Plan in February 1998.
The accompanying notes are an integral part of these financial statements.
24
DUANE READE INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
DOLLARS IN THOUSANDS
PREFERRED STOCK COMMON STOCK
------------------------ ------------------------- PAID-IN ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT
----------- ----------- ------------ ----------- ---------- ------------
Balance, December 30, 1995................. -- $ -- 10,184,565 $ 102 $ 24,909 $ (66,207)
Repurchase of common stock................. -- -- (122,068) (1) (345) --
Net loss................................... -- -- -- -- -- (17,854)
--- ----- ------------ ----- ---------- ------------
Balance, December 28, 1996................. -- -- 10,062,497 101 24,564 (84,061)
Issuance of common stock................... -- -- 198,080 2 (1) --
Net loss................................... -- -- -- -- -- (14,714)
--- ----- ------------ ----- ---------- ------------
Balance, December 27, 1997................. -- -- 10,260,577 103 24,563 (98,775)
Common stock offering...................... -- -- 6,700,000 67 101,539 --
Issuance of common stock................... -- -- 24,980 -- 105 --
Net loss................................... -- -- -- -- -- (4,813)
--- ----- ------------ ----- ---------- ------------
BALANCE, DECEMBER 26, 1998................. -- $ -- 16,985,557 $ 170 $ 126,207 $ (103,588)
--- ----- ------------ ----- ---------- ------------
--- ----- ------------ ----- ---------- ------------
TOTAL
----------
Balance, December 30, 1995................. $ (41,196)
Repurchase of common stock................. (346)
Net loss................................... (17,854)(1)
----------
Balance, December 28, 1996................. (59,396)
Issuance of common stock................... 1
Net loss................................... (14,714)(1)
----------
Balance, December 27, 1997................. (74,109)
Common stock offering...................... 101,606
Issuance of common stock................... 105
Net loss................................... (4,813)(1)
----------
BALANCE, DECEMBER 26, 1998................. $ 22,789
----------
----------
- ------------------------
(1) The Company has no comprehensive income other than its net loss and,
therefore, comprehensive income is equal to the net loss in each of the
three years presented.
The accompanying notes are an integral part of these financial statements.
25
DUANE READE INC.
NOTES TO CONSOLIDATED STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Duane Reade Inc. (the "Company") was formed on June 16, 1992 for the purpose
of acquiring Daboco, Inc. ("Daboco"). The acquisition took place on September
25, 1992. Daboco and DRI I Inc. ("DRI"), a subsidiary of Daboco, were general
partners in Duane Reade, which operates retail drugstores (128 at December 26,
1998) in the New York metropolitan area.
During June 1997, the Company entered into a recapitalization agreement (the
"Agreement") with its stockholders ("Stockholders") and DLJ Merchant Banking
Partners II, L.P. ("DLJMBPII") and certain of its affiliates (the "DLJMBP
Entities") as investors ("Investors"). The Agreement provided for (i) the
purchase by Investors from the Stockholders of substantially all their stock
holdings in the Company, (ii) a conversion of all of the outstanding shares of
the Company into a newly authorized class of Class B common stock and (iii) the
creation of a new authorized class of preferred stock which will carry the
rights and preferences granted by the Company's board of directors when issued.
Shares were converted as follows:
APPROXIMATE
PRIOR CLASS CONVERSION RATE
- ------------------------------------------------------------------------------------------------- -----------------
Common and Common Class A........................................................................ 28/1
Common Class P and Common Class P-1.............................................................. 355/1
In addition, because of the change in control, the Company was obligated to
and made offers to repurchase all outstanding 12% Senior Notes due 2002 and Zero
Coupon Notes at 101% of the principal amount or accreted value thereof,
respectively. Such offers expired on September 12, 1997. The Company repurchased
an aggregate of $107,000 principal amount of 12% Senior Notes due 2002 and
$9,000 of Zero Coupon Notes pursuant to the offers.
These financial statements do not reflect any adjustments as a result of the
June 1997 change in control.
On January 14, 1998, the Company effected an 8.326 reverse stock split of
its common stock. All references to common stock amounts, shares and per share
data included herein have been adjusted to give retroactive effect to such
reverse stock split.
In February 1998, the Company successfully completed an initial public
offering of its stock which was part of a plan to refinance all of the Company's
existing indebtedness in order to enhance the Company's financial flexibility.
In connection with this plan, Daboco was merged with and into the Company. The
Company, along with DRI, are now the general partners in Duane Reade.
Significant accounting policies followed in the preparation of the
consolidated financial statements are as follows:
PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include
the accounts of the Company and its subsidiaries. All intercompany transactions
and balances have been eliminated. Certain prior period amounts have been
reclassified to conform with the current presentation.
The Company has no assets or operations other than its investment in its
subsidiary guarantors. Accordingly, the consolidated financial statements
present the combined assets and operations of the subsidiary guarantors.
