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FREDS INC - 10-K - : Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) General Accounting Periods
The following information contains references to years 2011, 2010 and 2009,
which represent fiscal years ended January 28, 2012, January 29, 2011 and
January 30, 2010 (which were 52-week accounting periods). This discussion and
analysis should be read with, and is qualified in its entirety by, the
Consolidated Financial Statements and the notes thereto. Additionally, our
discussion and analysis should be read in conjunction with the Forward-Looking
Statements/Risk Factors disclosures included herein.
Executive Overview
Throughout 2011, we continued the implementation of our key initiatives to
differentiate our stores from other small-box discount retailers. The Core 5
Program is our long-term strategy designed to highlight key categories within
our stores that differentiate us from our competition. The Core 5 categories -
Home, Celebration, Pet, Pharmacy and Paper and Chemical - are strong trip
driving departments in which FRED'S has a clear and marketable advantage versus
small box competitors. Additionally, these categories have high household
penetration and resonate with customers across multiple demographics. This
initiative is also intended to shift our product mix toward the more
discretionary, higher margin categories and away from the lower margin
consumable categories, thus driving higher margin and leading to increased
operating profit.
The implementation of the Core 5 Program requires a moderate refresh of the
store to address space allocation, product placement and adjacencies and signage
in the Core 5 categories. The implementation is also accompanied by an extensive
direct mail marketing campaign timed to coincide with the refresh of the store
and then continuing for six months thereafter. In 2011, we implemented the Core
5 Program in 205 stores, bringing the total completed stores to 413 over the
past two years.
As mentioned previously, our Pharmacy department is one of our Core 5 categories
and is a key differentiating factor from other small-box discount retailers. As
such, we have accelerated our growth strategy in this area and are aggressively
pursuing opportunities to acquire independent pharmacies within our targeted
markets. Our emphasis will continue to be on acquiring prescription files, but
cold starts will be employed where it makes sense to do so. Pharmacy department
expansion is a proven driver of customer trips and loyalty. Our stores which
have a pharmacy department continue to perform better in general merchandise
department sales by over 10% than those without.
During the fourth quarter of fiscal year 2011, we opened sixteen new stores and
seven express pharmacy locations. Five express pharmacy locations and one
franchise store closed in the quarter. For the fiscal year, there were 26 new
stores and ten new express pharmacy locations. Eight stores and two express
pharmacy locations were closed during the year. Additionally, three franchise
stores closed during the year, bringing the net increase in Fred's locations to
23 for the year.
Another key focus throughout 2011 has been improvement of our store in-stock
position. Recognizing in-stock position as one of the fundamental drivers of our
business, we have dedicated significant resources to improving the tools we use
to monitor and measure in-stock position in our stores. Increased investments in
technology played a role in our improvements with implementations in merchandise
allocations, price optimization, ad planning, vendor performance tracking, and
several business intelligence applications. As an extension of this initiative,
we have made significant improvements to our freight flow processes to ensure
that product is in the store and available for our customers. Improvements in
store in-stock position during the year have been a factor in increasing store
sales, as well as improving customer service scores. Improvements being made in
the freight flow process will drive higher store in-stock results beyond 2011.
Our Own Brand initiative continues to be a key strategy for the Company in terms
of building customer loyalty and increasing gross margin. In 2011, our Own Brand
penetration rate was 19.0% of consumable product sales, which is relatively flat
with last year. Considering the sales mix shift toward basic and consumable
products and the strong increase in national brand sales, we see maintaining our
Own Brand penetration rate as a positive during this year. Our commitment to
quality in our Own Brand products is resonating with our customers and they
continue to make the switch to our "Fred's Brand". We are continuing to add new
products to our Own Brand line on an ongoing basis, with new items in food and
health and beauty aids introduced in the last half 2011.
While our private label, or FRED'S Brand products, continued to be a focus in
2011, we also carry many national brands in our stores, including products such
as Coke, Purina, Energizer, Prestone, and Sunbeam. Our customers identify with
these national brands, which provide them with a more complete shopping trip. On
an ongoing basis, we will continue to evaluate additional national brands that
are the most popular with our customers and will be adding those that complement
our current product mix.
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Gross margin improvement continues to be a key focus of the Company, as
highlighted above with our Core 5 and Own Brand strategies. We are aggressively
pursuing product sourcing improvements and cost reductions across all product
lines in order to drive overall product costs down and in turn raise our gross
margin. Additionally, we have implemented new processes intended to control both
promotional and clearance markdowns. We also continue to make improvements in
our loss prevention processes and procedures to control shrinkage in our stores
and consequently increase gross margin.
During 2011, we used $66.0 million for capital expenditures and pharmacy
acquisitions, a 71% increase over the prior year, with most of the expenditures
being used to open new stores and pharmacies, as well as continuing the upgrades
of our existing stores. Included in the total is $3.5 million for technology
upgrades such as computer software and hardware, and distribution equipment.
Looking to 2012 and beyond, we expect continuous improvement as we adapt our
strategic initiatives to the retail environment for the long-term. We have
developed our 2012 strategic initiatives to build on our momentum and break new
ground in key areas, with the goal to increase market share, comparable sales,
and customer traffic while driving toward higher operating margins. Our Core 5
Program will be an ongoing catalyst for sales growth. Two of our major sales and
marketing initiatives going forward are to help the economically challenged
customer and attract the younger mother. We will accomplish these initiatives
through greater value in basic products, continued expansion of own-brand or
private label products, and evolving our Fred's Kids line of products. We will
continue to leverage our pharmacy products and service in 2012 as we still view
pharmacy growth as a solid use of invested capital. Finally, we will continue to
focus on fundamentals and increase investments in technology to drive process
improvement and customer satisfaction.
