Item 1: Business
General
Fred's, founded in 1947, operates 488 discount general merchandise stores in fourteen states primarily in the southeastern United States. Fred's stores generally serve low, middle and fixed income families located in small- to medium- sized towns (approximately 65% of Fred's stores are in markets with populations of 15,000 or fewer people). Two hundred and forty-one of the Company's stores have full service pharmacies. The Company also markets goods and services to 26 franchised "Fred's" stores.
Fred's stores stock over 12,000 frequently purchased items which address the everyday needs of its customers, including nationally recognized brand name products, proprietary "Fred's" label products and lower priced off-brand products. Fred's management believes its customers shop Fred's stores as a result of their convenient locations and sizes, everyday low prices on key products and regularly advertised departmental promotions and seasonal specials. Fred's stores have average selling space of 15,112 square feet and had average sales of $3,008,430 in fiscal 2003. No single store accounted for more than 1.0% of net sales during fiscal 2003.
Business Strategy
The Company's strategy is to meet the general merchandise and pharmacy needs of the small- to medium- sized towns it serves by offering a wider variety of quality merchandise and a more attractive price-to-value relationship than either drug stores or smaller variety/dollar stores and a
shopper-friendly format which is more convenient than larger sized discount merchandise stores. The major elements of this strategy include:
Wide variety of frequently purchased, basic merchandise -Fred's combines everyday basic merchandise with certain specialty items to offer its customers a wide selection of general merchandise. The selection of merchandise is supplemented by seasonal specials, private label products, and the inclusion of pharmacies in 241 of its stores.
Discount prices - The Company provides value and low prices to its customers (i.e., a good "price-to-value relationship") through a coordinated discount strategy and an Everyday Low Pricing program that focuses on strong values daily, while minimizing the Company's reliance on promotional activities. As part of this strategy, Fred's maintains low opening price points and competitive prices on key products across all departments, and regularly offers seasonal specials and departmental promotions supported by direct mail, television, radio and newspaper advertising.
Convenient shopper-friendly environment - Fred's stores are typically located in convenient shopping and/or residential areas. Approximately 33% of the Company's stores are freestanding as opposed to being located in strip shopping center sites. Freestanding sites allow for easier access and shorter distances to the store entrance. Fred's stores are of a manageable size and have an understandable store layout, wide aisles and fast checkouts.
Expansion Strategy
The Company expects that expansion will occur primarily within its present geographic area and will be focused in small-to medium- sized towns. The Company may also enter larger metropolitan and urban markets where it already has a market presence in the surrounding area.
Fred's opened 79 stores in 2003 and closed 5 stores,and anticipates a net increase of 80 to 100 new stores in 2004. The Company's new store prototype has 16,000 square feet of space. Opening a new store currently costs between $350,000 and $475,000 for inventory, furniture, fixtures, equipment and leasehold improvements. The Company has 20 stand-alone "Xpress" locations which sell only pharmaceuticals and other health and beauty related items. These locations range in size from 1,000 to 8,000 square feet, and enable the Company to enter a new market with an initial investment of under $400,000. During 2003, the Company opened 4 Xpress locations. During 2004, the Company anticipates opening 5 to 10 new Xpress locations. It is the Company's intent to expand these locations into a full size Fred's location as market conditions permit.
The Company believes that its pharmaceuticals business will continue to be a significant growth area. In 2003, the Company added 27 new pharmacies and closed 2 pharmacies. During 2004, the Company anticipates
adding at least 35 additional pharmacies. Approximately 52% of Fred's stores contain a pharmacy and sell prescription drugs. The Company's primary mechanism for obtaining customers for new pharmacies is through the acquisition of prescription files from independent pharmacies. These acquisitions provide an immediate sales benefit, and in many cases, the independent pharmacist will move to Fred's, thereby providing continuity in the pharmacist-patient relationship.
The following tables set forth certain information with respect to stores and pharmacies for each of the last five years:
Merchandising and Marketing
The business in which the Company is engaged is highly competitive. The principal competitive factors include location of stores, price and quality of merchandise, in-stock consistency, merchandise assortment and presentation, and customer service. The Company competes for sales and store locations in varying degrees with national, regional and local retailing establishments, including department stores, discount stores, variety stores, dollar stores, discount clothing stores, drug stores, grocery stores, outlet stores, warehouse stores and other stores. Many of the largest retail merchandising companies in the nation have stores in areas in which the Company operates.
Management believes that Fred's has a distinctive niche in that it offers a wider variety of merchandise at a more attractive price-to-value relationship than either a drug store or smaller variety/dollar store and is more shopper-convenient than a larger discount store. The variety and depth of merchandise offered at Fred's stores in high traffic departments, such as health and beauty aids and paper and cleaning supplies, are comparable to those of larger discount retailers. Management believes that its knowledge of regional and local consumer preferences, developed in over fifty-five years of operation by the Company and its predecessors, enables
the Company to compete effectively in its region. Purchasing The Company's primary buying activities (other than prescription drug buying) are directed from the corporate office by the General Merchandise Manager through 3 Vice Presidents-Merchandising who are supported by a staff of 20 buyers and assistants. The buyers and assistants are participants in an incentive compensation program, which is based upon various factors primarily relating to gross margin returns on inventory controlled by each individual buyer. The Company purchases its merchandise from a wide variety of suppliers. Approximately 11% of the Company's purchases in 2003 were made from Procter and Gamble. Excluding the purchases made from our pharmaceutical supplier, no other supplier accounted for more than 3% of the Company's purchases in 2003. The Company believes that adequate alternative sources of products are available for these categories of merchandise.
During 2003, all of the Company's prescription drugs were purchased by its pharmacies individually and shipped direct from the Company's primary pharmaceutical wholesaler AmerisourceBergen Corporation ("Bergen"). Bergen provides substantially all of the Company's prescription drugs. During 2003, approximately 34% of the Company's total purchases were made from Bergen. Although there are alternative wholesalers that supply pharmaceutical products, the Company operates under a purchase and supply contract with one supplier as its primary wholesaler. Accordingly, the unplanned loss of this particular supplier could have a short-term gross margin impact on the Company's business until an alternative wholesaler arrangement could be implemented.
Sales Mix
Sales of merchandise through Company owned stores and to franchised Fred's locations are the only significant industry segment of which the Company is a part.
The Company's sales mix by major category for the preceding three years was as follows:
The sales mix varies from store to store depending upon local consumer preferences and whether the stores include pharmacies and/or a full-line of apparel. In 2003 the average customer transaction size was approximately
$17.78, and the number of customer transactions totaled approximately 73 million.
The private label program includes household cleaning supplies, health and beauty aids, disposable diapers, pet foods, paper products and a variety of beverage and other products. Private label products sold constituted approximately 3% of total sales in 2003. Private label products afford the Company higher than average gross margins while providing the customer with lower priced products that are of a quality comparable to that of competing branded products. An independent laboratory-testing program is used for substantially all of the Company's private label products.
The Company sells merchandise to its 26 franchised "Fred's" stores. These sales during the last three years totaled $34,780,000 in 2003, $35,261,000 in 2002, and $33,452,000 in 2001. Franchise and other fees earned totaled $1,964,000 in 2003, $2,016,000 in 2002, and $1,764,000 in 2001. These fees represent a reimbursement for use of the Fred's name and administrative costs incurred on behalf of the franchised stores. The Company does not intend to expand its franchise network, and therefore, expects that this category will continue to decrease as a percentage of the Company's total revenues.
Advertising and Promotions
Advertising and promotion costs represented 1.3% of net sales in 2003. The Company uses direct mail, television, radio and thirteen major newspaper-advertising circulars to promote its merchandise, special promotional events and a discount retail image.
The Company's buyers have discretion to mark down slow moving items. The Company runs regular clearances of seasonal merchandise and conducts sales and promotions of particular items. The Company also encourages its store managers to create in-store advertising displays and signage in order to increase customer traffic and impulse purchases. There is certain flexibility by the store managers to tailor the price structure at their particular store to meet competitive conditions within each store's marketing area.
Store Operations
All Fred's stores are open six days a week (Monday through Saturday), and most stores are open seven days a week (other than pharmacy). Store hours are generally from 9:00 a.m. to 9:00 p.m.; however, certain stores are open only until 6:00 p.m. Each Fred's store is managed by a full-time store manager and those stores with a pharmacy employ a full-time pharmacist. The Company's thirty-two district managers supervise the management and operation of Fred's stores.
Fred's operates 241 in-store pharmacies, which offer brand name and generic pharmaceuticals and are staffed by licensed pharmacists. The addition of acquired pharmacies in the Company's stores has resulted in
increased store sales and sales per selling square foot. Management believes that in-store pharmacies increase customer traffic and repeat visits and are an integral part of the store's operation.
The Company has an incentive compensation plan for store managers, pharmacists and district managers based on meeting or exceeding targeted profit percentage contributions. Various factors included in determining profit percentage contribution are gross profits and controllable expenses at the store level. Management believes that this incentive compensation plan, together with the Company's store management training program, are instrumental in maximizing store performance.
Inventory Control and Distribution
Inventory Control
The Company's computerized central management information system (known as "AURORA," which stands for Automation Utilizing Replenishment Ordering and Receiving Accuracy) maintains a daily stock-keeping unit ("SKU") level inventory and current and historical sales information for each store and the distribution center. This system is supported by in-store point-of-sale ("POS") cash registers, which capture SKU and other data at the time of sale for daily transmission to the Company's central data processing center. Data received from the stores is used to automatically replenish frequently purchased merchandise on a weekly basis and to assist the Company's buyers in their decision making process.
