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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For The Fiscal Year Ended March 2, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For The Transition Period From To
Commission File Number 1-5742
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RITE AID CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 23-1614034
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
30 Hunter Lane,
Camp Hill, Pennsylvania 17011
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (717) 761-2633
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Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
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Common Stock, $1.00 par value New York Stock Exchange
Pacific Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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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. |X| Yes |_| No
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |X|
The aggregate market value of the voting common stock of the registrant held
by non-affiliates of the registrant based on the closing price at which such
stock was sold on the New York Stock Exchange on May 1, 2002 was approximately
$1,086,492,393. For purposes of this calculation, executive officers,
directors and 5% shareholders are deemed to be affiliates of the registrant.
As of May 1, 2002 the registrant had outstanding 515,113,894 shares of
common stock, par value $1.00 per share.
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TABLE OF CONTENTS
Page
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PART I..................................................................................................................... 2
ITEM 1. Business..................................................................................................... 2
ITEM 2. Properties................................................................................................... 6
ITEM 3. Legal Proceedings............................................................................................ 8
ITEM 4. Submission of Matters to a Vote of Security Holders.......................................................... 10
PART II.................................................................................................................... 11
ITEM 5. Market for Registrant's Common Equity and Related Stockholder Matters........................................ 11
ITEM 6. Selected Financial Data...................................................................................... 11
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 13
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risks.................................................. 30
ITEM 8. Financial Statements and Supplementary Data.................................................................. 31
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure......................... 31
PART III................................................................................................................... 32
PART IV.................................................................................................................... 33
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................................. 33
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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This report includes forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. These forward-looking
statements are identified by terms and phrases such as "anticipate,"
"believe," "intend," "estimate," "expect," "continue," "should," "could,"
"may," "plan," "project," "predict," "will" and similar expressions and
include references to assumptions and relate to our future prospects,
developments and business strategies.
Factors that could cause actual results to differ materially from those
expressed or implied in such forward-looking statements include, but are not
limited to:
o our high level of indebtedness;
o our ability to make interest and principal payments on our debt and
satisfy the other covenants contained in our credit facilities and other
debt agreements;
o our ability to improve the operating performance of our existing stores,
and, in particular, our new and relocated stores in accordance with our
management's long term strategy;
o the outcomes of pending lawsuits and governmental investigations, both
civil and criminal, involving our financial reporting and other matters;
o competitive pricing pressures and continued consolidation of the
drugstore industry;
o third-party prescription reimbursement levels and regulatory changes
governing pharmacy practices;
o general economic conditions, inflation and interest rate movements;
o merchandise supply constraints or disruptions; and
o access to capital.
We undertake no obligation to revise the forward-looking statements included
in this report to reflect any future events or circumstances. Our actual
results, performance or achievements could differ materially from the results
expressed in, or implied by, these forward-looking statements. Factors that
could cause or contribute to such differences are discussed in the section
entitled "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Overview and Factors Affecting Our Future Prospects"
included in this annual report on Form 10-K.
1
PART I
Item 1. Business
Overview
We are the third largest retail drugstore chain in the United States. We
operate 3,497 retail drugstores in 28 states and in the District of Columbia.
We have a first or second market position in 55 of the 117 major U.S.
metropolitan markets in which we operate. We sell prescription drugs, which
accounted for approximately 61.3% of our total sales during fiscal 2002. Our
drugstores filled over 202 million prescriptions during fiscal 2002. Our
drugstores also offer other products, which we refer to as front-end products,
including nonprescription medications, health and beauty aids and personal
care items, cosmetics, photo processing and convenience items.
Our stores range in size from approximately 5,000 to 40,000 square feet. The
larger stores are concentrated in the western United States. Substantially all
of the stores we have opened since 1995 are based on our prototype and such
stores typically include a drive-thru pharmacy.
Our headquarters are located at 30 Hunter Lane, Camp Hill, Pennsylvania
17011, and our telephone number is (717) 761-2633. Our common stock is listed
on the New York Stock Exchange and the Pacific Exchange under the trading
symbol of "RAD".
Strategy
Our long term operating strategy is to focus on improving the productivity
of our existing store base. We believe that improving the sales of our
existing stores is important to achieving our future profitability and
improving cash flow. We also believe that the substantial investment made in
our store base over the last six years has given us one of the most modern
store bases in the industry. However, our store base has not yet achieved the
level of sales productivity that our major competitors achieve. We intend to
improve the performance of our existing stores by continuing to (i) capitalize
on the substantial investment in our stores and distribution facilities; (ii)
enhance our customer and employee relationships; and (iii) improve the product
offerings in our stores. Moreover, we estimate that pharmacy sales in the
United States will increase more than 75% over the next five years. This
anticipated growth is expected to be fueled by the "baby boom" generation
entering their fifties, the increasing life expectancy of the American
population, the introduction of several new successful drugs and inflation. We
believe that this growth will help increase the sales productivity of our
existing store base.
Since the beginning of fiscal 1997, we built 473 new stores, relocated 967
stores, generally to larger or freestanding sites, remodeled 470 stores and
closed 1,307 stores. We also acquired 1,564 stores during the same period. All
of our stores are integrated into a common information system. At March 2,
2002, approximately 55% of our stores had been constructed, relocated or
remodeled since the beginning of fiscal 1997. Our new and relocated stores are
generally larger and need to develop a critical mass of customers to achieve
profitability, which generally takes three to five years. Therefore,
attracting more customers is a key component of our long term operating
strategy. We have also improved our distribution network to support these new
stores by, among other things, opening two high capacity distribution centers.
We have implemented various programs that are designed to improve our image
with customers. These include our weekly distribution of a nationwide
advertising circular to announce vendor promotions, weekly sales items,
seasonal merchandising and direct marketing efforts. We have also implemented
programs that are specifically directed to our pharmacy business. These
include reduced cash prices, an increased focus on attracting and retaining
managed care customers and the establishment of several partnering
relationships with major drug suppliers to provide discount cards to senior
citizens. Through the use of technology and attention to customers' needs and
preferences, we are increasing our efforts to identify inventory and product
categories that will enable us to offer more personalized products and
services to our customers. We continue to develop and implement associate
training programs to improve customer service and educate our associates about
the products we offer. We have implemented associate programs that create
compensatory and other incentives for associates to provide customers with
quality service and to improve our corporate culture.
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We continue to add popular product departments, such as our General
Nutrition Companies, Inc. ("GNC") stores-within-Rite Aid-stores and one-hour
photo development departments. We continue to implement plans to expand the
categories of our front-end products and increase the emphasis on our Rite Aid
brand products and generic prescription drugs. As private brand and generic
prescription drugs generate higher margins than national brand label, we
expect that increases in the sales of these products would enhance our
profitability. We believe that increases in offerings of products and services
are integral components of our strategy to distinguish us from other national
drugstore chains.
Recovery
Under prior management, we were engaged in an aggressive expansion program
from the beginning of fiscal 1997 until December 1999. During that period, we
purchased 1,554 stores, relocated 866 stores, opened 445 new stores, remodeled
308 stores and acquired PCS Health Systems, Inc. ("PCS"). These activities had
a significant negative impact on our operating results and financial
condition, severely strained our liquidity and increased our indebtedness to
$6.6 billion as of February 26, 2000.
In October 1999, we announced that we had identified accounting
irregularities and our former chairman and chief executive officer resigned.
In November 1999, our former auditors resigned and withdrew their previously
issued opinions on our financial statements for the fiscal years 1998 and
1999. Thereafter, the SEC and the U.S. Attorney for the Middle District of
Pennsylvania began investigations into our affairs. In addition, the complaint
in a securities class action lawsuit, which had been filed in March 1999, was
amended to include allegations based upon the accounting irregularities we
disclosed. In December 1999, a new senior management team was hired.
At the time of their arrival, the new management team faced a series of
immediate challenges. These included:
o Deteriorating Store Operations. We experienced substantial operational
difficulties during fiscal 2000. The principal problem was a decline in
customer traffic and revenues due to inventory shortages, reduced
advertising and uncompetitive prices on front-end products. By November
1999, our out-of-stock level had reached 29% and many popular products
were not available in our stores. This situation resulted from liquidity
constraints and concerns, tighter vendor credit terms and a delay in the
opening of our distribution center in Perryman, MD, which caused delays
in the shipment of seasonal merchandise. During fiscal 2000, we also
suspended our practice of circulating regular newspaper advertising
supplements. This disrupted customer traffic and adversely affected
revenues. In order to offset the effects of these actions, former
management raised the prices of front-end products above competitive
levels. Customers rejected the higher prices and revenues continued to
decline.
o Inability to Access Capital Markets. From March 1995 through February
2000, we substantially increased our level of debt and placed a
significant strain on our short-term liquidity. The problems were
exacerbated by our inability to complete a planned public offering of
equity securities to repay the $1.3 billion short-term credit facility
due in October 1999, which had been established to support the commercial
paper issuances used to acquire PCS. By June 1999, we had issued the
maximum amount of commercial paper that was permitted under our credit
facilities. In September 1999, we informed our banks that we anticipated
being in default on various covenants under both our $1.3 billion PCS
credit facility and our $1.0 billion general credit facility and in
October 1999, Standard & Poor's and Moody's downgraded our credit rating.
As a result of these events, we lost access to the commercial paper
market.
In response to these challenges, we:
o Reduced our indebtedness, including lease financing obligations, from
$6.6 billion on February 26, 2000 to $4.1 billion on March 2, 2002;
o Improved our front-end same store sales growth from a negative 2.2% in
fiscal 2000 to a positive 3.6% during fiscal 2002 by improving store
conditions and product pricing and launching a competitive marketing
program;
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o Restated our financial statements for fiscal 1998 and fiscal 1999 and
engaged new auditors to audit our financial statements for fiscal 1998,
fiscal 1999 and fiscal 2000;
o Settled the securities class action and related lawsuits in February 2002
for $45.0 million funded with insurance proceeds and $149.5 million of
senior secured notes, issued in April 2002 and due March 15, 2006;
o Addressed our out of stock inventory level and strengthened our vendor
relationships;
o Implemented initiatives to improve all aspects of our supply chain,
including buying practices, category management systems and other
inventory issues;
o Addressed and corrected problems with our accounting systems and
controls, and resumed normal financial reporting; and
o Completed the refinancing of our indebtedness.
