Overview

Ingles, a leading supermarket chain in the Southeast, operates 200 supermarkets in Georgia (74), North Carolina (67), 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 March 28, 2009, the Company operated 68 in-store pharmacies and 65 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 Sheet.

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 $25.6 million and $25.6 million for the fiscal quarters ended March 28, 2009 and March 29, 2008, respectively. For the six-month periods ended March 28, 2009 and March 29, 2008, vendor allowances applied as a reduction of merchandise costs totaled $49.2 million and $50.5 million, 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 $3.2 million for the fiscal quarter ended March 28, 2009 and $4.1 million for the fiscal quarter ended March 29, 2008. For the six-month periods ended March 28, 2009 and March 29, 2008, vendor advertising allowances recorded as a reduction of advertising expense totaled $6.5 million and $6.7 million, 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 its product advertising, which could increase or decrease our expenditures.

Similarly, the Company is not able to assess the impact of vendor advertising allowances on the creation of additional revenues, as it has no way to measure whether such allowances directly generate revenue for its 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. There are 13 and 26 weeks of operations included in the unaudited condensed consolidated statements of income for the three- and six-month periods ended March 28, 2009 and March 29, 2008. 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- and six-month periods ended March 28, 2009 and March 29, 2008, comparable store sales include 195 and 194 stores, respectively.

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 Consolidated Financial Statements.

                                                   Three Months Ended                Six Months Ended
                                                March 28,       March 29,        March 28,       March 29,
                                                  2009            2008             2009            2008
Net sales                                           100.0 %         100.0 %          100.0 %         100.0 %
Gross profit                                         24.4 %          23.6 %           24.5 %          23.4 %
Operating and administrative expenses                21.4 %          19.5 %           21.1 %          19.4 %
Rental income, net                                    0.1 %           0.1 %            0.1 %           0.1 %
Gain (loss) from sale or disposal of assets           0.1 %          (0.1 )%            -  %            -  %
Income from operations                                3.2 %           4.1 %            3.5 %           4.1 %
Other income, net                                      -  %           0.1 %            0.1 %           0.1 %
Interest expense                                      1.7 %           1.5 %            1.6 %           1.5 %
Income before income taxes                            1.5 %           2.7 %            1.9 %           2.7 %
Income taxes                                          0.5 %           1.0 %            0.7 %           1.0 %
Net income                                            1.0 %           1.7 %            1.2 %           1.7 %

Three Months Ended March 28, 2009 Compared to the Three Months Ended March 29, 2008

Net income for the second quarter of fiscal 2009 totaled $7.8 million, compared with net income of $13.0 million earned for the second 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 by $6.4 million to $789.2 million for the three months ended March 28, 2009 from $782.8 million for the three months ended March 29, 2008. Ingles operated 200 stores at March 28, 2009, compared to 197 stores at March 29, 2008. Retail square footage was approximately 10.6 million at March 28, 2009 and 9.8 million at March 29, 2008. 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. Sales comparisons are also affected by the timing of the Easter holiday. In fiscal 2008, Easter fell in the Company's second fiscal quarter, but will occur in the Company's third quarter of fiscal year 2009. Excluding gasoline sales and the effect of additional Easter sales in fiscal 2008, grocery segment comparable store sales increased 4.9% for the three months ended March 28, 2009 compared with the three months ended March 29, 2008.

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 7.9%, while the average transaction size (excluding gasoline) decreased by approximately 1.4%.

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

                                             Three Months Ended
                                           March 28,    March 29,
                                              2009         2008
                   Grocery                 $  340,962   $  322,201
                   Non-foods                  160,337      151,547
                   Perishables                188,239      174,799
                   Gasoline                    72,284      102,025

                   Total grocery segment   $  761,822   $  750,572

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 March 28, 2009 are summarized as follows (in thousands):

  Total grocery sales for the three months ended March 29, 2008       $ 750,572
  Comparable store sales increase (including gasoline)                    1,179
  Additional Easter sales for the three months ended March 29, 2008      (7,730 )
  Impact of stores opened in fiscal 2008 and 2009                        20,308
  Impact of stores closed in fiscal 2008 and 2009                        (2,513 )
  Other                                                                       6

  Total grocery sales for the three months ended March 28, 2009       $ 761,822

Net sales to outside parties for the Company's milk processing subsidiary decreased $4.9 million or 15.1% in the March 2009 quarter compared to the March 2008 quarter. The sales decrease is attributable to an approximately 28% decrease in raw milk costs in the March 2009 quarter compared to the March 2008 quarter, offset by an increase in the case volume of products sold.