Key factors that will be critical to the Company's future success include the
successful roll-out of our Core 5 program, as well as managing the strategy for
opening new stores and pharmacies, including the ability to open and operate
efficiently, maintaining high standards of customer service, maximizing
efficiencies in the supply chain, controlling working capital needs through
improved inventory turnover, controlling the effects of inflation or deflation,
controlling product mix, increasing operating margin through improved gross
margin and leveraging operating costs, and generating adequate cash flow tofund
the Company's future needs.
Other factors that will affect Company performance in 2012 include the
continuing management of the impacts of the changing regulatory environment in
which our pharmacy department operates. Additionally, we believe that the
protracted elevation in commodity and fuel prices, as well as the unemployment
rate continues to place tremendous economic pressure on the consumer. However,
we also continue to believe that our affordable pricing and value proposition
make us an attractive destination for the price conscious consumer.
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
to the Consolidated Financial Statements. Our most critical accounting policies
are as follows:
Revenue Recognition. The Company markets goods and services through 679 Company
owned stores and 21 franchised stores as of January 28, 2012. Net sales include
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.
The Company also sells gift cards for which the revenue is recognized at time of
redemption. The Company records a gift card liability on the date the gift card
is issued to the customer. Revenue is recognized and the gift card liability is
reduced as the customer redeems the gift card. The Company will recognize aged
liabilities as revenue when the likelihood of the gift card being redeemed is
remote ("gift card breakage"). The Company has not recognized any revenue from
gift card breakage since the inception of the program in 2004 and does not
expect to record any gift card breakage revenue until there is more certainty
regarding our ability to retain such amounts in light of current consumer
protection and state escheatment laws.
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 2011, 2010 and
2009 was $1.8 million, $2.0 million and $2.1 million, respectively.
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Inventories. Merchandise inventories are valued at the lower of cost or market
using the retail first-in, first-out ("FIFO") method for goods in our stores and
the cost first-in, first-out method for goods in our distribution centers. The
retail inventory method is a reverse mark-up, averaging method which has been
widely used in the retail industry for many years. This method calculates a
cost-to-retail ratio that is applied to the retail value of inventory to
determine the cost value of inventory and the resulting cost of goods sold and
gross margin. The assumption that the retail inventory method provides for
valuation at lower of cost or market and the inherent uncertainties therein are
discussed in the following paragraphs.
In order to assure valuation at the lower of cost or market, the retail value of
our inventory is adjusted on a consistent basis to reflect current market
conditions. These adjustments include increases to the retail value of inventory
for initial markups to set the selling price of goods or additional markups to
adjust pricing for inflation and decreases to the retail value of inventory for
markdowns associated with promotional, seasonal or other declines in the market
value. Because these adjustments are made on a consistent basis and are based on
current prevailing market conditions, they approximate the carrying value of the
inventory at net realizable value ("market value"). Therefore, after applying
the cost to retail ratio, the cost value of our inventory is stated at the lower
of cost or market as is prescribed by Generally Accepted Accounting Principles
in the U.S. ("U.S. GAAP").
Because the approximation of net realizable value under the retail inventory
method is based on estimates such as markups, markdowns and inventory losses
("shrink"), there exists an inherent uncertainty in the final determination of
inventory cost and gross margin. In order to mitigate that uncertainty, the
Company has a formal review by product class which considers such variables as
current market trends, seasonality, weather patterns and age of merchandise to
ensure that markdowns are taken currently, or a markdown reserve is established
to cover future anticipated markdowns. This review also considers current
pricing trends and inflation to ensure that markups are taken if necessary. The
estimation of inventory losses is a significant element in approximating the
carrying value of inventory at net realizable value; thus the following
paragraph describes our estimation method as well as the steps we take to
mitigate the risk this estimate has in the determination of the cost valueof
inventory.
The Company calculates inventory losses based on actual inventory losses
occurring as a result of physical inventory counts during each fiscal period and
estimated inventory losses occurring between yearly physical inventory counts.
The estimate for shrink occurring in the interim period between physical counts
is calculated on a store-specific basis and is based on history, as well as
performance on the most recent physical count. It is calculated by multiplying
each store's shrink rate, which is based on the previously mentioned factors, by
the interim period's sales for each store. Additionally, the overall estimate
for shrink is adjusted at the corporate level to a three-year historical average
to ensure that the overall shrink estimate is the most accurate approximation of
shrink based on the Company's overall history of shrink. The three-year
historical estimate is calculated by dividing the "book to physical" inventory
adjustments for the trailing 36 months by the related sales for the same period.
In order to reduce the uncertainty inherent in the shrink calculation, the
Company first performs the calculation at the lowest practical level (by store)
using the most current performance indicators. This ensures a more reliable
number, as opposed to using a higher level aggregation or percentage method. The
second portion of the calculation ensures that the extreme negative or positive
performance of any particular store or group of stores does not skew the overall
estimation of shrink. This portion of the calculation removes additional
uncertainty by eliminating short-term peaks and valleys that could otherwise
cause the underlying carrying cost of inventory to fluctuate unnecessarily. The
Company has experienced improvement in reducing shrink as a percentage of sales
from year to year due to improved inventory control measures, which includes the
chain-wide utilization of the NEX/DEX technology.
Management believes that the Company's retail inventory method provides an
inventory valuation which reasonably approximates cost and results in carrying
inventory at the lower of cost or market. For pharmacy inventories, which were
approximately $40.4 million, and $32.5 million at January 28, 2012 and January
29, 2011, respectively, cost was determined using the retail LIFO ("last-in,
first-out") method in which inventory cost is maintained using the retail
inventory method, then adjusted by application of the Producer Price Index
published by the U.S. Department of Labor for the cumulative annual periods. The
current cost of inventories exceeded the LIFO cost by approximately
$26.8 million at January 28, 2012 and $24.0 million at January 29, 2011. The
LIFO reserve increased by approximately $2.8 million and $2.4 million during
2011 and 2010, respectively.
The Company has historically included an estimate of inbound freight and certain
general and administrative costs in merchandise inventory as prescribed by U.S.
