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EX-32 - FREDS INCv225424_ex32.htm
EX-31.1 - FREDS INCv225424_ex31-1.htm
EX-31.2 - FREDS INCv225424_ex31-2.htm
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended April 30, 2011.
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 001-14565

FRED'S, INC.
(Exact name of registrant as specified in its charter)

TENNESSEE
62-0634010
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification Number)

4300 New Getwell Road
Memphis, Tennessee 38118
(Address of Principal Executive Offices)

(901) 365-8880
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).  ¨ Yes  ¨ No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨
Accelerated filer x
   
Non-accelerated filer ¨
Smaller reporting company  ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ¨ No x.

The registrant had 39,421,212 shares of Class A voting, no par value common stock outstanding as of June 7, 2011.

 
 

 

FRED'S, INC.

INDEX

   
Page No.
     
Part I - Financial Information
   
     
Item 1 - Financial Statements:
   
     
Condensed Consolidated Balance Sheets as of April 30, 2011 (unaudited) and January 29, 2011
 
3
     
Condensed Consolidated Statements of Income for the Thirteen Weeks Ended April 30, 2011 (unaudited) and May 1, 2010 (unaudited)
 
4
     
Condensed Consolidated Statements of Cash Flows for the Thirteen Weeks Ended April 30, 2011 (unaudited) and May 1, 2010 (unaudited)
 
5
     
Notes to Condensed Consolidated Financial Statements (unaudited)
 
6-11
     
Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations
 
12-15
     
Item 3 – Quantitative and Qualitative Disclosure about Market Risk
 
16
     
Item 4 – Controls and Procedures
 
16
     
Part II - Other Information
 
16-17
     
Item 1. Legal Proceedings
   
Item 1A. Risk Factors
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
   
Item 6. Exhibits
   
     
Signatures
 
17
Ex-31.1   Section 302 Certification of the CEO
   
Ex-31.2   Section 302 Certification of the CFO
   
Ex-32.     Section 906 Certification of the CEO and CFO
   

 
2

 

Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

FRED’S, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except for number of shares)

   
April 30, 2011
   
January 29,
 
   
(unaudited)
   
2011
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 57,051     $ 49,182  
Receivables, less allowance for doubtful accounts of $1,153 and $1,218, respectively
    29,723       28,146  
Inventories
    331,302       313,384  
Other non-trade receivables
    20,535       26,378  
Prepaid expenses and other current assets
    11,635       12,723  
Total current assets
    450,246       429,813  
Property and equipment, at depreciated cost
    151,934       139,931  
Equipment under capital leases, less accumulated amortization of $4,976 and $4,967, respectively
    126       -  
Intangibles
    22,242       22,193  
Other noncurrent assets, net
    3,332       3,591  
Total assets
  $ 627,880     $ 595,528  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 104,493     $ 81,002  
Current portion of indebtedness
    378       201  
Accrued expenses and other
    41,445       45,371  
Capital lease obligation
    138       -  
Deferred income taxes
    22,275       21,142  
Total current liabilities
    168,729       147,716  
Long-term portion of indebtedness
    7,189       3,969  
Deferred income taxes
    1,563       2,069  
Other noncurrent liabilities
    18,461       17,886  
Total liabilities
    195,942       171,640  
                 
Commitments and Contingencies
               
                 
Shareholders’ equity:
               
Preferred stock, nonvoting, no par value, 10,000,000 shares authorized, none outstanding
    -       -  
Preferred stock, Series A junior participating nonvoting, no par value, 224,594 shares authorized, none outstanding
    -       -  
Common stock, Class A voting, no par value, 60,000,000 shares authorized, 39,309,107 and 39,363,462 shares issued and outstanding, respectively
    131,869       131,367  
Common stock, Class B nonvoting, no par value, 11,500,000 shares authorized, none outstanding
    -       -  
Retained earnings
    299,197       291,649  
Accumulated other comprehensive income
    872       872  
Total shareholders’ equity
    431,938       423,888  
Total liabilities and shareholders’ equity
  $ 627,880     $ 595,528  

See accompanying notes to condensed consolidated financial statements.

 
3

 
 
FRED’S, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except per share amounts)

   
Thirteen Weeks Ended
 
   
April 30,
   
May 1,
 
   
2011
   
2010
 
Net sales
  $ 484,399     $ 471,647  
Cost of goods sold
    346,457       334,698  
Gross profit
    137,942       136,949  
                 
Depreciation and amortization
    7,773       6,963  
Selling, general and administrative expenses
    115,046       116,804  
Operating income
    15,123       13,182  
                 
Interest income
    (57 )     (60 )
Interest expense
    127       110  
Income before income taxes
    15,053       13,132  
                 
Provision for income taxes
    5,539       4,941  
Net income
  $ 9,514     $ 8,191  
                 
Net income per share
               
Basic
  $ 0.24     $ 0.21  
                 
Diluted
  $ 0.24     $ 0.21  
                 
Weighted average shares outstanding
               
Basic
    39,149       39,203  
Effect of dilutive stock options
    97       43  
Diluted
    39,246       39,246  
                 
Comprehensive income:
               
Net income
  $ 9,514     $ 8,191  
Other comprehensive income (expense), net of tax
               
postretirement plan adjustment
    -       -  
                 
Comprehensive income
  $ 9,514     $ 8,191  

See accompanying notes to condensed consolidated financial statements.

