Overview

Ingles, a leading supermarket chain in the Southeastern United States, operates 199 supermarkets in Georgia (74), North Carolina (66), South Carolina (36), Tennessee (20), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products, including health and beauty care products and general merchandise, as well as quality private label items. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of book sections, media centers, floral departments, premium coffee kiosks, certified organic products, bakery departments and prepared foods, including delicatessen sections. As of December 27, 2008, the Company operated 66 in-store pharmacies and 60 fuel centers.

Ingles also operates two other lines of business, fluid dairy processing and shopping center rentals. The fluid dairy processing segment sells approximately 34% of its products to the retail grocery segment and approximately 66% of its products to third parties. Real estate ownership (including the shopping center rental segment) is an important component of the Company's operations, providing both operational and economic benefit.

Critical Accounting Policies

Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles' financial condition and results of operations, and require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Self-Insurance

The Company is self-insured for workers' compensation and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company's properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained.

Asset Impairments

The Company accounts for the impairment of long-lived assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates. Estimates of future

cash flows and expected sales prices are judgments based upon the Company's experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred.

Closed Store Accrual

For properties closed prior to December 31, 2002 that were under long-term lease agreements, the present value of any remaining liability under the lease, discounted using risk-free rates and net of expected sublease recovery, is recognized as a liability and expensed. For all store closures subsequent to the adoption of SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," effective December 31, 2002, the liability is recognized and expensed based on the difference between the present value of any remaining liability under the lease and the present value of the estimated market rate at which the Company expects to be able to sublease the properties. The Company's estimates of market rates are based on its experience, knowledge and typical third-party advice or market data. If the real estate and leasing markets change, sublease recovery could vary significantly from the recoveries originally assumed, resulting in a material change in the Company's recorded liability. The closed store accrual is included in the line item "Accrued expenses and current portion of other long-term liabilities" on the Condensed Consolidated Balance Sheets.

Vendor Allowances

The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor's products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a component of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $23.6 million and $24.9 million for the fiscal quarters ended December 27, 2008 and December 29, 2007, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor's specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $3.3 million and $2.6 million for the fiscal quarters ended December 27, 2008 and December 29, 2007, respectively.

If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of advertising, which could increase or decrease the Company's expenditures.

Similarly, the Company is not able to assess the impact of vendor advertising allowances on the creation of additional revenues; as such allowances do not directly generate revenue for the Company's stores.

Uncertain Tax Positions

Despite the Company's belief that its tax positions are consistent with applicable tax laws, the Company believes that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Significant judgment is required in evaluating the Company's tax positions. The Company's positions are evaluated in light of changing facts and circumstances, such as the progress of its tax audits as well as evolving case law. Income tax expense includes the impact of position provisions for and changes to uncertain tax positions as the Company considers appropriate. Unfavorable settlement of any particular position would require use of cash. Favorable resolution would be recognized as a reduction to income tax expense at the time of resolution.

Results of Operations

Ingles operates on a 52 or 53-week fiscal year ending on the last Saturday in September. The unaudited condensed consolidated statements of income for the three-month periods ended December 27, 2008 and December 29, 2007 both include 13 weeks of operations. Comparable store sales are defined as sales by grocery stores in operation for the entire duration of the previous and current fiscal periods. Sales from replacement stores, major remodels, minor remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date thereof. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. A minor remodel includes repainting, remodeling and updating the lighting and equipment throughout an existing store. For the three-month periods ended December 27, 2008 and December 29, 2007, comparable store sales include 195 stores.

The following table sets forth, for the periods indicated selected financial information as a percentage of net sales. For information regarding the various segments of the business, see Note I "Lines of Business" to the Unaudited Condensed Consolidated Financial Statements.

