Overview

Operations. The Company is a regional broad line retailer operating in 23 states in the central United States.

The Company's fiscal year ends on the Sunday closest to January 31. Fiscal years 2009, 2008 and 2007 consisted 52 weeks, 53 weeks and 52 weeks, respectively. For purposes of this management's discussion and analysis of financial condition and results of operations, the financial numbers are presented in thousands.

Strategy. The Company's overall business strategy involves identifying and opening stores in towns that will provide the Company with the highest return on investment. The Company prefers markets that do not have direct competition from national or regional broad line retail stores. The Company also somewhat competes for retail sales with other entities, such as mail order companies, specialty retailers, stores, manufacturer's outlets and the internet.

The Company is constantly evaluating the appropriate mix of merchandise to improve sales and gross margin performance. The Company uses centralized purchasing, merchandising, pricing and warehousing to obtain volume discounts, improve efficiencies and achieve consistency among stores and the best overall results. The Company utilizes information obtained from its new POS system and regular input from its store associates to determine its merchandise offerings.

The Company continually implements new merchandising and marketing initiatives in an effort to increase customer traffic and same-store sales. The Company is also adding new items and brands to its assortments and has made changes to its advertising program that combines promotional pricing and solution selling.

Recent Events.

· Lawrence J. Zigerelli joined the Company on July 1, 2008 to become the President - Chief Executive Officer.
· Donny R. Johnson was promoted to Executive Vice President - Chief Financial Officer on July 1, 2008 after serving as Interim Chief Executive Officer.
· Jane F. Gilmartin joined the Company on July 24, 2008 to become the Executive Vice President - Chief Operating Officer.
· Anthony C. Corradi, Senior Vice President - Technology and Supply Chain resigned from the Company on August 1, 2008.
· Edmond C. Beaith joined the Company on August 25, 2008 to become the Senior Vice President - Chief Information Officer.
· On September 3, 2008, the Company entered into an agreement with Accenture, LLP to provide the Company with consulting services to increase the Company's operating efficiency and reduce shrink "Store Transformation Project".
· James M. Spencer joined the Company on December 15, 2008 to become the Senior Vice President - Store Operations.
· Phillip D. Hixon, Senior Vice President was terminated on January 29, 2009.

Key Items in Fiscal 2009. The Company measures itself against a number of financial metrics to assess its performance. Some of the important financial items during fiscal 2009 were:

· Net sales increased 1.7% to $490,021. Same-store sales decreased 5.1%, excluding the Company's two fuel centers, compared to the prior year, as adjusted for 52 week comparability.
· Gross margin decreased to 31.4% of sales, compared to 31.6% in the prior year. Excluding the first quarter $1.3 million inventory review initiative charge, fiscal 2009 gross margin is 31.7%.
· Selling, general and administrative (SG&A) expenses were 30.2% of sales, compared to 28.7% in the prior year. Excluding executive and staff severance and Store Transformation Project expenses, fiscal 2009 SG&A expenses were 29.3%.
· Net loss per share was ($1.30), compared to a loss of ($0.05) per share in the prior year.
· Return on average equity was (4.8%), compared to (0.2%) in the prior year.

Same store sales growth is a measure which may indicate whether existing stores are maintaining their market share. Other factors, such as the overall economy, may also affect same store sales. The Company defines same stores as those stores that were open as of the first day of the prior fiscal year and remain open at the end of the reporting period (this may also be referred to as same-stores).

Gross margin percentage is a key measure of the Company's ability to maximize profit on the purchase and subsequent sale of merchandise, while minimizing promotional and clearance markdowns, shrinkage, damage and returns. Gross margin percentage is defined as sales less cost of sales, expressed as a percentage of sales.

Selling, general and administrative expenses are a measure of the Company's ability to manage and control its expenses to purchase, distribute and sell merchandise.

Earnings per share ("EPS") growth is an indicator of the returns generated for the Company's stockholders. EPS from continuing operations was $(0.79) per basic share for fiscal 2009, compared to $0.21 per basic share for the prior fiscal year. Return on average equity is a measure of how much income was produced on the average equity of the Company.

