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FRED > SEC Filings for FRED > Form 10-K on 17-Apr-2014All Recent SEC Filings

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Form 10-K for FREDS INC


Annual Report

ITEM 7: Management's Discussion and Analysis of Financial Condition and Results of Operations

General Accounting Periods

The following information contains references to years 2013, 2012 and 2011, which represent fiscal years ended February 1, 2014, February 2, 2013 (which was a 53-week accounting period) and January 28, 2012. This discussion and analysis should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. Additionally, our discussion and analysis should be read in conjunction with the Forward-Looking Statements/Risk Factors disclosures included herein.

Executive Overview

Fred's, Inc. and its subsidiaries ("We", "Our", "Us" or "Company") operates, as of February 1, 2014, 704 retail stores, including 21 franchised Fred's stores, in 15 states in the southeastern United States. We currently offer 355 full service pharmacies located within our stores. Our mission is to be the hometown pharmacy and discount store that provides a fast, fun and friendly low-price place to shop. Approximately 84% of our stores are located in markets with populations of 15,000 or less, where Fred's provides often the only, or one of only two, pharmacies in town.

Fred's is a unique combination of pharmacy, dollar store and mass merchant. We offer a broader assortment than traditional dollar stores and pharmacies with greater convenience than big box retailers. We offer different product categories to drive shopping frequency (including consumables such as tobacco, food and beverage, prescription pharmaceuticals, paper and cleaning supplies, pet supplies, health and beauty aids) and to drive higher profitability (including discretionary products such as home décor, seasonal merchandise, auto and hardware and lawn and garden). Our general merchandise selection includes a diverse array of brand name and private label staple and discretionary products at value prices. We operate in the discount retail variety sector and approximately 90% of the products offered in our stores retail between $1 and $10.

Fred's caters to value-oriented, budget-conscious, primarily female shoppers who prefer convenience over the hassles of big-box shopping. Similar to the other retailers in this sector, our customers have continued to be negatively impacted by the pressures of the current macroeconomic environment. Those primary pressures include employment challenges, the rising costs of food, gasoline and energy, increasing payroll taxes and the uncertainty of medical expenses just as the deadline to sign up for the Affordable Care Act ended on March 31, 2014. While some of these key factors have shown signs of improvement, the uncertainty about the length of time it will take for the economy to recover and the strength of that recovery has left consumers wary and understandably conservative. As percent of total sales, spending in our discretionary merchandise categories, which we classify as Household Goods and Apparel and Linens, declined to 27.6% of net sales in 2013 as compared to 28.9% in 2012 and 30.2% in 2011.

In the first quarter of 2013, the Company announced the launch of our three-year reconfiguration plan to regain the momentum we had in the prior three years in driving toward our 4% operating margin goal. In 2009, 2010 and 2011 our operating income as a percent of sales was 2.1%, 2.5% and 2.7%, respectively. The main focus of our reconfiguration plan is to improve our overall store productivity and space efficiency while enhancing the product selection in stores with pharmacies. The plan has two fundamental principles: to aggressively accelerate our pharmacy department presence and to improve our general merchandise space efficiency and productivity.

Fred's stores with pharmacy departments have an operating margin of 4.5% to 5.0%, which exceeds our 4.0% operating margin goal. Our pharmacy department is a key differentiating factor from other small-box discount retailers. Pharmacy department penetration was 50% at the end of 2012 and 52% at the end of 2013. Under the reconfiguration plan, we are increasing pharmacy department penetration to 65% to 70% by the end of 2015. To achieve this goal, we will concentrate on adding pharmacies to existing stores without pharmacy departments, open all new stores with a pharmacy department and make opportunistic acquisitions that will operate as Xpress pharmacy locations until they become a future full-service location. Our pharmacy departments should continue to benefit from the aging U.S. population, an expected increase in patient prescription compliance and newly insured customers under the Affordable Care Act.

