Fred's Inc.
Annual Report 2000

Plain-text annual report

We are exciting selections. We are great prices. We are convenient pharmacies. We are friendly service. We Are Fred’s. 2 0 0 0 A N N U A L R E P O R T about the company Fred's, Inc., founded in 1947, operates 320 discount general merchandise stores in 11 southeastern states. The Company also markets goods and services to 26 franchised stores. Fred's stores stock more than 12,000 frequently purchased items that address the everyday needs of its customers, including nationally recognized brand name products, proprietary Fred's label products, and lower-priced, off-brand products. The Company is headquartered in Memphis, Tennessee. 2 4 72 97 41 25 9 62 31 2 1 Number of Company-owned and Franchised Stores by State financial highlights (in thousands, except per share amounts) 2 0 0 0 A N N U A L R E P O R T Operating Data Net sales Operating income Net income Net income per share - diluted Weighted average shares outstanding - diluted Balance Sheet Data Working capital Total assets Long-term debt (including capital leases) Shareholders' equity Long-term debt to equity 53 Weeks Ended February 3, 2001 $ 781,249 25,720 14,849 1.22 12,197 52 Weeks Ended January 29, 2000 $ 665,777 18,943 10,702 .89 12,072 $ 110,529 254,795 31,705 159,687 $ 79,707 240,222 11,761 145,913 19.9% 8.1% Net Sales (in millions) 00 99 98 97 96 Comparable Store Sales Per Share Performance $781 $666 $601 00 99 98 97 96 2.2% $492 $418 5.2% 5.6% 9.2% 8.3% 00 99 98 97 96 $1.22 $.89 $.73 $.83 $1.11 $.50 $1.96 $1.91 $3.28 $2.55 Earnings before interest, taxes,depreciation and amortization (EBITDA) Diluted net income Number of Stores (end of period) Selling Space (Square Footage) (in thousands) Sales Per Square Foot 00 99 98 97 96 198 182 180 141 101 213 293 283 261 346 Stores Pharmacies 00 99 98 97 96 4,346 3,966 3,680 3,362 2,862 00 99 98 97 96 $189 $174 $171 $159 $149 1 to our shareholders: 2 0 0 0 A N N U A L R E P O R T To attain our goals for the year 2000, we I think it's important to understand these knew that Fred's would have to reach new accomplishments in a historical context. heights in all of the critical measurement The gain we achieved in 2000 reflected a standards. We set a high hurdle for welcomed acceleration to a level well ourselves in 2000, hoping to increase above the Company's average growth rate earnings at least 30%, on top of the strong for the last five years and was substantially growth we registered in 1999, and expand ahead of industry performance. Likewise, selling space by at least 10% – all while our comparable store sales increase for the reducing our debt 10%. I'm pleased to tell year was the strongest single-year you that Fred's accomplished all of that, performance since Fred's became a and more, in 2000. It was a very good year! publicly held company in 1992. Net sales in 2000 rose 17% to a record $781.2 million from $665.8 million in 1999 and reflected both vigorous new store additions and higher comparable sales per store. Fiscal 2000 Fred's earnings growth in 2000 was equally impressive as net income increased 39% to $14.8 million or $1.22 per diluted share versus $10.7 million or $0.89 per diluted share in 1999. This improvement also was a 53-week year for Fred's, which demonstrated increased sales leverage in contributed slightly to the increase for our selling, general and administrative the year. Adjusting for the extra week in expenses, particularly pharmacy 2000, sales for the year would have department and corporate expenses, increased 15%. which more than offset the slight decline in gross margins that occurred as a result of a Comparable store sales, a widely used shift in our sales mix and because of barometer for a retailer's health, jumped increased promotional activities to drive 9.2% in 2000. A 5.8% increase in customer customer traffic. transactions and a 3.4% increase in average customer purchases helped fuel We also are proud to note that Fred's this remarkable growth. balance sheet has mirrored the improvements we have registered in sales 3 We are exciting We are exciting selections. selections. We are convenient We are convenient pharmacies. pharmacies. 2 0 0 0 A N N U A L R E P O R T and earnings. In 2000, we improved decade has come from a combination of inventory turnover, increased working acquisitions, store expansion, and, most capital, and reduced total debt 19% to significantly, from an increasing customer approximately $34 million. During the base. The pharmacy department has year, we also replaced our existing served as the cornerstone of our strategy revolving bank debt, which provided a to make our stores more relevant to the total lending limit of $30 million including needs of our customers, producing solid seasonal overline capacity, with a new comparable store sales growth and revolver that has a total capacity of $40 offering an extra dimension to shopping at million. Moreover, we extended its Fred's that is not found in the other dollar- maturity to April 2003. store competitors. With this overview of the Company's performance year, I believe the following details about operational and financial highlights for 2000 will be more enlightening. Interestingly, we believe our pharmacy, distribution and merchandising strategies present a clear distinction over other pharmacy chains that are now seeking to reinvent themselves as value Pharmacy Department shopping destinations. Seasoned retailers In keeping with our store expansion, our know there are two essential elements to pharmacy department has continued to the retail business – price and distribution. post strong growth. With pharmacies in With a building footprint that has a 198 stores at year's end, up from 182 stores minimal stocking area, these chains are at the end of 1999, this department now limited in the types and quantity of accounts for almost one-third of our merchandise they can offer. Make no annual sales. Fred's is now one of the larger mistake, we continue to regard these pharmacy operations in the Southeast – competitors as formidable, but their the largest in some of our markets. distribution techniques are not well suited to support the volume that everyday value The growth we have achieved in our pricing requires. pharmacy department over the past 4 2 0 0 0 A N N U A L R E P O R T As part of a 50-year-old company, our they can navigate our stores comfortably. pharmacy department has long benefited We have reduced rack height and moved from some of the factors that currently are away from round garment racks in favor of reshaping the modern American stands that show our apparel better and consumer, including the so-called “Graying help customers find it more easily. Any of America” phenomenon and the long-time customer will tell you that our increasing demand for new prescription stores are brighter than ever, easier to medicines. We remain confident that there shop, and offer a more satisfying shopping are many attractive opportunities awaiting experience than ever before. The results of us in the health care field. these initiatives were reflected in our Merchandising overall sales growth for the year, our higher sales per square foot of selling space, and In last year's report we discussed the our increasing transactions and average significant strides Fred's has made in its merchandising programs. John Reier, our President, believes the old adage about real estate, emphasizing “location, purchase amounts. The most obvious way our customers ratify these steps, of course, is by voting with their pocket books – and with this vote they continue to reinforce location, location,” has implications for our our belief in the changes we have made, merchandising strategy. For Fred's, rewarding us with a 9.2% comparable store however, the three basic rules are sales gain in 2000. “presentation, presentation, presentation.” In many ways, presentation is the key to our Store Growth success. Our initial steps were intended to One of the key drivers of Fred's eliminate under-performing merchandise performance – past, present and future – is items and categories, use store size and our continued investment in new stores selection to our advantage, make our and pharmacies. This key strategy has stores more user-friendly, and, above all, worked in tandem with our ongoing maintain a keen focus on the customer. We program of remodeling and refurbishing have provided more space for shoppers so older stores. During 2000, we accelerated 7 We are great We are great prices. prices. We are friendly We are friendly service. service. 