GAAP. These costs include activities surrounding the procurement and storage of
merchandise inventory such as merchandise planning and buying, warehousing,
accounting, information technology and human resources, as well as inbound
freight. The total amount of procurement and storage costs and inbound freight
included in merchandise inventory at January 28, 2012 is $20.3 million compared
to $19.5 million at January 29, 2011.
Impairment. The Company's policy is to review the carrying value of all
long-lived assets for impairment whenever events or changes in circumstances
indicate that the carrying value of an asset may not be recoverable. In
accordance with FASB ASC 360, "Impairment or Disposal of Long-Lived Assets," we
review for impairment all stores open at least 3 years or remodeled more than 2
years. Impairment results when the carrying value of the assets exceeds the
undiscounted future cash flows over the life of the lease or 10 years for owned
stores. Our estimate of undiscounted future cash flows over the lease term is
based upon historical operations of the stores and estimates of future store
profitability, which encompasses many factors that are subject to management's
judgment and are difficult to predict. If a long-lived asset is found to be
impaired, the amount recognized for impairment is equal to the difference
between the carrying value and the asset's fair value. The fair value is based
on estimated market values for similar assets or other reasonable estimates of
fair market value based upon using a discounted cash flow model.
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Exit and Disposal Activities.
Lease Termination
Lease obligations still exist for some store closures that occurred in 2008. We
record the estimated future liability associated with the rental obligation on
the cease use date (when the stores were closed). The lease obligations are
established at the cease use date for the present value of any remaining
operating lease obligations, net of estimated sublease income, and at the
communication date for severance and other exit costs, as prescribed by FASB ASC
420, "Exit or Disposal Cost Obligations". Key assumptions in calculating the
liability include the timeframe expected to terminate lease agreements,
estimates related to the sublease potential of closed locations, and estimates
of other related exit costs. If actual timing and potential termination costs or
realization of sublease income differ from our estimates, the resulting
liabilities could vary from recorded amounts. These liabilities are reviewed
periodically and adjusted when necessary.
During fiscal 2011, we reserved an additional $0.1 million in rent expense
related to the revision of the estimated amount of the remaining lease liability
for the fiscal 2008 store closures. We also utilized $0.5 million, leaving $0.3
million in the reserve at January 28, 2012.
Beginning Balance Additions Utilized Ending Balance
January 29, 2011 FY11 FY11 January 28, 2012
Lease contract termination liability $ 0.7 $ 0.1 $ (0.5 ) $ 0.3
Property and Equipment and Intangibles. Property and equipment are carried at
cost. Depreciation is calculated using the straight-line method over the
estimated useful lives of the assets and recorded in selling, general and
administrative expenses. Improvements to leased premises are depreciated using
the straight-line method over the shorter of the initial term of the lease or
the useful life of the improvement. Leasehold improvements added late in the
lease term are depreciated over the shorter of the remaining term of the lease
(including the upcoming renewal option, if the renewal is reasonably assured) or
the useful life of the improvement. Gains or losses on the sale of assets are
recorded at disposal as a component of operating income. The following average
estimated useful lives are generally applied:
Estimated Useful Lives
Building and building improvements 8 - 31.5 years
Furniture, fixtures and equipment 3 - 10 years
Leasehold improvements 3 - 10 years or term of lease, if shorter
Automobiles and vehicles 3 - 10 years
Airplane 9 years
Assets under capital lease are amortized in accordance with the Company's normal
depreciation policy for owned assets or over the lease term (regardless of
renewal options), if shorter, and the charge to earnings is included in
depreciation expense in the Consolidated Financial Statements.
Other identifiable intangible assets, which are included in other noncurrent
assets, primarily represent customer lists associated with acquired pharmacies.
Based on the Company's history of intangible asset acquisitions beginning in
fiscal 2004, these assets are being amortized on a straight-line basis over five
years until such time as the Company's internal analysis has sufficient history
to indicate another method is preferable.
Vendor Rebates and Allowances and Advertising Costs. The Company receives
rebates for a variety of merchandising activities, such as volume commitment
rebates, relief for temporary and permanent price reductions, cooperative
advertising programs, and for the introduction of new products in our stores. In
accordance with FASB ASC 605-50 "Customer Payments and Incentives", rebates
received from a vendor are recorded as a reduction of cost of sales when the
product is sold or a reduction to selling, general and administrative expenses
if the reimbursement represents a specific incremental and identifiable cost.
Should the allowance received exceed the incremental cost, then the excess is
recorded as a reduction of cost of sales when the product is sold. Any excess
amounts for the periods reported are immaterial. Any rebates received subsequent
to merchandise being sold are recorded as a reduction to cost of goods soldwhen
received.
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As of January 28, 2012, the Company had approximately 1,050 vendors who
participate in vendor rebate programs, and the terms of the agreements with
those vendors vary in length from short-term arrangements to be completed within
a month to longer-term arrangements that could last up to three years.
In accordance with FASB ASC 720-35 "Advertising Costs", the Company charges
advertising, including production costs, to selling, general and administrative
expense on the first day of the advertising period. Gross advertising expenses
for 2011, 2010 and 2009, were $21.9 million, $24.5 million and $24.0 million,
respectively. Gross advertising expenses were reduced by vendor cooperative
advertising allowances of $2.4 million, $2.4 million and $2.6 million, for 2011,
2010 and 2009, respectively. It would be the Company's intention to incur a
similar amount of advertising expense as in prior years and in support of our
stores even if we did not receive support from our vendors in the form of
cooperative adverting programs.