This growth in pharmacy department locations positions us to expand our other pharmacy offerings such as our specialty pharmacy program, our customer-centric clinical services offerings and an improved over-the-counter offering in health and beauty aids. Specialty pharmacy is the fastest-growing segment of the pharmacy industry. During 2012, we entered into an agreement with Diplomat Specialty Pharmacy to provide clinical and patient administration services necessary to manage our patients who are receiving specialty medications. Specialty medications are high cost drugs that are used to treat chronic or rare conditions such as hepatitis, cancer, multiple sclerosis, rheumatoid arthritis and other complex diseases. We are pleased with the initial progress surrounding the execution of our specialty pharmacy initiative, including the on-going relationship with Diplomat Specialty Pharmacy and the launch of our internal specialty pharmacy facility, EIRIS Health Services, which opened late in the third quarter of 2013. Fred's clinical services offerings are focused on driving increased immunizations, assisting our customers with medication therapy management, rolling out "Time My Meds", which is focused on prescription adherence, and expanding our disease management services, beginning with diabetes management.

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Towards our efforts to aggressively accelerate our pharmacy department penetration, we added 24 pharmacy departments in fiscal 2013 consisting of sixteen acquisitions and eight cold starts. We also had the opportunity to sell the prescription files and close twelve underperforming pharmacies and convert 3 Xpress locations into full-service stores. These efforts brought the pharmacy department total to 355, up 2.6% from 2012. As a percent of our company-owned store locations, pharmacy department penetration increased from 50% to 52%. As a percent of total sales, pharmacy department sales increased to 37.7% of sales in 2013 from 36.3% of sales in 2012. Pharmacy department additions are planned in the range of 30 to 40, with closings of approximately 3 departments. Pharmacy department penetration by the end of fiscal 2014 will be approximately 56%.

Improving our general merchandise space efficiency and productivity is centered on expanding space in our discretionary product lines. The three main areas of focus of our reconfiguration plan are (1) the expansion of our Hometown Auto and Hardware program, (2) expansion of seasonal space and (3) expansion of health and beauty aids in stores with pharmacy departments.

We began testing our reconfiguration plan in the third quarter of 2012 by reallocating space in 78 stores to deploy our expanded Hometown Auto and Hardware program. As of February 1, 2014, 322 stores, or 46% of our retail stores, have been reset with the expanded Hometown Auto and Hardware program. Our expanded auto and hardware departments continued to perform well and are delivering comparable store sales increases of 18% to 44%, respectively, and outperforming on total comparable store sales above the remainder of the chain. By the end of the first half of 2014, an additional 79 stores will be reconfigured with the expanded hardware and auto format, bringing the total stores with the expansion to 401 or approximately 57% of our retail stores.

As part of our plan, we are committed to reconfigure 12% to 15% of our selling square feet from less productive categories on a sales-per-square foot and gross margin-per square foot basis to more productive categories. The goal of these changes is to shift our general merchandise business to a healthier balance between higher gross margin discretionary product lines and lower margin consumable products lines while accelerating our pharmacy department and healthcare services offerings. We believe these efforts can improve overall store productivity and space efficiency and enhance product selection in stores with pharmacies. To those efforts, the Company announced, in our press release filed Thursday, March 28, 2014, that we will exit three primary categories:
footwear, select indoor furniture and electronics, primarily televisions. As a result, we recorded an inventory markdown reserve of $1.7 million or $0.03 per diluted share in the fourth quarter of 2013. These categories do not fit in our long-term strategic plan to increase inventory turns and improve gross margin, which we expect to see beginning in the second half of 2014, and are highly susceptible to on-line purchasing. By exiting these product lines, our general merchandise product offerings will be better tailored to appeal to the pharmacy customer and will include the expansion of health and beauty aids, cosmetics, eye care, vitamins, pain relief and durable medical equipment. In stores without a pharmacy department, exiting these product lines will allow the space for ongoing automotive and hardware expansion plans.

2013 Financial Results

As reported in our earnings release published on March 27, 2014, sales in 2013 decreased 0.8% to $1.939 million from $1.955 million in 2012. To make fiscal 2013 results comparable with those of the prior year, we eliminated the first week of 2012 to make similar 52-week periods. On an adjusted basis, sales increased 1.4% in fiscal 2013. As a percent of sales, pharmacy department sales increased to 37.7% in 2013 from 36.3% in 2012.

For the full year, gross margin as a percent of net sales declined 10 basis points to 28.9% from 29.0%. Gross margin was negatively impacted by an inventory markdown reserve recorded in 2013 for the merchandise categories that the Company has chosen to exit as described above, and we experienced a year-over-year decrease in sales of higher-margin discretionary merchandise. We expect the increasing rate of pharmaceutical inflation will continue to have a negative impact on earnings in the first half of 2014.