Results of Operations. The following table sets forth, for the fiscal years indicated, the components of the Company's consolidated statements of operations expressed as a percentage of net sales:

                                                                       Fiscal Year Ended
                                                       52 Weeks            53 Weeks            52 Weeks
                                                      February 1,         February 3,         January 28,
                                                         2009                2008                2007
Net sales                                                    100.0 %             100.0 %             100.0 %
Cost of sales                                                 68.6                68.4                68.2
Gross margin                                                  31.4                31.6                31.8
Selling, general and administrative expenses                  30.2                28.7                27.7
Depreciation and amortization                                  1.9                 2.0                 1.5
Total operating expenses                                      32.1                30.7                29.2
Operating income (loss) from continuing operations            (0.7 )               0.9                 2.6
Interest expense                                               0.4                 0.7                 0.6
Earnings (loss) from continuing operations before
income
     taxes and discontinued operations                        (1.1 )               0.2                 2.0
Income tax expense (benefit)                                  (0.4 )               0.1                 0.7
Earnings (loss) from continuing operations before
discontinued operations                                       (0.7 )               0.1                 1.3
Earnings (loss) from discontinued operations, net
of income tax benefit                                         (0.4 )              (0.2 )               0.0
Net earnings (loss)                                           (1.1 ) %            (0.1 ) %             1.3 %

Critical Accounting Policies

Our analysis of operations and financial condition is based on our consolidated financial statements, prepared in accordance with U.S. generally accepted accounting principles (GAAP). Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In the Notes to Consolidated Financial Statements, we describe our significant accounting policies used in preparing the consolidated financial statements. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under different assumptions or conditions. The following items in our consolidated financial statements require significant estimation or judgment:

Inventory: As discussed in Note 1(d) to the Consolidated Financial Statements, inventories are stated at the lower of cost or net realizable value with cost determined using the last-in, first-out "LIFO" method. Merchandise inventories in our stores are valued by the retail method. The retail method is widely used in the retail industry due to its practicality. Under the retail method, cost is determined by applying a calculated cost-to-retail ratio across groupings of similar items, known as departments. As a result, the retail method results in an averaging of inventory costs across similar items within a department. The cost-to-retail ratio is applied to ending inventory at its current owned retail valuation to determine the cost of ending inventory on a department basis. Current owned retail represents the retail price for which merchandise is offered for sale on a regular basis reduced for any permanent or clearance markdowns. Use of the retail method does not eliminate the use of management judgments and estimates, including markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. The Company continually evaluates product categories to determine if markdown action is appropriate, or if a markdown reserve should be established. The Company recognizes that the use of the retail method 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. Management believes that the retail method provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market. For LIFO, the Company determines lower of cost or market by pool.

Insurance: The Company retains significant deductibles on its insurance policies for workers compensation, general liability, medical claims and prescriptions. Due to the fact that it often takes more than one year to determine the actual costs, these costs are estimated based on the Company's historical loss experience and estimates from the insurance carriers and consultants. The Company completes an actuarial evaluation of its loss experience twice each year. In between actuarial evaluations, management monitors the cost and number of claims and compares those results to historical amounts. The Company's actuarial method is the fully developed method. The Company records its reserves on an undiscounted basis. The Company's prior estimates have varied based on changes in assumptions related to actual claims versus estimated ultimate loss calculations. Current and future estimates could be affected by changes in those same assumptions and are reasonably likely to occur.

Consideration received from vendors: Cost of sales and SG&A expenses are partially offset by various forms of consideration received from our vendors. This "vendor income" is earned for a variety of vendor-sponsored programs, such as volume rebates, markdown allowances, promotions, warehouse cost reimbursement and advertising. Consideration received, to the extent that it reimburses specific, incremental and identifiable costs incurred to date, is recorded in selling, general and administrative expenses in the same period as the associated expenses are incurred. Reimbursements received that are in excess of specific, incremental and identifiable costs incurred to date are recognized as a reduction to the cost of the merchandise and are reflected in costs of sales as the merchandise is sold. The Company establishes a receivable for the vendor income that is earned but not yet received. Based on provisions of the agreements in place, this receivable is computed by estimating when the Company has completed its performance and the amount has been earned. The majority of year-end receivables associated with these activities are collected within the following fiscal quarter.