Products and Services
During fiscal 2002, sales of prescription drugs represented approximately
61.3% of our total sales. In fiscal years 2002, 2001 and 2000, prescription
drug sales were $9.3 billion, $8.6 billion, and $7.8 billion, respectively, of
our revenues. We sell approximately 24,700 different types of non-
prescription, or front-end, products. The types and number of front-end
products vary based on available space and customer needs and preferences. No
single front-end product category contributed significantly to our sales
during fiscal 2002 although certain front-end product classes contributed
notably to our sales. Our principal classes of products are the following:
Fiscal Year 2002
Percentage of
Product Class Revenues
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Prescription drugs.......................................... 61.3%
Over-the-counter and personal care.......................... 10.2
Health and beauty aids...................................... 5.3
General merchandise and other............................... 23.2
We offer approximately 1,700 products under the Rite Aid private brand,
which contributed approximately 10.6% of our front-end sales in fiscal 2002.
During fiscal 2002, we added approximately 300 products under our private
brand. We intend to increase the number and the sales of our private brand
products.
We have a strategic alliance with GNC under which we plan to open, own and
operate a minimum of 1,000 GNC "stores-within-Rite Aid-stores" across the
country by July 2003. GNC is a leading nationwide retailer of vitamin and
mineral supplements and personal care, fitness and other health-related
products. As of March 2, 2002, we operated 785 GNC stores-within-Rite Aid-
stores. We plan to open 209 GNC stores-within-our-stores during fiscal 2003.
Part of our strategy is to locate our stores at convenient locations in
fast-growing metropolitan areas. We have significantly reduced our store
development program in order to focus our efforts and resources on improving
the operations of our existing store base, although we routinely evaluate
expansion opportunities, including acquisitions. Consistent with our operating
strategy, during fiscal 2002, we opened 7 new stores, acquired 10 stores,
relocated 22 stores, remodeled 64 stores and closed 168 stores. Our current
plan for fiscal 2003 is to open approximately 3 new stores, relocate 18 stores
and remodel 140 stores. Our fiscal 2003 planned store openings and relocations
are not concentrated in any specific geographic region.
Technology
All of our stores are integrated into a common information system, which
enables our pharmacists to fill prescriptions more accurately and efficiently
with reduced chances of adverse drug interaction and which can be expanded to
accommodate new stores. Additionally, each of our stores employs point-of-sale
technology
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that facilitates inventory replenishment, sales analysis and recognition of
customer trends. As of March 2, 2002, we had installed ScriptPro automated
pharmacy dispensing units which are linked to our pharmacists' computers and
fill and label prescription drug orders, in 850 stores. The efficiency of
ScriptPro units allows our pharmacists to spend an increased amount of time
consulting with our customers. In fiscal 2002, we developed and implemented
several new technologies and applications, including productivity improvements
related to our piece picking and inventory movement management. We also made
modifications to our proprietary pharmacy information system in order to
improve its user interface and information output. We also simplified our cash
register or point of sale processes. Our customers may also order prescription
refills over the Internet through riteaid.com powered by drugstore.com or over
the phone through our telephonic rapid automated refill systems.
Suppliers
During fiscal 2002, we purchased approximately 93% of the dollar volume of
our prescription drugs from a single supplier, McKesson HBOC, Inc., under a
contract which runs until April 2004. Under the contract, McKesson HBOC has
agreed to sell to us all of our requirements of branded pharmaceutical
products. With limited exceptions, we are required to purchase all of our
branded pharmaceutical products from McKesson HBOC. If our relationship with
McKesson HBOC was disrupted, we could have difficulty filling prescriptions,
which would negatively affect our business. We purchase generic (non-brand
name) pharmaceuticals from a variety of sources. We purchase our non-
pharmaceutical merchandise from numerous manufacturers and wholesalers. We
believe that competitive sources are readily available for substantially all
of the non-pharmaceutical merchandise we carry and that the loss of any one
supplier would not have a material effect on our business.
We sell private brand and co-branded products that generally are supplied by
numerous competitive sources. The Rite Aid and GNC co-branded PharmAssure
vitamin and mineral supplement products and the GNC branded vitamin and
mineral supplement products that we sell in our stores are developed by GNC,
and along with our Rite Aid brand vitamin and mineral supplements, are
manufactured by GNC.
Customers and Third-Party Payors
During fiscal 2002, our stores served an average of 1.9 million customers
per day. The loss of any one customer would not have a material adverse impact
on our results of operations. No single customer accounted for more than 10%
of our revenues.
In fiscal 2002, 92.0% of our pharmacy sales were to customers covered by
third-party plans. In a typical third-party plan, we contract with a third-
party payor (such as an insurance company, a prescription benefit management
company, a governmental agency, a private employer, a health maintenance
organization or other managed care provider) that agrees to pay for all or a
portion of a customer's eligible prescription purchases. During fiscal 2002,
the top five third-party payors accounted for approximately 20.0% of our total
revenues, the largest of which represented approximately 9.0% of our total
revenues. Any significant loss of third-party payor business could have a
material adverse effect on our business and results of operations.
Competition
The retail drugstore industry is highly competitive. We compete with, among
others, retail drugstore chains, independently owned drugstores, mass
merchandisers, supermarkets, discount stores and mail order pharmacies. We
compete on the basis of store location and convenient access, customer
service, product selection and price. We believe continued consolidation of
the drugstore industry will further increase competitive pressures in the
industry.
Associates
As of March 2, 2002, we had approximately 75,000 associates of whom 12% are
pharmacists. Approximately 49% of our associates were part-time and
approximately 26,000 were unionized. There is a national shortage of
pharmacists. Our management has implemented various associate incentive plans,
5
including the implementation of a stock option plan for field associates, in
order to attract and retain qualified pharmacists. We believe that our
relationships with our associates are good.
Research and Development
We do not make significant expenditures for research and development.
Licenses, Trademarks and Patents
The Rite Aid name is our most significant trademark and the most important
factor in marketing our stores and private brand products. We hold licenses to
sell beer, wine and liquor, cigarettes and lottery tickets. Additionally, we
hold licenses granted to us by the Nevada Gaming Commission that allow us to
place slot machines in our Nevada stores. We also hold licenses to operate our
pharmacies and our distribution facilities. Together, these licenses are
material to our operations.
Regulation
Our business is subject to various federal and state regulations. For
example, pursuant to the Omnibus Budget Reconciliation Act of 1990 ("OBRA")
and comparable state regulations, our pharmacists are required to offer
counseling, without additional charge, to our customers about medication,
dosage, delivery systems, common side effects and other information deemed
significant by the pharmacists and may have a duty to warn customers regarding
any potential adverse effects of a prescription drug if the warning could
reduce or negate such affect.
Our pharmacies and pharmacists must be licensed by the appropriate state
boards of pharmacy. Our pharmacies and distribution centers are also
registered with the Federal Drug Enforcement Administration and are subject to
federal Drug Enforcement Agency regulations relative to our pharmacy
operations, including purchasing, storing and dispensing of controlled
substances. Applicable licensing and registration requirements require our
compliance with various state statutes, rules and/or regulations. If we were
to violate any applicable statute, rule or regulation, our licenses and
registrations could be suspended or revoked.
We are also subject to laws governing our relationship with associates,
including minimum wage requirements, overtime and working conditions.
Increases in the federal minimum wage rate, associate benefit costs or other
costs related to associates could adversely affect our results of operations.
In addition, in connection with the ownership and operations of our stores,
distribution centers and other sites, we are subject to laws and regulations
relating to the protection of the environment and health and safety matters,
including those governing the management and disposal of hazardous substances
and the cleanup of contaminated sites. Violations of or liabilities under
these laws and regulations as a result of our current or former operations or
historical activities at our sites, such as gasoline service stations and dry
cleaners, could result in significant costs.
In recent years, an increasing number of legislative proposals have been
introduced or proposed in Congress and in some state legislatures that would
effect major changes in the healthcare system, either nationally or at the
state level. The legislative initiatives include prescription drug benefit
proposals for Medicare participants. Although we believe we are well
positioned to respond to these developments, we cannot predict the outcome or
effect of legislation resulting from these reform efforts. Also, in recent
years, both federal and state authorities have proposed and have passed new
legislation that imposes on healthcare providers, including pharmacies,
significant additional obligations concerning the protection of confidential
patient medical records and information.
Item 2. Properties
We own our corporate headquarters, which is located in a 205,000 square foot
building at 30 Hunter Lane, Camp Hill, Pennsylvania 17011. We lease a 99,000
square foot building near Harrisburg, Pennsylvania for use by additional
administrative personnel. We lease 3,214 of our operating drugstore facilities
under non-cancelable leases, many of which have original terms of 10 to 22
years. In addition to minimum rental payments, which are set at competitive
market rates, certain leases require additional payments based on sales
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volume, as well as reimbursement for taxes, maintenance and insurance. Most of
our leases contain renewal options, some of which involve rent increases.
As of March 2, 2002, we operated 3,497 retail drugstores. Our stores range
in size from approximately 5,000 to 40,000 square feet. The larger stores are
concentrated in the western United States. Substantially all of the stores we
have opened since 1995 are based on our prototype and such stores typically
include a drive-thru pharmacy. The overall average selling square feet of each
store in our chain is 11,100 square feet. The overall average total square
feet of each store in our chain is 12,800. The stores on the east coast
average 8,600 selling square feet per store (9,500 average total square feet
per store). The west coast stores average 17,020 selling square feet per store
(21,100 average total square feet per store). The central stores average 9,500
selling square feet per store (10,200 average total square feet per store).