Earnings per diluted share for fiscal 2013, a 52-week year, were $0.71 as compared to $0.81 in fiscal 2012, a 53-week year. To make the earnings of 2013 and 2012 comparable, there are several components to consider, which are outlined below. As described above, the inventory markdown reserve recorded in 2013 for the merchandise categories the Company has chosen to exit had a negative $0.03 impact on earnings per diluted share. In addition, a year-over-year increase in LIFO expense in 2013 had a $0.02 impact on earnings per share. Earnings per diluted share for 2013 were $0.76 when adjusted for the $0.05 described above. The additional sales week in 2012 contributed approximately $1.0 million in earnings or $0.03 per diluted share, and the state tax settlement recorded in the second quarter of 2012 as well as other tax related adjustments had a favorable impact of $4.2 million or $0.12 per share. Earnings per diluted share for 2012 were $0.66 when adjusted for these favorable earnings impacts. This represents an increase in operational earnings per diluted share of 8% to $0.71 in 2013 compared to $0.66 on comparable 52-week basis in 2012.

In our sales release dated January 9, 2014, the Company announced that we have engaged financial advisors Bank of America Merrill Lynch and Peter J. Solomon to review strategic opportunities to enhance shareholder value. The Board of Directors, with the assistance of its financial advisors, will consider a range of options, which may include a sale or merger of the Company, a strategic alliance with another company, a recapitalization of the Company or none of the foregoing. No decision has been made to enter into a transaction at this time, and there can be no assurance that we will enter into a transaction in the future. The Company does not intend to comment further regarding this process until such time as its Board of Directors has determined the outcome of the process or otherwise determined that disclosure is required or appropriate.

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Critical Accounting Policies

The preparation of Fred's financial statements requires management to make estimates and judgments in the reporting of assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. Our estimates are based on historical experience and on other assumptions that we believe are applicable 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. While we believe that the historical experience and other factors considered provide a meaningful basis for the accounting policies applied in the Consolidated Financial Statements, the Company cannot guarantee that the estimates and assumptions will be accurate under different conditions and/or assumptions. The critical accounting policies presented are those policies the Company has identified as having both a highly subjective component and a material impact on the financial statements. These policies are intended to supplement the summary of our critical accounting policies and related estimates and judgments found in Note 1 to the Consolidated Financial Statements. Our most critical accounting policies are as follows:

Revenue Recognition. The Company markets goods and services through 683 company-owned stores and 21 franchised stores as of February 1, 2014. Net sales include sales of merchandise from company-owned stores, net of estimated returns and exclusive of sales taxes. Sales to franchised stores are recorded when the merchandise is shipped from the Company's warehouse. Revenues resulting from layaway sales are recorded upon delivery of the merchandise to the customer.

The Company also sells gift cards for which the revenue is recognized at time of redemption. The Company records a gift card liability on the date the gift card is issued to the customer. Revenue is recognized and the gift card liability is reduced as the customer redeems the gift card. The Company will recognize aged liabilities as revenue when the likelihood of the gift card being redeemed is remote ("gift card breakage"). The Company has not recognized any revenue from gift card breakage since the inception of the program in 2004 and does not expect to record any gift card breakage revenue until there is more certainty regarding our ability to retain such amounts in light of current consumer protection and state escheatment laws.

In addition, the Company charges the franchised stores a fee based on a percentage of their purchases from the Company. These fees represent a reimbursement for use of the Fred's name and other administrative costs incurred on behalf of the franchised stores and are therefore netted against selling, general and administrative expenses. Total franchise income for 2013, 2012 and 2011 was $1.6 million, $1.7 million and $1.8 million, respectively.

Inventories. Merchandise inventories are stated at the lower of cost or market using the retail first-in, first-out ("FIFO") method for goods in our stores and the cost first-in, first-out method for goods in our distribution centers. The retail inventory method is a reverse mark-up, averaging method which has been widely used in the retail industry for many years. This method calculates a cost-to-retail ratio that is applied to the retail value of inventory to determine the cost value of inventory and the resulting cost of goods sold and gross margin. The assumption that the retail inventory method provides for valuation at lower of cost or market and the inherent uncertainties therein are discussed in the following paragraphs.