                                                    THREE MONTHS ENDED
                                               DECEMBER 27,     DECEMBER 29,
                                                   2008             2007
       Net sales                                     100.0  %         100.0  %
       Gross profit                                   24.5  %          23.3  %
       Operating and administrative expenses          20.9  %          19.4  %
       Rental income, net                               0.1 %            0.2 %
       Loss from sale or disposal of assets              -  %             -  %
       Income from operations                           3.7 %            4.1 %
       Other income, net                                0.2 %            0.1 %
       Interest expense                                 1.6 %            1.5 %
       Income before income taxes                       2.3 %            2.7 %
       Income taxes                                     0.9 %            1.0 %
       Net income                                       1.4 %            1.7 %

Three Months Ended December 27, 2008 Compared to the Three Months Ended December 29, 2007

Net income for the first quarter of fiscal 2009 totaled $11.1 million, 12.3% lower than net income of $12.7 million earned for the first quarter of fiscal 2008. Total and comparable store sales increases were offset by higher expenses influenced by the Company's recent accelerated growth strategy.

Net Sales. Net sales increased 3.6% to $804.9 million for the three months ended December 27, 2008 from $777.1 million for the three months ended December 29, 2007. Ingles operated 199 stores at December 27, 2008 and at 197 stores at December 29, 2007. Retail square footage was approximately 10.4 million at December 27, 2008 and 9.9 million at December 29, 2007. Grocery segment sales increased in each product category except for gasoline, where gallons sold increased but the average sales price per gallon was substantially lower during the current fiscal quarter compared with the same quarter of last fiscal year. Excluding gasoline sales, grocery segment sales increased 6.4% for the three months ended December 27, 2008 compared with the three months ended December 29, 2007.

Grocery segment comparable store sales grew $22.4 million, or 3.0%, in the first quarter of fiscal 2009 compared to the first quarter of fiscal 2008. Excluding gasoline sales, comparable store sales increased $35.0 million, or 5.4%. Comparable store sales growth excluding gasoline is slightly lower than the Company's recent experience, reflecting the current economic recession and its effect on consumer spending. The number of customer transactions (excluding gasoline) increased 5.9%, while the average transaction size (excluding gasoline) increased by approximately 11 cents.

Sales by product category (amounts in thousands) are as follows:

                                             Three Months Ended
                                        December 27,     December 29,
                                            2008             2007
               Grocery                 $      344,574   $      322,824
               Non-foods                      161,118          153,213
               Perishables                    188,917          177,120
               Gasoline                        81,130           91,267

               Total grocery segment   $      775,739   $      744,424

The grocery category includes grocery, dairy, and frozen foods.

The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video.

The perishables category includes meat, produce, deli and bakery.

Changes in grocery segment sales for the quarter ended December 27, 2008 are summarized as follows (in thousands):

   Total grocery sales for the three months ended December 29, 2007   $ 744,424
   Comparable store sales increase (including gasoline)                  22,382
   Impact of stores opened in fiscal 2008 and 2009                       11,686
   Impact of stores closed in fiscal 2008 and 2009                       (2,758 )
   Other                                                                      5

   Total grocery sales for the three months ended December 27, 2008   $ 775,739

Net sales to outside parties for the Company's milk processing subsidiary decreased $3.6 million or 10.9% in the December 2008 quarter compared to the December 2007 quarter. The sales decrease is attributable to lower raw milk costs in the December 2008 quarter compared to the December 2007 quarter. The case volume of products sold increased slightly.

Sales for the first quarter of fiscal 2009 were bolstered by successful holiday promotions in November and December, and the contribution from new and expanded stores. Sales growth for the remainder of fiscal year 2009 will be influenced by these factors and increasingly by general economic conditions. The cost of gasoline has fluctuated significantly over the past six months and future fluctuations, if any, will have a significant impact on total sales.

Gross Profit. Gross profit for the three-month period ended December 27, 2008 increased $16.4 million, or 9.1%, to $197.1 million, or 24.5% of sales, compared to $180.7 million, or 23.3% of sales, for the three-month period ended December 29, 2007.

The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales was higher for the December 2008 quarter due primarily to lower dollar gasoline sales, which earn a lower gross margin. Excluding gasoline sales, grocery segment gross profit as a percentage of sales was relatively constant at 26.5% for the three months ended December 27, 2008 compared with 26.4% for the three months ended December 29, 2007.