The table below identifies the number of stores by state as of March 2,
2002:
State Store Count
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Alabama.......................................................... 123
Arizona.......................................................... 3
California....................................................... 594
Colorado......................................................... 30
Connecticut...................................................... 38
Delaware......................................................... 26
District of Columbia............................................. 8
Georgia.......................................................... 50
Idaho............................................................ 22
Indiana.......................................................... 9
Kentucky......................................................... 119
Louisiana........................................................ 91
Maine............................................................ 81
Maryland......................................................... 144
Michigan......................................................... 335
Mississippi...................................................... 32
Nevada........................................................... 37
New Hampshire.................................................... 39
New Jersey....................................................... 171
New York......................................................... 397
Ohio............................................................. 246
Oregon........................................................... 71
Pennsylvania..................................................... 359
Tennessee........................................................ 48
Utah............................................................. 30
Vermont.......................................................... 12
Virginia......................................................... 142
Washington....................................................... 137
West Virginia.................................................... 103
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Total........................................................... 3,497
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Our stores have the following attributes at March 2, 2002:
Attribute Number Percentage
--------- ------ ----------
Freestanding ............................................ 1,857 53.1%
Drive through pharmacy .................................. 1,277 36.5
One-hour photo development department ................... 2,287 65.4
GNC stores-within a Rite Aid-store ...................... 785 22.4
We operate the following distribution centers and overflow storage
locations, which we own or lease as indicated:
Approximate
Owned or Square
Location Leased Footage
-------- -------- -----------
Rome, New York ....................................... Owned 291,000
Utica, New York(1) ................................... Leased 115,000
Poca, West Virginia .................................. Owned 264,000
Dunbar, West Virginia(1) ............................. Leased 61,000
Perryman, Maryland ................................... Leased 885,000
Tuscaloosa, Alabama .................................. Owned 238,000
Cottondale, Alabama(1) ............................... Leased 125,000
Pontiac, Michigan .................................... Owned 362,000
Woodland, California ................................. Owned 521,300
Woodland, California(1) .............................. Leased 200,000
Wilsonville, Oregon .................................. Leased 518,000
Lancaster, California ................................ Leased 917,000
- ---------------
(1) Overflow storage locations.
The original terms of the leases for our distribution centers range from
five to 22 years. In addition to minimum rental payments, certain distribution
centers require tax reimbursement, maintenance and insurance. Most leases
contain renewal options, some of which involve rent increases. We believe that
the capacity of our distribution facilities is adequate.
We also own a 52,200 square foot ice cream manufacturing facility located in
El Monte, California.
On a regular basis and as part of our normal business, we evaluate store
performance and may reduce in size, close or relocate a store if the store is
redundant, under performing or otherwise deemed unsuitable. When we reduce in
size, close or relocate a store, we often continue to have leasing obligations
or own the property, but we attempt to sublease the space. As of March 2,
2002, we subleased 5,246,700 square feet of space and an additional 4,863,100
square feet of space in closed or relocated stores was not subleased.
Item 3. Legal Proceedings
We are party to numerous legal proceedings, as described below.
Federal investigations
There are currently pending federal governmental investigations, both civil
and criminal, by the SEC and the United States Attorney, involving our
financial reporting and other matters. We are cooperating fully with the SEC
and the United States Attorney. Settlement discussions have begun with the
United States Attorney for the Middle District of Pennsylvania. The United
States Attorney has proposed that the government would not institute any
criminal proceeding against us if we enter into a consent judgement providing
for a civil penalty payable over a period of years. The amount of the civil
penalty has not been agreed to and there can be no assurance that a settlement
will be reached or that the amount of such penalty will not have a material
adverse effect on our result of operations, financial condition or cash flows.
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The U.S. Department of Labor has commenced an investigation of matters
relating to our associate benefit plans, including the principal 401(k) plan,
which permitted associates to purchase our common stock. Purchases of our
common stock under the plan were suspended in October 1999. In January 2001,
we appointed an independent trustee to represent the interests of these plans
in relation to Rite Aid Corporation and to investigate possible claims the
plans may have against us. Both the independent trustee and the Department of
Labor have asserted that the plans may have claims against us. The
investigations, with which we are cooperating fully, are ongoing and we cannot
predict their outcomes. In addition, a putative class action lawsuit on behalf
of the plans and their participants has been filed by a participant in the
plans in the United States District Court for the Eastern District of
Pennsylvania. As a result of discussions we have had with the independent
trustee and the attorneys for the putative class action plaintiff, we have
arrived at a preliminary understanding which would resolve all claims arising
out of our associate benefit plans by an agreement to maintain the current
level of benefits and a current payment that will cost us, net of insurance,
approximately $3.3 million, which we have accrued. Various non-monetary terms
and conditions remain to be negotiated and agreed upon and any agreement
reached will be subject to the approval of the Department of Labor and the
District Court. There can be no assurance that a settlement of the matter will
be agreed upon or, if agreed upon, approved by the Department of Labor and the
District Court.
These investigations and settlement discussions are ongoing and we cannot
predict their outcomes. If we were convicted of any crime, certain licenses
and government contracts such as Medicaid plan reimbursement agreements that
are material to our operations may be revoked, which would have a material
adverse effect on our results of operations, financial condition or cash
flows. In addition, substantial penalties, damages or other monetary remedies
assessed against us, including a settlement, could also have a material
adverse effect on our results of operation's, financial condition or cash
flows.
Stockholder litigation
We, certain directors, our former chief executive officer Martin Grass, our
former president Timothy Noonan, our former chief financial officer Frank
Bergonzi, and our former auditor KPMG LLP, have been sued in a number of
actions, most of which purport to be class actions, brought on behalf of
stockholders who purchased our securities on the open market between May 2,
1997 and November 10, 1999. Most of the complaints asserted claims under
Sections 10 and 20 of the Securities Exchange Act of 1934, based upon the
allegation that our financial statements for fiscal 1997, fiscal 1998 and
fiscal 1999 fraudulently misrepresented our financial position and results of
operation for those periods. All of these cases have been consolidated in the
U.S. District Court for the Eastern District of Pennsylvania. On November 9,
2000, we announced that we had reached an agreement to settle the consolidated
securities class action lawsuits pending there and in the Delaware Court of
Chancery. Under the agreement, we issued $149.5 million of senior secured
notes due March 2006 and paid $45.0 million in cash, which was fully funded by
our officers' and directors' liability insurance. As additional consideration
for the settlement, we assigned to the plaintiffs all of our claims against
the above named executives and KPMG LLP. On August 16, 2001, the district
court approved the settlement. Certain of the nonsettling defendants have
appealed the order. We cannot predict the outcome of that appeal. If the
settlement does not become final, this litigation could result in a material
adverse effect on our results of operations, financial condition or cash
flows. Several members of the class have elected to "opt-out" of the class
and, as a result, approval of the settlement becomes final and they will be
free to individually pursue their claims. We believe that their claims,
individually and in the aggregate, are not material.
A purported class action has been instituted by a stockholder against us in
Delaware state court on behalf of stockholders who purchased shares of our
common stock prior to May 2, 1997, and who continued to hold them after
November 10, 1999, alleging claims similar to the claims alleged in the
consolidated securities class action lawsuits described above. The amount of
damages sought was not specified and may be material. We have filed a motion
to dismiss this claim which is pending before the court. These claims are
ongoing and we cannot predict their outcome. An unfavorable outcome could
result in a material adverse effect on our results of operations, financial
condition or cash flows.
9
Drug reimbursement matters
We are being investigated by multiple state attorneys general for our
reimbursement practices relating to partially-filled prescriptions and fully-
filled prescriptions that are not picked up by ordering customers. We are
supplying similar information with respect to these matters to the United
States Department of Justice. We believe that these investigations are similar
to investigations which were, and are being, undertaken with respect to the
practices of others in the retail drug industry. We also believe that our
existing policies and procedures fully comply with the requirements of
applicable law and intend to fully cooperate with these investigations. We
cannot, however, predict their outcomes at this time. An individual acting on
behalf of the United States of America, has filed a lawsuit in the United
States District Court for the Eastern District of Pennsylvania under the
Federal False Claims Act alleging that we defrauded federal healthcare plans
by failing to appropriately issue refunds for partially filled prescriptions
and prescriptions which were not picked up by customers. The United States
Department of Justice has intervened in this lawsuit, as is its right under
the law. We have reached an agreement to settle these investigations and the
lawsuit filed by the private individual for $7.2 million, which is subject to
court approval. We have reserved $7.2 million against this potential
liability.
These claims are ongoing and we cannot predict their outcome. If any of
these cases result in a substantial monetary judgement against us or are
settled on unfavorable terms, our results of operations, financial condition
or cash flows could be materially adversely affected.
Other
We, together with a significant number of major U.S. retailers, have been
sued by the Lemelson Foundation in a complaint which alleges that portions of
the technology included in our point-of-sale system infringe upon a patent
held by the plaintiffs. The amount of damages sought is unspecified and may be
material. We cannot predict the outcome of this litigation or whether it could
result in a material adverse effect on our results of operations, financial
conditions or cash flows.
We are subject from time to time to lawsuits arising in the ordinary course
of business. In our opinion, these matters are adequately covered by insurance
or, if not so covered, are without merit or are of such nature or involve
amounts that would not have a material adverse effect on our results of
operations, financial condition or cash flows if decided adversely.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of our security holders during the fourth
quarter of our fiscal year covered by this report.
10
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Our common stock is listed on the New York Stock Exchange and the Pacific
Exchange under the symbol "RAD." On May 1, 2002, we had approximately 11,982
record shareholders. Quarterly high and low stock prices, based on the New
York Stock Exchange composite transactions, are shown below.
Fiscal Year Quarter High Low
----------- ------- ---- ----
2003 (through May 1, 2002) ............................................................. First 4.22 3.08
2002 ................................................................................... First 9.06 5.35
Second 9.74 7.37
Third 8.39 4.69
Fourth 5.06 2.06
2001 ................................................................................... First 8.50 4.75
Second 8.50 4.00
Third 4.38 2.44
Fourth 6.09 1.75
We have not declared or paid any cash dividends on our common stock since
the third quarter of fiscal 2000 and we do not anticipate paying cash
dividends in the foreseeable future. Our credit facility does not allow us to
pay cash dividends. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
We have not sold any unregistered securities during the period covered by
this report that was not previously disclosed in one of our Quarterly Reports
on Form 10-Q.
Item 6. Selected Financial Data
The following selected financial data should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the audited consolidated financial statements and related
notes appearing on pages F-1 through F-43.
