GENERAL

Executive Overview

Fred's, Inc. and its subsidiaries ("We", "Our", "Us" or "Company") operates, as of October 27, 2012, 708 discount general merchandise stores, including 21 franchised Fred's stores, in 15 states in the southeastern United States. There are currently 342 full service pharmacies in our stores.

During the third quarter of fiscal 2012, our earnings per diluted share decreased 25% to $0.18 as compared to $0.24 during the third quarter of 2011. Net income during the third quarter decreased 27% to $6.6 million as compared to $9.0 million over the same quarter of 2011. As announced in our press release filed November 20, 2012, the third quarter performance reflects the impact of the shift in layaway sales to December, unfavorable LIFO expense charges on pharmacy inventory and higher operating expenses related to our store and pharmacy growth.

During the third quarter of 2012, our comparable store sales decreased 2.5%, primarily attributed to the impact of the continuing macroeconomic pressures being experienced in the Southeast as well as the continuing shift on pharmacy sales. Additionally, we continue to experience double-digit comparable sales decreases in our tobacco category. To address these current trends, we finalized an agreement with a major supplier in the second quarter of 2012 which gives Fred's more aggressive promotion capabilities in addition to new tobacco in-store signage which is currently rolling out to our stores. Also, we will add additional resources and capital to focus on driving more traffic into our stores during the remainder of the year.

Launched in 2010, the Core 5 Program is our long-term strategy designed to highlight key categories within our stores that differentiate us from our competition. The Core 5 categories are Pet, Household Supplies, Celebration, Home and Pharmacy and are strong trip driving departments in which Fred's has a clear and marketable advantage versus small box competitors. Through the third quarter of 2012, we have remodeled approximately 68% of our locations with the Core 5 layout. We continue to see improvement in stores that have been reformatted with the Core 5 layout, especially in the Pet, Household Supplies and Pharmacy Departments.

Our pharmacy department is one of our Core 5 categories and is a key differentiating factor from other small-box discount retailers. Accelerating pharmacy growth is a key strategy at Fred's. We aggressively pursue opportunities to acquire independent pharmacies within our targeted markets. Our emphasis is on opening a majority of our stores with pharmacies. Through the nine months of 2012, nineteen new pharmacies were opened, and two pharmacies were closed in existing locations, totaling 342 pharmacy locations at quarter end. This emphasis in growth was a major factor in the year-to-date pharmacy department sales increase as a percentage of sales of 160 basis points to 36.6% from 35.0% in the same period last year. Comparable script growth increased 3.7% and overall scripts increased 10.3% during the quarter. During the third quarter, our pharmacy department continued to experience sales pressure from the large brand-to generic drug conversions that have occurred thus far in 2012, as well as challenges in third-party reimbursements. Although the sales impact of the brand to generic drug conversion is negative, the gross margin of generic drugs is typically higher than brand drugs. Overall, pharmacy department produced strong results in the quarter, with higher comparable prescription counts and increased gross margins.

In addition to leveraging our pharmacy advantage, other key initiatives include improving store productivity through the Core 5 Program, finding ways to help our financially challenged customer, building customer loyalty and focusing on initiatives aimed at driving operating margin improvement. During the third quarter, we initiated our new Hometown Automotive and Hardware expansion program in 80 stores. Automotive and hardware are two of higher gross margin departments and this program doubles the existing space of these departments in our stores. This new program supports our focus on improving our overall store productivity.

Our markets, primarily southeastern U.S. rural towns, have been hard hit by high unemployment, fuel price increases and inflation. To help our financially challenged customer, we have focused our merchandising and marketing teams on key initiatives such as adding new value priced items, introducing new financial services and the expansion of fred's® brand products. The new financial services department carries prepaid and reloadable phone, gift, entertainment, debit and credit cards. We also provide Western Union services in some stores. We will continue expanding these programs over the remainder of the year.