2 0 0 0 A N N U A L R E P O R T this program with the opening of 32 stores, program of remodels, completing 20 to 30 which net of the four stores we closed in 2001 and focusing this program on the during the year, increased the number of second half of the year. company-owned and operated stores to 320 by year's end (excluding our 26 Conclusion franchised stores). These new stores Going forward, Fred's future is helped us increase our total selling space brighter than ever. Today's retail 10% to approximately 4.4 million square shopper will continue to make shopping feet in 2000. Additionally, we did extensive decisions that are increasingly based on remodeling of 10 stores in 2000. In both convenience and price - two factors cases, the results were on the high side of our expectations, reaffirming the long-term benefits of our development strategies. In the coming year, we that form the foundation of Fred's merchandising strategy. Our goals and expectations for 2001 are to build on our successes and set new highs in both sales and profit. The stage has been set for continued plan to maintain these solid trends in store success at Fred's, and we are ready. growth and increased selling space. In the first half of 2001, our focus will be on new store openings, and we intend to open Michael J. Hayes approximately 30 to 36 stores based on the Chief Executive Officer improved availability of retail locations. In the second half of the year, we plan to monitor the overall economic and retail climate as we consider additional opportunities for new stores, and we will remain opportunistic in committing capital beyond the stores we now have on the drawing boards. Our goal remains to increase our selling space 11% to 13% in 2001. We also plan to continue our 8 2 0 0 0 A N N U A L R E P O R T selected financial data (in thousands, except per share amounts) Statement of Income Data: Net sales Operating income Income before income taxes Provision for income taxes Net income Net income per share: Basic Diluted Selected Operating Data: Operating income as a percentage of sales Increase in comparable store sales 4 Company-owned stores open at end of period Balance Sheet Data (at period end): Total assets Short-term debt (including capital leases) Long-term debt (including capital leases) Shareholders' equity 20001 1999 19982 1997 1996 $ 781,249 25,720 22,494 7,645 14,849 $ 665,777 18,943 16,439 5,737 10,702 $ 600,902 14,711 13,605 4,775 8,830 $ 492,236 15,511 15,660 5,873 9,787 $ 418,297 6,7793 6,508 702 5,806 1.24 1.22 3.3% 9.2%5 320 .90 .89 2.9% 5.2% 293 .75 .73 2.4% 5.6% 283 .84 .83 3.2% 8.3% 261 .50 .50 1.6%3 2.2% 213 $ 254,795 2,678 31,705 159,687 $ 240,222 30,736 11,761 145,913 $ 220,757 11,914 11,821 136,983 $ 195,407 214 1,368 129,359 $ 161,148 1,641 138 119,579 1 Results for 2000 include 53 weeks. 2 Results for 1998 include the effect of the 1998 adoption of LIFO for pharmacy inventories. 3 After $3,289 of restructuring and other charges. 4 A store is first included in the comparable store sales calculation after the end of the twelfth month following the store's grand opening month. 5 The increase in comparable store sales for 2000 is computed on the same 53-week period for 1999. 10 management’s discussion and analysis 2 0 0 0 A N N U A L R E P O R T Results of Operations The following table provides a comparison of Fred's financial results for the past three years. In this table, categories of income and expense are expressed as a percentage of net sales. Net sales Cost of goods sold Gross profit Selling, general and administrative expenses Operating income Interest expense, net Income before taxes Income taxes Net income 2000 1999 1998 (1) 100.0% 72.5 27.5 24.2 3.3 .4 2.9 1.0 1.9% 100.0% 71.8 28.2 25.3 2.9 .4 2.5 .9 1.6% 100.0% 72.6 27.4 24.9 2.5 .2 2.3 .8 1.5% (1) Results of 1998 include the effect of the 1998 adoption of LIFO for Pharmacy inventories ($3,108,000). Fiscal 2000 Compared to Fiscal 1999 Sales Net sales increased 17.3% ($115 million) in 2000. Approximately $57 million of the increase was attributable to the addition of 31 new or upgraded stores, and 16 pharmacies during 2000, together with the sales of 20 store locations and 2 pharmacies that were opened or upgraded during 1999 and contributed a full year of sales in 2000. During 2000, the Company also closed 4 store locations. Comparable store sales based on a 53-week comparison, consisting of sales from stores that have been open for more than one year, increased 9.2% in 2000. The Company's front store (non-pharmacy) sales increased approximately 15% over 1999 front store sales. Front store sales growth benefited from the above mentioned store additions, and solid performances in categories such as home furnishings, floor coverings, bath, small appliances, giftware, ladies intimate, ladies accessories, men’s and boy’s apparel, ethnic products, beverages, food and snacks, and tobacco. Lawn and garden sales decreased due to reduced emphasis of large lawn and garden equipment that carried lower margins and required additional labor outside the stores. Fred's pharmacy sales grew to 33% of total sales in 2000 from 31% of total sales in 1999 and continues to rank as the largest sales category within the Company. The total sales in this department, including the Company's mail order operation, increased 25% over 1999, with third party prescription sales representing approximately 83% of total pharmacy sales, compared with 77% of total pharmacy sales in 1999. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing prescription files from independent pharmacies, the addition of pharmacy departments in existing store locations, and inflation caused by drug manufacturer increases. Sales to Fred's 26 franchised locations increased approximately $1 million in 2000 and represented 4% of the Company's total sales, as compared to 5% in 1999. It is anticipated that this category of business will decline as a percentage of total Company sales since the Company has not added and does not intend to add any additional franchisees. Gross Margin Gross margin as a percentage of sales was 27.5% in 2000 compared to 28.2% in 1999. The decrease in gross margin is primarily attributed to the changes in sales mix and promotional activities to increase customer traffic. 11 2 0 0 0 A N N U A L R E P O R T management’s discussion and analysis Selling, General and Administrative Expenses Selling, general and administrative expenses were 24.2% of net sales in 2000 compared with 25.3% of net sales in 1999. Labor expenses improved in the stores and pharmacies as a result of the strong sales coupled with store productivity initiatives. Advertising expense improved as a percentage of sales by reducing the cost of advertising circulars while maintaining the same number of circulars issued during the year. Other expenses such as store supplies and distribution center equipment rental also improved as a result of cost control efforts. Operating Income Operating income increased approximately $6.8 million or 35.8% to $25.7 million in 2000 from $18.9 million in 1999. Operating income as a percentage of sales increased to 3.3% in 2000 from 2.9% in 1999, due to the above-mentioned reasons. Interest Expense, Net Interest expense for 2000 totaled $3.2 million compared to net interest expense of $2.5 million in 1999. The interest expense for 2000 reflects higher average revolver borrowings for inventory purchases, caused by significantly improved in-stock positions over 1999 and inventory for the new stores opened throughout the year. Higher interest rates during 2000 were also a factor in the higher expense. Income Taxes The effective income tax rate decreased to 34.0% in 2000 from 34.9% in 1999, due to changes made in the Company's organizational structure during the fourth quarter of 1998 and the implementation of a federal program to generate employment related tax