11
Fiscal Year Ended
-------------------------------------------------------------------------------------------
March 2, 2002 March 3, 2001 February 26, 2000 February 27, 1999 February 28, 1998
(52 weeks) (53 weeks) (52 weeks) (52 weeks)(1) (52 weeks)(2)
------------- ------------- ----------------- ----------------- -----------------
(Dollars in thousands, except per share amounts)
Summary of Operations:
REVENUES............................ $ 15,171,146 $ 14,516,865 $ 13,338,947 $ 12,438,442 $ 11,352,637
COSTS AND EXPENSES:
Cost of goods sold, including
occupancy costs.................. 11,742,309 11,151,490 10,213,428 9,406,831 8,419,021
Selling, general and administrative
expenses......................... 3,382,962 3,412,442 3,651,248 3,168,363 2,751,360
Stock-based compensation (benefit)
expense.......................... (15,891) 45,865 (43,438) 32,200 22,200
Goodwill amortization.............. 21,007 20,670 24,457 26,055 26,169
Store closing and impairment
charges.......................... 251,617 388,078 139,448 195,359 155,024
Interest expense................... 396,064 649,926 542,028 274,826 202,688
Interest rate swap contracts....... 41,894 -- -- -- --
Loss on debt and lease conversions
and modifications................ 154,465 100,556 -- -- --
Share of loss from equity
investments...................... 12,092 36,675 15,181 448 1,886
Gain on sale of assets and
investments, net................. (42,536) (6,030) (80,109) -- (52,621)
------------ ------------ ------------ ------------ ------------
15,943,983 15,799,672 14,462,243 13,104,082 11,525,727
------------ ------------ ------------ ------------ ------------
Loss from continuing operations
before income taxes,
extraordinary item and cumulative
effect of accounting change...... (772,837) (1,282,807) (1,123,296) (665,640) (173,090)
INCOME TAX EXPENSE (BENEFIT)........ (11,745) 148,957 (8,375) (216,941) (28,064)
------------ ------------ ------------ ------------ ------------
Loss from continuing operations
before extraordinary item and
cumulative effect of accounting
change........................... (761,092) (1,431,764) (1,114,921) (448,699) (145,026)
INCOME (LOSS) FROM DISCONTINUED
OPERATIONS, net of income tax
expense (benefit) of $13,846,
$30,903, $(5,925) and $(10,885)... -- 11,335 9,178 (12,823) (20,214)
LOSS ON DISPOSAL OF DISCONTINUED
OPERATIONS, net of income tax
benefit of $734................... -- (168,795) -- -- --
EXTRAORDINARY ITEM, loss on early
extinguishment of debt, net of
income taxes of $0................ (66,589) -- -- -- --
CUMULATIVE EFFECT OF ACCOUNTING
CHANGE, net of income tax benefit
of $18,200........................ -- -- (27,300) -- --
------------ ------------ ------------ ------------ ------------
NET LOSS......................... $ (827,681) $ (1,589,224) $ (1,133,043) $ (461,522) $ (165,240)
============ ============ ============ ============ ============
BASIC AND DILUTED (LOSS) INCOME PER
SHARE:
Loss from continuing operations.... $ (1.68) $ (5.15) $ (4.34) $ (1.74) $ (0.58)
Income (loss) from discontinued
operations....................... -- (0.50) 0.04 (0.05) (0.08)
Loss from extraordinary item....... (0.14) -- -- -- --
Cumulative effect of accounting
change........................... -- -- (0.11) -- --
------------ ------------ ------------ ------------ ------------
Net loss per share............... $ (1.82) $ (5.65) $ (4.41) $ (1.79) $ (0.66)
============ ============ ============ ============ ============
Year-End Financial Position:
Working capital (deficit)........... $ 1,524,262 $ 1,955,877 $ 752,657 $ (892,115) $ 1,258,580
Property, plant and equipment (net). 2,096,030 3,041,008 3,445,828 3,328,499 2,460,513
Total assets........................ 6,479,208 7,913,911 9,845,566 9,778,451 7,392,147
Total debt (3)...................... 4,056,468 5,894,548 6,612,868 5,922,504 3,132,894
Redeemable preferred stock.......... 19,561 19,457 19,457 23,559 --
Stockholders' equity (deficit)...... 9,616 (354,435) 432,509 1,339,617 1,898,203
Other Data:
Cash flows from continuing
operations provided by (used in):
Operating activities............... 16,343 (704,554) (623,098) 278,947 622,865
Investing activities............... 342,531 677,653 (504,112) (2,705,043) (1,050,322)
Financing activities............... (107,109) (64,324) 905,091 2,660,341 535,066
Capital expenditures (4)............ 175,183 132,504 573,287 1,222,674 716,052
Cash dividends declared per common
share............................. $ 0 $ 0 $ .3450 $ .4375 $ .4075
Basic weighted average shares....... 474,028,000 314,189,000 259,139,000 258,516,000 250,659,000
Diluted weighted average shares..... 474,028,000 314,189,000 259,139,000 258,516,000 250,659,000
Number of retail drugstores......... 3,497 3,648 3,802 3,870 3,975
Number of associates................ 75,000 75,500 77,300 89,900 83,000
(Footnotes on next page)
12
- ---------------
(1) PCS was acquired on January 22, 1999. On October 2, 2000, we sold PCS.
Accordingly, our Pharmacy Benefit Management ("PBM") segment is reported as
a discontinued operation for all periods presented. See note 23 of the
notes to the consolidated financial statements.
(2) K&B, Incorporated and Harco, Inc. were acquired in August 1997.
(3) Total debt includes capital lease obligations of $183 million, $1.1
billion, $1.1 billion, $1.1 billion and $622 million as of March 2, 2002,
March 3, 2001, February 26, 2000, February 27, 1999 and February 28, 1998,
respectively.
(4) Capital expenditures represent expenditures for property and equipment.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview
Management believes that the following matters should be considered in
connection with the discussion of results of operations and financial
condition:
Recent Actions Affecting Operating Results. During fiscal 2002 and 2001, we
took a number of actions which had the short term effect of significantly
reducing our operating results but which management believes were nevertheless
necessary. In fiscal 2002, the actions taken were: (i) completion of the
refinancing, which extended the maturity of the majority of our debt,
converted a portion of our debt to equity, and reclassified capital leases to
operating leases, resulting in a aggregate loss of $221.1 million and (ii) our
decision to close or relocate certain stores, which resulted in a
$161.3 million charge which is included in the $251.6 million charge for store
closing and impairment. Among the actions taken in fiscal 2001 were: (i) the
sale of PCS which resulted in our recognizing a loss of $168.8 million and an
increase in income tax expense of $146.9 million; (ii) the exchange of
approximately $597.3 million of our debt for shares of our common stock which
resulted in a net loss of $100.6 million; (iii) our decision to close or
relocate certain stores that resulted in a $149.2 million charge which is
included in the $388.1 million charge for store closing and impairment; and
(iv) the restatement and audit of our fiscal 1999 and 1998 financial
statements and the related investigation conducted by our audit committee of
prior accounting irregularities resulted in our incurring and recording of
$82.1 million of accounting and legal expense. We anticipate taking similar
actions in the future that may have a material negative impact upon our
operating results for the period in which we take those actions or subsequent
periods.
Maturing Store Base. Since the beginning of fiscal 1997, we built 473 new
stores, relocated 967 stores, remodeled 470 stores and closed 1,307 stores.
These new, relocated and remodeled stores represented approximately 55% of our
total stores at March 2, 2002 and are generally larger, free standing stores
and have higher operating expenses than our older stores. New stores generally
do not become profitable until a critical mass of customers is developed.
Relocated stores also must attract additional customers to achieve comparable
profitability to the store that was replaced. We believe that the period of
time required for a new store to achieve profitable operations is generally
between three to five years. This period can vary significantly based on the
location of a particular store and on other factors, including the investments
made in purchasing prescription files for the location and advertising. Our
recent liquidity constraints have limited our ability to purchase prescription
files and make other investments to promote the development of our new and
relocated stores. We believe that our relatively high percentage of new and
relocated stores is a significant factor in our recent operating results.
Management believes that as these newer stores mature they should gain the
critical mass of customers needed for profitable operations. We believe this
continuing maturation should positively affect our operating performance in
future periods. If we are not able to improve the performance of these new and
relocated stores, it will have a material adverse effect on our ability to
restore the profitability of our operations.
Substantial Investigation Expenses. We have incurred substantial expenses
in connection with the process of reviewing and reconciling our books and
records, restating our 1998 and 1999 financial statements, investigating our
prior accounting practices, preparing our financial statements and defending
our company in pending investigations. Included in these expenses in fiscal
2001 are the costs of the Deloitte & Touche LLP audits, the investigation by
the law firm of Swidler, Berlin, Shereff, Friedman, assisted by Deloitte &
Touche
13
LLP, conducted for our audit committee concerning the accounting
irregularities which led to the restatement of our financial statements for
our 1999 and 1998 fiscal years and the costs of retaining Andersen LLP to
assist management in reviewing and reconciling our books and records. We
incurred $17.5 million in fiscal 2002, $82.1 million in fiscal 2001 and we
expect to incur $10.0 million to $15.0 million in fiscal 2003. We anticipate
that we will continue to incur significant legal and other expenses in
connection with the ongoing litigation and investigations to which we are
subject.
Dilutive Equity Issuances. At March 2, 2002, 515.1 million shares of common
stock were outstanding and an additional 174.7 million shares of common stock
were issuable related to outstanding stock options, convertible notes,
preferred stock and warrants. During fiscal 2002, we issued 86.4 million
shares of common stock in exchange for $588.7 million of indebtedness. We also
issued 80.1 million shares of common stock for $528.4 million. See
"--Liquidity and Capital Resources--Refinancing" for further details.
At March 2, 2002, our 174.7 million shares of common stock potentially
issuable consist of the following:
Outstanding Convertible Preferred Warrants and
Strike Price Stock Options(a) Notes(b) Stock Other Total
- ------------ ---------------- ----------- --------- ------------ -------
(Shares in thousands)
$5.50 and under........................................... 46,897 -- 65,728 30 112,655
$5.51 to $7.50............................................ 1,440 38,462 -- -- 39,902
$7.51 and over............................................ 12,422 4,206 -- 5,500 22,128
------ ------ ------ ----- -------
Total issuable shares..................................... 60,759 42,668 65,728 5,530 174,685
====== ====== ====== ===== =======
(a) The exercise of these options would provide cash of $375.4 million
(b) The conversion of these notes to equity would reduce the principal amount
of debt by $400.5 million
Sale of PCS. On October 2, 2000, we sold PCS, our PBM segment, to Advance
Paradigm (now AdvancePCS). The selling price of PCS consisted of $710.5 million
in cash, $200.0 million in principal amount of AdvancePCS's 11% promissory
notes and AdvancePCS equity securities. Accordingly, the PBM segment is
reported as a discontinued operation for all periods presented in the
accompanying financial statements, and the operating income of the PBM segment
through October 2, 2000, the date of sale, is reflected separately from the
income from continuing operations. The loss on disposal of the PBM segment was
$168.8 million. Additionally, we recorded an increase to the tax valuation
allowance and income tax expense of $146.9 million in the first quarter of
fiscal 2001 in continuing operations.