Insurance Reserves. The Company is largely self-insured for workers
compensation, general liability and employee medical insurance. The Company's
liability for self-insurance is determined based on claims known at the time of
determination of the reserve and estimates for future payments against incurred
losses and claims that have been incurred but not reported. Estimates for future
claims costs include uncertainty because of the variability of the factors
involved, such as the type of injury or claim, required services by the
providers, healing time, age of claimant, case management costs, location of the
claimant, and governmental regulations. These uncertainties or a deviation in
future claims trends from recent historical patterns could result in the Company
recording additional expenses or expense reductions that might be material to
the Company's results of operations. The Company's insurance policy coverage
runs August 1 through July 31 of each fiscal year. On August 1, 2011, the
Company increased its stop loss limits for excessive or catastrophic claims for
general liability to $350,000 from $250,000 and for employee medical to $175,000
from $150,000. The stop loss limit for worker's compensation remained unchanged
at $500,000. The Company's insurance reserve was $10.3 million and $10.3 million
on January 28, 2012 and January 29, 2011, respectively. Changes in the reserve
over that time period were attributable to additional reserve requirements of
$49.0 million netted with payments of $49.0 million.
Income Taxes. The Company reports income taxes in accordance with FASB ASC 740,
"Income Taxes." Under FASB ASC 740, 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 (see Note 4 - Income
Taxes).
In June 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48 ("FASB ASC 740"), Accounting for Uncertainty in Income
Taxes - an Interpretation of FASB Statement No.109 that is codified in FASB ASC
740. We adopted FASB ASC 740 as of February 4, 2007, the first day of fiscal
2007. This interpretation clarifies the accounting for uncertainty in income
taxes recognized in an enterprise's financial statements in accordance with FASB
ASC 740 and prescribes a minimum recognition threshold of more-likely-than-not
to be sustained upon examination that a tax position must meet before being
recognized in the financial statements. Under FASB ASC 740, the impact of an
uncertain income tax position on the income tax return must be recognized at the
largest amount that is more-likely-than-not to be sustained upon audit by the
relevant taxing authority. An uncertain income tax position will not be
recognized if it has less than a 50% likelihood of being sustained.
Additionally, FASB ASC 740 provides guidance on de-recognition, measurement,
classification, interest and penalties, accounting in interim periods,
disclosure and transition (see Note 4 - Income Taxes).
FASB ASC 740 further requires that interest and penalties required to be paid on
the underpayment of taxes should be accrued on the difference between the amount
claimed or expected to be claimed on the tax return and the tax benefit
recognized in the financial statements. The Company includes potential interest
and penalties recognized in accordance with FASB ASC 740 in the financial
statements as a component of income tax expense. As of January 28, 2012, accrued
interest and penalties related to our unrecognized tax benefits totaled
$1.3 million and $0.2 million, respectively, and are both recorded in the
consolidated balance sheet within "Other non-current liabilities."
Stock-Based Compensation.Effective January 29, 2006, the Company adopted the
fair value recognition provisions of FASB ASC 718, "Compensation - Stock
Compensation", using the modified prospective transition method. Under this
method, compensation expense recognized post adoption includes: (1) compensation
expense for all share-based payments granted prior to, but not yet vested as of
January 29, 2006, based on the grant date fair value estimated in accordance
with the FASB ASC 718, and (2) compensation cost for all share-based payments
granted subsequent to January 29, 2006, based on the grant date fair value
estimated in accordance with the provisions of FASB ASC 718. Results for prior
periods have not been restated.
Effective January 29, 2006, the Company elected to adopt the alternative
transition method provided in FASB ASC 718 for calculating the income tax
effects of stock-based compensation. The alternative transition method includes
simplified methods to establish the beginning balance of the additional
paid-in-capital pool ("APIC Pool") related to the income tax effects of stock
based compensation, and for determining the subsequent impact on the APIC pool
and consolidated statements of cash flows of the income tax effects of
stock-based compensation awards that are outstanding upon adoption of FASBASC
718.
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FASB ASC 718 also requires the benefits of income tax deductions in excess of
recognized compensation cost to be reported as a financing cash flow, rather
than as an operating cash flow. The impact of adopting FASB ASC 718 on future
results will depend on, among other things, levels of share-based payments
granted in the future, actual forfeiture rates and the timing of option
exercises.
Stock-based compensation expense, post adoption of FASB ASC 718, is based on
awards ultimately expected to vest, and therefore has been reduced for estimated
forfeitures. Forfeitures are estimated at the time of grant based on the
Company's historical forfeiture experience and will be revised in subsequent
periods if actual forfeitures differ from those estimates.
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.
For the Year Ended
January 28, January 29, January 30,
2012 2011 2010
Net sales 100.0 % 100.0 % 100.0 %
Cost of good sold 1 71.3 71.4 72.1
Gross profit 28.7 28.6 27.9
Selling, general and administrative expenses 2 25.9 26.1 25.8
Operating income 2.7 2.5 2.1
Interest expense, net - - -
Income before taxes 2.7 2.5 2.1
Income taxes 0.9 0.9 0.8
Net income 1.8 % 1.6 % 1.3 %
1 Cost of goods sold includes the cost of product sold, along with all costs
associated with inbound freight.
2 Selling, general and administrative expenses include the costs associated with
purchasing, receiving, handling, securing and storing product. These costs are
associated with products that have been sold and no longer remain in ending
inventory.
Comparable Stores Sales. Our calculation of comparable store sales represents
the increase or decrease in net sales for stores that have been opened after the
end of the 12th month following the store's grand opening month, and includes
stores that have been remodeled or relocated during the reporting period. The
majority of our remodels and relocations do not include expansion. The purpose
of the remodel or the relocation is to change the store's layout, refresh the
store with new fixtures, interiors or signage or to locate the store in a more
desirable area. This type of change to the store does not necessarily change the
product mix or product departments; therefore, on a comparable store sales
basis, the store is the same before and after the remodel or relocation. In
relation to remodels and relocations, expansions have been much more infrequent
and consequently, any increase in the selling square footage is immaterial to
the overall calculation of comparable store sales.