In order to assure valuation at the lower of cost or market, the retail value of our inventory is adjusted on a consistent basis to reflect current market conditions. These adjustments include increases to the retail value of inventory for initial markups to set the selling price of goods or additional markups to adjust pricing for inflation and decreases to the retail value of inventory for markdowns associated with promotional, seasonal or other declines in the market value. Because these adjustments are made on a consistent basis and are based on current prevailing market conditions, they approximate the carrying value of the inventory at net realizable value ("market value"). Therefore, after applying the cost to retail ratio, the cost value of our inventory is stated at the lower of cost or market as is prescribed by Generally Accepted Accounting Principles in the U.S. ("U.S. GAAP").

Because the approximation of net realizable value under the retail inventory method is based on estimates such as markups, markdowns and inventory losses ("shrink"), there exists an inherent uncertainty in the final determination of inventory cost and gross margin. In order to mitigate that uncertainty, the Company has a formal review by product class which considers such variables as current market trends, seasonality, weather patterns and age of merchandise to ensure that markdowns are taken currently, or a markdown reserve is established to cover future anticipated markdowns. This review also considers current pricing trends and inflation to ensure that markups are taken if necessary. The estimation of inventory losses is a significant element in approximating the carrying value of inventory at net realizable value; thus the following paragraph describes our estimation method as well as the steps we take to mitigate the risk this estimate has in the determination of the cost value of inventory.

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The Company calculates inventory losses based on actual inventory losses occurring as a result of physical inventory counts during each fiscal period and estimated inventory losses occurring between yearly physical inventory counts. The estimate for shrink occurring in the interim period between physical counts is calculated on a store-specific basis and is based on history, as well as performance on the most recent physical count. It is calculated by multiplying each store's shrink rate, which is based on the previously mentioned factors, by the interim period's sales for each store. Additionally, the overall estimate for shrink is adjusted at the corporate level to a three-year historical average to ensure that the overall shrink estimate is the most accurate approximation of shrink based on the Company's overall history of shrink. The three-year historical estimate is calculated by dividing the "book to physical" inventory adjustments for the trailing 36 months by the related sales for the same period. In order to reduce the uncertainty inherent in the shrink calculation, the Company first performs the calculation at the lowest practical level (by store) using the most current performance indicators. This ensures a more reliable number, as opposed to using a higher level aggregation or percentage method. The second portion of the calculation ensures that the extreme negative or positive performance of any particular store or group of stores does not skew the overall estimation of shrink. This portion of the calculation removes additional uncertainty by eliminating short-term peaks and valleys that could otherwise cause the underlying carrying cost of inventory to fluctuate unnecessarily. The methodology that we have applied in estimating shrink has resulted in variability in result that is not material to our financial statements. The Company has experienced improvement in reducing shrink as a percentage of sales from year to year due to improved inventory control measures, which includes the chain-wide utilization of the NEX/DEX technology.

Management believes that the Company's retail inventory method provides an inventory valuation which reasonably approximates cost and results in carrying inventory at the lower of cost or market. For pharmacy department inventories, which were approximately $40.4 million, and $33.8 million at February 1, 2014 and February 2, 2013, respectively, cost was determined using the retail LIFO ("last-in, first-out") method in which inventory cost is maintained using the retail inventory method, then adjusted by application of the highly inflationary Producer Price Index published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories exceeded the LIFO cost by approximately $35.2 million at February 1, 2014 and $30.7 million at February 2, 2013. The LIFO reserve increased by approximately $4.5 million and $3.9 million during 2013 and 2012, respectively.

The Company has historically included an estimate of inbound freight and certain general and administrative costs in merchandise inventory as prescribed by U.S. GAAP. These costs include activities surrounding the procurement and storage of merchandise inventory such as merchandise planning and buying, warehousing, accounting, information technology and human resources, as well as inbound freight. The total amount of procurement and storage costs and inbound freight included in merchandise inventory at February 1, 2014 is $21.6 million compared to $21.6 million at February 2, 2013.

Impairment. The Company's policy is to review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with FASB ASC 360, "Impairment or Disposal of Long-Lived Assets," we review for impairment all stores open at least 3 years or remodeled more than 2 years. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease or 10 years for owned stores. Our estimate of undiscounted future cash flows over the lease term is based upon historical operations of the stores and estimates of future store profitability, which encompasses many factors that are subject to management's judgment and are difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset's fair value. The fair value is based on estimated market values for similar assets or other reasonable estimates of fair market value based upon using a discounted cash flow model.

Exit and Disposal Activities.