Gross profit for the Company's milk processing subsidiary for the December 2008 quarter increased $0.5 million, or 10.0%, to $5.7 million, or 13.0% of sales, compared to $5.2 million, or 10.6% of sales, for the December 2007 quarter. Raw milk costs were substantially lower and the cents-per gallon margin were higher comparing the three months ended December 2008 with the three months ended December 2007. This resulted in higher total gross profit dollars and higher gross profit as a percentage of sales.

In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges. The milk processing segment is a manufacturing process; therefore, the costs mentioned above as well as purchasing and receiving costs, production costs, inspection costs, warehousing costs, internal transfer costs, and other costs of distribution incurred by the milk processing segment are included in the cost of goods sold line item, while these items are included in operating and administrative expenses by the grocery segment.

The Company's gross margins may not be comparable to those of other retailers, since some retailers include all of the costs related to their distribution network in cost of goods sold and others, like the Company, exclude a portion of the costs from gross profit, characterizing the costs as operating and administrative expenses.

Operating and Administrative Expenses. Operating and administrative expenses increased $17.6 million, or 11.7%, to $167.9 million for the three months ended December 27, 2008, from $150.3 million for the three months ended December 29, 2007. As a percentage of sales, operating and administrative expenses were 20.9% and 19.4% for the three months ended December 27, 2008 and December 29, 2007, respectively. Excluding gasoline sales and associated gasoline operating expenses (primarily payroll), operating expenses were 23.1% of sales for the first fiscal 2009 quarter compared with 21.8% for the first fiscal quarter of 2008. The Company's recent accelerated number of new and remodeled stores contributed to higher expenses, many of which are incurred prior to maturation of sales growth to cover such expenses.

The major increases in operating and administrative expenses were as follows:

                                                              Increase
                                                Increase       as a %
                                               in millions    of sales
              Salaries and wages              $         7.2       0.89 %
              Depreciation and amortization   $         2.6       0.32 %
              Warehouse expense               $         2.0       0.25 %
              Utilities and fuel              $         1.9       0.23 %
              Store supplies                  $         1.2       0.15 %

Salaries and wages expenses increased due to the additional labor hours required to support the increased sales volume and the accelerated number of new and remodeled stores.

Depreciation and amortization expense increased as a result of the Company's increased capital expenditures to improve its store base.

Warehouse expenses increased due to increased deliveries from the Company's warehouse to its stores and from additional labor costs needed to process increased volume of both incoming and outgoing product shipments.

Utilities and fuel expenses increased due to increases in the number of store square feet in operation.

Store supplies expenses increased as a result of overall sales increases, including higher proportionate sales increases in the deli and bakery departments, which require more wrapping and packaging.

Rental Income, Net. Rental income, net totaling $0.8 million decreased $0.4 million for the December 2008 quarter compared to the December 2007 quarter. The Company's expansion and relocation activities have resulted in less tenant space available for lease.

Other Income, Net. Other income, net increased $0.5 million to $1.2 million for the three-month period ended December 27, 2008 from $0.7 million for the three-month period ended December 29, 2007. The increase is principally due to higher income from waste paper and packaging sales.

Interest Expense. Interest expense increased $1.5 million for the three-month period ended December 27, 2008 to $13.0 million from $11.5 million for the three-month period ended December 29, 2007. Total debt at December 27, 2008 was $753.4 million compared to $605.1 million at December 29, 2007. In general, new debt added over the past twelve months has been at interest rates lower than existing or repaid debt.

Income Taxes. Income tax expense as a percentage of pre-tax income was 38.8% in the December 2008 quarter compared to 38.7% in the December 2007 quarter.

Net Income. Net income decreased $1.6 million or 12.3% for the three-month period ended December 27, 2008 to $11.1 million compared to $12.7 million for the three-month period ended December 29, 2007. Net income, as a percentage of sales, was 1.4% for the December 2008 quarter and 1.7% for the December 2007 quarter. Basic and diluted earnings per share for Class A Common Stock were $0.47 and $0.45, respectively, for the December 2008 quarter, compared to $0.54 and $0.52, respectively, for the December 2007 quarter. Basic and diluted earnings per share for Class B Common Stock were each $0.43 for the December 2008 quarter compared to $0.49 for the December 2007 quarter.