credits, which resulted in a reduction in the Company's liability for taxes. At February 3, 2001, the Company had certain net operating loss carryforwards which were acquired in reorganizations and certain purchase transactions and are available to reduce income taxes, subject to usage limitations. These carryforwards total approximately $43.8 million for state income tax purposes, which expire during the period 2002 through 2022. If certain substantial changes in the Company's ownership should occur, there would be an annual limitation on the amount of carryforwards which can be utilized. Net Income Net income for 2000 was $14.8 million (or $1.22 per diluted share) or approximately 39% higher than the $10.7 million (or $.89 per diluted share) reported in 1999. Fiscal 1999 Compared to Fiscal 1998 Sales Net sales increased 10.8% ($65 million) in 1999. Approximately $37 million of the increase was attributable to the addition and upgrade of 25 store locations and 2 pharmacies during 1999, together with the sales of 29 stores and pharmacies that were opened or upgraded during 1998 and contributed a full year of sales in 1999. During 1999, the Company also closed 10 store locations. Comparable store sales, consisting of sales from stores that have been open for more than one year, increased 5.2% in 1999. The Company's front store (non-pharmacy) sales increased approximately 6% over 1998 front store sales. Front store sales growth benefited from the above mentioned store additions, as solid performances in categories such as home furnishings, footwear, ladies accessories, plus size and girls apparel, and trim-a-home were mostly offset by weaker performances in missy and ladies intimate apparel, hardware and several of the Company’s basic hardlines departments. Fred's pharmacy sales grew from 27% of total sales in 1998 to 31% of total sales in 1999, and continues to rank as the largest sales category within the Company. The total sales in this department, including the Company's mail order operation, 12 management’s discussion and analysis 2 0 0 0 A N N U A L R E P O R T increased 27% over 1998, with third party prescription sales representing approximately 77% of total pharmacy sales, compared with 71% of total pharmacy sales in 1998. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing prescription files from independent pharmacies, the addition of pharmacy departments in existing store locations, and inflation caused by drug manufacturer increases. Sales to Fred's 26 franchised locations decreased approximately $3 million in 1999 and represented 5% of the Company's total It is anticipated that this category of business will continue to sales compared with approximately 6% of 1998 total sales. decline as a percentage of total Company sales since the Company has not added and does not intend to add any additional franchisees. Gross Margin Gross margin as a percentage of sales was 28.2% in 1999 compared to 27.4% in 1998. Gross margin benefited from reduced levels of markdowns as a percentage of sales, higher initial purchase margins resulting from greater volumes of import and opportunistic purchases, a lesser percentage of franchise sales, which carry substantially lower margins than retail sales, and a reduced level of inflation in pharmacy costs. Selling, General and Administrative Expenses Selling, general and administrative expenses were 25.3% of net sales in 1999 compared with 24.9% of net sales in 1998. Higher rental costs as a percentage of sales due to a greater percentage of company stores being leased and slightly higher rent costs associated with the Company's build-to-suit prototype store, an increase in repairs and maintenance expense resulting from store improvement programs implemented during 1999, and higher depreciation expense associated with capital investments made over the past 12 to 18 months contributed to most of the higher expense ratio in 1999. These increases were partially offset by the elimination of mailing costs associated with two major advertising circulars during 1999. Operating Income Operating income increased approximately $4.2 million or 28.8% to $18.9 million in 1999 from $14.7 million in 1998. Operating income as a percentage of sales, increased to 2.9% in 1999 from 2.5% in 1998, due to the above mentioned reasons. Interest Expense, Net Interest expense for 1999 totaled $2.5 million compared to net interest expense of $1.1 million in 1998 (interest expense of $1.2 million less interest income of $.1 million). The interest expense for 1999 reflects higher average revolver borrowings for inventory purchases, caused by significantly improved in-stock positions over 1998 and duplicate inventories in several remerchandised inventory categories, and the accelerated repayment of approximately $7.5 million in accounts payable, originally due in February, as a result of a change made in the company's pharmacy drug wholesaler in December of 1999. The company also experienced full year interest costs on term loan borrowings to finance the distribution center modernization and acquisition of a new mainframe computer. Income Taxes The effective income tax rate decreased to 34.9% in 1999 from 35.1% in 1998, due primarily to changes made in the Company's organizational structure during the fourth quarter of 1998, which resulted in a reduction in the Company's liability for taxes. At January 29, 2000, the Company had certain net operating loss carryforwards which were acquired in reorganizations and certain purchase transactions and are available to reduce income taxes, subject to usage limitations. These carryforwards total approximately $36.7 million for state income tax purposes, which expire during the period 2001 through 2021. If certain substantial changes in the Company's ownership should occur, there would be an annual limitation on the amount of carryforwards which can be utilized. 13 2 0 0 0 A N N U A L R E P O R T management’s discussion and analysis Net Income Net income for 1999 was $10.7 million (or $.89 per diluted share) or approximately 22% higher than the $8.8 million (or $.73 per diluted share) reported in 1998. Liquidity and Capital Resources Fred's primary sources of working capital are cash flow from operations and borrowings under its current facility. The Company had working capital of $110.5 million, $79.7 million and $72.8 million at year end 2000, 1999 and 1998, respectively. Working capital fluctuates in relation to profitability, seasonal inventory levels, net of trade accounts payable, and the level of store openings and closings. On April 3, 2000, the Company and a bank entered into a new Revolving Loan and Credit Agreement to replace the existing $15 million unsecured revolving credit commitment that has generally been used to finance inventory levels at specified periods. The expanded credit capacity is necessary to accommodate the Company's continued growth and shifting seasonal inventory needs. This $40 million credit commitment was supplemented with a $5 million seasonal overline, for a total revolving borrowing capacity of $45 million. The credit commitment expires on April 3, 2003 and bears interest at 1.5% below prime rate or a LIBOR-based rate (weighted average interest rate of 7.4% on 2000 outstanding borrowings). All other provisions of the new agreement are essentially the same as the prior agreement. At February 3, 2001, approximately $22.6 million of inventories were financed with outstanding borrowings under the Company's revolver. The reduction in borrowings from the prior year results from the Company’s focus on inventory management and the accelerated payment made in the prior year as explained below. At January 29, 2000, approximately $28.2 million of inventories were financed with outstanding borrowings under the Company's revolver. Higher year-end revolver borrowings resulted from significantly improved in-stock positions compared to 1998, duplicate inventories in several re-merchandised inventory categories, and the accelerated repayment of approximately $7.5 million in accounts payable, originally due in February, as a result of a change made in the Company's pharmacy drug wholesaler in December 1999. In May 1998, the Company entered into a seven-year