Distribution
The Company has an 850,000 square foot centralized distribution center in Memphis, Tennessee and a 600,000 square foot distribution center in Dublin, Georgia (see "Properties" below). Approximately 58% of the merchandise received by Fred's stores in 2003 was shipped through these distribution centers, with the remainder (primarily pharmaceuticals, certain Snack food items, greeting cards, beverages and tobacco products) being shipped directly to the stores by suppliers. For distribution, the Company uses owned and leased trailers and tractors, as well as common carriers.
Seasonality
The Company's business is somewhat seasonal. Generally, the highest volume of sales and net income occurs in the fourth fiscal quarter. In 2003, 2002 and 2001, the fourth quarter generated 29%, 30% and 30% of the Company's total annual revenue and 37%, 39% and 42% of the Company's net income, respectively.
Employees
At January 31, 2004, the Company had approximately 9,035 full-time and part-time employees, comprised of 950 corporate and distribution center employees and 8,085 store employees. The number of employees varies during the year, reaching a peak during the Christmas selling season. In May of 2002, certain of our Memphis distribution center employees voted in an
election conducted by the National Labor Relations Board ("NLRB") to decide whether or not they wished to be represented by the Union of Needletrades, Industrial and Textile Employees (UNITE). We received notice that the NLRB has reviewed the appeal and is certifying UNITE as the collective bargaining representative of those Memphis distribution center employees. The Company has informed the NLRB that it is taking a technical refusal to bargain in order to appeal the matter to the Federal Appeals Court: and at the same time, the Company is meeting with union representatives to see if the issues can be resolved. The Company believes that it continues to have good relations with these and all of its other employees. The Company does not believe union representation in our Memphis distribution center will have a material effect upon the Company's results of operations.
Available Information
Our website address is http://www.fredsinc.com. We make available through this address, without charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports as soon as reasonably practicable after these materials are electronically filed or furnished to the SEC.
Item 2:
Item 2: Properties
As of January 31, 2004, the geographical distribution of the Company's 488 retail store locations in 14 states was as follows:
The Company owns the real estate and the buildings for 60 locations, and owns the buildings at 5 locations which are subject to ground leases. The Company leases the remaining 423 locations from third parties pursuant to leases that provide for monthly rental payments primarily at fixed rates (although a number of leases provide for additional rent based on sales). Store locations range in size from 1,000 square feet to 27,000 square feet.
Three hundred and twenty-eight of the locations are in strip centers or adjacent to a downtown-shopping district, with the remainder being freestanding.
It is anticipated that existing buildings and buildings to be developed by others will be available for lease to satisfy the Company's expansion program in the near term. It is management's intention to enter into leases of relatively moderate length with renewal options, rather than entering into long-term leases. The Company will thus have maximum relocation flexibility in the future, since continued availability of existing buildings is anticipated in the Company's market areas.
The Company owns its distribution center and corporate headquarters situated on approximately 60 acres in Memphis, Tennessee. The site contains the distribution center with approximately 850,000 square feet of space, and 250,000 square feet of office and retail space. Presently, the Company utilizes 90,000 square feet of office space and 22,000 square feet of retail space at the site. The retail space is operated as a Fred's store and is used to test new products, merchandising ideas and technology. The Company financed the construction of its 600,000 square foot distribution center in Dublin, Georgia with taxable industrial development revenue bonds issued by the City of Dublin and County of Laurens Development Authority.
Item 3:
Item 3: Legal Proceedings
The Company is party to several pending legal proceedings and claims arising in the normal course of business. Although the outcome of the proceedings and claims cannot be determined with certainty, management of the Company is of the opinion that it is unlikely that these proceedings and claims will have a material adverse effect on the financial statements as a whole. However, litigation involves an element of uncertainty. There can be no assurance that pending lawsuits will not consume the time and energies of our management, or that future developments will not cause these actions or claims, individually or in aggregate, to have a material adverse effect on the financial statements as a whole. We intend to vigorously defend or prosecute each pending lawsuit.
Item 4:
Item 4: Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended January 31, 2004.
PART II
Item 5:
Item 5: Market for the Registrant's Common Equity and Related Stockholder Matters
The Company's common stock is traded on the Nasdaq Stock Market under the symbol "FRED." The following table sets forth the high and low sales prices, together with cash dividends paid per share of the Company's common stock during each quarter in 2003 and 2002. All amounts have been adjusted for a three-for-two stock split on July 1, 2003.
The Company's stock price at the close of the market on April 2, 2004, was $24.90. There were approximately 16,600 shareholders of record of the Company's common stock as of April 2, 2004. The Board of Directors regularly reviews the Company's dividend plans to ensure that they are consistent with the Company's earnings performance, financial condition, need for capital and other relevant factors. The Company has paid cash dividends on its common stock since 1993.
Item 6:
Item 6: Selected Financial Data (dollars in thousands, except per share amounts)
Item 7:
Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations
General
Accounting Periods
The following information contains references to years 2003, 2002, and 2001, which represent fiscal years ending or ended January 31, 2004, February 1, 2003 and February 2, 2002, each of which will be or was a 52-week accounting period. This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto.
Executive Overview
In 2003, the Company continued the strategic direction that it implemented in 2001 to grow its store base by approximately 15% per year and achieve same store sales growth producing strong earnings per share growth. Fred's operates 488 discount general merchandise stores in fourteen states primarily in the southeastern United States. We did not enter into any new states in 2003. The majority of our new store openings were in Alabama, Georgia, Florida, and South Carolina. Additionally, we opened 27 new pharmacies during the year.
The Company opened its second distribution center in Dublin, Georgia in April 2003. This 600,000 square foot center will service up to 350 stores within a 250 to 300 mile radius. At the end of 2003, the Dublin distribution center was providing service to approximately 200 stores.
We expect to continue the same growth strategy in 2004 with the addition of approximately 80 to 100 new stores. The majority of the new stores opening will be in the territory serviced by the Dublin distribution center. We anticipate opening an additional 35 pharmacies in 2004.
During 2003, the Company increased its executive management by announcing promotions of Executive Vice President & General Merchandise Manager, and Executive Vice President of Stores Operations.
We continue to focus our merchandising and store direction on maintaining a competitive differentiation within the $25 shopping trip. Our unique store format and strategy combine the attractive element of a discount dollar store, drug store and mass merchant. Our average customer transaction was approximately $17.78. In comparison, the discount dollar stores average $8
- $9 and chain drugs and mass merchants average in the range of $40 - $80 per transaction. Our stores operate equally well in rural and urban markets. Our everyday low pricing strategy is supplemented by 14 promotional circulars per year. Our product selection is enhanced by a private label program and opportunistic buys.
In 2004, we expect to continue this strategy with an additional emphasis on space and inventory productivity. The Company has implemented improvements in employee training, store POS systems upgrades, allocation system upgrades, and SKU level inventory management. In 2004, we anticipate sales in the range of $1.495 billion to $1.520 billion, up 15% to 17% over fiscal 2003. Comparable store sales increases are expected to be in the range of 4% to 7%.
Subsequent to our announcement of unaudited results for the year ended January 31, 2004, the Company determined that certain adjustments were needed in order to properly present the financial statements as a whole. These adjustments reflect the effect of a minor difference in methodology in determining inventory valuation under the "RIM" inventory method, reimbursement of cost incurred from a vendor in accordance with "EITF 02-16", fiscal versus calendar year timing differences regarding vacation expense accrual, and a cost accrual timing error. The Company does not consider any one of these items alone to be material, but we believe that the adjustments are necessary in aggregate for a proper presentation of our financial statements. The effect of these adjustments was a decrease in diluted earnings per share from $.87 to $.85 for the year ended January 31, 2004.
Critical Accounting Policies
The preparation of Fred's financial statements requires management to make estimates and judgments in the reporting of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. Our estimates are based on historical experience and on other assumptions that we believe are applicable under the circumstances, the results of which form the basis for making judgments about the values of assets and liabilities that are not readily apparent from other sources. While we believe that the historical experience and other factors considered provide a meaningful basis for the accounting policies applied in the consolidated financial statements, the Company cannot guarantee that the estimates and assumptions will be accurate under different conditions and/or assumptions. A summary of our critical accounting policies and related estimates and judgments, can be found in Note 1 and the most critical accounting policies are as follows:
Inventories
Warehouse inventories are stated at the lower of cost or market using the FIFO (first-in, first-out) method. Retail inventories are stated at the lower of cost or market as determined by the retail inventory method. Under the retail inventory method ("RIM"), the valuation of inventories at cost and the resulting gross margin are calculated by applying a calculated cost-to-retail ratio to the retail value of inventories. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventories. Inherent in the RIM calculation are certain significant management judgments and estimates including, among others, initial markups, markdowns, and
shrinkage, which significantly impact the ending inventory valuation at cost as well as resulting gross margin. These significant estimates, coupled with the fact that the RIM is an averaging process, can, under certain circumstances, produce distorted or inaccurate cost figures. Management believes that the Company's RIM provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market. For pharmacy inventories, which are $33,129 and $27,819 at January 31, 2004 and February 1, 2003, respectively, cost was determined using the LIFO (last-in, first-out) method. The current cost of inventories exceeded the LIFO cost by approximately $7,778 at January 31, 2004 and $6,138 at February 1, 2003. The LIFO reserve increased by $1,640, $1,535, and $642, at January 31, 2004, February 1, 2003, and February 2, 2002, respectively.