 
4

 

FRED’S, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)

   
Thirteen Weeks Ended
 
   
April 30, 2011
   
May 1, 2010
 
Cash flows from operating activities:
           
Net income
  $ 9,514     $ 8,191  
Adjustments to reconcile net income to net cash flows from operating activities:
               
Depreciation and amortization
    7,773       6,963  
Net (gain) loss on asset disposition
    219       7  
Provision for store closures and asset impairment
    232       -  
Stock-based compensation
    441       376  
Provision for uncollectible receivables
    (65 )     128  
LIFO reserve increase
    1,463       625  
Deferred income tax expense (benefit)
    629       (385 )
Income tax benefit upon exercise of stock options
    9       4  
Provision for postretirement medical
    -       -  
(Increase) decrease in operating assets:
               
Trade and non-trade receivables
    2,259       (4,081 )
Insurance receivables
    (4 )     110  
Inventories
    (19,613 )     (25,870 )
Other assets
    1,348       327  
Increase (decrease) in operating liabilities:
               
Accounts payable and accrued expenses
    19,710       11,397  
Income taxes payable
    2,131       4,576  
Other noncurrent liabilities
    505       432  
Net cash provided by operating activities
    26,551       2,800  
                 
Cash flows from investing activities:
               
Capital expenditures
    (15,050 )     (5,888 )
Proceeds from asset dispositions
    11       28  
Insurance recoveries for replacement assets
    -       91  
Asset acquisition, net  (primarily intangibles)
    (1,632 )     (835 )
Net cash used in investing activities
    (16,671 )     (6,604 )
                 
Cash flows from financing activities:
               
Payments of indebtedness and capital lease obligations
    (106 )     (562 )
Proceeds from revolving line of credit
    -       -  
Payments on revolving line of credit
    -       -  
Excess tax charges from stock-based compensation
    (9 )     (4 )
                 
Proceeds from exercise of stock options and employee stock purchase plan
    95       107  
Repurchase of shares
    (25 )     (652 )
Cash dividends paid
    (1,965 )     (1,572 )
Net cash used in financing activities
    (2,010 )     (2,683 )
                 
Increase in cash and cash equivalents
    7,870       (6,487 )
Cash and cash equivalents:
               
Beginning of year
    49,181       54,742  
End of year
  $ 57,051     $ 48,255  
                 
Supplemental disclosures of cash flow information:
               
Interest paid
  $ 70     $ 50  
Income taxes paid
  $ 1,079     $ 98  
                 
Non-cash investing and financial activities:
               
Assets acquired through term loan
  $ 3,497     $ -  
Assets acquired through capital lease
  $ 135     $ -  

See accompanying notes to consolidated financial statements.

 
5

 

FRED'S, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

NOTE 1:  BASIS OF PRESENTATION

Fred's, Inc. and subsidiaries (“We”, “Our”, “Us” or “Company”) operates, as of April 30, 2011, 673 discount general merchandise stores, including 23 franchised Fred's stores, in 15 states in the southeastern United States.  313 of the stores have full service pharmacies.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and are presented in accordance with the requirements of Form 10-Q and therefore do not include all information and notes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with GAAP.  The statements reflect all adjustments (consisting of only normal recurring accruals) which are, in the opinion of management, necessary for a fair presentation of financial position in conformity with GAAP.  The statements should be read in conjunction with the Notes to the Consolidated Financial Statements for the fiscal year ended January 29, 2011 incorporated into Our Annual Report on Form 10-K.

The results of operations for the thirteen week period ended April 30, 2011 are not necessarily indicative of the results to be expected for the full fiscal year.

NOTE 2:  INVENTORIES

Merchandise inventories are valued at the lower of cost or market using the retail first-in, first-out (FIFO) method for goods in our stores and the cost first-in, first-out (FIFO) method for goods in our distribution centers. The retail inventory method is a reverse mark-up, averaging method which has been widely used in the retail industry for many years. This method calculates a cost-to-retail ratio that is applied to the retail value of inventory to determine the cost value of inventory and the resulting cost of goods sold and gross margin. The assumption that the retail inventory method provides for valuation at lower of cost or market and the inherent uncertainties therein are discussed in the following paragraphs. In order to assure valuation at the lower of cost or market, the retail value of our inventory is adjusted on a consistent basis to reflect current market conditions. These adjustments include increases to the retail value of inventory for initial markups to set the selling price of goods or additional markups to adjust pricing for inflation and decreases to the retail value of inventory for markdowns associated with promotional, seasonal or other declines in the market value. Because these adjustments are made on a consistent basis and are based on current prevailing market conditions, they approximate the carrying value of the inventory at net realizable value (market value). Therefore, after applying the cost to retail ratio, the cost value of our inventory is stated at the lower of cost or market as is prescribed by U.S. GAAP.

Because the approximation of net realizable value (market value) under the retail inventory method is based on estimates such as markups, markdowns and inventory losses (shrink), there exists an inherent uncertainty in the final determination of inventory cost and gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such variables as current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently, or a markdown reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and inflation to ensure that markups are taken if necessary. The estimation of inventory losses (shrink) is a significant element in approximating the carrying value of inventory at net realizable value, and as such the following paragraph describes our estimation method as well as the steps we take to mitigate the risk of this estimate in the determination of the cost value of inventory.