unsecured term loan of $12 million to finance the modernization and automation of the Company's distribution center and corporate facilities. The Loan Agreement bears interest of 6.82% per annum and matures on November 1, 2005. At year-end 2000, the outstanding principal balance on the term loan was approximately $8.8 million compared with $10.3 million at year-end 1999. In April 1999, the Company entered into a four-year unsecured term loan of $2.3 million to finance the replacement of the Company's mainframe computer system. The Loan Agreement bears interest at 6.15% per annum and matures on April 15, 2003. At year-end 2000, the outstanding principal balance on the term loan was approximately $1.3 million compared with $1.8 million at year-end 1999. Cash provided by operations was $27.1 million in 2000 compared to cash used in operations of ($.8) million in 1999 and cash provided by operations of $.7 million in 1998. Year-end 2000 inventory levels were better managed to improve turnover and reduce duplicate inventories in several product categories. Also, income taxes payable increased as a result of tax strategies put in place in prior years that had a favorable effect in 2000. Year-end 1999 inventory levels were impacted by improved in- stock positions and duplicate inventories compared to 1998, and accounts payable were impacted by the accelerated repayment of $7.5 million of payables. Year-end 1998 accounts payable levels were adversely impacted as a result of merchandise processing delays, and were supplemented with short-term borrowings at year-end. 14 management’s discussion and analysis 2 0 0 0 A N N U A L R E P O R T Capital expenditures in 2000 totaled $15.8 million compared with $14.0 million in 1999 and $21.3 million in 1998. The 2000 capital expenditures included approximately $12.2 million of expenditures associated with upgraded or new stores and pharmacies. Approximately $3.6 million in expenditures related to technology upgrades, distribution center equipment, freight equipment, and capital maintenance. The 1999 capital expenditures included approximately $2.3 million of expenditures associated with replacement of the Company's mainframe computer system, and approximately $11.7 million of expenditures associated with new stores and pharmacies, store and pharmacy upgrades, distribution center equipment and annual capital maintenance. The 1998 capital expenditures included $12.0 million of expenditures associated with the Company's modernization and automation of its distribution center, $4.7 million of expenditures associated with new stores and pharmacies, and $4.6 million for store and pharmacy upgrades and annual capital maintenance. Cash used for investing activities also includes $2.8 million in 2000, $.8 million in 1999, and $2.0 million in 1998 for the acquisition of customer lists and other pharmacy related items. The Company believes that sufficient capital resources are available in both the short-term and long-term through currently available cash, cash generated from future operations and, if necessary, the ability to obtain additional financing. Recent Accounting Pronouncements In June 1999, the FASB issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the effective date of FASB Statement No. 133, which deferred the effective date provisions of SFAS No. 133 for the company to the first quarter of 2001. The Company does not believe this new standard will have an impact on its financial statements since it currently has no derivative instruments. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” (SAB 101). SAB 101 identifies various revenue recognition issues, several of which are common within the retail industry including treatment of revenue recognition on layaway sales. In the fourth quarter of 2000, the Company revised its revenue recognition for layaway sales to defer revenue recognition until all terms of the sale have been satisfied and the customer takes delivery of the merchandise. Under the prior method of accounting, net sales were recognized at the time the customer put the merchandise into layaway. The effects of this change on prior quarters in 2000 and the proforma effect on 1999 are reflected in Note 12. The effects of this change on the fourth quarter of 2000 was an increase in net sales, gross profit, net income per share (basic and diluted) of $1,932,000, $482,000, $318,000 and $.02, respectively. Annual financial results were not affected. Cautionary Statement Regarding Forward-looking Information Statements, other than those based on historical facts that the Company expects or anticipates may occur in the future are forward-looking statements which are based upon a number of assumptions concerning future conditions that may ultimately prove to be inaccurate. Actual events and results may materially differ from anticipated results described in such statements. The Company's ability to achieve such results is subject to certain risks and uncertainties, including, but not limited to, economic and weather conditions which affect buying patterns of the Company's customers, changes in consumer spending and the Company's 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, and other factors affecting business beyond the Company's control. Consequently, all of the forward-looking statements are qualified by these cautionary statements and there can be no assurance that the results or developments anticipated by the Company will be realized or that they will have the expected effects on the Company or its business or operations. 15 2 0 0 0 A N N U A L R E P O R T consolidated statements of income ( i n t h o u s a n d s , e x c e p t p e r s h a r e a m o u n t s ) Net sales Cost of goods sold Gross profit Selling, general and administrative expenses Operating income Interest expense, net Income before taxes Income taxes Net income Net income per share Basic Diluted Weighted average shares outstanding Basic Diluted February 3, 2001 $ 781,249 566,115 215,134 For the Years Ended January 29, 2000 $ 665,777 478,138 187,639 January 30, 1999 $ 600,902 436,523 164,379 189,414 25,720 3,226 22,494 168,696 18,943 2,504 16,439 7,645 $ 14,849 5,737 $ 10,702 $ $ 1.24 1.22 $ $ 0.90 0.89 149,668 14,711 1,106 13,605 4,775 8,830 0.75 0.73 $ $ $ 11,937 12,197 11,827 12,072 11,798 12,078 S e e a c c o m p a n y i n g n o t e s t o c o n s o l i d a t e d f i n a n c i a l s t a t e m e n t s . 16 consolidated balance sheets ( i n t h o u s a n d s , e x c e p t n u m b e r o f s h a r e s ) 2 0 0 0 A N N U A L R E P O R T ASSETS Current assets: Cash and cash equivalents Receivables, less allowance for doubtful accounts of $516 ($452 at January 29, 2000) Inventories Deferred income taxes Other current assets Total current assets Property and equipment, at depreciated cost Equipment under capital leases, less accumulated amortization of $1,305 ($856 at January 29, 2000) Deferred income taxes Other noncurrent assets, net Total assets LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable Current portion of indebtedness Current portion of capital lease obligations Accrued liabilities Income taxes payable Total current liabilities Long-term portion of indebtedness Capital lease obligations Other noncurrent liabilities Total liabilities Commitments and contingencies (Notes 6 and 10) Shareholders' equity: Common stock, Class A voting, no par value, 12,068,518 shares issued and outstanding (11,988,276 shares at January 29, 2000) Retained earnings Deferred compensation on restricted stock incentive plan Total shareholders' equity February 3, 2001 January 29, 2000 $ 2,569 $ 3,036 15,430 149,602 2,022 2,306 171,929 76,360 1,387 98 5,021 $ 254,795 $ 40,432 2,175 503 14,012 4,278 61,400 30,475 1,230 2,003 95,108 10,911 141,612 3,002 1,865 160,426 73,459 1,835 866 3,636 $ 240,222 $ 39,653 30,306 430 9,680 650 80,719 10,027 1,734 1,829 94,309 68,557 91,342 (212) 159,687 $ 254,795 67,326 78,902 (315) 145,913 $ 240,222 S e e a c c o m p a n y i n g n o t e s t o c o n s o l i d a t e d f i n a n c i a l s t a t e m e n t s . 