Additionally, we do not exclude newly added hardline, softline or pharmacy
departments from our comparable store sales calculation because we believe that
all departments within a Fred's store create a synergy supporting our overall
goals for managing the store, servicing our customer and promoting traffic and
sales growth. Therefore, the introduction of all new departments is included in
same store sales in the year in which the department is introduced. Likewise,
our same store sales calculation is not adjusted for the removal of a department
from a location.
Fiscal 2011 Compared to Fiscal 2010
Sales
Net sales for 2011 increased to $1,879.1 million from $1,841.8 million in 2010,
a year-over-year increase of $37.3 million or 2.0%. On a comparable store basis,
sales for 2011 increased 0.5% ($9.0 million) compared with a 2.2% ($33.3
million) increase in the same period last year.
The Company's 2011 front store ("non-pharmacy") sales increased 1.0% over 2010
front store sales We experienced sales increases in categories such as food,
pet, paper and chemical and beverage partially offset by decreases in
electronics and home furnishings.
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The Company's pharmacy sales were 34.9% of total sales in 2011 compared to 34.1%
of total sales in the prior year and continue to rank as the largest sales
category within the Company. The total sales in this department increased 4.2%
over 2010, with third party prescription sales representing approximately 91% of
total pharmacy sales, the same as in the prior year. The Company's pharmacy
department continues to benefit from an ongoing program of purchasing
prescription files from independent pharmacies as well as the addition of
pharmacy departments in existing store locations.
Sales to Fred's 21 franchised locations during 2011 declined 3.4% to $36.1
million (2.0% of sales) compared to fiscal 2010. The decrease in year-over-year
franchise sales was due to the impact of three franchise stores that closed
during the year as well as the ongoing economic challenges affecting our
customers' disposable income. The Company does not intend to expand its
franchise network.
The sales mix for the period, unadjusted for deferred layaway sales, was 34.9%
Pharmaceuticals, 23.3% Household Goods, 16.8% Food and Tobacco, 8.7% Paper and
Cleaning Supplies, 7.4% Health and Beauty Aids, 6.9% Apparel and Linens, and
2.0% Franchise. The sales mix for the same period last year was 34.1%
Pharmaceuticals, 24.1% Household Goods, 16.2% Food and Tobacco, 8.6% Paper and
Cleaning Supplies, 7.6% Apparel and Linens, 7.4% Health and Beauty Aids, and
2.0% Franchise.
For the year, comparable store customer traffic increased 0.7% over last year
while the average customer ticket decreased 0.2% to $19.96.
Gross Profit
Gross profit for the year increased to $538.5 million in 2011 from $527.0
million in 2010, a year-over-year increase of $11.5 million or 2.2%. Gross
margin, measured as a percentage of sales, increased to 28.7% in 2011 from 28.6%
in 2010, a 10 basis point improvement. Gross margin was favorably impacted by
higher pharmacy department rebates.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, including depreciation and
amortization, increased to $487.4 million in 2011 (26.0% of sales) from $480.3
million in 2010 (26.1% of sales). This 10 basis point expense leveraging
resulted primarily from the decrease in advertising costs of $2.5 million (13
basis points) and an increase in proceeds from the sale of pharmacy script files
of $1.0 million (21 basis points). This leveraging was partially offset by an
increase in incentive compensation (18 basis points).
Operating Income
Operating income increased to $51.2 million in 2011 (2.7% of sales) from $46.7
million in 2010 (2.5% of sales) due primarily to an increase in gross profit of
$11.5 million as a result of higher pharmacy department rebates as described in
the Gross Profit section above. This favorability was partially offset by an
increase in selling, general and administrative expenses of $7.1 million as
described in the Selling, General and Administrative Expenses section above.
Interest Expense, Net
Net interest expense for 2011 totaled $0.4 million or less than 0.1% of sales
compared to $0.2 million which was also less than 0.1% of sales in 2010. The
increase in interest expense was the result of real estate purchases done
throughout 2011 that had existing loans that were assumed.
Income Taxes
The effective income tax rate was 34.1% in 2011 compared to 36.4% in 2010. The
decrease in the effective tax rate was primarily attributable to the improved
utilization of the Work Opportunity Tax Credits, the favorable result of
finalized state tax audits and overall favorable state tax rates when compared
to the prior year.
The Company's estimates of income taxes and the significant items resulting in
the recognition of deferred tax assets and liabilities are described in Note 4
to the Consolidated Financial Statements and reflect the Company's assessment of
future tax consequences of transactions that have been reflected in the
Company's financial statements or tax returns for each taxing authority in which
it operates. Actual income taxes to be paid could vary from these estimates due
to future changes in income tax law or the outcome of audits completed by
federal and state taxing authorities. The reserves are determined based upon the
Company's judgment of the probable outcome of the tax contingencies and are
adjusted, from time to time, based upon changing facts and circumstances.
State net operating loss carry-forwards are available to reduce state income
taxes in future years. These carry-forwards total approximately $156.6 million
for state income tax purposes at January 28, 2012 and expire at various times
during 2012 through 2031. 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. We have provided a reserve for the portion
believed to be more likely than not to expire unused.
We expect our effective tax rate to be in the range of 36% to 37% in fiscal
2012.
- 25 -
Net Income
Net income increased to $33.4 million ($0.87 per diluted share) in 2011 from
$29.6 million ($0.75 per diluted share) in 2010, a 13.0% increase. The increase
in net income is primarily attributable to the favorable gross profit of $11.5
million as described in the Gross Profit section above. This favorability was
partially offset by the $7.1 million increase in selling, general and
administrative expenses as described in the Selling, General and Administrative
Expenses section above, as well as higher income tax expense due to a pretax
income increase of $4.2 million.
Fiscal 2010 Compared to Fiscal 2009
Sales
Net sales for 2010 increased to $1,841.8 million from $1,788.1 million in 2009,
a year-over-year increase of $53.6 million or 3.0%. On a comparable store basis,
sales for 2010 increased 2.2% ($33.3 million) compared with a 0.4% ($6.2
million) increase in the prior year.
