Management's Discussion and Analysis of Financial Condition and Results of Operations

GENERAL

Executive Overview

Recognizing our pharmacy department as a key differentiating factor to other small-box discount retailers, 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 acquisitions and file buys, but cold starts will be employed where it makes sense to do so. As we mentioned last quarter, we began offering our Prescription Plus $4 generic program to all pharmacies in the chain. We piloted this program on a limited basis last year and found it to be a traffic driver, and thus rolled it out to all pharmacies in the first quarter. We are pleased with this deployment and its effect on our prescription count.

Our Own Brand initiative continues to be a key strategy for the Company in terms of building customer loyalty and increasing gross margin. We have reached an Own Brand penetration rate of 16% of total consumable sales, and that number will continue to grow throughout the year as new Own Brand products are introduced. 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 chemicals and food introduced in the second quarter of 2009.

Expense reduction and containment continues to be a key focus of the Company, especially in light of current economic conditions. We are aggressively pursuing cost reductions in all functional areas and are also continuously reviewing internal processes to find efficiencies and/or redundancies and drive unnecessary costs and expenses out of the business. These efforts are being coordinated at the Executive Level and close attention is being paid not to sacrifice service to our customers. These efforts resulted in a 140 basis point reduction in expenses as a percentage of sales in the second quarter of 2009 compared to the same period last year.

Also in the second quarter, we continued the work that we began last year related to our real estate site selection and store layout programs. We continue to improve the interior layout of our stores so that our customers experience more open customer spaces, more logical product flow and a more consistent and meaningful price message, all of which are intended to provide a more pleasurable shopping trip. We also continue to hone our real estate strategy so that the proper site is selected to support our targeted demographics, thus driving traffic and sales. Many of these efforts will culminate in the third quarter with the grand opening of our "Pilot Store of the Future".

Over the remainder of 2009, we intend to continue with capital improvements in infrastructure, including new stores as well as existing store expansion and remodels, distribution center upgrades and further development of our information technology capabilities. Technology upgrades will be made in the areas of direct store delivery systems, in-store systems, and pharmacy systems.

As previously reported, the Company expects total earnings per diluted share for 2009 to be in the range of $0.73 to $0.80. These earnings projections include the following significant events affecting the balance of the year:

· The third year incremental raising of the federal minimum wage which will negatively impact our labor expense by approximately $2.3 million.

· The continued product mix shift to basic and consumable items, coupled with intense pharmacy competition, will continue to negatively affect gross margin.

· The positive margin impact of our Own Brand initiatives as mentioned in previous paragraphs.

Key factors that will be critical to the Company's future success include 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, managing 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 to fund the Company's future needs.

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Other factors that will affect Company performance in 2009 include the continuing management of the impacts of the changing regulatory environment in which our pharmacy department operates. Additionally, we believe that the ongoing recession and elevated unemployment rate continue 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 to wary consumers.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's condensed financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The critical accounting matters that are particularly important to the portrayal of the Company's financial condition and results of operations and require some of management's most difficult, subjective and complex judgments are described in detail in the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2009. The preparation of condensed financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to inventories, income taxes, insurance reserves, contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

RESULTS OF OPERATIONS

THIRTEEN WEEKS ENDED AUGUST 1, 2009 AND AUGUST 2, 2008

Sales
Net sales for the second quarter of 2009 decreased to $434.2 million from $447.1 million in 2008, a quarter-over-quarter decline of $12.9 million or 2.9%, reflecting the Company's store closing program coupled with the ongoing economic challenges impacting our customers' disposable income. Excluding sales from stores closed in 2008 ($12.0 million), total sales were down $0.9 million over the second quarter last year. On a comparable store basis, sales in the second quarter declined 1.3% ($5.3 million) compared with a 4.9% ($19.6 million) increase in the same period last year.