Gross Profit. Gross profit for the three-month period ended March 28, 2009 increased $8.3 million, or 4.5%, to $192.8 million, or 24.4% of sales, compared to $184.5 million, or 23.6% of sales, for the three-month period ended March 29, 2008.

Gross profit dollars increased due to the higher sales volume in the grocery segment. Grocery segment gross profit as a percentage of total sales was higher for the March 2009 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 26.9% for the three months ended March 28, 2009 compared with 27.4% for the three months ended March 29, 2008.

Gross profit for the Company's milk processing subsidiary for the March 2009 quarter increased $0.1 million, or 2.8%, to $5.4 million, or 13.1% of sales, compared to $5.3 million, or 11.1% of sales, for the March 2008 quarter. Raw milk prices were lower during the March 2009 quarter, which increased gross profit as a percentage of sales, as relatively stable per-gallon milk profit margins were applied to the lower sales price. Case volume sales increased, providing additional gross profit dollars.

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 inbound freight charges 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 $15.6 million, or 10.2%, to $168.7 million for the three months ended March 28, 2009, from $153.1 million for the three months ended March 29, 2008. As a percentage of sales, operating and administrative expenses were 21.4% for the three months ended March 28, 2009 compared with 19.6% for the three months ended March 29, 2008. In general, the Company's increased store development activities have resulted in higher personnel, depreciation and occupancy costs. Current unfavorable economic conditions have extended the time needed for new and redeveloped stores to reach targeted levels of sales and profitability.

A breakdown of the major increases in operating and administrative expenses is as follows:

                                                              Increase
                                                Increase       as a %
                                               in millions    of sales
              Salaries and wages              $         5.0       0.63 %
              Depreciation and amortization   $         2.5       0.32 %
              Utilities and fuel              $         1.8       0.22 %
              Warehouse expenses              $         1.6       0.20 %
              Taxes and licenses              $         1.5       0.19 %

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

Depreciation and amortization increased as a result of the Company's higher level of capital expenditures.

Utilities and fuel expense increased due to increases in retail square footage.

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.

Taxes and licenses increased due to increased property taxes in many of the Company's markets and the development of new and remodeled stores.

Rental Income, Net. Rental income, net totaled $0.7 million for the quarter ended March 28, 2009 and $0.9 million for the quarter ended March 29, 2008. The Company's expansion and relocation activities have resulted in less tenant space available for lease.

Gain (Loss) From Sale or Disposal of Assets. Gains from the sale or disposal of assets totaled $0.4 million for the three months ended March 28, 2009, compared with a loss on sale or disposal of assets totaling $0.5 million for the three months ended March 29, 2008. During the March 2009 quarter, the Company sold an outparcel at a gain of approximately $1.0 million, offset by losses on the disposal of equipment resulting from store redevelopment activities.

Other Income, Net. Other income, net totaled $0.1 million for the three-month period ended March 28, 2009 compared with $0.8 million for the three-month period ended March 29, 2008. The decrease was due primarily to substantial decreases in the selling price for waste paper and packaging.

Interest Expense. Interest expense increased $1.5 million for the three-month period ended March 28, 2009 to $13.1 million from $11.6 million for the three-month period ended March 29, 2008. Total debt at March 28, 2009 was $778.3 million compared with $626.1 million at March 29, 2008. New borrowings were incurred to fund the Company's higher level of capital expenditures during fiscal year 2008 and the first half of fiscal year 2009. Interest capitalized as construction costs increased due to the greater number of new store, remodel and relocation projects undertaken by the Company in recent quarters.

Income Taxes. Income tax expense as a percentage of pre-tax income decreased to 36.2% for the quarter ended March 28, 2009 compared to 38.1% in the quarter ended March 29, 2008. The effective tax rate decreased primarily as a result of lower state income taxes and increased tax credits.