The Company calculates inventory losses (shrink) based on actual inventory losses occurring as a result of physical inventory counts during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as performance on the most recent physical count. It is calculated by multiplying each store’s shrink rate, which is based on the previously mentioned factors, by the interim period’s sales for each store. Additionally, the overall estimate for shrink is adjusted at the corporate level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of shrink based on the Company’s overall history of shrink. The three-year historical estimate is calculated by dividing the “book to physical” inventory adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty inherent in the shrink calculation, the Company first performs the calculation at the lowest practical level (by store) using the most current performance indicators. This ensures a more reliable number, as opposed to using a higher level aggregation or percentage method. The second portion of the calculation ensures that the extreme negative or positive performance of any particular store or group of stores does not skew the overall estimation of shrink. This portion of the calculation removes additional uncertainty by eliminating short-term peaks and valleys that could otherwise cause the underlying carrying cost of inventory to fluctuate unnecessarily. Management believes that the Company’s retail inventory method provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market.

 
6

 

For pharmacy inventories, which were approximately $32.8 million and $32.5 million at April 30, 2011 and January 29, 2011, respectively, cost was determined using the retail LIFO (last-in, first-out) method in which inventory cost is maintained using the retail inventory method, then adjusted by application of the Producer Price Index published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories exceeded the LIFO cost by approximately $25.4 million at April 30, 2011 and $24.0 million at January 29, 2011.

The Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise inventory as prescribed by GAAP.  These costs include activities surrounding the procurement and storage of merchandise inventory such as merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight.  The total amount of procurement and storage costs and inbound freight included in merchandise inventory at April 30, 2011 is $20.9 million, with the corresponding amount of $19.5 million at January 29, 2011.

NOTE 3:  STOCK-BASED COMPENSATION

The Company accounts for its stock-based compensation plans in accordance with FASB ASC 718 “Compensation – Stock Compensation”.  Under FASB ASC 718, stock-based compensation expense is based on awards ultimately expected to vest, and therefore has been reduced for estimated forfeitures.  Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture experience and will be revised in subsequent periods if actual forfeitures differ from those estimates.

FASB ASC 718 also requires the benefits of income tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required prior to FASB ASC 718.  A summary of the Company’s stock-based compensation (a component of selling and general and administrative expenses) and related income tax benefit is as follows (in thousands):
 
   
Thirteen Weeks Ended
 
             
   
April 30, 2011
   
May 1, 2010
 
             
Stock option expense
  $ 169     $ 171  
Restricted stock expense
    229       170  
ESPP expense
    43       35  
Total stock-based compensation
  $ 441     $ 376  
                 
Income tax benefit on stock-based compensation
  $ 97     $ 96  

The fair value of each option granted during the thirteen week period ended April 30, 2011 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

 
7

 

   
Thirteen Weeks Ended
 
             
   
April 30, 2011
   
May 1, 2010
 
Stock Options
           
Expected volatility
    42.3 %     42.6 %
Risk-free interest rate
    1.9 %     3.1 %
Expected option life (in years)
    4.12       5.84  
Expected dividend yield
    0.97 %     0.69 %
                 
Weighted average fair value at grant date
  $ 4.28     $ 4.90  
                 
Employee Stock Purchase Plan
               
Expected volatility
    21.1 %     32.3 %
Risk-free interest rate
    0.3 %     0.6 %
Expected option life (in years)
    0.25       0.25  
Expected dividend yield
    0.34 %     0.23 %
                 
Weighted average fair value at grant date
  $ 2.69     $ 2.19  

The following is a summary of the methodology applied to develop each assumption:

Expected Volatility - This is a measure of the amount by which a price has fluctuated or is expected to fluctuate. The Company uses actual historical changes in the market value of our stock to calculate expected price volatility because management believes that this is the best indicator of future volatility. The Company calculates weekly market value changes from the date of grant over a past period representative of the expected life of the options to determine volatility. An increase in the expected volatility will increase compensation expense.

Risk-free Interest Rate - This is the yield of a U.S. Treasury zero-coupon bond issue effective at the grant date with a remaining term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.

Expected Lives - This is the period of time over which the options granted are expected to remain outstanding and is based on historical experience. Options granted have a maximum term of seven and one-half years. An increase in the expected life will increase compensation expense.

Dividend Yield – This is based on the historical yield for a period equivalent to the expected life of the option.  An increase in the dividend yield will decrease compensation expense.

Forfeiture Rate - This is the estimated percentage of options granted that are expected to be forfeited or cancelled before becoming fully vested. This estimate is based on historical experience. An increase in the forfeiture rate will decrease compensation expense.

Employee Stock Purchase Plan

The 2004 Employee Stock Purchase Plan (the “2004 Plan”), which was approved by Fred’s stockholders, permits eligible employees to purchase shares of our common stock through payroll deductions at the lower of 85% of the fair market value of the stock at the time of grant or 85% of the fair market value at the time of exercise.  There were 13,105 shares issued during the thirteen weeks ended April 30, 2011.  There are 1,410,928 shares approved to be issued under the 2004 Plan and as of April 30, 2011, there were 1,013,728 shares available.