17 2 0 0 0 A N N U A L R E P O R T consolidated statements of changes in stockholders’ equity ( i n t h o u s a n d s , e x c e p t s h a r e d a t a ) Balance, January 31, 1998 Cash dividends paid ($.20 per share) Repurchase of shares Issuance of restricted stock Cancellation of restricted stock Exercises of stock options Amortization of deferred compensation on restricted stock incentive plan Tax benefit on exercise of stock options Net income Balance, January 30, 1999 Cash dividends paid ($.20 per share) Issuance of restricted stock Cancellation of restricted stock Other issuances Exercises of stock options Amortization of deferred compensation on restricted stock incentive plan Tax benefit on exercise of stock options Net income Balance, January 29, 2000 Cash dividends paid ($.20 per share) Issuance of restricted stock Cancellation of restricted stock Exercises of stock options Amortization of deferred compensation on restricted stock incentive plan Tax benefit on exercise of stock options Net income Balance, February 3, 2001 Common Stock Shares 11,866,789 Amount $ 65,700 Retained Earnings $ 64,147 (2,381) Deferred Compensation $ (488) (30) 46,182 (5,500) 39,331 752 (38) 329 208 11,946,772 $ 66,951 9,900 (5,700) 1,714 35,590 124 (118) 30 296 43 11,988,276 $ 67,326 3,800 (29,072) 105,514 57 (218) 1,079 313 8,830 $ 70,596 (2,396) 10,702 $ 78,902 (2,409) (362) 38 248 $ (564) (124) 118 255 $ (315) (57) 15 145 12,068,518 $ 68,557 14,849 $ 91,342 $ (212) Total $ 129,359 (2,381) - 390 - 329 248 208 8,830 $ 136,983 (2,396) 30 296 255 43 10,702 $ 145,913 (2,406) (203) 1,079 145 313 14,849 $ 159,690 S e e a c c o m p a n y i n g n o t e s t o c o n s o l i d a t e d f i n a n c i a l s t a t e m e n t s . 18 consolidated statements of cash flows ( i n t h o u s a n d s ) 2 0 0 0 A N N U A L R E P O R T Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash flows from operating activities: Depreciation and amortization Provision for uncollectible receivables LIFO Reserve Deferred income taxes Amortization of deferred compensation on restricted stock incentive plan Issuance (net of cancellation) of restricted stock Tax benefit upon exercise of stock options Gain on sale of fixed assets (Increase) decrease in assets: Receivables Inventories Other assets Increase (decrease) in liabilities: Accounts payable and accrued liabilities Income taxes payable Other noncurrent liabilities Net cash (used in) provided by operating activities Cash flows from investing activities: Capital expenditures Proceeds from dispositions of property and equipment Asset acquisition, net of cash acquired (primarily intangibles) Net cash used in investing activities Cash flows from financing activities: Reduction of indebtedness and capital lease obligations Proceeds from revolving line of credit, net of payments Proceeds from term loan Proceeds from exercise of options Payment of cash for dividends and fractional shares Net cash provided by (used in) financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents: Beginning of year End of year Supplemental disclosures of cash flow information: Interest paid Income taxes paid Non cash investing and financing activities: Assets acquired through capital lease obligations Common stock issued for acquisition S e e a c c o m p a n y i n g n o t e s t o c o n s o l i d a t e d f i n a n c i a l s t a t e m e n t s . February 3, 2001 For the Years Ended January 29, 2000 January 30, 1999 $ 14,849 $ 10,702 $ 8,830 14,277 64 753 1,747 145 (203) 313 - (4,583) (8,743) (444) 5,110 3,628 174 27,087 (15,801) 493 (2,807) (18,115) (2,495) (5,617) - 1,079 (2,406) (9,439) (467) 3,036 2,569 3,332 2,000 - - $ $ $ $ $ 11,830 80 100 2,513 255 - 43 (41) (2,060) (15,135) (847) (8,210) (176) 159 (787) (14,043) 215 (805) (14,633) (2,139) 18,040 2,249 296 (2,396) 16,050 630 2,406 3,036 2,399 3,810 612 30 $ $ $ $ $ 8,939 124 3,108 2,344 248 390 208 - (1,969) (14,664) (2,354) (3,712) (890) 175 777 (21,273) - (1,993) (23,266) (556) 10,200 12,000 329 (2,381) 19,592 (2,897) 5,303 2,406 1,239 2,828 509 - $ $ $ $ $ 19 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements NOTE 1 - DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of business. The primary business of Fred’s, Inc. and subsidiaries (the “Company”) is the sale of general merchandise through its 320 retail discount stores located in the southeastern United States. In addition, the Company sells general merchandise to its 26 franchisees. Consolidated financial statements. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions are eliminated. Fiscal year. The Company utilizes a 52 - 53 week accounting period which ends on the Saturday closest to January 31. Fiscal years 2000, 1999 and 1998, as used herein, refer to the years ended February 3, 2001, January 29, 2000, and January 30, 1999, respectively. Use of estimates. The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Inventories. Wholesale inventories are stated at the lower of cost or market using the FIFO (first-in, first-out) method. Retail inventories are stated at the lower of cost or market as determined by the retail inventory method. For pharmacy inventories, which comprise approximately 19% and 18% of the retail inventories at February 3, 2001 and January 29, 2000, respectively, cost was determined using the LIFO (last-in, first-out) method. The current cost of inventories exceeded the LIFO cost by approximately $3,961,000 at February 3, 2001 and $3,208,000 at January 29, 2000. Property and equipment. Buildings, furniture, fixtures and equipment are stated at cost and depreciation is computed using the straight-line method over their estimated useful lives. Leasehold costs and improvements are amortized over the lesser of their estimated useful lives or the remaining lease terms. Average useful lives are as follows: buildings and improvements - 8 to 30 years; furniture and fixtures - 5 to 10 years; and equipment - 3 to 10 years. Amortization on equipment under capital leases is computed on a straight-line basis over the terms of the leases. Gains or losses on the sale of assets are recorded at disposal. Long lived assets. The Company’s policy is to review the recoverability of all long-lived assets annually and whenever events or changes indicate that the carrying amount of an asset may not be recoverable. Based upon the Company’s review as of February 3, 2001 and January 29, 2000, no material adjustments to the carrying value of such assets were necessary. Selling, general and administrative expenses. The Company includes buying, warehousing, transportation and occupancy costs in selling, general and administrative expenses. Advertising. The Company charges advertising, including production costs, to expense on the first day of the advertising period. Advertising expense for 2000, 1999, and 1998 was $10,166,000, $8,926,000, and $9,621,000 respectively. Preopening costs. The Company charges to expense the preopening costs of new stores as incurred. These costs are primarily labor to stock the store, preopening advertising, store supplies and other expendable items. Revenue recognition. The Company markets goods and services through Company owned stores and 26 franchised stores. Net sales includes sales of merchandise from Company owned stores, net of 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 In addition, the Company charges the layaway sales are recorded upon delivery of the merchandise to the customer. 20 notes to consolidated financial statements 2 0 0 0 A N N U A L R E P O R T 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. Total franchise income for 2000, 1999 and 1998 was $1,809,000, $1,761,000 and $1,957,000 respectively. Other intangible assets. Other identifiable intangible assets which are included in other noncurrent assets primarily represent amounts associated with acquired pharmacies and are being amortized on a straight line basis over five years. These intangibles, net of accumulated amortization, totaled $4,945,000 at February 3, 2001, and $3,559,000 at January 29, 2000. Accumulated amortization for 2000 and 1999 totaled $3,964,000 and $2,543,000, respectively. Amortization expense for 2000, 1999 and 1998 was $1,421,000, $1,307,000 and $1,214,000 respectively. Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments having original maturities of three months or less, are classified as cash equivalents. Included in accounts payable are outstanding checks in excess of funds on deposit which totaled $5,823,000 at February 3, 2001 and $14,089,000 at January 29, 2000. Financial instruments. At February 3, 2001, the Company did not have any outstanding derivative instruments. The recorded value of the Company’s financial instruments, which include cash and cash equivalents, receivables, accounts payable and indebtedness, approximates fair value. The following methods and assumptions were used to estimate fair value of each class of financial instrument: (1) the carrying amounts of current assets and liabilities approximate fair value because of the short maturity of those instruments and (2) the fair value of the Company’s indebtedness is estimated based on the current borrowing rates available to the Company for bank loans with similar terms and average maturities. Business segments. The Company’s only reportable operating segment is its sale of merchandise through its Company owned stores and to franchised Fred’s locations, which are organized around the products sold and markets served. Comprehensive income. Comprehensive income does not differ from the consolidated net income presented in the consolidated statements of income. Reclassifications. Certain prior year amounts have been reclassified to conform to the 2000 presentation. Recent accounting pronouncements. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” (SAB 101). SAB 101 identifies various revenue recognition issues, several of which are common within the retail industry including treatment of revenue recognition on layaway sales. In the fourth quarter of 2000, the Company revised its revenue recognition for layaway sales to defer revenue recognition until all terms of the sale have been satisfied and the customer takes delivery of the merchandise. Under the prior method of accounting, net sales were recognized at the time the customer put the merchandise into layaway. The effects of this change on prior quarters in 2000 and the proforma effects on 1999 are reflected in Note 12. The effects of this change on the fourth quarter of 2000 was an increase in net sales, gross profit, net income and net income per share (basic and diluted) of $1,932,000, $482,000, $318,000 and $.02, respectively. Annual financial results were not affected. In June 1999, the FASB issued SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities – Deferral of the effective date of FASB Statement No. 133, which deferred the effective date provisions of SFAS No. 133 for the company to the first quarter of 2001. The Company does not believe this new standard will have an impact on its financial statements since it currently has no derivative instruments. 21 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements NOTE 2 - PROPERTY AND EQUIPMENT Property and equipment, at cost, consist of the following (in thousands): Buildings and improvements Furniture, fixtures and equipment Less accumulated depreciation and amortization Land 2000 67,068 89,152 156,220 (84,100) 72,120 4,240 76,360 $ $ 1999 $ 65,660 81,424 147,084 (78,018) 69,066 4,393 $ 73,459 Depreciation expense totaled $12,407,000, $10,168,000 and $7,442,000 for 2000, 1999 and 1998, respectively. NOTE 3 - ACCRUED LIABILITIES The components of accrued liabilities are as follows (in thousands): Payroll and benefits Sales and use taxes Insurance Other NOTE 4 - INDEBTEDNESS 2000 5,136 2,000 2,497 4,379 14,012 $ $ 1999 2,992 1,726 2,904 2,058 9,680 $ $ On April 3, 2000, the Company and a bank entered into a new Revolving Loan and Credit Agreement (the “Agreement”) to replace the May 15, 1992 Revolving Loan and Credit Agreement, as amended. The Agreement provides the Company with an unsecured revolving line of credit commitment of up to $40 million and bears interest at 1.5% below prime rate or a LIBOR- based rate. Under the most restrictive covenants of the Agreement, the Company is required to maintain specified shareholders’ equity and net income levels.The Company is required to pay a commitment fee to the bank at a rate per annum equal to .18% on the unutilized portion of the revolving line commitment over the term of the Agreement. The term of the Agreement extends to April 3, 2003.There were $22,623,000 and $28,240,000 of borrowings outstanding under the Agreement at February 3, 2001 and January 29, 2000, respectively. On April 23, 1999, the Company and a bank entered into a Loan Agreement (the “Loan Agreement”). The Loan Agreement provided the Company with a four-year unsecured term loan of $2.3 million to finance the replacement of the Company’s mainframe computer system. The Loan Agreement bears interest of 6.15% per annum and matures on April 15, 2003. Under the most restrictive covenants of the Loan Agreement, the Company is required to maintain specified debt service levels.There were $1,265,500 and $1,828,000 borrowings outstanding under the Agreement at February 3, 2001 and January 29, 2000, respectively. The principal maturity under this Agreement for debt outstanding at February 3, 2001 is as follows: $562,500 in fiscal 2001; $562,500 in fiscal 2002 and $140,500 in fiscal 2003. 22 notes to consolidated financial statements 2 0 0 0 A N N U A L R E P O R T On May 5, 1998, the Company and a bank entered into a Loan Agreement (the “Term Loan Agreement”). The Term Loan Agreement provided the Company with an unsecured term loan of $12 million to finance the modernization and automation of the Company’s distribution center and corporate facilities. The Term Loan Agreement bears interest of 6.82% per annum and matures on November 1, 2005. Under the most restrictive covenants of the Term Loan Agreement, the Company is required to maintain specified shareholders’ equity and net income levels. Borrowings outstanding under this Term Loan Agreement totaled $8,762,000 at February 3, 2001 and $10,265,000 at January 29, 2000. The principal maturity under this Agreement for debt outstanding at February 3, 2001 is as follows: $1,612,742 in fiscal 2001; $1,727,860 in fiscal 2002; $1,851,199 in fiscal 2003; $1,983,338 in fiscal 2004 and $1,586,503 in fiscal 2005. Interest expense for 2000, 1999 and 1998 totaled $3,226,000, $2,504,000 and $1,206,000, respectively. NOTE 5 - INCOME TAXES Deferred income taxes are provided for the tax effects of temporary differences between the financial reporting basis and income tax basis of the Company’s assets and liabilities.The provision for income taxes consists of the following (in thousands): Current Federal State Deferred Federal State 2000 1999 1998 $ $ 5,597 - 5,597 1,423 324 1,747 7,344 $ $ 3,224 - 3,224 2,116 397 2,513 5,737 $ $ 2,639 (208) 2,431 1,974 370 2,344 4,775 23 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements Deferred tax assets (liabilities) are comprised of the following(in thousands): 2000 1999 Current deferred tax assets: Inventory valuation methods Accrual for inventory shrinkage Allowance for doubtful accounts Insurance accruals Other Gross current deferred tax assets Deferred tax asset valuation allowance Current deferred tax liabilities Net current deferred tax asset Noncurrent deferred tax assets: Net operating loss carryforwards Postretirement benefits other than pensions Restructuring costs Other Gross noncurrent deferred tax assets Deferred tax asset valuation allowance Noncurrent deferred tax liabilities: Depreciation Other Gross noncurrent deferred tax liabilities Net noncurrent deferred tax asset $ $ $ $ 465 768 310 1,200 654 2,467 (289) 2,178 (156) 2,022 1,685 760 82 1,769 4,296 (1,267) 3,029 (2,904) (27) (2,931) 98 $ $ $ $ 758 672 285 990 749 3,454 (182) 3,272 (270) 3,002 1,421 694 82 1,583 3,780 (1,239) 2,541 (1,648) (27) (1,675) 866 The ultimate realization of these assets is dependent upon the generation of future taxable income sufficient to offset the related deductions and loss carryforwards within the applicable carryforward periods as described below. The valuation allowance is based upon management’s conclusion that certain tax carryforward items will expire unused. During 2000 and 1999, the valuation allowance increased $264,000 and $393,000, respectively, as the result of the company generating additional net operating loss carryforwards in certain states. At February 3, 2001, the Company has certain