Net Income. Net income totaled $7.8 million for the three-month period ended March 28, 2009 compared with $13.0 million for the three-month period ended March 29, 2008. Net income, as a percentage of sales, was 1.0% for the quarter ended March 28, 2009 and 1.7% for the quarter ended March 29, 2008. Basic and diluted earnings per share for Class A Common Stock were $0.33 and $0.32 for the quarter ended March 28, 2009 compared to $0.56 and $0.53, respectively, for the quarter ended March 29, 2008. Basic and diluted earnings per share for Class B Common Stock were each $0.30 for the quarter ended March 28, 2009 compared to $0.51 of basic and diluted earnings per share for the quarter ended March 29, 2008.

Six Months Ended March 28, 2009 Compared to the Six Months Ended March 29, 2008

Net income for the first half of fiscal year 2009 totaled $18.9 million, compared with net income of $25.7 million earned for the comparable fiscal year 2008 period. Sales increases and gross margin improvement were offset by higher expenses influenced by the Company's recent accelerated growth strategy.

Net Sales. Net sales increased by $34.1 million to $1.59 billion for the six months ended March 28, 2009 from $1.56 billion for the six months ended March 29, 2008. 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 fiscal year 2009 than in fiscal year 2008. Sales comparisons are also affected by the timing of the Easter holiday. In fiscal 2008, Easter fell in the Company's second fiscal quarter, but will occur in the Company's third quarter of fiscal year 2009. Excluding gasoline sales and the effect of additional Easter sales in fiscal 2008, grocery segment sales increased 5.0% for the six months ended March 28, 2009 compared with the six months ended March 29, 2008. The number of customer transactions (excluding gasoline) increased 6.9%, while the average transaction size (excluding gasoline) was level over the comparable six month periods.

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

                                              Six Months Ended
                                           March 28,     March 29,
                                             2009          2008
                  Grocery                 $   685,536   $   645,025
                  Non-foods                   321,455       304,759
                  Perishables                 377,156       351,919
                  Gasoline                    153,414       193,293

                  Total grocery segment   $ 1,537,561   $ 1,494,996

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 six months ended March 28, 2009 are summarized as follows (in thousands):

  Total grocery sales for the six months ended March 29, 2008       $ 1,494,996
  Comparable store sales increase (including gasoline)                   24,022
  Additional Easter sales for the six months ended March 29, 2008        (8,190 )
  Impact of stores opened in fiscal 2008 and 2009                        31,994
  Impact of stores closed in fiscal 2008 and 2009                        (5,271 )
  Other                                                                      10

  Total grocery sales for the six months ended March 28, 2009       $ 1,537,561

Net sales to outside parties for the Company's milk processing subsidiary decreased $8.4 million or 13.0% for the six months ended March 2009 compared with the six months ended March 2008. The sales decrease is attributable to decreased raw milk costs offset by an increased case volume of products sold.

The Company expects sales growth for the remainder of fiscal 2009 to approximate the rate of growth experienced in the first six months of this fiscal year. Sales growth for the remainder of fiscal year 2009 will be influenced by market fluctuations in the per gallon price of gasoline, changes in commodity prices, and general economic conditions. The Company also expects that the maturation of new and expanded stores will contribute to sales growth.

Gross Profit. Gross profit for the six months ended March 28, 2009 increased $24.7 million, or 6.8%, to $389.9 million compared with $365.2 million, for the six months ended March 29, 2008. As a percent of sales, gross profit increased to 24.5% for the six months ended March 28, 2009 from 23.4% for the six months ended March 29, 2008.

Gross profit dollars increased due to the higher sales volume and a change in the mix of products sold in the grocery segment. Sales increases in grocery, non-foods and perishables offset decreased gasoline dollar sales. Gasoline dollar sales decreased due to substantial decreases in per-gallon market prices, while gallons sold and gross profit per gallon increased. Gasoline generally earns a lower gross margin than the Company's other departments, and non-perishable departments such as grocery generally earn lower gross margins than perishable departments. Excluding gasoline sales, grocery segment gross profit as a percentage of sales was 26.7% for the six months ended March 28, 2009 compared with 27.0% for the same period of last fiscal year.

Gross profit for the Company's milk processing subsidiary for the six months ended March 2009 increased $0.7 million, or 6.3%, to $11.2 million, or 13.1% of sales, compared to $10.5 million, or 10.8% of sales, for the six months ended March 2008. Lower raw milk prices, increased case volume sales and higher per-gallon milk profit margins contributed to the increase in gross profit dollars and margin.

Operating and Administrative Expenses. Operating and administrative expenses increased $33.2 million, or 10.9%, to $336.5 million for the six months ended . . .