Our fred's® brand initiative continues to be a key strategy for the Company in terms of building customer loyalty and increasing gross margin. As of October 27, 2012, our fred's® brand penetration rate was 19.7% of consumable product sales, which is up 60 basis points over last year. Our commitment to quality in our fred's® 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 and have seen significant penetration in our fred's® branded paper, pet and automotive categories. The launch of the Fred's loyalty card, called smartcard ™, during the second quarter rewards customers for qualifying purchases, primarily purchases of fred's® brand products. Through the third quarter, we had approximately 1.1 million activated cards with approximately 25% of those customers with enrolled accounts. The information gained from the usage of the smartcard ™ will be used to grow our loyal customer base and to direct the use of promotional funds towards those customers.

In 2012, we are continuing the focus on improving operating performance primarily through initiatives to increase gross margin. The margin drivers are expected to improve the sales mix through new product introductions in our home categories, expanding global sourcing resources to increase higher margin import purchases, the expansion of price optimization technology, managing promotional markdowns, reducing shrink and increasing volume rebates. During the third quarter, our gross margin improved 10 basis points, but our operating margin deleveraged 80 basis points. The shortfall resulted from the deleveraging of selling, general and administrative expenses, primarily attributed to higher labor, depreciation and amortization expenses and property rental related to our store and pharmacy growth.

Over the remainder of 2012, we intend to continue with capital improvements in infrastructure, including new stores and pharmacies, distribution center upgrades and further development of our information technology capabilities. In the fourth quarter, the Company expects to open 9 net new locations, bringing the total net location growth to 17 for the year. Technology upgrades will be made in the areas of corporate software and hardware, RF gun replacements and pharmacy server upgrades.

As previously published in our third quarter press release filed November 20, 2012, the Company expects total sales in the fourth quarter to increase in the range of 9% to 11%, or 2% to 4% excluding the 53rd week. Comparable store sales are expected to increase 6% to 8%, or decrease in the range of (2%) to flat excluding the 53rd week, compared to an increase of 0.1% in the fourth quarter last year. Over the remainder of 2012, Fred's anticipates that ongoing brand-to-generic drug conversions, as well as the high unemployment rate in the Southeast and expiration of unemployment benefits, will continue to negatively affect comparable store sales. Fourth quarter 2012 earnings per diluted share are forecasted to be in the range of $0.31 to $0.36 compared with earnings per diluted share of $0.26 in the same period last year. Based on actual results for the first half of 2012 and this outlook, the Company now expects total earnings per diluted share for 2012 to be in the range of $0.94 to $0.99.

Key factors that will be critical to the Company's future success include the successful performance of our Core 5 program, as well as managing the strategy for opening new stores and pharmacies. The successful opening of new stores and pharmacies includes the ability to open and operate efficiently, maintaining high standards of customer service, maximizing efficiencies in the supply chain, controlling working capital needs through improved inventory turnover, controlling the effects of inflation or deflation, controlling product mix, increasing operating margin through improved gross margin and leveraging operating costs and generating adequate cash flow to fund the Company's future needs.

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 28, 2012. 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 October 27, 2012 and October 29, 2011

Sales

Net sales for the third quarter of 2012 were $450.6 million compared to $444.4 million in 2011, a year-over-year increase of $6.2 million or 1.4%. Deferred layaway sales during the quarter totaled $3.7 million in 2012 as compared to $1.2 million in 2011, an increase of $2.5 million. The increase in deferred layaway sales is driven by layaway program changes introduced in the third quarter of 2012. Program changes included lowering the down payment from 10% of the transaction to $1 and eliminating the restocking fee of $2. The net sales increase during the quarter was driven by higher pharmacy department sales. General merchandise (non-pharmacy) sales decreased 0.5% from 2011. In the general merchandise departments, we experienced sales decreases primarily in the tobacco and home furnishing categories which were partially offset by increases in food, paper and chemical, beverage and pet. On a comparable store basis, sales decreased 2.5% compared with an increase of 1.5% in the same period last year.