In March 2001, the Company sold its investment in AdvancePCS equity
securities for $284.2 million, resulting in a gain of $53.2 million.
Additionally, AdvancePCS repurchased the 11% promissory notes for
$200.0 million, plus accrued interest.
Working Capital. We generally finance our inventory and capital expenditure
requirements with internally generated funds and borrowings. We expect to use
borrowings to finance inventories and to support our continued growth. Over
82% of our front-end sales are in cash. Third-party payors, which typically
settle in fewer than 30 days, accounted for 92.0% of our pharmacy sales and
56.4% of our revenues in fiscal 2002.
Seasonality. We experience seasonal fluctuations in our results of
operations in the first and fourth quarters as the result of the concentration
of holidays and the flu season. We tailor certain front-end merchandise to
capitalize on holidays and seasons.
Industry Trends. It is anticipated that pharmacy sales in the United States
will increase 75% over the next five years. This anticipated growth is
expected to be driven by the "baby boom" generation entering their fifties,
the increasing life expectancy of the American population, the introduction of
several new drugs and inflation. The retail drugstore industry is highly
fragmented and has been experiencing consolidation. We believe that the
continued consolidation of the drugstore industry will further increase
competitive pressures in the industry. We expect to continue to compete on the
basis of price and convenience, particularly in front-end products, and
therefore will continue to focus on programs designed to improve our image
with customers. Prescription drug sales continue to represent a great portion
of our new business due to the general aging of the population, the use of
pharmaceuticals to treat a growing number of healthcare problems, and the
14
introduction of a number of successful new prescription drugs. In fiscal 2002,
we were reimbursed by third party payors for approximately 92.0% of all of the
prescription drugs that we sold. If third-party payors reduce their
reimbursement levels or if Medicare covers prescription drugs at reimbursement
levels lower than our current retail prices, our margins on these sales would
be reduced and the profitability of our business could be adversely affected.
Results of Operations
Revenue and Other Operating Data
Year Ended
--------------------------------------------------
March 2, 2002 March 3, 2001 February 26, 2000
(52 Weeks) (53 Weeks) (52 Weeks)
------------- ------------- -----------------
(Dollars in thousands)
Revenue ................................................................ $15,171,146 $14,516,865 $13,338,947
Revenue growth ......................................................... 4.5% 8.8% 7.2%
Same store sales growth ................................................ 8.3% 9.1% 7.9%
Pharmacy sales growth .................................................. 9.6% 8.7% 15.6%
Same store pharmacy sales growth ....................................... 11.4% 10.9% 16.2%
Pharmacy as a % of total sales ......................................... 61.3% 59.5% 58.4%
Third-party sales as a % of total pharmacy sales ....................... 92.0% 90.3% 87.8%
Front-end sales growth ................................................. 1.9% 3.8% (2.6)%
Same store front-end sales growth ...................................... 3.6% 6.5% (2.2)%
Front-end as a % of total sales ........................................ 38.7% 40.5% 41.6%
Store data:
Total stores (beginning of period) .................................... 3,648 3,802 3,870
New stores ............................................................ 7 9 77
Closed stores ......................................................... (168) (163) (181)
Store acquisitions, net ............................................... 10 -- 36
Total stores (end of period) .......................................... 3,497 3,648 3,802
Remodeled stores ...................................................... 64 98 14
Relocated stores ...................................................... 22 63 180
Note: Except for revenue growth, all percentages in the above table are
based on a comparable 52 week period.
Revenues
Fiscal 2002 (52 weeks) revenues increased 4.5% over fiscal 2001 (53 weeks).
Excluding the extra week, revenues would have increased 6.5%, driven by
increases of 1.9% in front-end sales and 9.6% in pharmacy. Same store sales
growth for fiscal 2002 was 8.3% (pharmacy of 11.4% and front-end of 3.6%). As
fiscal 2001 was a 53 week year, same store sales are calculated by comparing the
52 week period ended March 2, 2002 with the 52 week period ended March 3, 2001.
Fiscal 2002 pharmacy sales led sales growth due to an increase in both
prescriptions filled (on a comparable 52 week basis) and sales price per
prescription. Factors contributing to our pharmacy same store sales increases
include inflation, improved attraction and retention of managed care
customers, our reduced cash pricing, our increased focus on pharmacy
initiatives such as predictive refill, and favorable industry trends. These
trends include an aging population, the use of pharmaceuticals to treat a
growing number of healthcare problems, and the introduction of a number of
successful new prescription drugs.
Front-end fiscal 2002 sales, which includes all non-prescription sales, such
as seasonal merchandise, convenience items, and food and other non-
prescription sales, also increased. The increase was primarily a result of
increased sales volume due to improved assortments, lower prices on key items
and distributing a nationwide weekly advertising circular.
Our total revenue growth in fiscal 2001 of 8.8% was also fueled by strong
growth in pharmacy sales of 8.7%, an increase in front end sales of 3.8% and
the additional week in fiscal 2001. Pharmacy sales led
15
revenue growth with same store sales increases of 10.9% accompanied by very
strong front-end same store sales growth of 6.5%. The pharmacy and front-end
increases were due to the same factors as described above for fiscal 2002.
For fiscal 2000, total revenue increased 7.2% based on pharmacy sales growth
of 15.6% with front-end sales declining 2.6%. Pharmacy sales had same store
increases of 16.2% due to the same factors as described above for fiscal 2002
and 2001 as well as the purchase of prescription files from independent
pharmacies. The front-end decrease was consistent with front-end same store
sales decreases of 2.2% due to elevated levels of out-of-stock merchandise in
the third and fourth quarters of fiscal 2000, and the decisions of former
management to suspend the weekly advertising program in fiscal 2000 and to
raise front-end prices to levels that were not competitive.
The growth rates in pharmacy sales for fiscal 2002 and 2001 were lower than
fiscal 2000 due primarily to a significant reduction in the number of
prescription files we purchased and store relocations we effected.
Costs and Expenses
Year Ended
--------------------------------------------------
March 2, 2002 March 3, 2001 February 26, 2000
(52 Weeks) (53 Weeks) (52 Weeks)
------------- ------------- -----------------
(Dollars in thousands)
Costs of goods sold .................................................... $11,742,309 $11,151,490 $10,213,428
Gross margin ........................................................... 22.6% 23.2% 23.4%
Selling, general and administrative expenses ........................... $ 3,382,962 $ 3,412,442 $ 3,651,248
Selling, general and administrative expenses as a percentage of
revenues .............................................................. 22.3% 23.5% 27.4%
Stock-based compensation (benefit) expense ............................. $ (15,891) $ 45,865 $ (43,438)
Goodwill amortization .................................................. 21,007 20,670 24,457
Store closing and impairment charges ................................... 251,617 388,078 139,448
Interest expense ....................................................... 396,064 649,926 542,028
Interest rate swap contracts ........................................... 41,894 -- --
Loss on debt and lease conversions and modifications ................... 154,465 100,556 --
Share of loss from equity investments .................................. 12,092 36,675 15,181
Gain on sale of assets and investments, net ............................ (42,536) (6,030) (80,109)
Cost of Goods Sold
Gross margin was 22.6% for fiscal 2002 compared to 23.2% in fiscal 2001.
Gross margin was negatively impacted by the continuing trend of a shifting in
sales mix from front-end to pharmacy, inflation, increased third party
reimbursed prescription sales as a percent of total prescription sales, and
lower cash prices on pharmacy sales. The increase in third party prescription
sales had a negative impact on gross profit because they are paid by a person
or entity other than the recipient of the prescribed pharmaceutical, and are
generally subject to lower negotiated reimbursement rates in conjunction with
a pharmacy benefit plan. Third party sales as a percentage of total pharmacy
sales were 92.0% and 90.3% in fiscal 2002 and 2001, respectively.
Additionally, we incurred $31.4 million primarily in inventory liquidation
losses related to our closed stores compared to the $17.5 million incurred in
fiscal 2001. Also negatively impacting gross margin were higher LIFO costs,
higher shrink costs and the reclassification of certain leases from capital to
operating in connection with the June 2001 refinancing, which caused an
increase in fiscal 2002 occupancy costs. Partially offsetting these items was
an increase in gross margin on front end merchandise driven by increased
markdown support from vendors, improvements in returns losses and lower
depreciation expense.
Gross margin was 23.2% for fiscal 2001 compared to 23.4% in fiscal 2000. The
slight decline in margin is attributable to a shifting in sales mix to
pharmacy from front-end. In fiscal 2001, the percentage of front-end sales to
total sales decreased to 40.5% from 41.6% in 2000. Also contributing to the
lower margin in 2001 was an increase in sales of cigarettes and liquor as a
percentage of front-end sales. Additionally, we
16
incurred $17.5 million in inventory liquidation losses related to our closed
stores. Partially offsetting the items above was an improvement in the margin
of front-end goods (exclusive of cigarettes and liquor). These increases
resulted from a more profitable product mix, and from increases in the levels
of one-hour photo and phone card sales.
We use the last-in, first-out (LIFO) method of inventory valuation. The LIFO
charge was $69.3 million in fiscal 2002, $40.7 million in fiscal 2001 and
$34.6 million in fiscal 2000.
Selling, General and Administrative Expenses
Selling, general and administrative ("SG&A") expenses for 2002 includes
$17.5 million incurred in connection with our defense of shareholder
litigation and cooperating with various governmental investigations. Also
included in SG&A expense for fiscal 2002 is a charge of $7.1 million for the
accrual of anticipated loss on non-recurring litigation, and $8.8 million to
terminate an exclusivity contract with a certain vendor. Offsetting these
items are receipts of $39.1 million for the settlement of litigation with
certain drug manufacturers and $7.1 million of expense reduction resulting
primarily from senior executives releasing their rights to their non-qualified
defined benefit arrangements. Excluding these items, SG&A as a percentage of
revenues was 22.4% in fiscal 2002.