Stock Options

The following table summarizes stock option activity during the thirteen weeks ended April 30, 2011:

 
8

 

   
Options
   
Weighted
Average
Exercise Price
   
Weighted Average
Remaining
Contractual Life
(Years)
   
Aggregate
Intrinsic
Value
(Thousands)
 
                         
Outstanding at January 29, 2011
    918,462     $ 12.15       3.2     $ 1,524  
Granted
    40,000     $ 12.94                  
Forfeited / Cancelled
    (26,800 )   $ 15.03                  
Exercised
    (1,400 )   $ 11.35                  
Outstanding at April 30, 2011
    930,262     $ 12.10       3.0     $ 1,525  
                                 
Exercisable at April 30, 2011
    621,752     $ 12.60       2.3     $ 798  

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between Fred’s closing stock price on the last trading day of the period ended April 30, 2011 and the exercise price of the option multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on that date.  As of April 30, 2011, total unrecognized stock-based compensation expense net of estimated forfeitures related to non-vested stock options was approximately $559 thousand, which is expected to be recognized over a weighted average period of approximately 2.9 years.  The total fair value of options vested during the thirteen weeks ended April 30, 2011 was $340.6 thousand.

Restricted Stock

The following table summarizes restricted stock activity during the thirteen weeks ended April 30, 2011:

   
Number of Shares
   
Weighted Average
Grant Date Fair
Value
 
             
Non-vested Restricted Stock at January 29, 2011
    472,927     $ 12.55  
Granted
    -          
Forfeited / Cancelled
    (12,638 )   $ 12.95  
Vested
    (16,034 )   $ 14.73  
Non-vested Restricted Stock at April 30, 2011
    444,255     $ 12.46  

The aggregate pre-tax intrinsic value of restricted stock outstanding as of April 30, 2011 is $5.9 million with a weighted average remaining contractual life of 4.4 years.  The unrecognized compensation expense net of estimated forfeitures, related to the outstanding stock is approximately $2.8 million, which is expected to be recognized over a weighted average period of approximately 6.0 years.  The total fair value of restricted stock awards that vested during the thirteen weeks ended April 30, 2011 was $233.8 thousand.

NOTE 4:  PROPERTY AND EQUIPMENT

Property and Equipment are carried at cost.  Depreciation is recorded using the straight-line method over the estimated useful lives of the assets.  Improvements to leased premises are amortized using the straight-line method over the shorter of the initial term of the lease or the useful life of the improvement.  Leasehold improvements added late in the lease term are amortized over the shorter of the remaining term of the lease (including the upcoming renewal option, if the renewal is reasonably assured) or the useful life of the improvement.  Assets under capital leases are amortized in accordance with the Company’s normal depreciation policy for owned assets or over the lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the consolidated financial statements.  Gains or losses on the sale of assets are recorded as a component of operating income.

The following illustrates the breakdown of the major categories within Property and Equipment:

 
9

 

   
April 30, 2011
   
January 29, 2011
 
Property and equipment, at cost:
           
             
Buildings and building improvements
  $ 107,890     $ 96,923  
Leasehold improvements
    64,446       62,504  
Automobiles and vehicles
    5,218       5,198  
Airplane
    4,697       4,697  
Furniture, fixtures and equipment
    238,421       234,710  
      420,672       404,032  
Less: Accumulated depreciation and amortization
    (276,925 )     (271,129 )
      143,747       132,903  
Construction in progress
    473       198  
Land
    7,714       6,830  
Total Property and equipment, at depreciated cost
  $ 151,934     $ 139,931  

NOTE 5:  EXIT AND DISPOSAL ACTIVITIES

Lease Termination

A lease obligation still exists for some store closures that occurred in 2008.  We record the estimated future liability associated with the rental obligation on the cease use date (when the stores were closed).  The lease obligations are established at the cease use date for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by FASB ASC 420, “Exit or Disposal Cost Obligations”. Key assumptions in calculating the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimates of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.

During the first quarter of fiscal 2011, we utilized $0.1 million of the remaining lease liability for 2008 store closures, leaving $0.6 million in the reserve at April 30, 2011.

The following table illustrates the exit and disposal activity related to the store closures discussed in the previous paragraph (in millions):
 
   
Balance at
January 29, 2011
   
Additions
   
Utilization
   
Ending Balance
April 30, 2011
 
                         
Lease contract termination liability
  $ 0.7     $ -     $ 0.1     $ 0.6  

NOTE 6:  ACCUMULATED OTHER COMPREHENSIVE INCOME

Comprehensive income consists of two components, net income and other comprehensive income (loss).  Other comprehensive income (loss) refers to gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income.  The Company’s accumulated other comprehensive income includes the unrecognized prior service costs, transition obligations and actuarial gains/losses associated with our postretirement benefit plan.