The Company's pharmacy department sales were 38.2% of total sales ($172.3 million) in 2012 compared to 36.7% of total sales ($163.6 million) in the prior year and continue to rank as the largest department within the Company. The total sales in this department increased 5.3% over 2011 with third party prescription sales representing approximately 91% of total pharmacy sales, the same as in the prior year. Despite the continued pressure of the brand-to-generic shift on top-line sales, 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.

During the quarter, there were no changes to the franchised locations leaving 21 franchised locations at October 27, 2012 as compared to 22 franchised locations as of October 29, 2011. Sales to these locations during the quarter decreased to $8.5 million (1.9% of sales) from $9.5 million (2.1% of sales) in 2011. The Company does not intend to expand its franchise network.

The following table illustrates the sales mix unadjusted for deferred layaway sales:

                                         Thirteen Weeks Ended
                               October 27, 2012         October 29, 2011
Pharmaceuticals                             37.9 %                   36.7 %
Household Goods                             19.9 %                   20.3 %
Food and Tobacco                            17.3 %                   17.8 %
Paper and Cleaning Supplies                  9.4 %                    9.3 %
Health and Beauty Aids                       7.7 %                    7.6 %
Apparel and Linens                           5.9 %                    6.2 %
Franchise                                    1.9 %                    2.1 %
                                           100.0 %                  100.0 %

For the quarter, comparable store customer traffic decreased 2.5% over last year while the average customer ticket was flat at $19.65.

Gross Profit

Gross profit for the quarter was $138.1 million in 2012 compared to $136.0 million in 2011, a year-over-year increase of $2.1 million or 1.6%. Gross margin, measured as a percentage of sales was 30.7% in 2012, compared with 30.6% in the same quarter last year. The 10 basis point improvement was driven by an increase in generic sales which typically have a higher pharmacy department gross margin, as well as an increase in pharmacy rebates. This improvement was offset by an increase in LIFO charges, which is due to higher pharmacy product inflation than in prior years, and the deleveraging of general merchandise gross margin.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, including depreciation and amortization, were $128.0 million in 2012 (28.5% of sales) compared to $122.4 million in 2011 (27.6% of sales), an increase of $5.6 million. Selling, general and administrative expenses deleveraged 90 basis points as a percent of sales due to an increase in labor expense of $2.6 million (38 basis points), $1.4 million in higher depreciation and amortization (29 basis points) and $0.7 million of additional property rental (11 basis points), which are associated with new store and pharmacy growth, as well as an increase in professional fees of $0.7 million (15 basis points). The deleveraging was partially offset by a reduction in insurance expense of $0.6 million (17 basis points).

Operating Income

Operating income was $10.1 million in 2012 (2.2% of sales) compared to $13.6 million in 2011 (3.0% of sales). The year-over-year unfavorable variance is attributable to the $5.6 million increase in selling, general and administrative expenses as detailed in the Selling, General and Administrative Expenses section above, which was partially offset by the $2.1 million increase in gross profit that was driven by the higher pharmacy department margins.

Interest Expense, Net

Net interest expense for the third quarter of 2012 totaled $.1 million or less than .1% of sales compared to $.1 million in the same period last year, which was also less than .1% of sales in 2011.

Income Taxes

The effective income tax rate was 34.3% in 2012 compared to 32.9% in 2011. The increase in the effective income tax rate is due to the expiration of the federal Work Opportunity Tax Credits (WOTC) at the end of 2011. These credits are expected to be reinstated later in the fiscal year.

Net Income

Net income decreased to $6.6 million ($0.18 per diluted share) in 2012 compared to $9.0 million ($0.24 per diluted share) in 2011, a decrease of $2.4 million. The decrease in net income is due to the $5.6 million increase in selling, general and administrative expenses as detailed in the Selling, General and Administrative Expenses section above, which was partially offset by the $2.1 million increase in gross profit as described in the Gross Profit section above and the $1.0 million reduction in income tax expense primarily as a result of $3.5 million in reduced taxable income.