Property and equipment
Property and equipment are stated at cost, and depreciation is computed using the straight-line method over their estimated useful lives. Leasehold costs and improvements which are included in buildings and improvements are amortized over the lesser of their estimated useful lives or the remaining lease terms. Average useful lives are as follows: buildings and improvements - 8 to 30 years; furniture,fixtures,and equipment - 3 to 10 years. Amortization on equipment under capital leases is computed on a straight-line basis over the terms of the leases. Gains or losses on the sale of assets are recorded at disposal.
Vendor rebates and allowances.
The Company receives vendor rebates for achieving certain purchase or sales volume and receives vendor allowances to fund certain expenses. The Emerging Issues Task Force ("EITF") Issue No. 02-16, "Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor" ("EITF 02-16") is effective for arrangements with vendors initiated on or after January 1, 2003. EITF 02-16 addresses the accounting and income statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor's products or for the promotion of sales of the vendor's products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of specific, identifiable incremental costs. The provisions of this consensus have been applied prospectively. The adoption of EITF 02-16 did not have a material impact on the Company's financial statements as a whole.
For vendor funding arrangements that were entered into prior to December 31, 2002 and have not been modified subsequently, the Company recognizes a reduction to selling, general and administrative expenses or cost of goods sold when earned. If these arrangements are modified in the future, the provisions of EITF 02-16 will apply and the effect may be material to the financial statements as a whole.
Insurance reserves
The Company is largely self-insured for workers compensation, general liability and medical insurance. The Company's liability for self-insurance is determined based on known claims and estimates for incurred but not reported claims. If future claim trends deviate from recent historical patterns, the Company may be required to record additional expense or expense reductions which could be material to the Company's financial statements as a whole.
Results of Operations
The following table provides a comparison of Fred's financial results for the past three years. In this table, categories of income and expense are expressed as a percentage of sales.
Fiscal 2003 Compared to Fiscal 2002
Sales
Net sales increased 18.1% ($199.2 million) in 2003. Approximately $138.6 million of the increase was attributable to a net addition of 74 new stores, upgraded stores, and a net addition of 25 pharmacies during 2003, together with the sales of 62 store locations and 14 pharmacies that were opened or upgraded during 2002 and contributed a full year of sales in 2003. During 2003, the Company closed two pharmacy locations. Comparable store sales, consisting of sales from stores that have been open for more than one year, increased 5.7% in 2003.
The Company's front store (non-pharmacy) sales increased approximately 20.5% over 2002 front store sales. Front store sales growth benefited from the above mentioned store additions and improvements, and solid sales increases in categories such as ladies, ladies accessories, missy, footwear, home furnishings, small appliances, photo supplies, prepaid products, stationery, electronics, and tobacco.
Fred's pharmacy sales were 32.4% of total sales in 2003 from 33.2% of total sales in 2002 and continues to rank as the largest sales category within the Company. The total sales in this department, including the Company's mail order operation, increased 15.0% over 2002, with third party prescription sales representing approximately 85% of total pharmacy sales, the same percentage as the prior year. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing prescription files from independent pharmacies and the addition of pharmacy departments in existing store locations.
Sales to Fred's 26 franchised locations decreased approximately $.5 million in 2003 and represented 2.7% of the Company's total sales, as compared to 3.2% in 2002. It is anticipated that this category of business will continue to decline as a percentage of total Company sales since the Company has not added and does not intend to add any additional franchisees.
Gross Margin
Gross margin as a percentage of sales increased to 28.3% in 2003 compared to 27.6% in 2002. The increase in gross margin is a result of higher initial markup, vendor slotting allowances, and other vendor allowances.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were 24.4% of net sales in 2003 compared with 23.7% of net sales in 2002. The increase for the year was attributed to costs associated with the Company's expansion of store and distribution facilities.
Operating Income
Operating income increased approximately $7.9 million or 18.6% to $50.6 million in 2003 from $42.7 million in 2002. Operating income as a percentage of sales was 3.9% in 2003 the same as in 2002.
Interest Expense, Net
Interest expense for 2003 totaled $.4 million (less than .1% of sales) compared to net interest expense of $.2 million (less than .1% of sales) in 2002. The increase in interest expense were attributed to the Company's expansion program.
Income Taxes
The effective income tax rate decreased to 32.9% in 2003 from 33.6% in 2002, primarily due to realization of income tax credits in the amount of $.8 million related to empowerment zone and renewal communities, vesting of restricted stock previously granted to employees and state income tax planning that allowed utilization of $7.2 million of state operating losses that were previously reserved.
State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total approximately $57.5 million for state income tax purposes and expire at various times during the period 2004 through 2023. If certain substantial changes in the Company's ownership should occur, there would be an annual limitation on the amount of carry-forwards that can be utilized.
Net Income
Net income for 2003 was $33.7 million (or $.85 per diluted share) or approximately 19.5% higher than the $28.2 million (or $.72 per diluted share) reported in 2002.
Fiscal 2002 Compared to Fiscal 2001
Sales
Net sales increased 21.1% ($192.6 million) in 2002. Approximately $95.0 million of the increase was attributable to a net addition of 61 new stores, upgraded stores, and a net addition of 14 pharmacies during 2002, together with the sales of 33 store locations and 7 pharmacies that were opened or upgraded during 2001 and contributed a full year of sales in 2002. During 2002, the Company closed one pharmacy location. Comparable store sales, consisting of sales from stores that have been open for more than one year, increased 11.2% in 2002.
The Company's front store (non-pharmacy) sales during 2002 increased approximately 24.2% over 2001 front store sales. Front store sales growth benefited from the above mentioned store additions and improvements, and solid sales increases in categories such as ladies and plus size apparel, ladies accessories, footwear, bedding and windows, home furnishings, floor coverings, giftware, small appliances, photo supplies, electronics, tobacco and auto.
Fred's pharmacy sales were 33.2% of total sales in 2002 from 34.4% of total sales in 2001 and continues to rank as the largest sales category within the Company. The total sales in this department, including the Company's mail order operation, increased 17.1% over 2001, with third party
prescription sales representing approximately 85% of total pharmacy sales, the same percentage as the prior year. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing prescription files from independent pharmacies and the addition of pharmacy departments in existing store locations.
Sales to Fred's 26 franchised locations increased approximately $1.8 million in 2002 and represented 3.2% of the Company's total sales, as compared to 3.7% in 2001. It is anticipated that this category of business will continue to decline as a percentage of total Company sales since the Company has not added and does not intend to add any additional franchisees.
Gross Margin
Gross margin as a percentage of sales increased to 27.6% in 2002 compared to 27.4% in 2001. The increase in gross margin is a result of product mix in the general merchandise categories and increased margins in the pharmacy department due in part to the shift to more generic medications.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were 23.7% of net sales in 2002 compared with 23.9% of net sales in 2001. Labor expenses as a percent of sales improved in the stores and pharmacies as a result of strong sales coupled with store productivity initiatives. Expenses in the stores and pharmacies improved by .4% as a percent of net sales. Increases offsetting these improvements were in insurance, distribution and transportation expenses. Insurance expense rose in 2002 due to premium increases for insurance coverage, as well as increasing reserves associated with business growth. Distribution and transportation expenses increased as a percent of sales due to the distances required to service newer stores, which opened in the area of the new distribution center in Dublin, Georgia, which opened in 2003.
Operating Income
Operating income increased approximately $10.9 million or 34.4% to $42.7 million in 2002 from $31.8 million in 2001. Operating income as a percentage of sales increased to 3.9% in 2002 from 3.5% in 2001, due to the above-mentioned improvements in gross margins and selling, general and administrative expense control.
Interest Expense, Net
Interest expense for 2002 totaled $.2 million (less than .1% of sales) compared to net interest expense of $1.6 million (.2% of sales) in 2001. The significant reduction results from the funds raised from our public offering in September 2001 and March 2002 coupled with cash flows from operations, effective working capital management throughout the year and controlling capital expenditures.
Income Taxes
The effective income tax rate decreased to 33.6% in 2002 from 34.9% in 2001, primarily due to state income tax planning that allowed utilization of $.8 million of state operating losses that were previously reserved.
As a result of certain changes in methods of accounting for income tax purposes, net operating loss carry forwards increased in certain states during 2002. These state net operating loss carry forwards are available to reduce state income taxes in future years. These carry forwards total
approximately $63.7 million for state income tax purposes and expire at various times during the period 2003 through 2022. If certain substantial changes in the Company's ownership should occur, there would be an annual limitation on the amount of carry forwards that can be utilized.
Net Income
Net income for 2002 was $28.2 million (or $.72 per diluted share) or approximately 43.8% higher than the $19.6 million (or $.54 per diluted share) reported in 2001.
Liquidity and Capital Resources
Fred's primary sources of working capital have traditionally been cash flow from operations and borrowings under its credit facility. In June 2003 the Company raised proceeds of $5.5 million from the offering of 225,000 Company shares. In March 2002 the Company raised proceeds of $3.5 million from the offering of 148,134 Company shares. The Company had working capital of $165.4 million, $138.5 million, and $138.4 million at year-end 2003, 2002 and 2001, respectively. Working capital fluctuates in relation to profitability, seasonal inventory levels, net of trade accounts payable, and the level of store openings and closings. Working capital at year-end 2003 increased by approximately $27.0 million from 2002. The increase was primarily attributed to inventory purchased for new store openings scheduled for the first quarter of 2004. The Company plans to open 22 new stores during the first quarter of 2004.