Lease Termination

Lease obligations still exist for some store closures that occurred in 2008. We record the estimated future liability associated with the rental obligation on the cease use date (when the stores were closed). The lease obligations are established at the cease use date for the present value of any remaining operating lease obligations, net of estimated sublease income, and at the communication date for severance and other exit costs, as prescribed by FASB ASC 420, "Exit or Disposal Cost Obligations". Key assumptions in calculating the liability include the timeframe expected to terminate lease agreements, estimates related to the sublease potential of closed locations, and estimates of other related exit costs. If actual timing and potential termination costs or realization of sublease income differ from our estimates, the resulting liabilities could vary from recorded amounts. These liabilities are reviewed periodically and adjusted when necessary.

During fiscal 2013, we utilized $0.1 million of the remaining lease liability for the fiscal 2008 store closures, leaving $0.1 million in the reserve at February 1, 2014.

                      Beginning Balance       Additions       Utilized       Ending Balance
(in millions)         February 2, 2013          FY13            FY13        February 1, 2014

Lease contract
liability            $               0.2     $         -     $     (0.1 )   $             0.1

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Property and Equipment and Intangibles. Property and equipment are carried at cost. Depreciation is recorded using the straight-line method over the estimated useful lives of the assets and presented in selling, general and administrative expenses. Improvements to leased premises are amortized using the straight-line method over the shorter of the initial term of the lease or the useful life of the improvement. Leasehold improvements added late in the lease term are amortized over the lesser of the remaining term of the lease (including the upcoming renewal option, if the renewal is reasonably assured) or the useful life of the improvement. Gains or losses on the sale of assets are recorded at disposal as a component of operating income. The following average estimated useful lives are generally applied:

Estimated Useful Lives Building and building improvements 8 - 31.5 years

Furniture, fixtures and equipment  3 - 10 years
Leasehold improvements             3 - 10 years or term of lease, if shorter
Automobiles and vehicles           3 - 10 years
Airplane                           9 years

Assets under capital lease are amortized in accordance with the Company's normal depreciation policy for owned assets or over the lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the Consolidated Financial Statements.

Other identifiable intangible assets primarily represent customer lists associated with acquired pharmacies. Based on the Company's history of intangible asset acquisitions that began in fiscal 2004, these assets were being amortized on a straight-line basis over five years until such time as the Company's internal analysis had sufficient history to indicate another method is preferable.

After testing the retention rate of customers obtained in acquisitions over the last eight years, the Company changed the estimated life of customer lists associated with acquired pharmacy intangible assets from five to seven years in the fourth quarter of 2013. Based on the Company's historical experience, seven years is a closer approximation of the actual lives of these assets. The change in estimate is applied prospectively. Expenses for the fourth quarter of 2013 were favorably impacted by approximately $1.5 million ($.03 per diluted share) as a result of this change. The Company expects this change in estimate to have a positive effect on earnings across all four quarters of 2014.

Vendor Rebates and Allowances and Advertising Costs. The Company receives rebates for a variety of merchandising activities, such as volume commitment rebates, relief for temporary and permanent price reductions, cooperative advertising programs, and for the introduction of new products in our stores. In accordance with FASB ASC 605-50 "Customer Payments and Incentives", rebates received from a vendor are recorded as a reduction of cost of sales when the product is sold or a reduction to selling, general and administrative expenses if the reimbursement represents a specific incremental and identifiable cost. Should the allowance received exceed the incremental cost, then the excess is recorded as a reduction of cost of sales when the product is sold. Any excess amounts for the periods reported are immaterial. Any rebates received subsequent to merchandise being sold are recorded as a reduction to cost of goods sold when received.

As of February 1, 2014, the Company had approximately 1,100 vendors who participate in vendor rebate programs, and the terms of the agreements with those vendors vary in length from short-term arrangements to be completed within a month to longer-term arrangements that could last up to three years.

In accordance with FASB ASC 720-35 "Advertising Costs", the Company charges advertising, including production costs, to selling, general and administrative expense on the first day of the advertising period. Gross advertising expenses for 2013, 2012 and 2011, were $22.8 million, $24.0 million and $21.9 million, respectively. Gross advertising expenses were reduced by vendor cooperative advertising allowances of $2.8 million, $2.4 million and $2.4 million, for 2013, 2012 and 2011, respectively. It would be the Company's intention to incur a . . .

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