REPORTING YEAR: The fiscal year for the Company is the 52/53 week reporting
period ending on the last Saturday in December.
26
RECEIVABLES: Receivables consist primarily of amounts due from various
insurance companies and governmental agencies under third party payment plans
for prescription sales and amounts due from vendors, a majority of which relate
to promotional programs. The Company has not provided an allowance for doubtful
accounts as its historical write-offs have been immaterial. The Company reflects
promotional allowances from vendors as income when such allowances are earned.
The carrying value of the Company's receivables approximate fair value given the
short-term maturity of these financial instruments.
INVENTORIES AND COST OF SALES: During the third quarter of 1998, the
Company changed its inventory costing method from the last-in, first-out retail
dollar value method (LIFO) to the first-in, first-out (FIFO) method. The effect
of this change was immaterial to the accompanying financial statements. If FIFO
had been used, inventories at December 27, 1997 would not be materially
different from the amounts reflected on the accompanying balance sheet as the
carrying value approximated current cost. Inventories are stated at the lower of
cost or market. When appropriate, provision is made for obsolete, slow-moving or
damaged inventory. In 1998, the Company entered into an arrangement with a
pharmaceutical distributor whereby prescription drug inventory is shipped
directly to the Company's stores, with payment due only when inventory is sold.
Such inventory is accounted for as consigned merchandise and is not recorded on
the Company's balance sheet. As of December 26, 1998, the cost of such inventory
was approximately $15 million. Cost of sales includes distribution and occupancy
costs.
PROPERTY AND EQUIPMENT: Property and equipment are stated at cost.
Depreciation and amortization are provided using the straight-line method over
estimated useful lives of assets as follows:
Buildings and improvements................... 30 years
Furniture, fixtures and equipment............ 5-10 years
Leasehold improvements....................... Life of lease or, if shorter, asset
OTHER ASSETS: Deferred financing costs which arose in connection with
borrowings under the Term Loan and with the issuance of the 12% Senior
Subordinated Notes and the Zero Coupon Notes are amortized using the
straight-line method, the results of which are not materially different from the
interest method, over the term of the respective debt issue. Deferred financing
costs which arose in connection with the September 1997 (written off in
conjunction with the February 1998 credit agreement) and February 1998 credit
agreements and the Senior Subordinated Notes due 2008 are amortized using the
interest method, over the term of the debt.
Systems development costs, consisting principally of costs relating to the
new management information systems, are amortized using the straight-line method
over a period of seven years.
INTANGIBLE ASSETS: In September 1992, the Company entered into agreements
with certain former members of management of Duane Reade, former shareholders of
Daboco and shareholders of former partners of Duane Reade (collectively, the
"Group") precluding such persons from competing with the operations of Duane
Reade for a period of five years. The covenants not to compete were recorded at
acquisition cost and were being amortized over the period of benefit using an
accelerated method. During the first quarter of 1997, the Company entered into
agreements in which the Company received consideration from the Group to
terminate the non-compete agreements. In accordance with APB Opinion No. 17,
"Intangible Assets," the remaining carrying value of the non-compete agreements
which was $4.86 million as of December 28, 1996 was written off and has been
included in the accompanying consolidated statement of operations as
amortization expense during the 52 weeks ended December 28, 1996.
Goodwill is amortized on the straight-line method over 40 years. The
carrying value of goodwill is periodically reviewed and evaluated by the Company
based principally on its expected future undiscounted operating cash flows.
Should such evaluation result in the Company concluding that the carrying amount
of goodwill has been impaired, an appropriate write-down would be made.
27
PRE-OPENING EXPENSES: Store pre-opening costs, other than capital
expenditures, are expensed when incurred.
INCOME TAXES: Income taxes are accounted for under the liability method
prescribed by Statement of Financial Accounting Standards No. 109.
RECENTLY ISSUED ACCOUNTING STANDARDS: The Financial Accounting Standards
Board (FASB) has issued several accounting pronouncements which the company will
be required to adopt in future periods.
FASB Statement No. 133 "Accounting for Derivative Instruments and Hedging
Activities" requires that derivative instruments such as options, forward
contracts and swaps be recorded as assets and liabilities at fair value and
provides guidance for recognition of changes in fair value depending on the
reason for holding the derivative. The Company does not presently have
significant transactions involving derivative instruments, but may do so in the
future. The Company is required to adopt Statement No. 133 for the first quarter
of 2000 and may adopt it earlier.
ACCOUNTING ESTIMATES: The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosures of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues, costs and
expenses during the reporting period. Actual results could differ from those
estimates.
NET LOSS PER COMMON SHARE: Net loss per common share is based on the
weighted average shares outstanding during each period. The Company adopted the
provisions of FASB Statement No. 128 "Earnings per Share" in 1997. Basic
earnings per share is computed based on the weighted average number of common
shares outstanding during the period. Diluted earnings per share gives effect to
all dilutive potential common shares outstanding during the period. Potential
common shares include shares issuable upon exercise of the Company's stock
options.