Net cash flow provided by operating activities totaled $36.2 million in 2003, $43.7 million in 2002, and $26.4 million in 2001.
In fiscal 2003, cash was primarily used to increase inventories by approximately $47.9 million during the fiscal year. This increase is primarily attributable to our adding a net of 74 new stores, upgrading 26 stores and adding a net of 25 new pharmacies, as well as supporting the improved comparable store sales. Accounts payable and accrued liabilities increased by $15.9 million due primarily to higher inventory purchases. Income taxes payable increased by approximately $.9 million and the net deferred income tax liability increased by approximately $6.6 million primarily as a result of first-year depreciation allowance for income tax purposes.
In fiscal 2002, cash was primarily used to increase inventories by approximately $31.4 million during the fiscal year. This increase is primarily attributable to our adding a net of 61 new stores, upgrading 30 stores and adding a net of 14 new pharmacies, as well as supporting the improved comparable store sales. Accounts payable and accrued liabilities increased by $20.0 million due primarily to higher inventory purchases. Income taxes payable decreased by approximately $6.8 million and the net deferred income tax liability increased by approximately $12.3 million primarily as a result of certain changes in method of accounting for income tax purposes. The majority of the adjustment from the accounting method changes is due to a change in method of accounting for inventory in retail stores from the retail inventory method to the cost method.
Capital expenditures in 2003 totaled $48.0 million compared with $50.8 million in 2002 and $17.4 million in 2001. The 2003 capital expenditures included approximately $23.2 million for new stores and pharmacies, $3.4 million for existing stores, $9.0 million related to the completion of the new Georgia distribution center that was completed in April 2003, $2.2 million for the Memphis distribution center and 10.2 million for technology, corporate and other capital expenditures. The 2002 capital expenditures included approximately $23.9 million for the new distribution center constructed in Dublin, Georgia. Expenditures totaling approximately $24.2 million were associated with upgraded, remodeled, or new stores and pharmacies. Approximately $2.7 million in expenditures related to technology upgrades, distribution center equipment, freight equipment, and capital maintenance. The 2001 capital expenditures included approximately $13.5 million of expenditures associated with upgraded, remodeled, or new stores and pharmacies and approximately $3.9 million in expenditures related to technology upgrades, distribution center equipment, freight equipment, and capital maintenance. Cash used for investing activities also includes $.9 million in 2003, $1.8 million in 2002, and $1.0 million in 2001 for the acquisition of customer lists and other pharmacy related items.
In 2004, the Company is planning capital expenditures totaling approximately $41.6 million. Expenditures are planned totaling $31.1 million for the upgrades, remodels, or new stores and pharmacies. Planned expenditures of $6.9 million relate to technology upgrades, distribution center equipment and capital maintenance. The Company also plans expenditures of $3.6 million in 2004 for the acquisition of customer lists and other pharmacy related items.
Cash and cash equivalents were $4.7 million at the end of 2003 compared to $8.2 million at year-end 2002. Short-term investment objectives are to maximize yields while minimizing company risk and maintaining liquidity. Accordingly, limitations are placed on amounts and types of investments.
On July 31, 2003, the Company and a bank entered into the third loan modification agreement (the "Agreement") to modify the April 3, 2000 Revolving Loan and Credit Agreement, as amended. The Agreement provides the Company with an unsecured revolving line of credit commitment of up to $40 million and bears interest at 1.5% below the prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified shareholders' equity (which was $247,677 at January 31, 2004) and net income levels. The Company is required to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the unutilized portion of the revolving line commitment over the term of the Agreement. The term of the Agreement extends to July 31, 2006. There were $5.5 million of borrowings outstanding under the Agreement at January 31, 2004.
On April 23, 1999, the Company and a bank entered into a Loan Agreement (the "Loan Agreement"). The Loan Agreement provided the Company with a four-year unsecured term loan of $2.3 million to finance the replacement of the Company's mainframe computer system. The interest rate for the Loan Agreement was 6.15% per annum and matured on April 15, 2003. There were $141 borrowings outstanding under the Loan Agreement at February 1, 2003.
On March 6, 2002, the Company filed a Registration Statement on Form S-3 registering 750,000 shares of Class A common stock. The common stock may be used from time to time as consideration in the acquisition of assets,
goods, or services for use or sale in the conduct of our business. On March 22, 2002, the Company raised proceeds of $3.5 million from the offering of 148,134 shares. On June 6, 2003, the Company raised proceeds of $5.5 million from the offering of 225,000 shares. On September 3, 2003, the Company sold 75,000 shares in common stock for $2.6 million with the intention of purchasing an airplane. Later, the Company decided not to purchase the airplane, whereupon the Company purchased and retired $2.6 million of common stock of the CEO. A Limited Liability Company (LLC) of which the CEO is the sole member purchased the airplane for $4.7 million. The Company entered into a dry lease agreement with the LLC for its usage at the annualized rate of 2.5%. On December 30, 2003, the Company purchased the LLC for $4.7 million. As of January 31, 2004, the Company has 301,866 shares of Class A common stock available to be issued from the March 6, 2002 Registration Statement.
The Company believes that sufficient capital resources are available in both the short-term and long-term through currently available cash, cash generated from future operations and, if necessary, the ability to obtain additional financing.
Off-Balance Sheet Arrangements
The Company has no off-balance sheet financing arrangements.
Effects of Inflation and Changing Prices. The Company believes that inflation and/or deflation had a minimal impact on its overall operations during fiscal years 2003, 2002 and 2001.
Contractual Obligations and Commercial Commitments
As discussed in Note 6 of the consolidated financial statements, the Company leases certain of its store locations under noncancelable operating leases expiring at various dates through 2029. Many of these leases contain renewal options and require the Company to pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased properties. In addition, the Company leases various equipment under noncancelable operating leases and certain transportation equipment under capital leases.
The following table summarizes the Company's significant contractual obligations as of January 31, 2004, which excludes the effect of imputed interest:
As discussed in Note 10 of the consolidated financial statements, the Company had commitments approximating $11.1 million at January 31, 2004 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding letters of credit aggregating $8.5 million at January 31, 2004 utilized as collateral for their risk management programs.
The Company financed the construction of its Dublin, Georgia distribution center with taxable industrial development revenue bonds issued by the City of Dublin and County of Laurens development authority. The Company purchased 100% of the bonds and intends to hold them to maturity, effectively financing the construction with internal cash flow. Because a legal right of offset exists, the Company has offset the investment in the bonds ($33,234) against the related liability and neither is reflected in the consolidated balance sheet.
Recent Accounting Pronouncements
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds both SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt," and the amendment to SFAS No. 4, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." Generally, under SFAS No. 145, gains and losses from debt extinguishments will no longer be classified as extraordinary items. The Company adopted the provisions of SFAS No. 145 on February 2, 2003 and the adoption of SFAS No. 145 did not have a material effect on the Company's financial statements as a whole.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF 94-3 had recognized the liability at the commitment date to an exit plan. The Company was required to adopt the provisions of SFAS No. 146 effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material impact on the Company's financial statements as a whole.
FASB Interpretation No. 46, "Accounting for Variable Interest Entities" ("FIN 46"), expands upon current guidance relating to when a company should include in its financial statements the assets, liabilities and activities of a variable interest entity. The consolidation requirements of FIN 46 apply immediately to variable interest entities ("VIE") created after January 31, 2003. In October 2003, the FASB deferred the effective date of Fin 46, and the consolidation requirements for "older" VIEs to the first fiscal year or interim period after March 15, 2004. Additional modifications to FIN 46 may be proposed by the FASB, and the Company will continue to monitor future developments related to this interpretation. The Company does not believe that the adoption of FIN 46 in 2004 will have a material effect on the Company's financial statements as a whole.
Item 7a:
Item 7a: Quantitative and Qualitative Disclosure about Market Risk
The Company has no holdings of derivative financial or commodity instruments as of January 31, 2004. The Company is exposed to financial market risks, including changes in interest rates. All borrowings under the Company's Revolving Credit Agreement bear interest at 1.5% below prime rate or a LIBOR-based rate. An increase in interest rates of 100 basis points would not significantly affect the Company's income. All of the Company's business is transacted in U.S. dollars and, accordingly, foreign exchange rate fluctuations have never had a significant impact on the Company, and they are not expected to in the foreseeable future.
Item 8:
Item 8: Financial Statements and Supplementary Data Report of Independent Auditors
To the Board of Directors and Shareholders of Fred's, Inc., Memphis, Tennessee
We have audited the accompanying consolidated balance sheets of Fred's, Inc. and subsidiaries as of January 31, 2004 and February 1, 2003, and the related consolidated statements of income, shareholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. The consolidated financial statements of Fred's, Inc. and subsidiaries for the year ended February 2, 2002, were audited by other auditors whose report dated March 15, 2002, expressed an unqualified opinion on those statements.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Fred's, Inc. and subsidiaries at January 31, 2004 and February 1, 2003, and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Memphis, Tennessee April 5, 2004
Fred's, Inc. Consolidated Balance Sheets --------------------------- (in thousands, except for number of shares) - --------------------------------------------------------------------------------
Fred's, Inc. Consolidated Statements of Income (in thousands, except per share amounts) - --------------------------------------------------------------------------------
Fred's, Inc. Consolidated Statements of Changes in Shareholders' Equity (in thousands, except share data) - --------------------------------------------------------------------------------
Fred's, Inc. Consolidated Statements of Cash Flows (in thousands, except share data) - --------------------------------------------------------------------------------
NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business. The primary business of Fred's, Inc. and subsidiaries (the "Company") is the sale of general merchandise through its 488 retail discount stores located in fourteen states mainly in the Southeastern United States. Two hundred and forty-one of the Company's stores have full service pharmacies. In addition, the Company sells general merchandise to its 26 franchisees.