net operating loss carryforwards which were acquired in reorganizations and purchase transactions which are available to reduce income taxes, subject to usage limitations. These carryforwards total approximately $43,784,000 for state income tax purposes, and expire at various times during the period 2002 through 2022. If certain substantial changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carryforwards which can be utilized. A reconciliation of the statutory Federal income tax rate to the effective tax rate is as follows: Income tax provision at statutory rate State income taxes, net of federal benefit Change in valuation allowance Surtax Exemptions Other 24 2000 35.0% 0.9 - (1.0) (0.9) 34.0% 1999 35.0% 1.6 - (1.0) (0.7) 34.9% 1998 35.0% 0.8 0.7 (1.0) (0.4) 35.1% notes to consolidated financial statements 2 0 0 0 A N N U A L R E P O R T NOTE 6 - LONG-TERM LEASES The Company leases certain of its store locations under noncancelable operating leases expiring at various dates through 2031. Many of these leases contain renewal options and require the Company to pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased properties. In addition, the Company leases various equipment under noncancelable operating leases and certain transportation equipment under capital leases. Total rent expense under operating leases was $17,465,000, $15,329,000 and $13,618,000 for 2000, 1999 and 1998, respectively. Amortization expense on assets under capital lease for 2000, 1999 and 1998 was $449,000, $355,000 and $283,000, respectively. Future minimum rental payments under all operating and capital leases as of February 3, 2001 are as follows: 2001 2002 2003 2004 2005 Thereafter Total minimum lease payments Imputed interest Present value of net minimum lease payments, including $503 classified as current portion of capital lease obligations Operating Leases Capital Leases (in thousands) $ $ 16,055 14,189 11,505 8,491 6,121 11,426 67,787 $ $ 741 741 364 255 142 0 2,243 (510) $ 1,733 NOTE 7 - SHAREHOLDERS’ EQUITY The Company has 30 million shares of Class A voting common stock authorized. The Company’s authorized capital also In addition, the consists of 11.5 million shares of Class B nonvoting common stock, of which no shares have been issued. Company has authorized 10 million shares of preferred stock, of which no shares have been issued. Effective October 12, 1998 the Company adopted a Shareholders Rights Plan which granted a dividend of one preferred share purchase right (“the Right”) for each common share outstanding at that date. Each Right represents the right to purchase one- hundredth of a preferred share of stock at a preset price to be exercised when any one individual, firm, corporation or other entity acquires 15% or more of the Company’s common stock. The Rights will become dilutive at the time of exercise and will expire, if unexercised, on October 12, 2008. NOTE 8 - EMPLOYEE BENEFIT PLANS Incentive stock option plan. The Company has a long-term incentive plan under which an aggregate of 1,168,750 shares may be granted. These options expire five years from the date of grant. Options outstanding at February 3, 2001 expire in 2001 through 2005. 25 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements A summary of activity in the plan follows: 2000 1999 1998 Weighted Average Exercise Price $ 13.13 15.04 11.02 8.67 15.29 10.62 Weighted Average Exercise Price $ 13.40 11.82 14.79 11.33 8.38 13.13 9.1 Weighted Average Exercise Price $ 8.55 25.61 12.46 - 8.42 13.4 9.85 Options 411,298 150,695 (32,523) - (39,331) 490,139 152,483 Options 490,139 136,750 (26,101) (1,744) (35,590) 563,454 169,313 Options 563,454 345,507 (140,825) - (105,514) 662,622 154,065 Outstanding at beginning of year Granted Canceled Expired Exercised Outstanding at end of year Exercisable at end of year The weighted average remaining contractual life of all outstanding options was 3.2 years at February 3, 2001. The following table summarizes information about stock options outstanding at February 3, 2001: Range of Exercise Prices $ 5.90 to $ 7.20 $ 11.50 to $16.19 $ 20.00 to $25.88 Number Outstanding at February 3, 2001 70,634 483,113 108,875 662,622 Options Outstanding Weighted Average Remaining Contractual Life (in Years) 1 3.8 2.1 Options Exercisable Weighted Average Exercise Price $ 7.04 $ 14.19 $ 25.52 Number Exercisable at February 3, 2001 69,084 80,881 4,100 154,065 Weighted Average Exercise Price $ 7.03 $12.94 $25.50 The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensation. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant date for awards in 2000, 1999, and 1998 consistent with the method prescribed by SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s operating results for 2000, 1999, and 1998 would have been reduced to the pro forma amounts indicated below: Net income As reported Pro forma Basic earnings per share As reported Pro forma Diluted earnings per share As reported Pro forma 26 2001 1999 2000 (in thousands, except per share data) $ 14,849 14,260 $ 10,702 10,363 $ 8,830 8,322 1.24 1.19 1.22 1.17 0.9 0.88 0.89 0.86 0.75 0.71 0.73 0.69 notes to consolidated financial statements 2 0 0 0 A N N U A L R E P O R T The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions using grants in 2000, 1999 and 1998, respectively: Average expected life (years) Average expected volatility Risk-free interest rates Dividend yield 2000 3 39.00% 5.60% 1.30% 1999 3 43.30% 4.80% 1.50% 1998 3 41.50% 5.50% 1.30% The weighted average grant-date fair value of options granted during 2000, 1999,and 1998 was $3.90, $4.17, and $7.85 respectively. Restricted stock. During 2000, 1999, and 1998, the Company issued (cancelled) a net of (25,272), 4,200, and 40,682 restricted shares,respectively. Compensation expense related to the shares issued is recognized over the period for which restrictions apply. Employee stock ownership plan. The Company has a non-contributory employee stock ownership plan for the benefit of qualifying employees who have completed one year of service and attained the age of 18. Benefits are fully vested upon completion of seven years of service. The Company has not made any contributions to the plan since 1996. Salary reduction profit sharing plan. The Company has a defined contribution profit sharing plan for the benefit of qualifying employees who have completed one year of service and attained the age of 21. Participants may elect to make contributions to the plan up to a maximum of 15% of their compensation. Company contributions are made at the discretion of the Company’s Board of Directors. Participants are 100% vested in their contributions and earnings thereon. Contributions by the Company and earnings thereon are fully vested upon completion of seven years of service. The Company’s contributions for the years ended February 3, 2001, January 29, 2000 and January 30, 1999 were $100,000, $96,000 and $83,000, respectively. Postretirement benefits. The Company provides certain health care benefits to its full-time employees that retire between the ages of 58 and 65 with certain specified levels of credited service. Health care coverage options for retirees under the plan are the same as those available to active employees. The Company’s change in benefit obligation based upon an actuarial valuation is as follows: Benefit obligation at beginning of year Service cost Interest cost Participant contributions Amendments Actuarial (gain) loss Benefits paid Benefit obligation at end of year February 3, 2001 $ $ 1,377 132 116 - - 68 (76) 1,617 For the Years Ended January 29, 2000 (in thousands) $ $ 1,252 127 91 - - (17) (76) 1,377 January 30, 1999 $ $ 1,132 103 85 4 - (67) (5) 1,252 27 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements A reconciliation of the Plan’s funded status to accrued benefit cost follows: Funded status Unrecognized net actuarial gain Unrecognized prior service cost Accrued benefit costs February 3, 2001 January 29, 2000 (in thousands) January 30, 1999 $ (1,617) (322) (5) $ (1,944) $ (1,377) (406) (6) $ (1,789) $ (1,252) (405) (6) $ (1,663) The medical care cost trend used in determining this obligation is 10.0% effective February 1, 1997, decreasing annually before leveling at 6.0% in 2003. This trend rate has a significant effect on the amounts reported. To illustrate, increasing the health care cost trend by 1% would increase the accumulated postretirement benefit obligation by $238,000. The discount rate used in calculating the obligation was 7.5% in 2000, 7.75% in 1999 and 6.75% in 1998. The annual net postretirement cost is as follows: February 3, 2001 $ $ 132 116 (17) 1 232 For the Years Ended January 29, 2000 (in thousands) $ $ 127 91 (17) 1 202 January 30, 1999 $ $ 103 85 (21) 1 168 Service cost Interest cost Amortization of net gain from prior periods Amortization of unrecognized prior service cost Net periodic postretirement benefit cost The Company’s policy is to fund claims as incurred. NOTE 9 - NET INCOME PER SHARE Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Restricted stock is considered contingently issuable and is excluded from the computation of basic earnings per share. 