Analysis of long-lived assets for impairment: The Company reviews assets for impairment at the lowest level for which there are identifiable cash flows, usually at the store level. The carrying amount of assets is compared with the expected undiscounted future cash flows to be generated by those assets over their estimated remaining economic lives. If the undiscounted cash flows are less than the carrying amount of the asset, the asset is written down to fair value. Factors that could result in an impairment review include, but are not limited to, a current period cash flow loss combined with a history of cash flow losses or a projection that demonstrates continuing losses associated with the use of a long-lived asset or significant changes in a manner of use of the assets due to business strategies or competitive environment. Additionally, when a commitment is made to close a store beyond the quarter in which the disclosure commitment is made, it is reviewed for impairment and depreciable lives are adjusted. The impairment evaluation is based on the estimated cash flows from continuing use until the expected disposal date plus the expected terminal value. Actual results could vary from management estimates.

Income Taxes: The Company adopted the provisions of Financial Accounting Standards Board, ("FASB") interpretation No 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), on January 29, 2007. FIN 48 prescribes a recognition threshold and a measurement standard for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. The recognition and measurement of tax benefits is often highly judgmental. Determinations regarding the recognition and measurement of a tax benefit can change as additional developments occur relative to the issue. Accordingly, the Company's future results may include favorable or unfavorable adjustments to our unrecognized tax benefits.

The Company records valuation allowances against our deferred tax assets, when necessary, in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Realization of deferred tax assets (such as net operating loss carryforwards) is dependent on future taxable earnings and is therefore uncertain. The Company will assess the likelihood that our deferred tax assets in each of the jurisdictions in which it operates will be recovered from future taxable income. Deferred tax assets are reduced by a valuation allowance to recognize the extent to which, more likely than not, the future tax benefits will not be realized.

Share-Based Payments: Effective January 30, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 "Share-Based Payment" ("SFAS 123(R)") and began recognizing share-based compensation expense for its share-based payments based on the fair value of the awards. Share-based payments consist of stock option grants. SFAS 123(R) requires share-based compensation expense recognized since January 30, 2006 to be based on the following: a) grant date fair value estimated in accordance with the original provisions of SFAS 123 for unvested options granted prior to the adoption date and b) grant date fair value estimated in accordance with the provisions of SFAS 123(R) for all share-based payments granted subsequent to the adoption date. For Executives, Directors and non-Executives, the Company estimates a forfeiture rate for each group. An actual turnover rate, lower or higher than historical trends and changes in estimated forfeiture rates would impact the share-based compensation expense recorded by the Company.

Fiscal 2009 Compared to Fiscal 2008

Net sales for fiscal 2009 increased $8.3 million or 1.7% to $490.0 million compared to $481.8 million for fiscal 2008. During fiscal 2009, the Company opened fifteen ALCO stores, of which four were in markets previously occupied by a Duckwall store. Eleven ALCO stores were closed and four Duckwall stores were closed, resulting in a year end total of 258 stores. Net sales for all stores open the full year in both fiscal 2009 and 2008 (same-stores), decreased by $22.6 million or (5.1%), excluding the two fuel centers, in fiscal 2009 compared to fiscal 2008, as adjusted for 52 week comparability.

Gross margin for fiscal 2009 increased $1.5 million, or 1.0%, to $153.9 million compared to $152.4 million in fiscal 2008. As a percentage of net sales, gross margin decreased to 31.4% in fiscal 2009 compared to 31.6% in fiscal 2008. Fiscal 2009 gross margin was positively impacted by continued shrink improvement and increased vendor considerations, offset by inventory review initiative expenses. Excluding the first quarter $1.3 million inventory review initiative charge, fiscal 2009 gross margin is 31.7%.