Liquidity and Capital Resources

Capital Expenditures

The Company believes that a key to its ability to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores that provide customers with good service and a broad selection of competitively priced products. Accordingly, the Company has invested and plans to continue to invest significant amounts of capital toward the modernization of its store base. The Company's modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations.

Capital expenditures totaled $60.2 million for the three-month period ended December 27, 2008, including the opening of two new stores, one replacement store and the construction of five fuel centers. Capital expenditures also included the costs of upgrading and replacing store equipment, technology investments, capital expenditures related to the Company's distribution operation and its milk processing plant, and expenditures for stores to open later in fiscal 2009 and in fiscal 2010.

Ingles' capital expenditure plans for fiscal 2009 include investments of approximately $140 to $160 million. A significant portion of capital expenditures for the first fiscal quarter of 2009 were for the completion of store development projects begun in the previous fiscal year. The timing and extent of current year development projects will be influenced by Company financial performance, overall economic conditions and the availability of financing. At the present time, for the remainder of fiscal year 2009 the Company intends to open nine new, replacement or remodeled stores and add approximately four new fuel stations at either new or existing stores. Most of these projects were started in the previous fiscal year. Expenditures will also include investments in stores expected to open in fiscal 2010 as well as technology improvements, upgrading and replacing existing store, warehouse and transportation equipment and improvements to the Company's milk processing plant.

The Company expects that its net annual capital expenditures will be in the range of approximately $150 to $200 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be influenced by Company financial performance, overall economic conditions and the availability of financing, which is currently limited. In general, the Company is increasing the average size of stores being built, which could affect both the number of projects pursued at any given time and the cost of these projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued and the availability of suitable financing. The Company makes decisions on the allocation of capital expenditure dollars based on many factors, including the competitive environment, other Company capital initiatives and its financial condition.

The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at December 27, 2008 totaled $24.0 million.

Liquidity

The Company generated $27.2 million of net cash from operations in the December 2008 quarter compared to $2.7 million of net cash provided by operations in the December 2007 quarter. Most of the change is attributable to a decrease in refundable income taxes and slower inventory growth.

Cash used in investing activities for the December 2008 quarter totaled $60.2 million of capital expenditures, compared to $60.5 million of cash used in investing activities (substantially all capital expenditures) for the December 2007 quarter.

Cash provided by financing activities during the December 2008 quarter totaled $32.4 million. Principal payments on long-term debt and lines of credit were $16.0 million and dividend payments were $3.9 million. New borrowings, primarily secured by real estate and equipment, totaled $52.3 million.

At December 27, 2008, the Company had lines of credit with five banks totaling $185.0 million, of which $24.2 million was outstanding at December 27, 2008. The lines of credit mature between October 2009 and November 2010. The lines provide the Company with various interest rate options generally at rates less than the prime rate. The Company also has a facility with a bank to issue up to $30.0 million of unused letters of credit, of which $25.2 million of unused letters of credit were issued at December 27, 2008. This facility matures in April 2009. The Company is not required to maintain compensating balances in connection with these lines of credit. The lines of credit contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of lines of credit to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documentation. The Company was in compliance with all financial covenants related to these lines of credit at December 27, 2008.

At December 27, 2008, the Company had $349.8 million principal amount of senior subordinated notes (the "Notes") outstanding to mature in December 2011. The indenture governing the Notes contains certain restrictive covenants relating to, among other things, the issuance of indebtedness and the payment of dividends. The Notes are currently redeemable by the Company at a premium rate of 101.369%. Beginning December 1, 2009 the Notes can be redeemed at par. The Company was in compliance with all financial covenants related to the Notes at December 27, 2008.

The Company's long term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company's lines of credit and the Notes in the event of default under any one instrument.

The Company's principal sources of liquidity are expected to be cash flow from operations, borrowings under its lines of credit and long-term financing. As of . . .