Potential common shares relating to options to purchase common stock were
not included in the weighted average number of shares for the fiscal years 1997
and 1996 because their effect would have been anti-dilutive.
2. REFINANCING PLAN AND INITIAL PUBLIC OFFERING
In February 1998, the Company successfully completed an initial public
offering of its stock which was part of a plan to refinance all of the Company's
existing indebtedness (the "Refinancing Plan") in order to enhance the Company's
financial flexibility to pursue growth opportunities and implement capital
improvements. The Refinancing Plan resulted in a reduction in the Company's
overall indebtedness, a simplification of the Company's capital structure and
access to additional borrowings. The principal components of the Refinancing
Plan were: (i) the sale by the Company of 6.7 million shares of common stock for
net proceeds of approximately $102 million; (ii) the execution of a new secured
credit agreement (the "Existing Credit Agreement") which provided for borrowings
up to approximately $160 million ($130 million of term loans and up to $30
million of revolving loans); (iii) the issuance of $80 million in aggregate
principal amount of the Company's 9 1/4% Senior Subordinated Notes due 2008 (the
"Senior Notes") for net proceeds of approximately $77 million (the "Notes
Offering"); (iv) the repayment of all outstanding borrowings under the Company's
former credit agreement (the "Old Credit Agreement"); (v) the redemption of the
Company's outstanding Zero Coupon Notes; and (vi) the redemption of the
Company's outstanding 12% Senior Notes due 2002. The interest rates under the
Existing Credit Agreement are approximately the same as interest rates under the
Old Credit Agreement.
28
3. ACQUISITION
On September 11, 1998, the Company purchased substantially all of the
operating assets (including inventory and leases) of Rock Bottom Stores, Inc., a
health and beauty aid retailer operating 38 stores primarily in the outer
boroughs of New York City (the "Rock Bottom Acquisition"). The purchase price
paid was $64.9 million, subject to certain post-closing adjustments. The
acquisition, accounted for under the purchase method, was financed with $80
million in additional term loans under the Existing Credit Agreement. The
purchase price is allocable to inventory ($18.2 million), property held for sale
($8.2 million), property ($14.7 million), identifiable intangibles ($5.2
million) and goodwill ($27.8 million) net of reserves for expenses and store
closings ($9.2 million).
Ten stores acquired as part of the acquisition are being held for sale or
were designated for closure as of December 26, 1998. These stores were operated
for a period of time after the acquisition. As indicated in Note 22, six of
these stores were sold in March 1999. One of the remaining stores has been
turned back to the landlord and the Company has been released from the lease
obligations. The results of operations for these ten stores are not included in
the Company's statement of operations for the 52 weeks ended December 26, 1998.
Their results have been included in goodwill. Any gain or loss resulting from
the stores' sale will be included in goodwill in the period sold.
The operating results of the Rock Bottom stores to be retained have been
included in the consolidated statement of income from the date of acquisition.
The unaudited pro forma results below assume the acquisition occurred as of
December 29, 1996 (in thousands, except per share amounts):
FOR THE 52 WEEKS ENDED
--------------------------
DECEMBER 26, DECEMBER 27,
(UNAUDITED) 1998 1997
- ------------------------------------------------------------------------------------- ------------ ------------
Net sales............................................................................ $ 725,069 $ 614,302
------------ ------------
------------ ------------
Operating income..................................................................... $ 49,431 $ 26,622
------------ ------------
------------ ------------
Income (loss) before extraordinary charge............................................ $ 19,429 $ (14,301)
Extraordinary charge, net of income taxes of $-0-.................................... (23,600) --
------------ ------------
Net loss............................................................................. $ (4,171) $ (14,301)
------------ ------------
------------ ------------
Per Common Share--Basic:
Income (loss) before extraordinary charge............................................ $ 1.20 $ (1.41)
Extraordinary charge................................................................. (1.46) --
------------ ------------
Net loss............................................................................. $ (0.26) $ (1.41)
------------ ------------
------------ ------------
Per Common Share-Diluted:
Income (loss) before extraordinary charge............................................ $ 1.10 $ (1.41)
Extraordinary charge................................................................. (1.34) --
------------ ------------
Net loss............................................................................. $ (0.24) $ (1.41)
------------ ------------
------------ ------------
In management's opinion, the unaudited pro forma combined results are not
necessarily indicative of the actual results that would have occurred had the
acquisition been consummated at the beginning of fiscal 1997 or of future
results of the combined operations under the ownership and management of the
Company.
29
4. RECEIVABLES
Receivables are summarized as follows (in thousands):
DECEMBER 26, DECEMBER 27,
1998 1997
------------ -------------
Third party pharmacy plans........................................................... $ 13,02