The Company's 2009 front store (non-pharmacy) sales decreased 5.8% over 2008 front store sales. Excluding the front store sales from stores closed in 2008 ($12.0 million), sales decreased 1.75% over the second quarter last year. Although front store sales growth declined in the quarter in categories such as home furnishings, men's clothing, health and beauty aids and toys, we did experience sales increases in the more discretionary consumable categories such as tobacco, direct beverages, paper and cleaning supplies and pets.

The Company's pharmacy sales were 32.8% of total sales in the second quarter of 2009 compared to 30.7% of total sales in the same quarter last 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 3.6% over 2008, 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 the second quarter of 2009 decreased to $9.2 million (2.1% of sales) from $9.7 million (2.2% of sales) in 2008. The decrease in quarter over quarter franchise sales resulted from the ongoing economic challenges impacting our customers' disposable income. The Company does not intend to expand its franchise network in the future.

The sales mix for the period was 32.8% Pharmaceuticals, 23.6% Household Goods, 16.7% Food and Tobacco, 9.5% Paper and Cleaning Supplies, 7.8% Apparel and Linens, 7.5% Health and Beauty Aids, and 2.1% Franchise. The sales mix for the same period last year was 30.7% Pharmaceuticals, 25.5% Household Goods, 15.3% Food and Tobacco, 9.3% Paper and Cleaning Supplies, 9.1% Apparel and Linens, 7.9% Health and Beauty Aids, and 2.2% Franchise.

For the quarter, comparable store customer traffic decreased 0.4% over the same quarter last year while the average customer ticket decreased 0.9% to $18.68.

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Gross Margin
Gross margin for the second quarter of 2009 decreased to $120.7 million from $123.9 million in 2008, a quarter-over-quarter decline of 2.5%. Gross margin, measured as a percentage of sales, increased slightly to 27.8% from 27.7% in the same quarter last year. The overall improvement in gross margin percentage results primarily from an increase in vendor consideration, better management of inventory resulting in fewer clearance markdowns and lower freight costs.

Selling, General and Administrative Expenses Selling, general and administrative expenses, including depreciation and amortization, decreased to $112.6 million in 2009 (25.9% of sales) from $121.9 million in 2008 (27.3% of sales). This 140 basis point expense leverage resulted primarily from the effect of our store closures in fiscal 2008 ($7.3 million), lowering distribution costs ($1.5 million) and managing costs in our stores by increasing labor efficiencies ($0.5 million).

Operating Income
Operating income increased to $8.2 million in the second quarter of 2009 (1.9% of sales) from $1.9 million in 2008 (0.4% of sales) due primarily to a reduction in selling, general and administrative expenses as the Company did not incur expenses related to store closures in the current fiscal quarter, as well as continued focus on managing costs in our stores, as described in the Selling, General and Administrative Expenses section above. This favorability in expenses was partially offset by a decrease in gross margin of $3.2 million (2.5% of sales), as described in the Gross Margin section above.

Interest Expense
The Company incurred net interest expense of $0.1 million in the second quarter of 2009 and 2008.

Income Taxes
For the second quarter of 2009, the effective income tax rate was 47.5%, as compared to 44.7% in the second quarter of 2008. The increase in the effective tax rate during the second quarter of 2009 was primarily due to the final assessment and settlement of the Internal Revenue Service exam for tax years 2004 - 2007.

Net Income
As a result of the fluctuations described in the preceding sections, net income increased 310.5% to $4.2 million (or $.11 per diluted share) in the second quarter of 2009 from $1.0 million (or $.03 per diluted share) during the same period last year. While net sales decreased by 2.9% and gross margin decreased 2.5% over the same period last year, the improvement in selling, general and administrative expenses (7.6%) more than offset this unfavorability.