Consolidated financial statements. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions are eliminated.
Fiscal year. The Company utilizes a 52 - 53 week accounting period which ends on the Saturday closest to January 31. Fiscal years 2003, 2002, and 2001, as used herein, refer to the years ended January 31, 2004, February 1, 2003, and February 2, 2002, respectively.
Use of estimates. The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates and such differences could be material to the financial statements.
Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments which are subject to market fluctuations and having original maturities of three months or less, are classified as cash equivalents.
Allowance for doubtful accounts. The Company is reimbursed for drugs sold by its pharmacies by many different payors including insurance companies, Medicare and various state Medicaid programs. The Company estimates the allowance on a payor-specific basis, given its interpretation of the contract terms or applicable regulations. However, the reimbursement rates are often subject to interpretations that could result in payments that differ from the Company's estimates. Additionally, updated regulations and contract negotiations occur frequently, necessitating the Company's continual review and assessment of the estimation process.
Inventories. Warehouse inventories are stated at the lower of cost or market using the FIFO (first-in, first-out) method. Retail inventories are stated at the lower of cost or market as determined by the retail inventory method ("RIM"). Under RIM, the valuation of inventories at cost and the resulting gross margin are calculated by applying a calculated cost-to-retail ratio to the retail value of inventories. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventories. Inherent in the RIM calculation are certain significant management judgments and estimates including, among others, initial markups, markdowns, and shrinkage, which significantly impact the ending inventory valuation at cost as well as resulting gross margin. These significant estimates, coupled with the fact that the RIM is an averaging process, can, under certain circumstances, produce distorted or inaccurate cost figures. Management believes that the Company's RIM provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market. For pharmacy inventories, which are $33,129 and $27,819 at January 31, 2004 and February 1, 2003, respectively, cost was determined using the LIFO (last-in, first-out) method. The current cost of inventories exceeded the LIFO cost by $7,778 at January 31, 2004 and $6,138 at February 1, 2003. The LIFO reserve increased by $1,640, $1,535, and $642, during 2003, 2002, and 2001, respectively.
Property and equipment. Property and equipment are stated at cost, and depreciation is computed using the straight-line method over their estimated useful lives. Leasehold costs and improvements which are included in buildings and improvements are amortized over the lesser of their estimated useful lives or the remaining lease terms. Average useful lives are as follows: buildings and improvements - 8 to 30 years; furniture, fixtures and equipment - 3 to 10 years. Amortization on equipment under capital leases is computed on a straight-line basis over the terms of the leases. Gains or losses on the sale of assets are recorded at disposal.
Impairment of Long-lived assets. The Company's policy is to review the carrying value of all long-lived assets annually and whenever events or changes indicate that the carrying amount of an asset may not be recoverable. The Company adjusts the net book value of the underlying assets if the sum of expected future cash flows is less than the book value. Assets to be disposed of are adjusted to the fair value less the cost to sell if less than the book value. Based upon the Company's review as of January 31, 2004 and February 1, 2003, no material adjustments to the carrying value of such assets were necessary.
Vendor rebates and allowances. The Company receives vendor rebates for achieving certain purchase or sales volume and receives vendor allowances to fund certain expenses. The Emerging Issues Task Force ("EITF") Issue No. 02-16, "Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor" ("EITF 02-16") is effective for arrangements with vendors initiated on or after January 1, 2003. EITF 02-16 addresses the accounting and income statement classification for consideration given by a vendor to a retailer in connection with the sale of the vendor's products or for the promotion of sales of the vendor's products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying the consideration for treatment as reimbursement of specific, identifiable incremental costs. The provisions of this consensus have been applied prospectively. The adoption of EITF 02-16 did not have a material impact on the Company's financial statements as a whole.
For vendor funding arrangements that were entered into prior to December 31, 2002 and have not been modified subsequently, the Company recognizes a reduction to selling, general and administrative expenses or cost of goods sold when earned. If these arrangements are modified in the future, the provisions of EITF 02-16 will apply and the effect may be material to the financial statements as a whole.
Selling, general and administrative expenses. The Company includes buying, warehousing, distribution, depreciation and occupancy costs in selling, general and administrative expenses.
Advertising. The Company charges advertising, including production costs, to expense on the first day of the advertising period. Advertising expense for 2003, 2002, and 2001 was $16,956, $14,124, and $12,079, respectively.
Preopening costs. The Company charges to expense the preopening costs of new stores as incurred. These costs are primarily labor to stock the store, preopening advertising, store supplies and other expendable items.
Revenue Recognition. The Company markets goods and services through Company owned stores and 26 franchised stores. Net sales includes sales of merchandise from Company owned stores, net of returns and exclusive of sales taxes. Sales to franchised stores are recorded when the merchandise is shipped from the Company's warehouse. Revenues resulting from layaway sales are recorded upon delivery of the merchandise to the customer. In addition, the Company charges
the franchised stores a fee based on a percentage of their purchases from the Company. These fees represent a reimbursement for use of the Fred's name and other administrative costs incurred on behalf of the franchised stores and are therefore netted against selling, general and administrative expenses. Total franchise income for 2003, 2002, and 2001 was $1,964, $2,016, and $1,764, respectively.
Other intangible assets. Other identifiable intangible assets, which are included in other noncurrent assets, primarily represent amounts associated with acquired pharmacies and are being amortized on a straight-line basis over five years. During 2002 and 2001 the Company issued 2,949 and 83,970 shares for pharmacy acquisitions, respectively. Intangibles, net of accumulated amortization, totaled $3,913 at January 31, 2004 and $4,661 at February 1, 2003. Accumulated amortization for 2003 and 2002 totaled $8,882 and $7,218, respectively. Amortization expense for 2003, 2002, and 2001, was $1,664, $1,945, and $1,795, respectively. Estimated amortization expense for each of the next 5 years is as follows: 2004 - $1,547, 2005 - $1,192, 2006 - $702, 2007- $381 and 2008 - $91.
Financial instruments. At January 31, 2004, the Company did not have any outstanding derivative instruments. The recorded value of the Company's financial instruments, which include cash and cash equivalents, receivables, accounts payable and indebtedness, approximates fair value. The following methods and assumptions were used to estimate fair value of each class of financial instrument: (1) the carrying amounts of current assets and liabilities approximate fair value because of the short maturity of those instruments and (2) the fair value of the Company's indebtedness is estimated based on the current borrowing rates available to the Company for bank loans with similar terms and average maturities.
Insurance reserves. The Company is largely self-insured for workers compensation, general liability and medical insurance. The Company's liability for self-insurance is determined based on known claims and estimates for future claims cost and incurred but not reported claims. If future claim trends deviate from recent historical patterns, the Company may be required to record additional expense or expense reductions which could be material to the Company's results of operations.
Deferred rent. The Company records rental expense on a straight-line basis over the base, non-cancelable lease term. Any differences between the calculated expense and the amounts actually paid are reflected as a liability in accrued liabilities in the accompanying consolidated balance sheet and totaled approximately $886 and $714 at January 31, 2004 and February 1, 2003, respectively.
Stock-based compensation. The Company grants stock options having a fixed number of shares and an exercise price equal to the fair value of the stock on the date of grant to certain executive officers, directors and key employees. The Company accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), and related interpretations because the Company believes the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB No. 25, compensation expense is generally not recognized for plans in which the exercise price of the stock options equals the market price of the
underlying stock on the date of grant and the number of shares subject to exercise is fixed. Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, net income and earnings per share would have been reduced to the pro forma amounts indicated in the following table.
The Company also periodically awards restricted stock having a fixed number of shares at a purchase price that is set by the Compensation Committee of the Company's Board of Directors, which purchase price may be set at zero, to certain executive officers, directors and key employees. The Company also accounts for restricted stock grants in accordance with APB No. 25 and related interpretations. Under APB No. 25, the Company calculates compensation expense as the difference between the market price of the underlying stock on the date of grant and the purchase price, if any, and recognizes such amount on a straight-line basis over the period in which the restricted stock award is earned by the recipient. The Company recognized compensation expense relating to its restricted stock awards of approximately $28, $54, and $137 in 2003, 2002, and 2001, respectively. (See Note 8 for further disclosure relating to stock incentive plans).
Income taxes. The Company reports income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109, the asset and liability method is used for computing future income tax consequences of events, which have been recognized in the Company's consolidated financial statements or income tax returns. Deferred income tax expense or benefit is the net change during the year in the Company's deferred income tax assets and liabilities.
Business segments. The Company's only reportable operating segment is its sale of merchandise through its Company owned stores and to franchised Fred's locations.
Comprehensive income. Comprehensive income does not differ from the consolidated net income presented in the consolidated statements of income.
Reclassifications. Certain prior year amounts have been reclassified to conform to the 2003 presentation.