The Company's 2010 front store sales increased 2.1% over 2009 front store sales
We experienced sales increases in categories such as direct beverage, small
appliances, greeting cards and tobacco partially offset by decreases in food and
electronics.
The Company's pharmacy sales were 34.2% of total sales in 2010 compared to 33.5%
of total sales in the prior year and continue to rank as the largest sales
category within the Company. The total sales in this department, including the
Company's mail order operation which we closed during the first quarter of 2009,
increased 5.2% over 2009, with third party prescription sales representing
approximately 93% of total pharmacy sales, the same as in the prior year. The
Company's pharmacy department continues to benefit from an ongoing program of
purchasing prescription files from independent pharmacies as well as the
addition of pharmacy departments in existing store locations.
Sales to Fred's 24 franchised locations during 2010 decreased to $37.4 million
(2.0% of sales) from $38.4 million (2.2% of sales) in 2009. The decrease in
year-over-year franchise sales continues to be impacted by the ongoing economic
challenges affecting our customers' disposable income. The Company does not
intend to expand its franchise network.
The sales mix for the period, unadjusted for deferred layaway sales, was 34.1%
Pharmaceuticals, 24.1% Household Goods, 16.2% Food and Tobacco, 8.6% Paper and
Cleaning Supplies, 7.6% Apparel and Linens, 7.4% Health and Beauty Aids, and
2.0% Franchise. The sales mix for the same period in 2009 was 33.5%
Pharmaceuticals, 23.4% Household Goods, 16.2% Food and Tobacco, 9.2% Paper and
Cleaning Supplies, 7.9% Apparel and Linens, 7.6% Health and Beauty Aids, and
2.2% Franchise.
For 2010, comparable store customer traffic increased 0.3% over the prior year
while the average customer ticket increased 1.6% to $19.75.
Gross Profit
Gross profit for the year increased to $527.0 million in 2010 from $499.2
million in 2009, a year-over-year increase of $27.8 million or 5.6%. Gross
margin, measured as a percentage of sales, increased to 28.6% in 2010 from 27.9%
in 2009, a 70 basis point improvement. Gross margin was favorably impacted by
the improved product mix shift toward household goods which carry higher
margins, continued management of shrink in our stores, improved pharmacy
department margins and an increase in vendor consideration. This favorability
was partially offset by an increase in store markdowns and pharmacy shrinkage.
Selling, General and Administrative Expenses
Selling, general and administrative expenses, including depreciation and
amortization, increased to $480.3 million in 2010 (26.1% of
sales) from $460.7 million in 2009 (25.8% of sales). This 30 basis point expense
deleveraging resulted primarily from the increase in labor of $8.8 million and
amortization expense of $2.5 million related mainly to pharmacy acquisitions
during the year, as well as an increase in incentive compensation of $2.6
million.
Operating Income
Operating income increased to $46.7 million in 2010 (2.5% of sales) from $38.5
million in 2009 (2.1% of sales) due primarily to an increase in gross profit of
$27.8 million due to the improved product mix shift toward household goods which
carry higher margins, continued management of shrink in our stores, improved
pharmacy department margins and an increase in vendor dollar consideration. This
favorability was partially offset by an increase in selling, general and
administrative expenses of $19.6 million as described in the Selling, General
and Administrative Expenses section above.
Interest Expense, Net
Net interest expense for 2010 totaled $0.2 million or less than 0.1% of sales
compared to $0.3 million which was also less than 0.1% of sales in 2009.
- 26 -
Income Taxes
The effective income tax rate was 36.4% in 2010 compared to 38.2% in 2009. The
decrease in the effective tax rate was primarily due to the finalization and
settlement of the Internal Revenue Exam which was incurred in 2009.
The Company's estimates of income taxes and the significant items resulting in
the recognition of deferred tax assets and liabilities are described in Note 4
to the Consolidated Financial Statements and reflect the Company's assessment of
future tax consequences of transactions that have been reflected in the
Company's financial statements or tax returns for each taxing authority in which
it operates. Actual income taxes to be paid could vary from these estimates due
to future changes in income tax law or the outcome of audits completed by
federal and state taxing authorities. The reserves are determined based upon the
Company's judgment of the probable outcome of the tax contingencies and are
adjusted, from time to time, based upon changing facts and circumstances.
State net operating loss carry-forwards are available to reduce state income
taxes in future years. These carry-forwards total approximately $142.5 million
for state income tax purposes and expire at various times during 2011 through
2029. 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. We have provided a reserve for the portion believed to be more likely
than not to expire unused.
Net Income
Net income increased to $29.6 million ($0.75 per diluted share) in 2010 from
$23.6 million ($0.59 per diluted share) in 2009, a 25.3% increase. The increase
in net income is primarily attributable to the favorable gross profit of $27.8
million as described in the Gross Profit section above. This favorability was
partially offset by the $19.6 million increase in selling, general and
administrative expenses as described in the Selling, General and Administrative
Expenses section above, as well as higher income tax expense due to a pretax
income increase of $8.3 million.
Liquidity and Capital Resources
The Company's principal capital requirements include funding new stores and
pharmacies, remodeling existing stores and pharmacies, maintenance of stores and
distribution centers, and the ongoing investment in information systems. Fred's
primary sources of working capital have traditionally been cash flow from
operations and borrowings under its credit facility. The Company had working
capital of $259.0 million, $282.1 million and $266.7 million at year-end 2011,
2010 and 2009, respectively. Working capital fluctuates in relation to
profitability, seasonal inventory levels, and the level of store openings and
closings. Working capital at year-end 2011 decreased by $23.1 million from 2010.
The decrease was primarily due to a year-over-year decrease in cash and cash
equivalents of $22.1 million as a result of share repurchases totaling $28.5
million and $10.0 million for the acquisition of leased properties. Accounts
payable increased $25.9 million as a result of the increased inventory at year
end and improved vendor terms. Partially offsetting the decreased in working
capital, inventory increased by $18.5 million primarily due to inflation and new
store growth, and other non-trade receivables increased $5.7 million primarily
from increases in vendor related allowances and income tax receivables. In 2012,
the Company intends to open approximately 22-28 stores and pharmacies and close
an estimated 10 stores and 5 pharmacies.