TWENTY-SIX WEEKS ENDED AUGUST 1, 2009 AND AUGUST 2, 2008

Sales
Net sales decreased to $892.6 million in 2009 from $911.4 million in 2008, a year-over-year decline of $18.8 million or 2.1%, reflecting the Company's store closing program coupled with the ongoing economic challenges impacting our customers' disposable income. Excluding sales from stores closed in 2008 ($37.7 million), total sales increased 2.2% ($18.9 million) over last year. This increase was attributable to an increase in comparable store sales of .8% ($6.5 million) and increase in non-comparable store sales of 1.4% ($12.4 million).

The Company's 2009 front store (non-pharmacy) sales decreased 4.7% over 2008 front store sales. Excluding the front store sales from stores closed in 2008 ($37.7 million), sales increased 1.6% over last year. Although front store sales growth declined in the quarter in the more discretionary categories such as home furnishings, health and beauty aids, men's clothing and footwear, we did experience sales increases in consumable categories such as tobacco, pets, direct beverages, food and prepaid products.

The Company's pharmacy sales were 33.1% of total sales in the first half of 2009 compared to 31.2% of total sales in the same period last 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 3.6% over 2008, 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.

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Sales to FRED'S 24 franchised locations during the first half of 2009 decreased to $19.4 million (2.2% of sales) from $20.0 million (2.2% of sales) in 2008. The decrease in year-over-year franchise sales were a result of the ongoing economic challenges impacting our customers' disposable income.

The sales mix for the period was 33.1% Pharmaceuticals, 23.5% Household Goods, 16.4% Food and Tobacco, 9.3% Paper and Cleaning Supplies, 7.8% Apparel and Linens, 7.7% Health and Beauty Aids, and 2.2% Franchise. The sales mix for the same period last year was 31.3% Pharmaceuticals, 24.9% Household Goods, 15.4% Food and Tobacco, 8.9% Apparel and Linens, 9.2% Paper and Cleaning Supplies, 8.1% Health and Beauty Aids, and 2.2% Franchise.

For the year, comparable store customer traffic increased 0.6% over the same period last year while the average customer ticket increased 0.2% to $19.05.

Gross Margin
Gross margin for the first half of 2009 decreased to $249.7 million from $256.3 million in 2008, a year-over-year decline of 2.6%. Gross margin, measured as a percentage of sales, declined to 28.0% from 28.1% last year. Gross margin was unfavorably impacted by continued competitive pressures, an unfavorable shift in the product mix toward lower margin basic and consumable products while being favorably impacted by an increase in vendor dollar consideration.

Selling, General and Administrative Expenses Selling, general and administrative expenses, including depreciation and amortization, decreased to $227.9 million in 2009 (25.5% of sales) from $242.6 million in 2008 (26.6% of sales). This 110 basis point expense leverage resulted primarily from the effect of our store closures in fiscal 2008 ($7.9 million), lowering distribution costs ($3.4 million) and managing costs in our stores by increasing labor efficiencies ($2.3 million).

Operating Income
Operating income increased 59.6% to $21.8 million in the first half of 2009 (2.4% of sales) from $13.7 million in 2008 (1.5% of sales) due primarily to a reduction in selling, general and administrative expenses as the Company did not incur expenses related to store closures in the first half of this year as well as continued focus on managing costs in our stores and distribution centers, as described in the Selling, General and Administrative Expenses section above. This favorability in expenses was partially offset by a decrease in gross margin of $6.6 million, a year-over-year decline of 2.6%, as described in the Gross Margin section above.

Interest Expense
The Company incurred net interest expense of $0.2 million in the first half of 2009 and 2008.

Income Taxes
For the first half of 2009, the effective income tax rate was 40.9%, as compared to 38.3% for the same period last year. The increase in the effective tax rate was primarily due to the final assessment and settlement in the second quarter of the Internal Revenue Service exam for tax years 2004 - 2007. We anticipate the tax rate for the remaining two quarters to be in the range of 35% to 37%.

Net Income
As a result of the fluctuations described in the preceding sections, net income increased 54.4% to $12.8 million (or $.32 per diluted share) in the first half of 2009 from $8.3 million (or $.21 per diluted share) during the same period last year. While net sales decreased by 2.1% and gross margin decreased 2.6% over the same period last year, the improvement in selling, general and administrative expenses (6.1%) more than offset this unfavorability.