Recent Accounting Pronouncements. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds both SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt," and the amendment to SFAS No. 4, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." Generally, under SFAS No. 145, gains and losses from debt extinguishments will no longer be classified as extraordinary items. The Company adopted the provisions of SFAS No. 145 on February 2, 2003 and the adoption of SFAS No. 145 did not have a material effect on the Company's financial statements as a whole.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF 94-3 had recognized the liability at the commitment date to an exit plan. The Company was required to adopt the provisions of SFAS No. 146 effective for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material impact on the Company's financial statements as a whole.
FASB Interpretation No. 46, "Accounting for Variable Interest Entities" ("FIN 46"), expands upon current guidance relating to when a company should include in its financial statements the assets, liabilities and activities of a variable interest entity. The consolidation requirements of FIN 46 apply immediately to variable interest entities ("VIE") created after January 31, 2003. In October 2003, the FASB deferred the effective date of Fin 46, and the consolidation requirements for "older" VIEs to the first fiscal year or interim period ending after March 15, 2004. Additional modifications to FIN 46 may be proposed by the FASB, and the Company will continue to monitor future developments related to this interpretation. The Company does not believe that the adoption of FIN 46 in 2004 will have a material effect on the Company's financial statements as a whole.
NOTE 2 - PROPERTY AND EQUIPMENT
Property and equipment, at cost, consist of the following:
Depreciation expense totaled $23,380, $18,394, and $15,507, for 2003, 2002, and 2001, respectively.
NOTE 3 - ACCRUED LIABILITIES
The components of accrued liabilities are as follows:
NOTE 4 - INDEBTEDNESS
On July 31, 2003, the Company and a bank entered into a new Revolving Loan and Credit Agreement (the "Agreement") to replace the April 3, 2000 Revolving Loan and Credit Agreement, as amended. The Agreement provides the Company with an unsecured revolving line of credit commitment of up to $40 million and bears interest at 1.5% below the prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified shareholders' equity (which was $247,677 at January 31, 2004) and net income levels. The Company is required to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the unutilized portion of the revolving line commitment over the term of the Agreement. The term of the Agreement extends to July 31, 2006. There were $5.5 million of borrowings outstanding under the Agreement at January 31, 2004.
On April 23, 1999, the Company and a bank entered into a Loan Agreement (the "Loan Agreement"). The Loan Agreement provided the Company with a four-year unsecured term loan of $2.3 million to finance the replacement of the Company's mainframe computer system. The interest rate for the Loan Agreement was 6.15% per annum and matured on April 15, 2003. There were $141 borrowings outstanding under the loan Agreement at February 1, 2003.
The Company has other miscellaneous financing obligations totaling $121, which relate primarily to business acquisitions. The Company's indebtedness under miscellaneous financing matures as follows: 2004 - $18; 2005 - $18; 2006 - $19; 2007 - $21; 2008 - $21 and $24 thereafter.
The Company financed the construction of its Dublin, Georgia distribution center with taxable industrial development revenue bonds issued by the City of Dublin and County of Laurens Development Authority. The Company purchased 100% of the issued bonds and intends to hold them to maturity, effectively financing the construction with internal cash flow. Because a legal right of offset exists, the Company has offset the investment in the bonds ($33,234) against the related liability and neither is reflected on the consolidated balance sheet.
NOTE 5 - INCOME TAXES
The provision for income taxes consists of the following:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are presented below:
The net operating loss carryforwards are available to reduce state income taxes in future years. These carryforwards total approximately $57.5 million for state income tax purposes and expire at various times during the period 2004 through 2023.
During 2003, the valuation allowance decreased $120, and during 2002, the valuation allowance decreased $832. Based upon expected future income, management believes that it is more likely than not that the results of operations will generate sufficient taxable income to realize the deferred tax asset after giving consideration to the valuation allowance.
A reconciliation of the statutory federal income tax rate to the effective tax rate is as follows:
NOTE 6 - LONG-TERM LEASES
The Company leases certain of its store locations under noncancelable operating leases that require monthly rental payments primarily at fixed rates (although a number of the leases provide for additional rent based upon sales) expiring at various dates through 2029. Many of these leases contain renewal options and require the Company to pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased properties. In addition, the Company leases various equipment under noncancelable operating leases and certain transportation equipment under capital leases. Total rent expense under operating leases was $34,287, $26,844, and $22,207, for 2003, 2002, and 2001, respectively. Total contingent rentals included in operating leases above was $1,135, $786, and $409, for 2003, 2002, and 2001, respectively. Amortization expense on assets under capital lease for 2003, 2002, and 2001 was $627, $693, and $544, respectively.
Future minimum rental payments under all operating and capital leases as of January 31, 2004 are as follows:
The gross amount of property and equipment under capital leases at January 31, 2004 and February 1, 2003, was $38,201 and $23,452, respectively. Accumulated depreciation on property and equipment under capital leases at January 31, 2004 and February 1, 2003, was $4,428 and $2,551, respectively.
NOTE 7 - SHAREHOLDERS' EQUITY
In 1998, the Company adopted a Shareholders Rights Plan which granted a dividend of one preferred share purchase right (a "Right") for each common share outstanding at that date. Each Right represents the right to purchase one-hundredth of a preferred share of stock at a preset price to be exercised when any one individual, firm, corporation or other entity acquires 15% or more of the Company's common stock. The Rights will become dilutive at the time of exercise and will expire, if unexercised, in October 2008.
On May 24, 2001, the Company announced a five-for-four stock split of its common stock, Class A voting, no par value. The new shares, one additional share for each four shares held by stockholders, were distributed on June 18, 2001 to stockholders of record on June 4, 2001. All share and per share amounts included in the accompanying financial statements have been adjusted to reflect this stock split.
In October 2001, the Company completed a secondary stock offering of 3,566,250 company shares raising net proceeds to the Company of $38.2 million dollars.
On January 15, 2002, the Company announced a three-for-two stock split of its common stock, Class A voting, no par value. The new shares, one additional share for each two shares held by stockholders, were distributed on February 1, 2002 to stockholders of record on January 25, 2002. All share and per share amounts included in the accompanying financial statements have been adjusted to reflect this stock split.
On March 6, 2002, the Company filed a Registration Statement on Form S-3 registering 750,000 shares of Class A common stock. The common stock may be used from time to time as consideration in the acquisition of assets, goods, or services for use or sale in the conduct of our business. On March 22, 2002, the Company raised proceeds of $3.5 million from the offering of 148,134 shares. On June 6, 2003, the Company raised proceeds of $5.5 million from the offering of 225,000 shares. On September 3, 2003, the Company sold 75,000 shares in common stock for $2.6 million with the intention of purchasing an airplane. Later, the Company decided not to purchase the airplane, whereupon the Company purchased and retired $2.6 million of common stock of the CEO. A Limited Liability Company (LLC) of which the CEO is the sole member purchased the airplane for $4.7 million. The Company entered into a dry lease agreement with the LLC for its usage at the annualized rate of 2.5%. On December 30, 2003, the Company purchased the LLC for $4.7 million. As of January 31, 2004, the Company has 301,866 shares of Class A common stock available to be issued from the March 6, 2002 Registration Statement.
On June 5, 2003, the Company announced a three-for-two stock split of its common stock, Class A voting, no par value. The new shares, one additional share for each two shares held by stockholders, were distributed on July 1, 2003 to stockholders of record on June 26, 2003. All share and per share amounts included in the accompanying financial statements have been adjusted to reflect this stock split.
NOTE 8 - EMPLOYEE BENEFIT PLANS
Incentive stock option plan. The Company has a long-term incentive plan under which an aggregate of 3,013,652 shares are available to be granted as of January 31, 2004. These options expire five years to seven and one-half years from the date of grant. Options outstanding at January 31, 2004 expire in 2004 through 2010.
Under the plan, stock option grants are made to key employees including executive officers, as well as other employees, as prescribed by the
Compensation Committee (the "Committee") of the Board of Directors. The number of options granted is directly linked to the employee's job classification. Options, which include non-qualified stock options and incentive stock options, are rights to purchase a specified number of shares of Fred's Common Stock at a price fixed by the Committee. The exercise price for stock options issued under the plan that qualify as incentive stock options within the meaning of Section 422(b) of the Code shall not be less than 100% of the fair value as of the date of grant. The option exercise price may be satisfied in cash or by exchanging shares of Fred's Common Stock owned by the optionee, or a combination of cash and shares. Options have a maximum term of ten years from the date of grant. Options granted under the plan generally become exercisable ten percent during each of the first four years on the anniversary and sixty percent on the fifth anniversary. The plan also contains a provision that if the Company meets or exceeds a specified operating income margin during the most recently completed fiscal year that the annual vesting percentage will accelerate from ten to twenty percent during that vesting period. The plan also provides for annual stock grants at the fair value of the stock on the grant date to non-employee directors according to a non-discretionary formula. The number of shares granted is dependent upon current director compensation levels.
A summary of activity in the plan follows:
The weighted average remaining contractual life of all outstanding options was 3.6 years at January 31, 2004.
The following table summarizes information about stock options outstanding at January 31, 2004:
Pro forma information regarding net income and earnings per share, as disclosed in Note 1, has been determined as if the Company had accounted for its employee stock-based compensation plans under the fair value method of SFAS No. 123. The fair value of options granted during 2003, 2002, and 2001 was $6.68, $6.69 and $4.60, respectively. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:
The Black-Scholes option model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Restricted Stock. During 2003, 2002, and 2001, the Company issued (forfeited/ cancelled) a net of 1,406, 1,125, and (22,778) restricted shares, respectively. Compensation expense related to the shares issued is recognized over the period for which restrictions apply.