The following table illustrates the activity in accumulated other comprehensive income:
 
   
Thirteen Weeks Ended
   
Year Ended
 
(in thousands)
 
April 30, 2011
   
May 1, 2010
   
January 29, 2011
 
                   
Accumulated other comprehensive income
  $ 872     $ 904     $ 872  
Amortization of postretirement benefit
    -       -       -  
Ending balance
  $ 872     $ 904     $ 872  

 
10

 

NOTE 7: RELATED PARTY TRANSACTIONS

Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, a director of the Company, owned the land and buildings occupied by twelve Fred’s stores, until March 2011 when, as described below, a portion of these properties were purchased by the Company.  The terms and conditions regarding the leases on these locations were consistent in all material respects with other stores leases of the Company with unrelated landlords.

In February 2011, Atlantic Retail Investors, LLC, purchased the land and building occupied by one of Fred’s stores, bringing the total related party leases to thirteen. The store was purchased by Atlantic Retail Investors, LLC, from an independent landlord/developer.  On March 30, 2011, Fred’s purchased ten of the thirteen properties leased from Atlantic Retail Investors, LLC, one of which has an additional parcel that is leased to an unrelated party, for $7.5 million in cash and assumed mortgage debt of $3.5 million. The Board of Directors approved these transactions based on an evaluation by an independent real estate broker, who concluded that all were acquired at less than market value and were financially beneficial to Fred’s as the depreciation expense for the newly acquired assets will be less than the future value of the lease payments that would have been due. 

The total rental payments related to these leases were $153.0 thousand and $332.8 thousand for the thirteen weeks ended April 30, 2011 and May 1, 2010, respectively.

In May 2011, subsequent to the end of the first quarter fiscal 2011, Atlantic Retail Investors, LLC, purchased land and buildings occupied by four Fred’s stores, bringing the number of locations leased from Atlantic Retail Investors, LLC to seven. Stores were purchased by Atlantic Retail Investors, LLC, from an independent landlord/developer. The terms and conditions regarding the leases on these locations are consistent in all material respects with the Company’s other store leases of the Company. The total rental payments related to these leases will be $77.2 thousand quarterly.

 
11

 

Item 2:
Management's Discussion and Analysis of Financial
Condition and Results of Operations

GENERAL
 
Executive Overview

In the first quarter of 2011, we continued the implementation of our key initiatives to differentiate our stores from other small-box discount retailers.  The Core 5 Program is our long-term strategy designed to highlight key categories within our stores that differentiate us from our competition.  The Core 5 categories - Home, Celebration, Pet, Pharmacy and Paper and Chemical – are strong trip driving departments in which FRED’S has a clear and marketable advantage versus small box competitors.  Additionally, these categories have high household penetration and resonate with customers across multiple demographics.  This initiative is also intended to shift our product mix toward the more discretionary, higher margin categories and away from the lower margin consumable categories, thus driving higher margin and leading to increased operating profit.

The implementation of the Core 5 Program requires a moderate refresh of the store to address space allocation, product placement and adjacencies and signage in the Core 5 categories.  The implementation is also accompanied by an extensive direct mail marketing campaign timed to coincide with the refresh of the store and then continuing for six months thereafter.  During the first quarter of 2011, we implemented the Core 5 Program in 56 remodeled and upgraded stores, bringing the total completed stores to 256 during 2010 and 2011 to date.  We plan to implement the program in approximately 200 stores during fiscal 2011, bringing the total number of stores during the two year period to over 400 stores.

As mentioned, our Pharmacy department is one of our Core 5 categories and is a key differentiating factor from other small-box discount retailers. As such, we have accelerated our growth strategy in this area and are aggressively pursuing opportunities to acquire independent pharmacies within our targeted markets.   Our emphasis will continue to be on acquisitions and file buys, but cold starts will be employed where it makes sense to do so.  During the first quarter, we opened four new pharmacy locations in our chain.

Another key focus in the first quarter of 2011 has been improvement of our store in-stock position.  Recognizing in-stock position as one of the fundamental drivers of our business, we have dedicated significant resources to improving the tools we use to monitor and measure in-stock position in our stores.  As an extension of this initiative, we have made significant improvements to our freight flow processes to ensure that product is in the store and available for our customers.  Improvement in store in-stock position will continue to be a key initiative in FY 2011, and additional enhancements that are currently in development, both in terms of freight flow processes and in-stock measurement, will be deployed later in the year.

Our Own Brand initiative continues to be a key strategy for the Company in terms of building customer loyalty and increasing gross margin.  We exceeded an Own Brand penetration rate of 18.4% of consumable product sales, and expect that number will continue to grow throughout the year as new Own Brand products are introduced.  Our commitment to quality in our Own Brand products is resonating with our customers and they continue to make the switch to our “Fred’s Brand”.  We are continuing to add new products to our Own Brand line on an ongoing basis, with new items in food and health and beauty aids introduced in the first quarter of 2011.

While our private label, or FRED’S Brand products, continues to be a focus in 2011, we also carry several national brands in our stores, such as Coke, Purina, Energizer, Prestone, and Sunbeam.  Our customers identify with these national brands, which provide them with a more complete shopping trip.  Throughout the year, we will be evaluating more name brands that are the most popular with our customers and will be adding those that complement our current product mix.

Gross margin improvement continues to be a key focus of the Company, as highlighted above with our Core 5 and Own Brand strategies.  We are aggressively pursuing product sourcing improvements and cost reductions across all product lines in order to drive overall product costs down and in turn raise our gross margin.  Additionally, we have implemented new processes intended to control both promotional and clearance markdowns.  We also continue to make improvements in our loss prevention processes and procedures to control shrinkage in our stores and consequently increase gross margin.