SG&A expenses for fiscal 2001 were favorably impacted by a $20.0 million
increase in estimated insurance recovery related to the settlement of the
shareholder's class action lawsuit, and by $20.1 million received related to
the partial settlement of litigation with certain drug manufacturers.
Offsetting these items was $82.1 million incurred in connection with the
restatement of our historical financial statements and various governmental
investigations. Excluding these items, SG&A as a percentage of revenue was
23.2%.
After considering the items described in the previous paragraphs, SG&A on an
adjusted basis of 22.4% for fiscal 2002 compares favorably with SG&A on an
adjusted basis of 23.2% for fiscal 2001 due to decreased depreciation and
amortization charges resulting from a reduced store count and better
leveraging of our fixed costs resulting from higher sales volume, partially
offset by higher associate benefit costs and higher advertising costs.
SG&A expense for 2000 was unfavorably impacted by a charge of $232.8 million
related to litigation issues. Excluding this item results in an adjusted SG&A
as a percentage of sales of 25.6% in fiscal 2000. SG&A on an adjusted basis of
23.2% for fiscal 2001 compares favorably with SG&A on an adjusted basis of
25.6% for fiscal 2000 due to lower depreciation expense resulting from a net
reduction in our store count, decreased repair and maintenance and terminated
project costs, and the better leveraging of fixed SG&A costs resulting from
our higher sales volume.
Store Closing and Impairment Charges
Store closing and impairment charges consist of:
Year Ended
--------------------------------------------------
March 2, 2002 March 3, 2001 February 26, 2000
------------- ------------- -----------------
(Dollars in thousands)
Impairment charges ..................................................... $157,962 $214,224 $120,593
Store and equipment lease exit charges ................................. 93,303 57,668 18,855
Impairment of investments .............................................. 352 116,186 --
======== ======== ========
$251,617 $388,078 $139,448
======== ======== ========
Impairment Charges. In fiscal 2002, 2001 and 2000, store closing and
impairment charges include non-cash charges of $158.0 million, $214.2 million
and $120.6 million, respectively, for the impairment of long-lived assets
(including allocable goodwill) of 365, 495 and 249 stores, respectively. These
amounts include the write-down of long-lived assets to estimated fair value at
stores that were assessed for impairment as part of our on-going review of the
performance of our stores or management's intention to relocate or close the
store.
17
Store and Equipment Lease Exit Charges. Charges incurred to close a store,
which principally consist of lease termination costs, are recorded at the time
management commits to closing the store, which is the date that the closure is
formally approved by senior management, or in the case of a store to be
relocated, the date the new property is leased or purchased. We calculate our
liability for closed stores on a store-by-store basis. The calculation
includes the future minimum lease payments and related ancillary costs, from
the date of closure to the end of the remaining lease term, net of estimated
cost recoveries that may be achieved through subletting properties or through
favorable lease terminations. This liability is discounted using a risk-free
rate of interest. We evaluate these assumptions each quarter and adjust the
liability accordingly. Also included in store and equipment lease exit costs
are charges of $1.3 million incurred in fiscal 2002 related to the early
termination of an equipment lease.
Impairment of Investments. We have an investment in the common stock of
drugstore.com, which is accounted for under the equity method. The initial
investment was valued based upon the initial public offering price for
drugstore.com. During fiscal 2001, we recorded an impairment of our investment
in drugstore.com of $112.1 million. This write-down was based upon a decline
in the market value of drugstore.com's stock that we believe to be other than
temporary. Additionally, we recorded impairment charges of $4.1 million for
other investments.
Interest Expense
Interest expense was $396.1 million infiscal 2002 compared to $649.9 million
in fiscal 2001. Interest expense for fiscal 2002 decreased from 2001 due to
the reduction of debt resulting from the sale of PCS, debt for equity
exchanges and the June 2001 refinancing, which included the relinquishment of
certain renewal options on real estate leases that resulted in a
reclassification from capital leases to operating leases.
Interest expense was $649.9 million infiscal 2001 compared to $542.0 million
in fiscal 2001. In fiscal 2001, we increased our average outstanding debt with
the addition of the $1.1 billion senior secured credit facility, which
included a $600.0 million term loan and a $500.0 million revolving credit
facility. We used the term loan to terminate our accounts receivable
securitization facility and repurchased $300.0 million of unpaid receivables
thereunder and funded $66.4 million of transaction costs related to our debt
restructuring. The remainder of the term loan together with the revolving
credit facility were used for general corporate purposes, including reviewing,
reconciling and restating our 1998 and 1999 financial statements, the cost of
the audit of our restated financial statements and investigation costs.
The annual weighted average interest rates on our indebtedness in fiscal
2002, fiscal 2001 and fiscal 2000 were 8.2%, 8.2% and 7.4% respectively.
For fiscal 2003, annual interest expense is expected to be $350.0 million to
$370.0 million.
Interest Rate Swap Contracts
We entered into interest rate swap contracts to hedge the exposure to
increasing rates with respect to our variable rate debt. As a result of the
June 2001 refinancing, the interest rate swap contracts no longer qualify for
hedge accounting treatment, and therefore the changes in fair value of these
interest rate swap contracts is required to be recorded as a component of net
loss. Accordingly, we recognized a charge of $31.0 million representing the
amount that we would have to pay the counter party to terminate the contracts
as of that date. Subsequent changes in the market value of the interest rate
swaps, inclusive of cash payments, have been recorded in this caption on the
statement of operations. The total expense recorded in this caption for fiscal
2002 is $41.9 million. This amount exceeds the initial charge resulting from
the June 27, 2001 refinancing because of a further reduction of interest rates
from the June 27, 2001 refinancing through March 2, 2002. Our termination
liability is $19.0 million as of March 2, 2002. These contracts expire in the
second quarter of fiscal 2003.
Income Taxes
We had net losses in fiscal 2002, fiscal 2001 and fiscal 2000. A tax benefit
of $11.7 million, expense of $149.0 million and benefit of $26.6 million
(including the benefit related to cumulative effect of accounting
18
change) have been recorded for fiscal 2002, fiscal 2001 and fiscal 2000,
respectively. The fiscal 2002 benefit is primarily due to the favorable
outcome of federal income tax litigation. The fiscal 2001 expense is primarily
due to the increase in the income tax valuation allowance caused by the sale
of PCS. The benefit of the net operating loss carryforwards ("NOLs") generated
in each period has been fully offset by a valuation allowance as a result of
management's determination that, based on available evidence, it is more
likely than not that the deferred tax assets will not be realized.
We have undergone an ownership change for statutory purposes during fiscal
2002, which resulted in a limitation on the future use of net operating loss
carryforwards. We believe that this limitation does not further impair the net
operating loss carryforwards because they are fully reserved.
Based on the tax law changes enacted on March 9, 2002, we expect to record a
tax benefit of approximately $44.0 million from the five-year net operating
loss carry-back provision. This benefit will be recorded in the first quarter
of fiscal 2003.
Other Significant Charges
In addition to the operational matters discussed above, our results in
fiscal 2002 and 2001 have been adversely affected by other significant
charges. We recorded losses of $12.1 million and $36.7 million in fiscal 2002
and 2001, respectively, representing our share of drugstore.com losses. We
recorded $154.5 million and $100.6 million in fiscal 2002 and 2001,
respectively for losses on debt and lease conversions and modifications and an
extraordinary loss of $66.6 million in fiscal 2002 relating to early
extinguishment of debt resulting from the June 27, 2001 refinancing. We
recorded stock-based compensation benefit of $15.9 million and expense of
$45.9 million in fiscal 2002 and 2001, respectively, resulting primarily from
the impact of applying variable plan accounting to several of our stock-based
compensation plans. We also recorded a gain of $53.2 million in fiscal 2002
resulting from the sale of AdvancePCS securities. In fiscal 2001, we recorded
a net loss of $168.8 million on the disposal of the PBM segment.
Liquidity and Capital Resources
General
We have two primary sources of liquidity: (i) cash provided by operations
and (ii) the revolving credit facility under our new senior secured credit
facility. Our principal uses of cash are to provide working capital for
operations, service our obligations to pay interest and principal on debt, and
to provide funds for capital expenditures.
Our ability to borrow under the senior secured credit facility is based on a
specified borrowing base consisting of eligible accounts receivable and
inventory. On March 2, 2002, the term loan was fully drawn except for
$21.5 million, which is available and may be drawn to pay for the remaining
outstanding 10.5% senior secured notes when they mature on September 15, 2002.
In addition, we had $438.7 million in additional available borrowing capacity
under the revolving credit facility net of outstanding letters of credit of
$61.3 million.
The senior secured credit facility, as amended, also allows us, at our
option, to issue up to $893.0 million of unsecured debt that is not guaranteed
by any of our subsidiaries, reduced by the following debt to the extent
incurred: (i) $150.0 million of financing transactions of existing owned real
estate; (ii) $643.0 million of additional debt secured by the facility's
collateral on a second priority basis; and (iii) $100.0 million of financing
transactions for property or assets acquired after June 27, 2001. The
$893.0 million of permitted debt, whether secured or unsecured, is reduced by
the aggregate outstanding, undefeased balances of the 5.25% convertible
subordinated notes, the 6.0% dealer remarketable securities and the 4.75%
convertible notes and the senior secured notes (see "Other Transactions"
below). As of March 2, 2002, we had outstanding principal balances of
$150.5 million, $83.6 million, $250.0 million and $149.5 million of the 5.25%
convertible subordinated notes, 6.0% dealer remarketable securities, 4.75%
convertible notes and the senior secured notes, respectively. As of March 2,
2002, our remaining permitted debt under the senior secured credit facility is
$259.4 million. Our 11.25% senior notes due July 2008 also permit
$150.0 million of real estate financing, $400.0 million of additional other
debt and $600.0 million of additional permitted debt,
19
which includes allowing us to increase our senior secured credit facility. As
of March 2, 2002 our remaining permitted debt under the 11.25% senior notes
due 2008 is $600.5 million.