Selling, general and administrative expenses increased $9.5 million or 6.9% to $147.8 million in fiscal 2009 compared to $138.3 million in fiscal 2008. As a percentage of net sales, selling, general and administrative expenses were 30.2% in fiscal 2009 and 28.7% in fiscal 2008. This increase is primarily attributable to operating 33 new stores along with $2.2 million in fees to Accenture associated with the Store Transformation Project and executive and staff severance of $1.9 million. This increase of new stores contributed to increased employee labor and benefits of $5.6 million and real property rent of $4.7 million. In addition to the Store Transformation Project fees of $2.2 million, also impacting SG&A expenses were executive and staff severance of $1.9 million and reduced co-op advertising offset of $603. These expense increases were somewhat mitigated by reduced share-based compensation of $944, reduced floor care services of $520 and reduced advertising expense of $631. Excluding share-based compensation, preopening store costs, Store Transformation Project fees and executive and staff severance (Adjusted SG&A expenses) were 28.9% and 27.9% respectively for the fiscal 2009 and fiscal 2008.

Depreciation and amortization expense decreased $162 or (1.7%) to $9.3 million in fiscal 2009 compared to $9.5 million in fiscal 2008. The decrease is attributable to reduced asset impairment for fiscal 2009 compared to fiscal 2008 offset by increased depreciation from stores opened in fiscal 2009 and 2008.

Operating income (loss) from continuing operations decreased $7.8 million, or (171.3%), to ($3.2) million in fiscal 2009 compared to $4.6 million in fiscal 2008. Operating income (loss) from continuing operations as a percentage of net sales was (0.7%) in fiscal 2009 compared to 0.9% in fiscal 2008.

Income tax expense (benefit) on continuing operations were ($2.1) million in fiscal 2009 compared to $388 in fiscal 2008. The Company's effective tax rate was 40.9% in fiscal 2009 and 33.2% in fiscal 2008. The effective tax rate is higher due to the impact of permanent book and tax differences which have remained relatively constant over the reporting periods as compared to a decrease in book income.

Loss from discontinued operations, net of income tax benefit was $2.0 million in fiscal 2009, compared to $1.0 million in fiscal 2008.

Fiscal 2008 Compared to Fiscal 2007

Net sales for fiscal 2008 increased $34.9 million or 7.8% to $481.8 million compared to $446.9 million for fiscal 2007. During fiscal 2008, the Company opened eighteen ALCO stores, of which two were in markets previously occupied by a Duckwall store. Three ALCO stores were closed and nine Duckwall stores were closed, resulting in a year end total of 262 stores. Net sales for all stores open the full year in both fiscal 2008 and 2007 (same-stores), increased by $17.5 million or 4.2%, excluding the Company's two fuel centers and adjusted for 52 week comparability, in fiscal 2008 compared to fiscal 2007.

Gross margin for fiscal 2008 increased $10.4 million, or 7.3%, to $152.4 million compared to $142.0 million in fiscal 2007. As a percentage of net sales, gross margin decreased to 31.6% in fiscal 2008 compared to 31.8% in fiscal 2007. Fiscal 2008 gross margin was positively impacted by an increased initial mark-on percentage, offset by reduced vendor considerations and additional shrinkage reserve.

Selling, general and administrative expenses increased $14.7 million or 11.9% to $138.3 million in fiscal 2008 compared to $123.7 million in fiscal 2007. As a percentage of net sales, selling, general and administrative expenses were 28.7% in fiscal 2008 and 27.7% in fiscal 2007. The increase in selling, general and administrative expenses as a percentage of net sales was due in part to decreased vendor participation in CO-OP advertising, increased payroll, credit card fees, advertising, utilities, new store rents and professional services and software maintenance fees associated with rollout of IT initiative.

Depreciation and amortization expense increased $3.0 million or 45.3% to $9.5 million in fiscal 2008 compared to $6.5 million in fiscal 2007. The increase is attributable to a full year depreciation on stores opened in fiscal 2007, new stores opened in fiscal 2008 and a long-lived asset impairment of $2.1 million.

Operating income from continuing operations decreased $7.2 million, or (61.5%), to $4.6 million in fiscal 2008 compared to $11.8 million in fiscal 2007. Operating income from continuing operations as a percentage of net sales was 0.9% in fiscal 2008 compared to 2.7% in fiscal 2007.

Interest expense increased $653 or 23.9%, to $3.4 million in fiscal 2008 compared to $2.7 million in fiscal 2007. The increase in interest expense was attributable to increased borrowings by the Company during fiscal 2008 compared to fiscal 2007.