Over the remainder of 2011, we intend to continue with capital improvements in infrastructure, including new stores as well as existing store expansion and remodels, including the 200 Core 5 Program upgrades, distribution center upgrades and further development of our information technology capabilities.  Technology upgrades will be made in the areas of IT software and hardware, RF gun replacements and pharmacy server upgrades.

 
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As previously reported in the first quarter press release filed May 26, 2011, the Company expects total sales to increase 2% to 4% during the second quarter.  Comparable store sales are expected to increase 1% to 2% versus an increase of 2.5% in the second quarter last year.  Earnings per diluted share are forecasted to increase 8% to 23% to a range of $0.14 to $0.16 for the second quarter compared with $0.13 per diluted share in the same period last year.  Based on this outlook, the Company continues to expect total earnings per diluted share for 2011 to be in the range of $0.84 to $0.90, representing an increase of 12% to 20% over last year.

Key factors that will be critical to the Company’s future success include the successful roll-out of our Core 5 program, as well as managing the strategy for opening new stores and pharmacies, including the ability to open and operate efficiently, maintaining high standards of customer service, maximizing efficiencies in the supply chain, controlling working capital needs through improved inventory turnover, controlling the effects of inflation or deflation, controlling product mix, increasing operating margin through improved gross margin and leveraging operating costs, and generating adequate cash flow to fund the Company’s future needs.

Other factors that will affect Company performance in 2011 include the continuing management of the impacts of the changing regulatory environment in which our pharmacy department operates.  Additionally, we believe that the protracted elevation in commodity and fuel prices, as well as the unemployment rate continues to place tremendous economic pressure on the consumer.  However, we also continue to believe that our affordable pricing and value proposition make us an attractive destination to wary consumers.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The Company’s discussion and analysis of its financial condition and results of operations are based upon the Company’s condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The critical accounting matters that are particularly important to the portrayal of the Company’s financial condition and results of operations, and require some of management’s most difficult, subjective and complex judgments, are described in detail in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011. The preparation of condensed financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to inventories, income taxes, insurance reserves, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

RESULTS OF OPERATIONS

Thirteen Weeks Ended April 30, 2011 and May 1, 2010

Sales
Net sales for the first quarter of 2011 increased to $484.4 million from $471.6 million in 2010, a year-over-year increase of $12.8 million or 2.7%.  On a comparable store basis, sales increased 1.0% ($5.7 million) compared with a 2.2% ($9.9 million) increase in the same period last year.

The Company’s 2011 general merchandise (non-pharmacy) sales increased 3.0% over 2010.  We experienced sales increases in categories such as health and beauty, tobacco, lawn and garden, pet and beverage.

The Company’s pharmacy department sales were 33.6% of total sales ($163.4 million) in 2011 compared to 33.8% of total sales ($159.2 million) in the prior year and continue to rank as the largest department within the Company. The total sales in this department increased 2.6% over 2010 with third party prescription sales representing approximately 91% of total pharmacy sales, the same as in the prior year. The Company’s pharmacy department continues to benefit from an ongoing program of purchasing prescription files from independent pharmacies as well as the addition of pharmacy departments in existing store locations

During the first quarter, one franchised location closed leaving 23 franchised locations as of April 30, 2011.  Sales to these 23 franchised locations during 2011 decreased to $9.4 million (1.9% of sales) from $9.8 million (2.1% of sales) in 2010.  The Company does not intend to expand its franchise network.

 
13

 

The following table illustrates the sales mix unadjusted for deferred layaway sales:

   
Thirteen Weeks Ended
 
   
April 30, 2011
   
May 1, 2010
 
Pharmaceuticals
    33.6 %     33.8 %
Household Goods
    24.6 %     24.1 %
Food and Tobacco
    16.5 %     16.3 %
Paper and Cleaning Supplies
    8.5 %     8.6 %
Apparel and Linens
    7.5 %     7.9 %
Health and Beauty Aids
    7.4 %     7.2 %
Franchise
    1.9 %     2.1 %
      100.0 %     100.0 %

For the quarter, comparable store customer traffic increased .5% over last year while the average customer ticket increased .5% to $20.44.

Gross Profit
Gross profit for the quarter increased to $137.9 million in 2011 from $136.9 million in 2010, a year-over-year increase of $1.0 million or 0.7%.  Gross margin, measured as a percentage of sales, decreased to 28.5% in 2011 from 29.0% in 2010.   The deleveraging in gross margin for the quarter resulted primarily from lower pharmacy department reimbursement rates, higher LIFO impact on cost of goods sold, and fuel price increases on inbound freight.

Selling, General and Administrative Expenses
Selling, general and administrative expenses, including depreciation and amortization, decreased to $122.8 million in 2011 (25.4% of sales) from $123.8 million in 2010 (26.2% of sales).  This 80 basis point expense leveraging was primarily attributable to a reduction in insurance expense ($1.2 million), professional fees ($1.0 million) and advertising expense ($0.7 million).  This leveraging was offset by deleveraging in depreciation expense ($0.8 million) and supplies expense ($0.7 million).