The senior secured credit facility, as amended, requires us to meet various
financial ratios and limits capital expenditures. Beginning with the 12 months
ended March 2, 2002, the covenants require us to maintain a maximum leverage
ratio of 8.40:1, increasing to 9.50:1 for the twelve months ending June 1,
2002, and increasing again to 10.00:1 for the twelve months ending August 31,
2002, before gradually decreasing to 6.00:1 for the twelve months ending
May 31, 2005. We must also maintain a minimum interest coverage ratio of
1.20:1 for the twelve months ending March 2, 2002, decreasing to 1.15:1 for
the twelve months ending June 1, 2002 and decreasing again to 1.10:1 for the
twelve months ending August 31, 2002 before gradually increasing to 2.00:1 for
the twelve months ending November 30, 2004. In addition, we must maintain a
minimum fixed charge ratio of 0.9:1 for the twelve months ending March 2,
2002, gradually increasing to 1.10:1 for the twelve months ending August 31,
2004. Capital expenditures not relating to the June 27, 2001 refinancing are
limited to $150.0 million annually beginning with the twelve months ending
March 2, 2002. These capital expenditure limits are subject to upward
adjustment based upon availability of excess liquidity as defined in our
senior secured credit facility.
We were in compliance with the covenants of the senior secured credit
facility, as amended, and our other credit facilities and debt instruments as
of March 2, 2002. With continuing improvements in operating performance, we
anticipate that we will remain in compliance with our debt covenants. However,
variations in our operating performance and unanticipated developments may
adversely affect our ability to remain in compliance with the applicable debt
covenants.
The senior secured credit facility provides for customary events of default,
including nonpayment, misrepresentation, breach of covenants and bankruptcy.
It is also an event of default if any event occurs that enables, or which with
the giving of notice or the lapse of time would enable, the holder of our debt
to accelerate the maturity of debt having a principal amount of $25.0 million
or more.
Refinancing
On June 27, 2001, we completed a major refinancing that extended the
maturity dates of the majority of our debt to 2005 or beyond, provided
additional equity, converted a portion of our debt to equity and reclassified
capital leases to operating leases. The components of the refinancing are
described in detail in the footnotes to the consolidated financial statements.
Major components of the refinancing are summarized below:
New Secured Credit Facility. We entered into a new $1.9 billion syndicated
senior secured credit facility with a syndicate of banks led by Citicorp USA,
Inc. as senior agent. The new facility matures on June 27, 2005 unless more
than $20.0 million of our 7.625% senior notes due April 15, 2005 are
outstanding on December 31, 2004, in which event the maturity date is March 15,
2005. The new facility consists of a $1.4 billion term loan facility and a
$500.0 million revolving credit facility. The term loan was used to prepay
various outstanding debt balances.
High Yield Notes. We issued $150.0 million of 11.25% senior notes due July
2008 in a private placement offering. These notes are unsecured and are
effectively subordinate to our secured debt.
Debt for Debt Exchange. We exchanged $152.0 million of our existing 10.50%
senior secured notes for an equal principal amount of 12.50% senior secured
notes due September 15, 2006. The 12.50% notes are secured by a second
priority lien on the collateral of the senior secured credit facility. In
addition, holders of these notes received warrants to purchase 3.0 million
shares of our common stock at $6.00 per share. On June 29, 2001, the warrant
holders elected to exercise these warrants, on a cashless basis, and as a
result 1.0 million shares of common stock were issued.
Tender Offer. On May 24, 2001, we commenced a tender offer for the 10.50%
senior secured notes due 2002 at a price of 103.25% of the principal amount.
The tender offer was closed on June 27, 2001, at which time $174.5 million
principal was tendered. We incurred a tender offer premium of $5.7 million as
a result of the transaction. We used proceeds from the new senior secured
credit facility to pay for the tender offer.
20
Debt for Equity Exchanges. We completed exchanges of $588.7 million of debt
for 86.4 million shares of common stock.
Sales of Common Stock. We issued 80.1 million shares of our common stock
for net proceeds of $528.4 million.
Lease Obligations. We relinquished certain renewal options which had been
available under the terms of certain real estate leases on property previously
sold and leased back and accordingly, we reclassified the related leases as
operating leases thereby reducing outstanding capital lease obligations by
$850.8 million.
Impact on Results of Operations for Fiscal 2002. As a result of the
refinancing, we: i) recorded an extraordinary loss on early extinguishment of
debt of $66.6 million; ii) recognized a loss of $21.9 million related to debt
and lease conversions and modifications; and iii) recognized a charge of
$31.0 million related to our interest rate swap agreements.
Other Transactions
Convertible Notes. We issued $250.0 million of our 4.75% convertible notes
due December 2006 in November 2001. These notes were issued at a 3% discount
resulting in cash proceeds of $242.5 million. These notes are unsecured and
are effectively subordinate to our secured debt. The notes are convertible, at
the option of the holder, into shares of our common stock at a conversion
price of $6.50 per share, subject to adjustments to prevent dilution, at any
time.
Repurchase of Debt. We repurchased $24.2 million of our 6.0% dealer
remarketable securities due 2003, $1.0 million of our 10.50% notes due 2002
and $1.5 million of our 5.25% convertible subordinated notes due 2002 during
fiscal 2002.
Senior Secured Notes. We issued $149.5 million of our senior secured notes
due 2006 as part of our settlement of a lawsuit with shareholders. When
issued, we paid interest for the period from October 15, 2001 to January 25,
2002 of $2.1 million. From January 26, 2002, the notes accrue interest at a
variable rate equal to our average bank borrowing rate plus 3.75% until the
final settlement is approved. At that time, the notes will be given an
interest rate, enabling the notes to be traded at face value upon
determination of such rate.
Other
Debt Maturities and Other Obligations. The following table details the
maturities of our indebtedness and lease financing obligations as of March 2,
2002, as well as other contractual cash obligations and commitments.
21
Contractual Obligations and Commitment
Less Than
Total 1 Year 1 to 3 Years 4 to 5 Years After 5 Years
----------- --------- ------------ ------------ -------------
(Dollars in thousands)
Contractual Cash Obligations
Long Term Debt.......................................... $ 3,873,843 $202,913 $ 184,540 $2,389,404 $1,096,986
Capital lease obligations............................... 182,625 6,544 13,765 14,954 147,362
Operating leases........................................ 6,680,051 585,128 1,087,263 921,951 4,085,709
----------- -------- ---------- ---------- ----------
Total Contractual Cash Obligations..................... $10,736,519 $794,585 $1,285,568 $3,326,309 $5,330,057
=========== ======== ========== ========== ==========
Commitments
Lease guarantees........................................ 360,500 -- -- -- --
Outstanding letters of credit........................... 61,324 61,324 -- -- --
----------- -------- ---------- ---------- ----------
Total commitments...................................... $ 421,824 $ 61,324 -- -- --
=========== ======== ========== ========== ==========
We lease certain distribution facilities under a synthetic lease agreement.
The agreement is accounted for as an operating lease. The lease agreement
terminates on June 27, 2005 at which time we intend to either extend the term
of the agreement or make a payment of $106.9 million to purchase the
facilities. Renewal is subject to our meeting certain financial conditions, as
defined in the synthetic lease agreement. Our guaranteed residual obligation
of $85.5 million under the agreement is included in the table above in lease
guarantees.
Net Cash Provided By (Used In) Operating, Investing and Financing Activities
Cash provided by operations was $16.3 million in fiscal 2002. Cash was
provided primarily through improved operating results, a significant reduction
in interest payments and a reduction in inventory levels net of a decrease in
accounts payable.
We used $704.6 million of cash to fund continuing operations in fiscal 2001.
Operating cash flow was negatively impacted by $543.3 million of interest
payments. Operating cash flow was also negatively impacted from an increase in
current assets, primarily resulting from repurchasing $300.0 million of
accounts receivable when we refinanced the accounts receivable securitization
facility, and a decrease in accounts payable and other liabilities.
In fiscal 2000, we used $623.1 million of cash to fund continuing
operations. Operating cash flow was negatively impacted by $501.8 million of
interest payments. Operating cash flow was also negatively impacted from an
increase in current assets and a decrease in accounts payable partially offset
by an increase in other liabilities.
Cash provided by investing activities was $342.5 million for fiscal 2002.
Cash was provided from the sale of our investment in AdvancePCS, less
expenditures for fixed assets and script file purchases.
Cash provided by investing activities was $677.7 million for fiscal 2001.
Cash was provided from the sale of our discontinued operations, less
expenditures for fixed assets and script file purchases.
Cash used for investing activities was $552.1 million for fiscal 2000. Cash
used for store construction and relocations amounted to $573.3 million, with
an additional $67.8 million used for the acquisition of intangible assets.
These amounts were offset by $169.5 million provided by the sale of assets.
Cash used in financing activities was $107.1 million for fiscal 2002. The
cash used consisted of repayments of long-term debt of $2.3 billion and
payments of deferred financing costs of $83.1 million, offset with new
borrowing of $1.4 billion, bond proceeds of $392.5 million and $530.6 million
of proceeds from the issuance of common stock.
Cash used in financing activities was $64.3 million for fiscal 2001. The
cash used consisted of payments of $78.1 million of deferred financing costs
partially offset by net debt borrowings of $6.8 million and proceeds from
sale-leaseback transactions of $7.0 million. During fiscal 2001, we used the
proceeds from the sale of our PBM segment to reduce our borrowings.
22
Cash provided by financing activities was $905.1 million for fiscal 2000.
Increased borrowings under then existing credit facilities which replaced our
commercial paper program and the sale of $300.0 million of preferred stock
were the main financing activities during fiscal 2000. Cash provided by
financing activities included proceeds received from store sale-leaseback
transactions of $74.9 million.
Capital Expenditures
We plan to make total capital expenditures of approximately $130.0 million
during fiscal 2003, consisting of approximately $61.0 million related to new
store construction, store relocation and store remodel projects. An additional
$69.0 million will be dedicated to the purchase of prescription files from
independent pharmacists, improvements to distribution centers, technology
enhancements and other corporate requirements. Management expects that these
capital expenditures will be financed primarily with cash flow from operations
and borrowings under the revolving credit facility available under our senior
secured facility.