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LIQUIDITY AND CAPITAL RESOURCES

Due to the seasonality of our business and the continued increase in the number of stores and pharmacies, inventories are generally lower at year-end than at each quarter-end of the following year.

Cash provided by operating activities totaled $33.6 million during the twenty-six week period ended August 1, 2009 compared to $39.3 million in the same period of the prior year. While cash was used for the purchase of inventories, we generated operating cash flow through quarterly income and from our ongoing initiative to better manage our Accounts Payable processes.

Cash used in investing activities totaled $15.5 million, and consisted primarily of expenditures related to existing stores ($9.0 million), pharmacy acquisitions ($3.6 million), capital expenditures associated with the store and pharmacy expansion program ($1.0 million) and technology and other corporate expenditures ($1.9 million). During the first six months of 2009, we opened 6 stores and 7 pharmacies and closed 3 pharmacies. The Company anticipates that in the remainder of 2009 it will open 10 to 14 stores and 5 to 10 pharmacies. In 2009, the Company is planning capital expenditures totaling approximately $21.4 million. Expenditures are planned totaling approximately $13.5 million for upgrades, remodels, or new stores and pharmacies; $3.9 million for technology upgrades, $2.4 million for distribution center equipment and capital replacements and $1.6 million for other corporate expenditures. In addition, the Company also plans expenditures of $5.0 million for the acquisition of customer lists and other pharmacy related items. Depreciation expense for 2009 will be approximately $26.0 million.

Cash used by financing activities totaled $1.9 million and included $2.0 million for the payment of cash dividends and was offset by $0.2 million in proceeds from the exercise of stock options and employee stock purchase plan. There were $5.0 million in borrowings outstanding at August 1, 2009 related to real estate mortgages compared to $5.1 million at January 31, 2009.

We believe that sufficient capital resources are available in both the short-term and long-term through currently available cash and cash generated from future operations and, if necessary, the ability to obtain additional financing.

FORWARD-LOOKING STATEMENTS

Other than statements based on historical facts, many of the matters discussed in this Form 10-Q relate to events which we expect or anticipate may occur in the future. Such statements are defined as "forward-looking statements" under the Private Securities Litigation Reform Act of 1995 (the "Reform Act"), 15 U.S.C. Sections 77z-2 and 78u-5. The Reform Act created a safe harbor to protect companies from securities law liability in connection with forward-looking statements. We intend to qualify both our written and oral forward-looking statements for protection under the Reform Act and any other similar safe harbor provisions.

The words "believe", "anticipate", "project", "plan", "expect", "estimate", "objective", "forecast", "goal", "intend", "will likely result", or "will continue" and similar expressions generally identify forward-looking statements. All forward-looking statements are inherently uncertain, and concern matters that involve risks and other factors that may cause the actual performance of the Company to differ materially from the performance expressed or implied by these statements. Therefore, forward-looking statements should be evaluated in the context of these uncertainties and risks, including but not limited to:

· Economic and weather conditions which affect buying patterns of our customers and supply chain efficiency.

· Changes in consumer spending and our ability to anticipate buying patterns and implement appropriate inventory strategies.

· Continued availability of capital and financing.

· Competitive factors.

· Changes in reimbursement practices for pharmaceuticals.

· Governmental regulation.

· Increases in fuel and utility rates.

· Potential adverse results in the Fair Labor Standards Act ("FSLA") litigation described under Legal Proceedings on page 20.

· Other factors affecting business beyond our control, including (but not limited to) those discussed under Part 1, ITEM 1A "Risk Factors" of the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2009.

Consequently, all forward-looking statements are qualified by this cautionary statement. Readers should not place undue reliance on any forward-looking statements. We undertake no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which it was made.

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Item 3.