Operating Income
Operating income increased to $15.1 million in 2011 (3.1% of sales) from $13.2 million in 2010 (2.8% of sales).  The $1.9 million increase in operating income is attributable to the $1.0 million increase in gross profit as described in the Gross Profit section above as well as the $1.0 million decrease in selling, general and administrative expenses as detailed in the Selling, General and Administrative Expenses section above.

Interest Expense, Net
Net interest expense for 2011 totaled $.07 million or less than .1% of sales compared to $.05 million which was also less than .1% of sales in 2010.

Income Taxes
The effective income tax rate was 36.8% in 2011 compared to 37.6% in 2010.  The decrease in the effective tax rate was primarily attributable to one year employment tax credits resulting from the New Hire Act.  The year over year benefit was partially offset by reduced federal benefit from Work Opportunity Tax Credits.

Net Income
Net income increased to $9.5 million ($.24 per diluted share) in 2011 from $8.2 million ($.21 per diluted share) in 2010.  The increase in net income is primarily attributable to an increase in gross profit of $1.0 million and a decrease in selling, general and administrative expenses of $1.0 million, which was primarily attributable to a reduction in insurance expense ($1.2 million), professional fees ($1.0 million) and advertising expense ($0.7 million) and partially offset by an increase in depreciation expense ($0.8 million) and supplies expense ($0.7 million).

LIQUIDITY AND CAPITAL RESOURCES

Due to the seasonality of our business and the continued increase in the number of stores and pharmacies, inventories are generally lower at year-end than at each quarter-end of the following year.

 
14

 

Cash provided by operating activities totaled $26.6 million during the thirteen week period ended April 30, 2011 compared to $2.8 million in the same period of the prior year.  We generated operating cash flow primarily through $1.3 million more in quarterly income and $8.3 million from our ongoing initiative to better manage our Accounts Payable processes. We also used $6.3 million less to purchase inventory in the first quarter of 2011 versus the same time last year and had $6.3 million less in trade and non-trade receivables.

Cash used in investing activities totaled $16.7 million, and consisted primarily of expenditures related to existing stores ($12.6 million) of which $7.5 million was related to the acquisition of land and building as described in Note 7: Related Party Transactions, pharmacy acquisitions and new store openings ($1.0 million) and technology and other corporate expenditures ($1.5 million). During the first quarter of 2011, we opened one new store and four pharmacy express locations and closed seven underperforming stores and one pharmacy express location.  We also refreshed 56 stores with the new Core 5 elements, bringing the total refreshed over 2010 and 2011 to 256 locations. In 2011, the Company is planning capital expenditures totaling approximately $29.0 million. Expenditures are planned totaling $22.9 million for new and existing stores and pharmacies. Planned expenditures also include approximately $3.6 million for technology upgrades and approximately $2.5 million for distribution center equipment and other capital maintenance. Technology upgrades in 2011 will be made in the areas of IT software and hardware, RF gun replacements and pharmacy server upgrades. To date, the Company has spent $18.5 million towards these transactions. In addition, the Company planned expenditures of approximately $12.5 million in 2011 for the acquisition of prescription lists and other pharmacy related items.

Cash used by financing activities totaled $2.0 million and included $2.0 million for the payment of cash dividends and $25.0 thousand for the repurchase of shares and $.1 million for the repayment of debt.  There were $7.6 million in borrowings outstanding at April 30, 2011 related to real estate mortgages compared to $4.2 million at January 29, 2011.  The $3.4 million increase in mortgage debt is attributable to the related party acquisition completed on March 30, 2011 as described in the Note 8: Related Party Transactions.

We believe that sufficient capital resources are available in both the short-term and long-term through currently available cash and cash generated from future operations and, if necessary, the ability to obtain additional financing.

FORWARD-LOOKING STATEMENTS

Other than statements based on historical facts, many of the matters discussed in this Form 10-Q relate to events which we expect or anticipate may occur in the future.  Such statements are defined as “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”), 15 U.S.C. Sections 77z-2 and 78u-5.  The Reform Act created a safe harbor to protect companies from securities law liability in connection with forward-looking statements.  We intend to qualify both our written and oral forward-looking statements for protection under the Reform Act and any other similar safe harbor provisions.

The words “believe”, “anticipate”, “project”, “plan”, “expect”, “estimate”, “objective”, “forecast”, “goal”, “intend”, “will likely result”, or “will continue” and similar expressions generally identify forward-looking statements.  All forward-looking statements are inherently uncertain, and concern matters that involve risks and other factors that may cause the actual performance of the Company to differ materially from the performance expressed or implied by these statements.  Therefore, forward-looking statements should be evaluated in the context of these uncertainties and risks, including but not limited to:

 
·
Economic and weather conditions which affect buying patterns of our customers and supply chain efficiency.
 
·
Changes in consumer spending and our ability to anticipate buying patterns and implement appropriate inventory strategies.
 
·
Continued availability of capital and financing.
 
·
Competitive factors.
 
·
Changes in reimbursement practices for pharmaceuticals.
 
·
Governmental regulation.
 
·
Increases in fuel and utility rates.
 
·
Potential adverse results in the litigation described under Legal Proceedings on page 16.
 
·
Other factors affecting business beyond our control, including (but not limited to) those discussed under Part 1, ITEM 1A “Risk Factors” of the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011.