We have incurred losses caused by fire, tornado and flood damage, which
consisted primarily of losses of inventory and fixed assets. Insurance proceeds
related to fixed assets are included in cash flows from investing activities and
proceeds related to inventory losses and business interruption are included in
cash flows from operating activities.
Net cash flow provided by operating activities totaled $76.6 million in 2011,
$42.1 million in 2010 and $64.2 million in 2009.
In fiscal 2011, accounts payable and accrued expenses increased by approximately
$25.4 million. Deferred income tax expense increased by $4.6 million and
depreciation and amortization increased by $5.0 million.
In fiscal 2010, inventory, net of the LIFO reserve, increased by approximately
$19.4 million due to many factors including our drive to support our in-stock
position, additional toy and trim-a-home inventory purchased for the 2010
holiday season and a strategic decision to purchase import goods earlier in an
effort to avoid business interruptions from the Chinese New Year. Accounts
receivable increased by approximately $6.2 million due primarily to an increase
in vendor related allowances. Accounts payable and accrued expenses decreased by
approximately $0.6 million. Income taxes payable increased by $3.8 million while
deferred income tax liability increased by $1.9 million. Other non-current
liabilities increased by $0.7 million.
In fiscal 2009, inventory, net of the LIFO reserve, decreased by approximately
$7.5 million due to higher inventory turn rates in our stores, the average of
which has increased to 4.1 in fiscal 2009 from 3.8 in fiscal 2008. Accounts
receivable increased by approximately $1.6 million due primarily to an increase
in vendor related allowances. Accounts payable and accrued expenses increased by
approximately $11.4 million primarily as a result of the focus on improving our
terms with our vendors. Income taxes payable decreased by $8.0 million while
deferred income tax expense increased by $5.9 million. Other non-current
liabilities decreased by $3.4 million due to a reduction in the Company FASB ASC
740 reserves.
- 27 -
Net cash used in investing activities totaled $62.3 million in 2011, $38.2
million in 2010 and $33.2 million in 2009.
Capital expenditures in 2011 totaled $49.2 million compared to $27.0 million in
2010 and $22.7 million in 2009. The capital expenditures during 2011 consisted
primarily of existing store improvements ($19.4 million), the purchase of 17
existing store properties ($14.5 million), the store and pharmacy expansion
program ($9.6 million), technology ($3.5 million), and distribution and
corporate expenditures ($2.2 million). Additionally, $16.8 million was expended
related to acquisitions of pharmacies during 2011.
Capital expenditures in 2010 totaled $27.0 million compared to $22.7 million in
2009 and $17.0 million in 2008. The capital expenditures during 2010 consisted
primarily of the store and pharmacy expansion program ($22.4 million),
technology enhancements ($2.9 million), transportation and distribution center
expenditures ($1.0 million) and other corporate expenditures ($.7 million).
Additionally, $11.5 million was expended related to acquisitions of pharmacies
during 2010.
Capital expenditures during 2009 consisted primarily of the store and pharmacy
expansion program ($15.7 million), technology enhancements ($3.3 million),
transportation and distribution center expenditures ($2.1 million) and other
corporate expenditures ($1.6 million). Additionally, $10.7 million was expended
related to acquisitions of pharmacies during 2009.
In 2012, the Company is planning capital expenditures totaling approximately
$26.0 million. Expenditures are planned totaling $18.0 million for new and
existing stores and pharmacies. Planned expenditures also include approximately
$5.0 million for technology upgrades and approximately $3.0 million for
distribution center equipment and other capital maintenance. In addition, the
Company plans expenditures of approximately $18.0 million in 2012 for the
acquisition of prescription lists and other pharmacy related items.
Net cash used in financing activities totaled $36.3 million in 2011, $9.4
million in 2010 and $11.4 million in 2009.
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. As part of that review
and in light of the Company's current financial position, the Board of Directors
raised the dividend from $0.03 per share to $0.04 per share in the first quarter
of 2010. On March 2, 2011, the Board of Directors increased the dividend to
shareholders of record as of March 10, 2011 to $0.05, a 25 % increase. For the
fourth consecutive year, on February 16, 2012, the Board of Directors increased
the dividend to shareholders of record as of March 1, 2012 to $0.06, a 20%
increase.
On August 27, 2007, the Board of Directors approved a plan that authorized stock
repurchases of up to 4.0 million shares of the Company's common stock. Under the
plan, the Company may repurchase its common stock in open market or privately
negotiated transactions at such times and at such prices as determined to be in
the Company's best interest. These purchases may be commenced or suspended
without prior notice depending on then-existing business or market conditions
and other factors. In fiscal 2011, the Company repurchased 2,447,823 shares for
$28.5 million compared to 293,000 shares for $3.0 million in 2010, and 742,663
shares for $7.2 million in 2009. On February 16, 2012, Fred's Board authorized
the expansion of the Company's existing stock repurchase program by increasing
the authorization to repurchase an additional 3.6 million shares or
approximately 10% of the current outstanding shares.
On September 27, 2010, the Company and Regions Bank entered into the Tenth Loan
Modification of the Revolving Loan and Credit Agreement which decreased the
credit line from $60 million to $50 million and extended the term until
September 27, 2013. All other terms, conditions and covenants remained in place
after the amendment, with only a slight modification to one of the financial
covenants required by the Agreement. Under the most restrictive covenants of the
Agreement, the Company is required to maintain specified shareholders' equity
(which was $423.6 million at January 28, 2012) and positive net income levels.
The Company was in compliance with all loan covenants at January 28, 2012.