Thirty-Nine Weeks Ended October 27, 2012 and October 29, 2011

Sales

Net sales for the first nine months of 2012 increased to $1.422 billion from $1.381 billion in 2011, a year-over-year increase of $40.4 million or 2.9%. Deferred layaway sales during the quarter totaled $4.4 million in 2012 as compared to $1.8 million in 2011, an increase of $2.6 million driven by the layaway program changes introduced in the third quarter of 2012. The net sales increase during the quarter was driven by both higher general merchandise and pharmacy department sales. General merchandise (non-pharmacy) sales increased 0.7% over 2011. In the general merchandise departments, we experienced sales increases primarily in the food, paper and chemical, pet, beverage and auto and hardware categories, which were partially offset by sales decreases in tobacco and home furnishings. On a comparable store basis, sales decreased 0.8% compared with a 0.7% increase in the same period last year.

The Company's pharmacy department sales were 36.6% of total sales ($519.9 million) in 2012 compared to 35.0% of total sales ($484.0 million) in the prior year and continue to rank as the largest department within the Company. The total sales in this department increased 7.4% over 2011 with third party prescription sales representing approximately 91% of total pharmacy sales, the same as in the prior year. Despite the continued pressure of the brand to generic shift on top-line sales, 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.

During the first nine months of 2012, there were no changes to the franchised locations leaving 21 franchised locations at October 27, 2012 as compared to 22 franchised locations as of October 29, 2011. Sales to these locations decreased to $25.9 million (1.8% of sales) from $27.5 million (2.0% of sales) in 2011. The Company does not intend to expand its franchise network.

The following table illustrates the sales mix unadjusted for deferred layaway sales:

                                        Thirty-Nine Weeks Ended
                               October 27, 2012         October 29, 2011
Pharmaceuticals                             36.4 %                   35.0 %
Household Goods                             22.3 %                   22.8 %
Food and Tobacco                            16.7 %                   17.0 %
Paper and Cleaning Supplies                  9.0 %                    8.9 %
Health and Beauty Aids                       7.5 %                    7.5 %
Apparel and Linens                           6.3 %                    6.8 %
Franchise                                    1.8 %                    2.0 %
                                           100.0 %                  100.0 %

For the first nine months, comparable store customer traffic decreased 1.6% over last year while the average customer ticket increased 0.8% to $20.26.

Gross Profit

Gross profit for the first nine months of 2012 was $417.7 million in 2012 compared to $400.8 million in 2011, a year-over-year increase of $16.9 million or 4.2%. Gross margin, measured as a percentage of sales was 29.4% in 2012, compared with 29.0% in the same period last year. The 40 basis point improvement was driven by an increase in generic sales which typically have a higher pharmacy department gross margin, as well and higher pharmacy rebates. This improvement was offset by an increase in LIFO charges, which is due to higher pharmacy product inflation than in prior years, as well as the deleveraging of general merchandise gross margin.

Selling, General and Administrative Expenses

Selling, general and administrative expenses, including depreciation and amortization were $387.1 million in 2012 (27.2% of sales) compared to $363.9 million in 2011 (26.3% of sales), an increase of $23.2 million. The 90 basis points deleveraging as a percent of sales during the year resulted from an increase in labor expense of $9.2 million (27 basis points), $4.4 million in higher depreciation and amortization (26 basis points) and $3.2 million of additional property rental (14 basis points), which are associated with new store and pharmacy growth, as well as an increase in advertising spending of $1.7 million (10 basis points).

Operating Income

Operating income was $30.6 million in 2012 (2.2% of sales) compared to $37.0 million in 2011 (2.7% of sales), a decrease of $6.4 million. The year-over-year variance of $6.4 million is attributable to the $23.2 million increase in selling, general and administrative expenses as detailed in the Selling, General and Administrative Expenses section above, which was partially offset by the $16.9 million increase in gross profit that was driven by higher pharmacy department margins as described in the Gross Profit section above.