Future Liquidity
We are highly leveraged. Our high level of indebtedness: (a) limits our
ability to obtain additional financing; (b) limits our flexibility in planning
for, or reacting to, changes in our business and the industry; (c) places us
at a competitive disadvantage relative to our competitors with less debt; (d)
renders us more vulnerable to general adverse economic and industry
conditions; and (e) requires us to dedicate a substantial portion of our cash
flow to service our debt. Based upon current levels of operations and planned
improvements in our operating performance, management believes that cash flow
from operations together with available borrowing under the senior secured
credit facility and other sources of liquidity will be adequate to meet our
anticipated annual requirements for working capital, debt service and capital
expenditures for the next twelve months. We will continue to assess our
liquidity position and potential sources of supplemental liquidity in light of
our operating performance and other relevant circumstances. Should we
determine, at any time, that it is necessary to obtain additional short-term
liquidity, we will evaluate our alternatives and take appropriate steps to
obtain sufficient additional funds. Obtaining any such supplemental liquidity
through the increase of indebtedness or asset sales may require the consent of
the lenders under one or more of our debt agreements. There can be no
assurance that any such supplemental funding, if sought, could be obtained or
that our lenders would provide the necessary consents, if required.
Accounting Change
In fiscal 2000, we changed our application of the LIFO method of accounting
by restructuring our LIFO pool structure through a combination of certain
geographic pools. The reduction in the number of LIFO pools was made to more
closely align the LIFO pool structure to store merchandise categories. The
effect of this change in fiscal 2000 was to decrease our earnings by
$6.8 million (net of income tax benefit of $4.6 million) or $.03 per diluted
common share. The cumulative effect of the accounting change was a charge of
$27.3 million (net of income tax benefit of $18.2 million) or $.11 per diluted
common share.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board ("FASB") issued two
new pronouncements: Statement of Financial Accounting Standards ("SFAS") No.
141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 141 is effective as follows: a) use of the pooling-of-
interest method is prohibited for business combinations initiated after
June 30, 2001; and b) the provisions of SFAS No. 141 also apply to all
business combinations accounted for by the purchase method that are completed
after June 30, 2001 (that is, the date of the acquisition is July 2001 or
later). The adoption of SFAS No. 141 had no impact on our consolidated
financial position or results of operations. SFAS No. 142 is effective for the
fiscal years beginning after December 15, 2001 with respect to all goodwill
and other intangible assets recognized in an entity's statement of financial
position at that date, regardless of when those assets were initially
recognized. SFAS No. 142 specifies that all goodwill and intangibles with
indefinite lives shall not be amortized. Goodwill must be allocated to
reporting units and evaluated for impairment on an annual basis with an
initial impairment assessment to be performed upon adoption of the Statement.
We have evaluated the provisions of SFAS No. 142 and will not have to record
any impairment of goodwill upon
23
our adoption of SFAS No. 142, which is effective March 3, 2002. At March 2,
2002, we had unamortized goodwill of $684.5 million and recorded $21.0 million
of goodwill amortization expense in fiscal 2002.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets." SFAS No. 144 retains the requirements of
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of," to recognize an impairment loss if the
carrying amount of a long-lived asset is not recoverable from its undiscounted
cash flows and to measure an impairment loss as the difference between the
carrying amount and fair value of the asset. SFAS No. 144 modifies SFAS No.
121 in that it eliminates the requirement to allocate goodwill to long-lived
assets to be tested for impairment. SFAS No. 144 also modifies APB Opinion No.
30, "Reporting the Results of Operations " Reporting the Effects of Disposal
of a Segment of a Business and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions," to require discontinued operations
presentation in the income statement for a component of an entity that is to
be disposed. SFAS No. 144 is effective for fiscal years beginning after
December 15, 2001, and early adoption is encouraged. We plan to adopt SFAS No.
144 effective March 3, 2002 and the impact is not believed to be material.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent
assets and liabilities. On an on-going basis, we evaluate our estimates,
including those related to allowance for uncollectible receivables and vendor
debits, pension benefits, self insured liabilities, lease exit liabilities,
impairment, litigation and income taxes. We base our estimates on historical
experience, current and anticipated business conditions, the condition of the
financial markets, and various other assumptions that are believed to be
reasonable under existing conditions. Actual results may differ from these
estimates.
We believe that the following critical accounting policies affect our more
significant judgements and estimates used in the preparation of our
consolidated financial statements:
Allowance for uncollectible receivables. The majority of our prescription
sales are made to customers that are covered by third party payors, such as
insurance companies, government agencies and employers. We carry receivables
that represent the amount owed to us for sales made to customers or employees
of those payors that have not yet been paid. We maintain a reserve for the
amount of these receivables deemed to be uncollectible. This reserve is
calculated based upon historical collection activity adjusted for current
conditions. If the financial condition of the payors were to deteriorate,
resulting in an inability to make payments, then an additional reserve would
be required.
Impairment. We evaluate long-lived assets, including stores, for impairment
annually, or whenever events or changes in circumstances indicate that the
assets may not be recoverable. The impairment is measured by calculating the
estimated future cash flows expected to be generated by the store, and
comparing this amount to the carrying value of the store's assets. Cash flows
are calculated utilizing individual store forecasts and total company
projections for the remaining estimated lease lives of the stores being
analyzed. Should actual results differ from those forecasted and projected, we
are subject to future impairment charges related to these facilities.
Goodwill Impairment. As disclosed in the consolidated financial statements,
we have unamortized goodwill in the amount of $684.5 million. In connection
with the adoption of SFAS No. 142, we have performed an impairment test of
goodwill as of March 3, 2002, which resulted in no impairment being
identified. However, the process of evaluating goodwill for impairment
involves the determination of the fair value of our company. Inherent in such
fair value determinations are certain judgements and estimates, including the
interpretation of economic indicators and market valuations and assumptions
about our strategic plans. To the extent that our strategic plans change, or
that economic and market conditions worsen, it is possible that our conclusion
regarding goodwill impairment could change and result in a material effect on
our financial position or results of operations.
24
Vendor debit reserve. We maintain a contra-payable for returns and vendor
allowances that have been earned under the terms of the corresponding
agreements, but have not been charged against a payment to the vendor or
received in cash. We record a reserve against this contra-payable based upon
historical realization of these items and known issues with the vendors.
Differences in actual results from historical experience, or a deterioration
in a vendor relationship could cause write-offs of vendor debits that are
currently not reserved.
Self insurance liabilities. We record estimates for self insured medical,
dental, worker's compensation and general liability insurance coverage. Should
a greater amount of claims occur compared to what was estimated, or medical
costs increase beyond what was anticipated, reserves recorded may not be
sufficient, and additional expense may be recorded.
Benefit plan accruals. We have several defined benefit plans, under which
participants earn a retirement benefit based upon a formula set forth in the
plan. We record expense related to these plans using actuarially determined
amounts that are calculated under the provisions of SFAS No. 87, "Employer's
Accounting for Pensions". Key assumptions used in the actuarial valuations
include the discount rate and the anticipated rate of return on plan assets.
These rates are based on market interest rates, and therefore fluctuations in
market interest rates could impact the amount of pension expense recorded for
these plans.
Litigation reserves. We are involved in litigation on an ongoing basis. We
accrue our best estimate of the probable loss related to legal claims. Such
estimates are developed in consultation with in-house and outside counsel, and
are based upon a combination of litigation and settlement strategies. To the
extent additional information arises or our strategies change, it is possible
that our best estimate of the probable liability may also change.
Lease exit liabilities. We record reserves for closed stores based on
future lease commitments, anticipated ancillary occupancy costs, anticipated
future subleases of properties and current risk free interest rates. If
interest rates or the real estate leasing markets change, additional reserves
may be required.
Stock-based compensation. We maintain various stock-based incentive
compensation programs for executives and key associates. We account for
several of the awards under these plans using variable plan accounting. Under
variable plan accounting, we record expense on the awards over the option
period period based on the difference between the actual market value of the
stock, and the strike price of the award. Therefore, fluctuations in the
market value of the stock will cause fluctuations in the amount of expense
recorded on these awards.
Income taxes. We currently have net operating loss ("NOL") carryforwards
that can be utilized to offset future income for federal and state tax
purposes. These NOLs generate a significant deferred tax asset. However, we
have recorded a valuation allowance against this deferred tax asset as we have
determined that it is more likely than not that we will not be able to fully
utilize the NOLs. Should our assumptions regarding the utilization of these
NOLs change, we may reduce some or all of this valuation allowance, which
would result in the recording of an income tax benefit.
Factors Affecting our Future Prospects
Risks Related to Our Financial Condition
We are highly leveraged. Our substantial indebtedness will severely limit cash
flow available for our operations and could adversely affect our ability to
service debt or obtain additional financing if necessary.
We had, as of March 2, 2002, $4.1 billion of outstanding indebtedness and
stockholders' equity of $9.6 million. We also had additional borrowing
capacity under our new revolving credit facility of $438.7 million at that
time, net of outstanding letters of credit of $61.3 million. Our debt
obligations adversely affect our operations in a number of ways and our cash
flow from operations is insufficient to service our debt, which may require us
to borrow additional funds for that purpose, restructure or otherwise
refinance that debt. Our earnings were insufficient to cover our fixed charges
for fiscal 2002 by $761.6 million.
25
Our high level of indebtedness will continue to restrict our operations.
Among other things, our indebtedness will:
o limit our ability to obtain additional financing;
o limit our flexibility in planning for, or reacting to, changes in the
markets in which we compete;
o place us at a competitive disadvantage relative to our competitors with
less indebtedness;
o render us more vulnerable to general adverse economic and industry
conditions; and
o require us to dedicate substantially all our cash flow to service our
debt.
In fiscal 2000, we experienced operational and financial difficulties,
resulting in disputes with suppliers and vendors. Although we believe that our
prior disputes with suppliers and vendors have been largely resolved, any
future material deterioration in our operational or our financial situation
could again impact vendors' and suppliers' willingness to do business with us.
Our ability to make payments on our debt depends upon our ability to
substantially improve our future operating performance, which is subject to
general economic and competitive conditions and to financial, business and
other factors, many of which we cannot control. If our cash flow from our
operating activities is insufficient, we may take certain actions, including
delaying