28 notes to consolidated financial statements 2 0 0 0 A N N U A L R E P O R T A reconciliation of basic earnings per share to diluted earnings per share follows (in thousands, except per share data): February 3, 2001 Years Ended January 29, 2000 January 31, 1999 Income $ 14,849 Shares 11,937 Per Share Amount $ 1.24 Income $ 10,702 Shares 11,827 Per Share Income Amount $ 0.90 $ 8,830 78 182 12,197 $ 1.22 $ 10,702 108 137 12,072 $ 0.89 $ 8,830 Basic EPS Effect of Dilutive Securities Restricted stock Stock options Diluted EPS $ 14,849 Per Share Amount $ 0.75 $ 0.73 Shares 11,798 79 201 12,078 NOTE 10 - COMMITMENTS AND CONTINGENCIES Commitments. At February 3, 2001, the Company had commitments approximating $5,082,000 on issued letters of credit which support purchase orders for merchandise. Additionally, the Company had outstanding letters of credit aggregating $2,552,000 utilized as collateral for their risk management programs. Litigation. The Company is a party to several pending legal proceedings and claims in the normal course of business. Although the outcome of the proceedings and claims cannot be determined with certainty, management of the Company is of the opinion that it is unlikely that these proceedings and claims will have a material adverse effect on the results of operations, cash flows, or the financial condition of the Company. NOTE 11 - OTHER EXPENSES During the fourth quarter of 1996, the Company recorded a $2,860,000 accrual for the closure of certain underperforming stores and the repositioning of certain merchandise categories. This charge included an accrual for closed facility lease obligations of $1,156,000. The remaining lease obligation at February 3, 2001 represents remaining future base payments required on one location that has been closed. The 2000 activity in this reserve is as follows: Lease obligations $ 400 $ 215 $ (129) $ 86 January 30, 1999 January 29, 2000 Payments February 3, 2001 (in thousands) 29 2 0 0 0 A N N U A L R E P O R T notes to consolidated financial statements NOTE 12 – QUARTERLY FINANCIAL DATA (UNAUDITED) Year Ended February 3, 2001 - restated (1) (2) Net sales Gross profit Net income Net income per share Basic Diluted Cash dividends paid per share Year Ended January 29, 2000 - pro forma (3) Net sales Gross profit Net income Net income per share Basic Diluted Cash dividends paid per share Year Ended January 29, 2000 - as reported Net sales Gross profit Net income Net income per share Basic Diluted Cash dividends paid per share First Quarter Second Quarter Third Quarter Fourth Quarter (in thousands, except per share data) $ 176,132 48,990 3,345 $ 180,353 49,060 1,654 $ 180,141 51,850 3,829 $ 244,623 65,234 6,021 0.28 0.28 0.05 0.14 0.14 0.05 0.32 0.31 0.05 0.5 0.49 0.05 $ 154,226 44,135 2,766 $ 155,792 43,775 920 $ 156,741 $ 199,018 52,949 4,339 46,780 2,677 0.23 0.23 0.05 0.08 0.08 0.05 0.22 0.22 0.05 0.37 0.36 0.05 $ 154,934 44,319 2,886 $ 156,498 43,952 1,037 $ 158,049 $ 196,296 52,251 3,883 47,117 2,896 0.24 0.24 0.05 0.09 0.09 0.05 0.24 0.24 0.05 0.33 0.32 0.05 (1) (2) Based upon a 53 week year. As discussed in “Recent Accounting Pronouncements” in Note 1, the above information has been restated to reflect the impact of the Company implementing the interpretations in SAB 101 related to layaway sales during the fourth quarter of 2000. In the quarters in the year ended February 3, 2001, the effects of this restated on previously reported net sales, gross profit, net income and net income per share (basic & diluted) was a decrease of $528,000, $132,000, $87,000 and $.01, respectively, for the 1st quarter; a decrease of $453,000, $111,000, $73,000 and $.00, respectively, for the 2nd quarter; and a decrease of $951,000, $239,000, $158,000 and $.01, respectively, for the 3rd quarter. (3) For informational purposes only, 1999 quarterly results have been restated on proforma basis as if the effects of SAB 101 on layaway sales had been applied to the 1999 quarterly reports. 30 report of independent accountants To the Board of Directors and Shareholders of Fred’s, Inc. 2 0 0 0 A N N U A L R E P O R T In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of changes in shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of Fred’s, Inc. and its subsidiaries at February 3, 2001 and January 29, 2000, and the results of their operations and their cash flows for each of the three years in the period ended February 3, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion expressed above. April 4, 2001 31 2 0 0 0 A N N U A L R E P O R T directors and officers Executive Officers Michael J. Hayes Chief Executive Officer David A. Gardner Managing Director John D. Reier President John A. Casey Executive Vice President – Pharmacy Operations Jerry A. Shore Executive Vice President and Chief Financial Officer Charles A. Brunjes Senior Vice President of Store Operations Charles S. Vail Corporate Secretary, Vice President – Legal Services and General Counsel Board of Directors Michael J. Hayes Chief Executive Officer Fred's, Inc. David A. Gardner Managing Director Fred's, Inc. President Gardner Capital Corporation (a real estate and venture capital investment firm) John R. Eisenman Real Estate Investments REMAX Island Realty, Inc. Former President of Sally's, Inc. (a restaurant chain) Former commercial real estate developer Roger T. Knox Chief Executive Officer and President Memphis Zoological Society Former Chairman of the Board and Chief Executive Officer Goldsmith's Department Stores (retailing) John D. Reier President Fred's Inc. Thomas J. Tashjian Private Investor 32 corporate information Corporate Offices Fred's, Inc. 4300 New Getwell Road Memphis, Tennessee 38118 (901) 365-8880 Transfer Agent Union Planters National Bank Memphis, Tennessee Independent Accountants PricewaterhouseCoopers LLP Memphis, Tennessee Securities Counsel Baker, Donelson, Bearman & Caldwell Memphis, Tennessee Annual Report on Form 10-K A copy of the Company's Annual Report on Form 10-K for the year ended February 3, 2001, as filed with the Securities and Exchange Commission, may be obtained by shareholders of record without charge upon written request to Jerry A. Shore, Executive Vice President and Chief Financial Officer. Annual Meeting of Shareholders The 2001 annual meeting of shareholders will be held at 10:00 a.m. local time on Wednesday, June 6, 2001, at the Memphis Marriott Hotel, 2625 Thousand Oaks Boulevard, Memphis, Tennessee. Shareholders of record as of April 20, 2001, are invited to attend this meeting. Stock Market Information The Company's common stock trades on the Nasdaq Stock Market under the symbol FRED (CUSIP No. 356108-10-0). At April 20, 2001, the Company had an estimated 5,400 shareholders, including beneficial owners holding shares in nominee or street name. The table below sets forth the high and low stock prices, together with cash dividends paid per share, for each fiscal quarter in the past two fiscal years: High Low Dividends Per Share 1999 First Second Third Fourth 2000 First Second Third Fourth SIC 5331 $ 15.00 $ 17.63 $ 18.00 $ 17.63 $ 16.00 $ 21.06 $ 25.00 $ 23.69 $ 9.75 $ 10.31 $ 10.69 $ 11.50 $ 14.13 $ 15.00 $ 18.75 $ 17.13 $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.05 $ 0.05 4300 New Getwell Road Memphis, Tennessee 38118 

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