Interest Expense, Net

Net interest expense for 2012 totaled $0.4 million or less than .1% of sales compared to $.3 million, which was also less than .1% of sales in 2011.

Income Taxes

The effective income tax rate was 23.6% in 2012 compared to 35.6% in 2011. Income tax expense was favorably impacted by $4.2 million, or $0.12 per diluted share, of tax credits primarily related to a second quarter state income tax settlement of $3.6 million and $0.6 million of other tax-related assumptions and estimates. Excluding the impact of these favorable tax credits, the effective income tax rate for the first nine months of the year was 37.5% in 2012 compared to 35.6% in 2011. The increase in the effective income tax rate is due to the federal Work Opportunity Tax Credits (WOTC) that expired at the end of 2011. These credits are expected to be reinstated later in the fiscal year.

Net Income

Net income was $23.1 million ($.63 per diluted share) in 2012 compared to $23.6 million ($.61 per diluted share) in 2011, a year-over-year decrease of $0.5 million. The decrease in net income is primarily attributable to a $23.2 million increase in selling, general and administration expenses as detailed in the Selling, General and Administrative Expenses section above and was partially offset by a $16.9 million increase in gross profit driven by higher pharmacy department margins as described in the Gross Profit section above as well as a reduction in income tax expense of $5.9 million primarily attributable to the $4.2 million in favorable tax credits and a $6.5 million reduction in taxable income.

LIQUIDITY AND CAPITAL RESOURCES

Due to the seasonality of our business, inventories are generally lower at year-end than at each quarter-end of the following year.

Cash provided by operating activities totaled $36.5 million during the thirty-nine week period ended October 27, 2012 compared to $51.3 million in the same period of the prior year. We generated operating cash flow primarily through $23.1 million in year-to-date net income, an increase in operating liabilities of $45.0 million due to a higher accounts payable balance related to the increased inventory balance and our seasonality, $28.7 million in depreciation and amortization and an increase in the LIFO reserve of $3.0 million. Operating cash flows were partially offset by an inventory increase of $63.6 million which is due to new store and pharmacy growth, inflation and seasonality.

Cash used in investing activities totaled $32.0 million during the thirty-nine week period ended October 27, 2012 and consisted primarily of capital expenditures of $19.1 million related to existing store and pharmacy expenditures ($9.4 million), new store and pharmacy expenditures ($4.7 million) and technology and other corporate expenditures ($5.0 million). In addition, the Company planned expenditures of approximately $16.4 million in 2012 for the acquisition of prescription lists and other pharmacy related items of which $13.1 million has been spent to date. During the first three quarters of 2012, we opened 27 new locations, comprising 14 new stores and 13 new Xpress pharmacies. Fred's also closed 13 stores during the year and converted six Xpress pharmacies to full size stores. In 2012, the Company is planning capital expenditures excluding the acquisition of prescription lists of approximately $30.1 million. Expenditures are planned totaling $23.8 million for new and existing stores and pharmacies. Planned expenditures also include approximately $3.6 million for technology upgrades and approximately $2.6 million for distribution center equipment and other capital maintenance. Technology upgrades in 2012 will be made in the areas of IT software and hardware, RF gun replacements and pharmacy server upgrades. To date, the Company has spent $4.0 million towards these transactions.

Cash used by financing activities totaled $15.5 million during the thirty-nine week period ended October 27, 2012 and included $9.2 million for the repurchase of shares, $6.7 million for the payment of cash dividends and $0.6 million for the repayment of debt offset by $0.9 million for the exercise of stock options. There were $6.7 million in borrowings outstanding at October 27, 2012 related to real estate mortgages compared to $7.3 million at January 28, 2012. The decrease is attributable to $0.6 million of payments on mortgage debt.

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, we have 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.

· Unemployment.

· Changes in reimbursement practices for pharmaceuticals.

· Governmental regulation.

· Increases in fuel and utility rates.

· Potential adverse results in the litigation described under Legal Proceedings on page 18.

· 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 28, 2012.

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