Borrowings and the unused fees under the agreement bear interest at a tiered
rate based on the Company's previous four quarter average of the Fixed Charge
Coverage Ratio. Currently the Company's rates are 100 basis points over LIBOR
for borrowings and 20 basis points over LIBOR for the unused portion of the
credit line. There were no borrowings outstanding under the Agreement at
January 28, 2012 and January 29, 2011.
Cash and cash equivalents were $27.1 million at the end of 2011 compared to
$49.2 million at the end of 2010 and $54.7 million at the end of 2009.
Short-term investment objectives are to maximize yields while minimizing company
risk and maintaining liquidity. Accordingly, limitations are placed on the
amounts and types of investments the Company can select.
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 2011, 2010 and 2009.
- 28 -
Contractual Obligations and Commercial Commitments
As discussed in Note 5 to 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 contingent rent based upon a percentage
of sales, taxes, maintenance, insurance and certain other operating expenses
applicable to the leased properties. In addition, the Company leases various
equipment under noncancelable operating leases.
The following table summarizes the Company's significant contractual obligations
as of January 28, 2012, which excludes the effect of imputed interest:
(dollars in thousands) 2012 2013 2014 2015
2016 Thereafter Total
Operating leases 1 $ 49,082 $ 36,886 $ 27,334 $ 21,527 $ 15,619 $ 44,102 $ 194,550
Inventory purchase
obligations 2 110,592 110,592
Equipment leases 3 1,689 1,062 945 710 707 210 5,323
Mortgage loans on land
& buildings and other
4 676 1,307 2,076 998 68 2,195 7,320
Postretirement
benefits 5 35 38 40 36 37 209 395
Total contractual
obligations $ 162,074 $ 39,293 $ 30,395 $ 23,271 $ 16,431 $ 46,716 $ 318,180
1 Operating leases are described in Note 5 to the Consolidated Financial
Statements.
2 Inventory purchase obligations represent open purchase orders and any
outstanding purchase commitments as of January 28, 2012.
3 Equipment leases represent the cooler program and other equipment operating
leases.
4 Mortgage loans for purchased land and buildings and other debt.
5 Postretirement benefits are described in Note 9 to the Consolidated Financial
Statements.
The Company had commitments approximating $10.7 million at January 28, 2012 and
$10.5 million at January 29, 2011 on issued letters of credit, which support
purchase orders for merchandise. Additionally, the Company had outstanding
standby letters of credit aggregating approximately $11.2 million at January 28,
2012 and $11.0 million at January 29, 2011 utilized as collateral for its 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. The Company has offset the investment in
the bonds ($34.6 million) against the related liability and neither is reflected
in the consolidated balance sheet.
Related Party Transactions
Atlantic Retail Investors, LLC, which is partially owned by Michael J. Hayes, a
director of the Company, owned the land and buildings occupied by thirteen
Fred's stores, until March 2011 when, as described below, a portion of these
properties were purchased by the Company. The terms and conditions regarding the
leases on these locations were consistent in all material respects with other
stores leases of the Company with unrelated landlords.
On March 30, 2011, Fred's selected and purchased ten of the thirteen properties
leased from Atlantic Retail Investors, LLC, one of which has an adjacent parcel
and building that is leased to an unrelated party for a total of eleven
properties, for $7.5 million in cash and assumed mortgage debt of $3.5 million.
The Board of Directors approved these transactions after receiving an evaluation
by an independent real estate broker, who concluded that all were acquired at
comparable, and favorable, purchase prices to market value and were financially
beneficial to Fred's as the depreciation expense for the newly acquired assets
will be less than the future value of the lease payments that would have been
due.
In May 2011 after approximately 18 months of negotiation, Atlantic Retail
Investors, LLC purchased the land and building of four additional properties
that the Company had previously evaluated multiple times and eventually passed
for purchase. These stores were subsequently purchased by Atlantic Retail
Investors, LLC, from a lender who had foreclosed on the independent
landlord/developer at terms and conditions favorable to those earlier evaluated
by the Company. Upon closing, Atlantic Retail Investors, LLC informed the
Company of the purchase and offered them at substantially the same terms. The
terms and conditions regarding the leases on these locations were consistent or
better, in all material respects with other stores leases of the Company with
unrelated landlords.
In June 2011, Fred's purchased these four properties together with an adjacent
parcel and building at an existing owned location for a total consideration of
$2.4 million in cash. No mortgage debt was assumed in this transaction. The
Board of Directors approved these transactions based on the financial terms that
were more favorable to market value and financially beneficial to Fred's as a
result of the depreciation expense on the newly acquired assets being less than
the future value of lease payments that would have been due.
- 29 -
As of January 28, 2012, Fred's is leasing three properties from Atlantic Retail
Investors, LLC. The total rental payments for related party leases were
$451.2 thousand for the year ended January 28, 2012 and $1.3 million for the
years ended January 29, 2011 and January 30, 2010, respectively.
Recent Accounting Pronouncements
In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting
Standards Update ("ASU") 2011-04, Fair Value Measurement (Topic 820): Amendments
to Achieve Common Fair Value Measurement and Disclosure Requirements in U. S.
GAAP and IFRSs, which amends the current fair value measurement and disclosure
guidance to include increased transparency around valuation inputs and
investment categorization. This guidance will be effective beginning in fiscal
2012. The adoption of ASU 2011-04 is not expected to have a material impact on
the Company's consolidated net earnings, cash flows or financial position.
In June 2011, the FASB issued ASI 2011-05, Comprehensive Income (Topic 22):
Presentation of Comprehensive Income, which revises the current practice of
including other comprehensive income within the equity section of the statement
of financial position and requires disclosure of other comprehensive income
either in a single continuous statement of comprehensive income or in a separate
statement. This guidance will be effective beginning in fiscal 2012. The
adoption of ASU 2011-05 is not expected to have an impact on the Company's
consolidated net earnings, cash flows or financial position, but the adoption
will change the current presentation of other comprehensive income in the
Company's consolidated financial statements.
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