Income taxes on continuing operations were $388 in fiscal 2008 compared to $3.2 million in fiscal 2007. The Company's effective tax rate was 33.2% in fiscal 2008 and 35.2% in fiscal 2007. The effective tax rate is lower due to the increase in employment tax credits. Employment tax credits increased significantly over prior year; however, this increase in favorable credits was partially offset by an increase in state tax expense and share-based compensation.

Loss from discontinued operations, net of income taxes was $1.0 million in fiscal 2008, compared to $190 in fiscal 2007.

The Company has included Adjusted SG&A and Adjusted EBITDA, non-GAAP performance measures, as part of its disclosure as a means to enhance its communications with stockholders. Certain stockholders have specifically requested this information as a means of comparing the Company to other retailers that disclose similar non-GAAP performance measures. Further, management utilizes these measures in internal evaluation; review of performance and to compare the Company's financial measures to that of its peers. Adjusted EBITDA differs from the most comparable GAAP financial measure (earnings from continuing operations before discontinued operations) in that it does not include certain items, as does Adjusted SG&A. These items are excluded by management to better evaluate normalized operational cash flow and expenses excluding unusual, inconsistent and non-cash charges. To compensate for the limitations of evaluating the Company's performance using Adjusted SG&A and Adjusted EBITDA, management also utilizes GAAP performance measures such as gross margin return on investment, return on equity and cash flow. As a result, Adjusted SG&A and Adjusted EBITDA may not reflect important aspects of the results of the Company's operations.

                                                                       For the Years Ended
                                                                   52 Weeks           53 Weeks
                                                                 February 1,         February 3,
SG&A Expenses Breakout                                               2009               2008
Store support center (1)                                         $     26,427             21,430
Distribution center                                                     9,470              9,327
401K expense                                                              462                480
Same-store SG&A                                                        92,792             98,768
Non same-store SG&A (2)                                                18,509              7,214
Share-based compensation                                                  186              1,130
Final SG&A as reported                                                147,846            138,349
Less:
Share-based compensation                                                 (186 )           (1,130 )
Preopening store costs (2)                                             (1,846 )           (2,783 )
Executive and staff severance (1)                                      (1,942 )                -
Store Transformation Project                                           (2,220 )                -
Adjusted SG&A                                                    $    141,652            134,436

Adjusted SG&A as % of sales                                              28.9 %             27.9 %

Sales per average selling square feet (3)                        $     111.95             119.47

Adjusted gross margin dollars per average selling square
feet (3)(4)                                                      $      35.47              37.78

Adjusted SG&A per average selling square feet (3)                $      32.36              33.33

Adjusted EBITDA per average selling square feet (3)(5)           $       3.11               4.45

Average inventory per average selling square feet (3)(6)(7)      $      28.29              27.97

Average selling square feet (3)                                         4,377              4,033

Total stores operating beginning of period                                262                256
Total stores operating end of period                                      258                262
Total stores less than twelve months old                                   15
Total non same-stores                                                      33

Supplemental Data: (8)
Same-store gross margin dollar change                                    (8.4 )%             7.8 %
Same-store SG&A dollar change                                            (6.1 )%             5.6 %
Same-store total customer count change                                  (10.4 )%            (3.1 )%
Same-store average sale per ticket change                                 4.0 %              8.1 %

(1) Store Support Center includes executive and staff severance
(2) Non same-stores are those stores opened in fiscal 2009 and fiscal 2008 and includes preopening costs
(3) Average selling square feet is (beginning square feet plus ending square feet) divided by 2
(4) Adjusted gross margin includes $1.3 million inventory review initiative charge added back
(5) Adjusted EBITDA per selling square foot is a non-GAAP financial measure and is calculated as Adjusted EBITDA divided by selling square feet
(6) Average inventory is store level merchandise inventory for fiscal 2009 and fiscal 2008, respectively (beginning inventory plus ending inventory) divided by 2
(7) Excludes inventory for unopened stores
(8) Same-store information has not been adjusted to 52 weeks for comparability

. . .