Employee stock ownership plan. The Company has a non-contributory employee stock ownership plan for the benefit of qualifying employees who have completed one year of service and attained the age of 18. Benefits are fully vested upon completion of seven years of service. The Company has not made any contributions to the plan since 1996 and the plan owns 376,812 shares of Company stock. All shares are included in shares outstanding for computation of net income per share.
Salary reduction profit sharing plan. The Company has a defined contribution profit sharing plan for the benefit of qualifying employees who have completed one year of service and attained the age of 21. Participants may elect to make contributions to the plan up to a maximum of 15% of their compensation. Company contributions are made at the discretion of the Company's Board of Directors. Participants are 100% vested in their contributions and earnings thereon. Contributions by the Company and earnings thereon are fully vested upon completion of six years of service. The Company's contributions for 2003, 2002, and 2001 were $207, $176, and $117, respectively.
Postretirement benefits. The Company provides certain health care benefits to its full-time employees that retire between the ages of 58 (effective January 1, 2004 this was changed to 62) and 65 with certain specified levels of credited service. Health care coverage options for retirees under the plan are the same as those available to active employees. The Company's change in benefit obligation based upon an actuarial valuation is as follows:
A reconciliation of the Plan's funded status to accrued benefit cost follows:
The medical care cost trend used in determining this obligation is 11.0% effective December 1, 2001, decreasing annually before leveling at 5.0% in 2011. To illustrate the trend rate used, increasing the health care cost trend by 1% would increase the effect on the total of service cost and interest cost by $10
and the accumulated postretirement benefit obligation by $75. By decreasing the health care cost trend by 1% would decrease the effect on the total of service cost and interest cost by $9 and the accumulated postretirement benefit obligation by $66. The discount rate used in calculating the obligation was 6.25% in 2003 and 7.00% in 2002. The net periodic benefit cost decreased in 2003 due to changes in actuarial assumptions regarding turnover, participation in the plan, the medical inflation rate and the rate of contribution by participants.
The annual net postretirement cost is as follows:
The Company's policy is to fund claims as incurred.
NOTE 9 - NET INCOME PER SHARE
Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Restricted stock is considered contingently issuable and is excluded from the computation of basic earnings per share.
A reconciliation of basic earnings per share to diluted earnings per share follows:
Options to purchase shares of common stock that were outstanding at the end of the respective fiscal year were not included in the computation of diluted earnings per share when the options' exercise prices were greater than the
average market price of the common shares. There were no such options outstanding at the end of fiscal 2003 and 2001 and there were 84,938 such options outstanding at February 1, 2003.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Commitments. The Company had commitments approximating $11.1 million at January 31, 2004 and $10.4 million at February 1, 2003 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding letters of credit aggregating approximately $8.5 million at January 31, 2004 and $7.9 million at February 1, 2003 utilized as collateral for its risk management programs.
Litigation. The Company is a party to several pending legal proceedings and claims arising in the normal course of business. Although the outcome of the proceedings and claims cannot be determined with certainty, management of the Company is of the opinion that it is unlikely that these proceedings and claims will have a material adverse effect on the financial statements as a whole. However, litigation involves an element of uncertainty. Future developments could cause these actions or claims to have a material adverse effect on the results of the financial statements as a whole.
Note 11 - Sales Mix
The Company manages its business on the basis of one reportable segment. See Note 1 for a brief description of the Company's business. As of January 31, 2004, all of the Company's operations were located within the United States. The following data is presented in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information."
The Company's sales mix by major category during the last 3 years was as follows:
Note 12 - QUARTERLY FINANCIAL DATA (UNAUDITED)
Item 9:
Item 9: Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
The information required by this item is incorporated herein by reference to Form 8-K dated May 14, 2002, filed on May 14, 2002.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures. The Company, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) promulgated under the Securities and Exchange Act of 1934, as amended (the "Exchange Act")) as of January 31, 2004. Based on that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that, as
of January 31, 2004, the Company's disclosure controls and procedures are effective for the purposes set forth in the definition thereof in Exchange Act Rule 13a-15(e).
(b) Changes in Internal Control Over Financial Reporting. There have been no changes during the quarter ended January 31, 2004 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 III
Item 10:
Item 10: Directors and Executive Officers of the Registrant
The following information is furnished with respect to each of the directors and executive officers of the Company:
Name Age Positions and Offices -------------------------------------------------------- Michael J. Hayes (1) 62 Director, Chairman of the Board, Chief Executive Officer John R. Eisenman (1) 62 Director Roger T. Knox (1) 66 Director John Reier (1) 64 President and Director Thomas H. Tashjian (1) 49 Director John A. Casey 57 Executive Vice President - Pharmacy Operations Jerry A Shore 51 Executive Vice President and Chief Financial Officer Charles A. Brunjes 44 Executive Vice-President - General Merchandise Manager Dennis K Curtis 44 Executive Vice-President - Store Operation Charles S. Vail 61 Corporate Secretary, Vice President - Legal Services and General Counsel
(1) Five directors, constituting the entire Board of Directors, are to be elected at the Annual Meeting to serve one year or until their successors are elected.
Michael J. Hayes was elected a director of the Company in January 1987. Mr. Hayes served as Managing Director of the Company from October 1989 until March 2002 when he was elected Chairman of the Board. He has been Chief Executive Officer since October 1989. He was previously employed by Oppenheimer & Company, Inc. in various capacities from 1976 to 1985, including Managing Director and Executive Vice President - Corporate Finance and Financial Services.
John R. Eisenman is involved in real estate investment and development with REMAX Island Realty, Inc., located in Hilton Head Island, South Carolina. Mr. Eisenman has been engaged in commercial and industrial real estate brokerage and
development since 1983. Previously, he founded and served as President of Sally's, a chain of fast food restaurants from 1976 to 1983, and prior thereto held various management positions in manufacturing and in securities brokerage.
Roger T. Knox is President Emeritus of the Memphis Zoological Society and was its President and Chief Executive Officer from January 1989 thru March 2003. Mr. Knox was the President and Chief Operating Officer of Goldsmith's Department Stores, Inc. (a full-line department store in Memphis and Jackson, Tennessee) from 1983 to 1987 and its Chairman of the Board and Chief Executive Officer from 1987 to 1989. Prior thereto, Mr. Knox was with Foley's Department Stores in Houston, Texas for 20 years. Mr. Knox is also a director of Hancock Fabrics, Inc.
John D. Reier is President and a Director. Mr. Reier joined the Company in May of 1999 as President and was elected a Director of the Company in August 2000. Prior to joining the company, Mr. Reier was President and Chief Executive Officer of Sunny's Great Outdoors Stores, Inc. from 1997 to 1999, and was President, Chief Operating Officer, Senior Vice President of Merchandising, and General Merchandise Manager at Family Dollar Stores, Inc. from 1987 to 1997.
Thomas H. Tashjian was elected a director of the Company in March 2001. Mr. Tashjian is a private investor. Mr. Tashjian has served as a managing director and consumer group leader at Banc of America Montgomery Securities in San Francisco. Prior to that, Mr. Tashjian held similar positions at First Manhattan Company, Seidler Companies, and Prudential Securities. Mr. Tashjian's earlier retail operating experience was in discount retailing at the Ayrway Stores, which were acquired by Target, and in the restaurant business at Noble Roman's.
John A. Casey has served as Executive Vice President - Pharmacy Operations since February 1997. Mr. Casey joined the Company in 1979 and has served in various positions in Pharmacy Operations. Mr. Casey is a registered Pharmacist.
Jerry A. Shore joined the Company in April 2000 as Executive Vice President and Chief Financial Officer. Prior to joining the Company, Mr. Shore was employed by Wang's International, a major importing and wholesale distribution company as Chief Financial Officer from 1989 to 2000, and in various financial management capacities with IPS Corp., and Caterpillar, Inc. from 1975 to 1989.
Charles A. Brunjes was promoted to Executive Vice-President - General Merchandise Manager in July 2003. Mr. Brunjes joined the Company in July 2000 as Senior Vice-President of Store Operations. Prior to joining the Company, Mr. Brunjes was employed by Family Dollar as Vice-President of Store Development.
Dennis K. Curtis was promoted to Executive Vice-President in July 2003. Prior to this position, Mr. Curtis joined the Company in 1980 as a management trainee in store operations. Mr. Curtis was recently held the position of Senior Vice-President - Divisional Merchandising Manager of Hardlines.
Charles S. Vail has served the Company as General Counsel since 1973, as Corporate Secretary since 1975, and as Vice President - Legal since 1984. Mr. Vail joined the Company in 1968.
The remainder of the information required by this item is incorporated herein by reference to the proxy statement for our 2004 annual meeting.
Item 11:
Item 11: Executive Compensation
Information required by this item is incorporated herein by reference to the proxy statement for our 2004 annual meeting.
Item 12:
Item 12: Security Ownership of Certain Beneficial Owners and Management
Information required by this item is incorporated herein by reference to the proxy statement for our 2004 annual meeting.
Item 13:
Item 13: Certain Relationships and Related Transactions
Information required by this item is incorporated herein by reference to the proxy statement for our 2004 annual meeting.
ITEM 14.
ITEM 14. Principal Accountants Fees and Services
Information required by this item is incorporated herein by reference to the proxy statement for our 2004 annual meeting.