Consequently, all forward-looking statements are qualified by this cautionary statement.  Readers should not place undue reliance on any forward-looking statements.  We undertake no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which it was made.

 
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Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We have no holdings of derivative financial or commodity instruments as of April 30, 2011.  We are exposed to financial market risks, including changes in interest rates.  All borrowings under our Revolving Credit Agreement bear interest at 1.5% below prime rate or a LIBOR-based rate.  An increase in interest rates of 100 basis points would not significantly affect our income.  All of our business is transacted in U.S. dollars and, accordingly, foreign exchange rate fluctuations have not had a significant impact on us, and they are not expected to in the foreseeable future.
 
Item 4.

CONTROLS AND PROCEDURES

(a) Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”)).  Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78 et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms.  Additionally, they concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports that the Company is required to file or submit under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.

(b) Changes in Internal Control over Financial Reporting. There have been no changes during the quarter ended April 30, 2011 in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II.  OTHER INFORMATION
 
Item 1.     Legal Proceedings

In December 2008, a lawsuit entitled Whiteaker, et al v. FRED’S Stores of Tennessee, Inc., et al, was filed in the United States District Court in the Northern District of Mississippi, in which the plaintiffs allege past and future damages as a result of a 2006 trip and fall accident at a Fred’s store. The Company denied liability and vigorously defended the case on its merits. In accordance with FASB ASC 450, “Contingencies”, the Company did not feel that a loss in this matter was probable or could be reasonably estimated.  However, on November 17, 2010, a jury rendered a $1.1 million verdict and apportioned the Company with 81% fault.  The judge then vacated the $1.1 million verdict and ordered a new trial on damages. This case is covered by the Company’s General Liability insurance, which has a $250 thousand deductible. 

In July 2008, a lawsuit styled Jessica Chapman, on behalf of herself and others similarly situated, v. FRED’S Stores of Tennessee, Inc. was filed in the United States District Court for the Northern District of Alabama, Southern Division, in which the plaintiff alleges that she and other female assistant store managers are paid less than comparable males and seeks compensable damages, liquidated damages, attorney fees and court costs.  The plaintiff filed a motion seeking collective action.  Briefs have been filed, but the court has not ruled.  The Company believes that all assistant managers have been properly paid and that the matter is not appropriate for collective action treatment.  Discovery has not yet begun.  The Company is and will continue to vigorously defend this matter.  In accordance with FASB ASC 450, “Contingencies”, the Company does not feel that a loss in this matter is probable or can be reasonably estimated.  Therefore, we have not recorded a liability for this case.

In addition to the matters disclosed above, the Company is party to several pending legal proceedings and claims arising in the normal course of business.  Although the outcome of the proceedings and claims cannot be determined with certainty, management of the Company is of the opinion that it is unlikely that these proceedings and claims will have a material adverse effect on the financial statements as a whole.  However, litigation involves an element of uncertainty.  There can be no assurance that pending lawsuits will not consume the time and energy of our management or that future developments will not cause these actions or claims, individually or in aggregate, to have a material adverse effect on the financial statements as a whole.  We intend to vigorously defend or prosecute each pending lawsuit.

 
16

 

Item 1A.  Risk Factors

The risk factors listed in Part I, “Item 1A. Risk Factors” in the Annual Report on Form 10-K for the fiscal year ended January 29, 2011, should be considered with the information provided elsewhere in this Quarterly Report on Form 10-Q, which could materially adversely affect the business, financial condition or results of operations.  There have been no material changes to the risk factors as previously disclosed in such Annual Report on Form 10-K.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

On August 27, 2007, the Board of Directors approved a plan that authorized stock repurchases of up to 4.0 million shares of the Company’s common stock. Under the plan, the Company may repurchase its common stock in the open market or through privately negotiated transactions at such times and at such prices as determined to be in the Company’s best interest. These repurchases may be commenced or suspended without prior notice depending on then-existing business or market conditions and other factors. The following table sets forth the amounts of our common stock purchased by the Company through April 30, 2011 (amounts in thousands, except price data). The repurchased shares have been cancelled and returned to authorized but unissued shares.
 
   
Total Number of
Shares Purchased
   
Average Price Paid
Per Share
   
Total Number of Shares
Purchased as Part of
Publicly Announced
Plans or Program
   
Maximum Number of
Shares That May Yet Be
Purchased Under the
Plans or Program
 
                         
Balance at January 29, 2011
                      2,537.8  
January 30 - February 26, 2011
    -     $ -       -       2,537.8  
February 27 - April 2, 2011
    2.0     $ 12.50       2.0       2,535.8  
April 3, - April 30, 2011
    -     $ -       -       2,535.8  
 
Item 6.  Exhibits

Exhibits
31.1
Certification of Chief Executive Officer.
31.2
Certification of Chief Financial Officer.
32
Certification of Chief Executive Officer and Chief Financial Officer pursuant to rule 13a–14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
FRED'S, INC.
 
     
Date: June 9, 2011
/s/ Bruce A. Efird
 
 
Bruce A. Efird
 
 
Chief Executive Officer and President
 
     
Date: June 9, 2011
/s/ Jerry A. Shore
 
 
Jerry A. Shore
 
 
Executive Vice President and
 
 
Chief Financial Officer
 

 
17