PART IV
Item 15:
Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) Consolidated Financial Statements (See Item 8)
Report of Independent Auditors - Ernst & Young LLP.
(a)(2) Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts
(a)(3) Those exhibits required to be filed as Exhibits to this Annual Report on Form 10-K pursuant to Item 601 of Regulation S-K are as follows:
3.1 Certificate of Incorporation, as amended [incorporated herein by reference to Exhibit 3.1 to the registration statement on Form S-8 as filed with the Securities and Exchange Commission ("SEC") on March 18, 2003 (SEC File No. 333-103904) (such registration statement, the "Form S-8")]. 3.2 By-laws, as amended [incorporated herein by reference to Exhibit 3.2 to the Form S-8]. 4.1 Specimen Common Stock Certificate [incorporated herein by reference to Exhibit 4.2 to Pre-Effective Amendment No. 3 to the Registration Statement on Form S-1 (SEC File No. 33-45637) (such Registration Statement, the "Form S-1")]. 4.2 Preferred Share Purchase Plan [incorporated herein by reference to the Company's Report on Form 10-Q for the quarter ended October 31, 1998].
10.1 Form of Fred's, Inc. Franchise Agreement [incorporated herein by reference to Exhibit 10.8 to the Form S-1]. 10.2 401(k) Plan dated as of May 13, 1991 [incorporated herein by reference to Exhibit 10.9 to the Form S-1]. 10.3 Employee Stock Ownership Plan (ESOP) dated as of January 1, 1987 [incorporated herein by reference to Exhibit 10.10 to the Form S-1]. 10.4 Lease Agreement by and between Hogan Motor Leasing, Inc. and Fred's, Inc. dated February 5, 1992 for the lease of truck tractors to Fred's, Inc. and the servicing of those vehicles and other equipment of Fred's, Inc. [incorporated herein by reference to Exhibit 10.15 to Pre-Effective Amendment No. 1 to the Form S-1]. *10.5 1993 Long Term Incentive Plan dated as of January 21, 1993 [incorporated herein by reference to the Company's report on Form 10-Q for the quarter ended July 31, 1993]. ***10.6 Term Loan Agreement between Fred's, Inc. and First American National Bank dated as of April 23, 1999 [incorporated herein by reference to the Company's Report on Form 10-Q for the quarter ended May 1, 1999]. ***10.7 Prime Vendor Agreement between Fred's Stores of Tennessee, Inc. and Bergen Brunswig Drug Company, dated as of November 24, 1999 [incorporated herein by reference to Company's Report on Form 10-Q for the quarter ended October 31, 1999]. ***10.8 Addendum to Leasing Agreement and Form of Schedules 7 through 8 of Schedule A, by and between Hogan Motor Leasing, Inc. and Fred's, Inc dated September 20, 1999 (modifies the Lease Agreement included as Exhibit 10.4) [incorporated herein by reference to the Company's report on Form 10-K for the year ended January 29, 2000]. ***10.9 Revolving Loan Agreement between Fred's, Inc.and Union Planters Bank, NA and Suntrust Bank dated April 3, 2000 [incorporated herein by reference to the Company's report on Form 10-K for year ended January 29, 2000].
***10.10 Loan modification agreement dated May 26, 2000 (modifies the Revolving Loan Agreement included as Exhibit 10.9) [incorporated herein by reference to the Company's report on Form 10-K for the year ended January 29, 2000]. ***10.11 Seasonal Overline Agreement between Fred's, Inc. and Union Planters National Bank dated as of October 11, 2000 [incorporated herein by reference to the Company's Report on Form 10-Q for the quarter ended October 28, 2000]. ***10.12 Second Loan modification agreement dated April 30, 2002 (modifies the Revolving Loan and Credit Agreement included as exhibit 10.9). [incorporated herein by reference to the Company's Report on Form 10-Q for the quarter ended August 3, 2002]. 10.15 Third loan modification agreement dated July 31, 2003 (modified the Revolving Loan and Credit Agreement dated April 3, 2000.) [incorporated herein by reference to the Company's Report on Form 10-Q for the quarter ended August 2, 2003]. **21.1 Subsidiaries of Registrant **23.1 Consent of Ernst & Young LLP **23.2 Consent of PricewaterhouseCoopers LLP **31.1 Certification of Chief Executive Officer pursuant to Exchange Rule 13a-14(a) of the Securities Exchange Act. **31.2 Certification of Chief Financial Officer pursuant to Exchange Rule 13a-14(a) of the Securities Exchange Act. **32. Certification of Chief Financial Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.
(b) Reports on Form 8-K
None.
* Management Compensatory Plan ** Filed herewith *** (SEC File No. under the Securities Exchange Act of 1934 is 00-19288)
Exhibit 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements (Form S-8 Nos. 33-48380, 33-67606, 333-103904, and Form S-3 Nos. 333-68478 and 333-83918) of Fred's, Inc. of our report dated April 5, 2004, with respect to the consolidated financial statements of Fred's, Inc. included in this Annual Report (Form 10-K) for the year ended January 31, 2004.
Our audit also included the financial statement schedule of Fred's, Inc. listed in Item 15(a) as of January 31, 2004 and February 1, 2003. This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audit. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein as of January 31, 2004 and February 1, 2003 and for the years then ended.
/s/ Ernst & Young LLP April 14, 2004 Memphis, Tennessee
Exhibit 23.2
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Registration Statement on Form S-3 (No. 33-68478 and No. 333-83918) and Form S-8 (No. 33-48380, No. 33-67606 and No. 333-103904) of Fred's, Inc. of our report dated March 15, 2002, except for the effects of the 3-for-2 stock split effected on July 1, 2003 as described in Note 7 as to which the date is April 14, 2004, relating to the consolidated statements of income, shareholders' equity and cash flows and financial statement schedule for the year ended February 2, 2002, which appears in this Form 10-K.
/s/ PricewaterhouseCoopers LLP
Memphis, Tennessee April 15, 2004
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 14th day of April, 2004.
FRED'S, INC.
By: /s/ Michael J. Hayes ------------------------------------- Michael J. Hayes, Chief Executive Officer
By: /s/ Jerry A. Shore ------------------------------------- Jerry A. Shore, Executive Vice President and Chief Financial Officer (Principal Accounting and Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on this 14th day of April, 2004.
Signature Title --------- -----
/s/ Michael J. Hayes Director, Chairman of the Board, - -------------------------- Chief Executive Officer Michael J. Hayes
/s/ Roger T. Knox Director - -------------------------- Roger T. Knox
/s/ John R. Eisenman Director - -------------------------- John R. Eisenman
/s/ John D. Reier President and Director - -------------------------- John D. Reier
/s/ Thomas H. Tashjian Director - -------------------------- Thomas H. Tashjian
SIGNATURES ----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, on this 14th day of April, 2004.
FRED'S, INC.
By: /s/ Michael J. Hayes ---------------------------------------- Michael J. Hayes, Chief Executive Officer
By: /s/ Jerry A. Shore ---------------------------------------- Jerry A. Shore, Executive Vice President and Chief Financial Officer (Principal Accounting and Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on this 14th day of April, 2004.
Signature Title --------- -----
/s/ Michael J. Hayes - ---------------------------- Director, Chairman of the Board, Michael J. Hayes Chief Executive Officer
/s/ Roger T. Knox - ---------------------------- Director Roger T. Knox
/s/ John R. Eisenman - ---------------------------- Director John R. Eisenman
/s/ John D. Reier - ---------------------------- President and Director John D. Reier
/s/ Thomas H. Tashjian - ---------------------------- Director Thomas H. Tashjian
Exhibit 31.1
Certification of Chief Executive Officer
I, Michael J. Hayes, certify that:
1. I have reviewed this annual report on Form 10-K of Fred's, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designated under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b) Designated such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls
and procedures, as of the end of the period covered by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors:
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: April 14, 2004 /s/ Michael J. Hayes ------------------------------------- Michael J. Hayes Chief Executive Officer
Exhibit 31.2
Certification of Chief Financial Officer
I, Jerry A. Shore, certify that:
1. I have reviewed this annual report on Form 10-K of Fred's, Inc.
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designated under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b) Designated such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d) Disclosed in this report any changes in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of registrant's board of directors:
a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: April 14, 2004 /s/ Jerry A. Shore ------------------------------------- Jerry A. Shore Executive Vice President and Chief Financial Officer
Exhibit 32
Certification of Chief Executive Officer AND CHIEF FINANCIAL OFFICER Pursuant to Section 18 U.S.C. Section 1350
In connection with this annual report on Form 10-K of Fred's, Inc. each of the undersigned, Michael J. Hayes and Jerry A Shore, certifies, pursuant to Section 18 U.S.C. Section 1350, that:
1. The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
2. The information contained in this report fairly presents, in all material respects, the financial condition and results of operations of Fred's, Inc.
Date: April 14, 2004 /s/ Michael J. Hayes ------------------------------------ Michael J. Hayes Chief Executive Officer
/s/ Jerry A. Shore ------------------------------------ Jerry A Shore Executive Vice President and Chief Financial Officer
Exhibit 21.1
FRED'S, INC.
SUBSIDIARIES OF REGISTRANT
Fred's, Inc. has the following subsidiaries, all of which are 100% owned:
Fred's Stores of Tennessee, Inc. Fred's Capital Management Company, Inc. National Equipment Management and Leasing, Inc. Fred's Capital Finance, Inc. Insurance Value Protection Group, LTD