Fred's Inc. Annual Report 2001

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FY2001 Annual Report · Fred's Inc.

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freds2001arREV 5/31/02 10:39 AM Page 1

2 0 0 1 A N N U A L R E P O R T

A Formula for Growth

$911

$781

$666

$601

$492

$418

$410

$381

$348

$316

$292

Net Sales
(in millions)

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About the Company

Fred's, Inc., founded in 1947, operates 353 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 prod-

ucts, and lower-priced, off-brand products. The Company is headquartered in Memphis, Tennessee.

Number of Company-owned and Franchised Stores by State

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Financial Highlights
(in thousands, except per share amounts)

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

F R E D S 2 0 0 1 A N N U A L R E P O R T

52 Weeks
Ended
February 2,
2002

$ 910,831
31,751
19,629
.81
24,197

$ 138,379
284,059
1,320
218,907

53 Weeks
Ended
February 3,
2001

$ 781,249
25,720
14,849
.65
22,869

$ 110,529
254,795
31,705
159,687

0.6%

19.9%

* Adjusted for the 5-for-4 stock split effected on June 18, 2001 and the 3-for-2 stock split effected on February 1, 2002.

$911

$781

$666

$601

$492

10.5%

9.2%

8.3%

5.6% 5.2%

$2.05

$1.75

$1.36

$1.02

$1.04

$.81

$.65

$.44

$.39

$.47

Net Sales
(in millions)

Comparable
Store Sales

Per Share
Performance

379

346

312

319

292

198

202

180

182

141

4,892

4,346

3,966

3,680

3,362

Earnings before interest, taxes, depreciation
and amortization (EBITDA)

Diluted net income

$197

$189

$171 $174

$159

Number of
Stores
(end of period)

Selling Space
(Square Footage)
(in thousands)

Sales Per
Square Foot

Stores

Pharmacies

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Pharmacy = Growth

Our pharmacy department is one of the important
differentiating features for Fred's and is a key element
of our growth strategy. Today, we have more than 200
pharmacies across our markets, and we expect that this
part of our business will continue to expand as we add
new stores.

freds2001arREV 5/31/02 10:41 AM Page 5

To Our Shareholders

F R E D S 2 0 0 1 A N N U A L R E P O R T

When we were reviewing this year's
final numbers for public release, we
realized it was almost 10 years to
the day that the Company completed
its initial public offering. At this
juncture, we thought it might be
appropriate to make a few comparisons.
The first thing to stand out, of
course, was sales. To put it into
perspective, sales for all of 1991
were just slightly greater than those
for the fourth quarter of 2001.
Next, as you might suspect, was
store count. Fred’s was a 45-year-old
company in 1992, with fewer than
200 stores. Should all go as
planned, we will open 210 stores
between 2001 and 2004.
Remarkable! The most significant
comparison, however, was how well
our defined goals and objectives
have served the Company and its
shareholders – then and still today.
How have our shareholders fared?
Well, a 100-share purchase during
the IPO would equal 234 shares
today as a result of the stock splits
and would be worth more than six
times the original IPO price.

As We Began
When we made the decision to seek
public capital to fulfill the promise we
envisioned for Fred's, we identified
five goals to improve Fred's profitability
and lay the groundwork for long-
term success. These goals involved
growing market share, enhancing

incentives for store managers and
pharmacists to focus on profits,
reducing employee turnover, rightsizing
our corporate overhead, and growing
our pharmacy business. Now, with
the passing of the 10-year milestone,
these goals – and the results we have
achieved in working toward them –
provide a useful and instructive
context for measuring and assessing
our progress.

By its nature, the word ’goal‘
expresses a desire or need to
improve, and as we ended fiscal
1991 – and looked forward to our
public offering that was just months
away – we knew that Fred's could
be better. In the five years
immediately preceding our IPO, sales
had virtually stagnated. Profits in those
years were volatile (my euphemism
for significant operating losses in
some years), and the Company
languished under a heavy debt load.

As you can see, the goals we set to
improve profitability were important.
Taken together, they focused on the
basics – the customer and the
employee. They showed our resolve
and recognition of the fact that our
customers are king, and everything
we do in our stores should be
geared toward making their shopping
experience easier and friendlier at
Fred's. Our goals signified the
importance of having the proper
incentives for our entire management

team – from pharmacists and store
managers to buyers and Company
officers – that would ensure we all
shared a singular focus on profits
and cost control. These goals
underscored the importance of
human resources so our employees
would see good reason to stay on
board and grow with our Company.
Considering Fred's improving record
over the past decade, we think it is
fair to say that these goals have kept
the Company in good stead.

Fast Forward to Today
We know that a company cannot
rest on its history, but we'd like to
believe that a company's record of
performance and its growth over an
extended period of time, through up
and down cycles, are important
criteria for investors. We recognize
that markets only judge from a
company's history the ability to
execute its future plans and, from
that, will place a value on that
company. It is with this understanding
that we look back on 2001 with
pride, knowing that the year will be
remembered not only for the records
set in virtually all areas of our business,
but also for the way in which they
were set. For Fred's, fiscal 2001
served as a sound exclamation point
on a great 10-year performance and
the springboard for the future.

In 2001, net income rose 32% to
$19.6 million from $14.8 million in
2000, reflecting our continued

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F R E D S 2 0 0 1 A N N U A L R E P O R T

– especially clocks and lamps – as
well as other housewares and
apparel. In sum, you might say
merchandising is the heart and soul
of our retailing strategy at Fred's.

Our strategy also relies on continuing
to build our pharmacy department
as one of the important differentiating
features for Fred's. Our pharmacy
department accounted for over
34% of sales in 2001 – up from
33% in 2000 and, together with
our concentration on the items
customers need everyday, it's the
core of our plan to make Fred's a
quick and convenient stop for our
customers. Our pharmacy departments
place us in a favorable position relative
to many other dollar-store competitors,
and our ability to offer pharmacy
products and services, together with
an extensive line of apparel and
other merchandise in volume, gives
us an advantage with many customers.
During 2001, we expanded our
pharmacy department in step with
our store growth, increasing its
breadth to 202 pharmacies by the
end of 2001, giving us one of the
more sizable pharmacy operations in
our market region.

The expansion of our store base
remains the fundamental part of our

1,585,000 Company shares at
$25.50 per share raised approximately
$38 million in net proceeds for the
Company, which were used to repay
most of Fred's long-term debt.
Consequently, we ended 2001 virtually
debt-free compared with last year
when long-term debt totaled about
$32 million, or approximately 17%
of our total capitalization. Elsewhere
on the balance sheet, we continued
to see sound inventory management,
with turnover increasing to 4.1
times versus 3.9 times last year.

Performance Drivers
As we look ahead to the next few
years, we can point to many of our
current strategies that will continue
to drive sales and profits higher.
The central change, which has had
such a profound effect on our
comparable store sales growth
recently, is merchandising. This is
really a two-pronged strategy. First,
maintaining a theme from the past
few years, we will strive to make
our stores more shopper-friendly
through more effective displays,
better organization of merchandise,
and a brighter environment. We
also continue to fine-tune our
prototype store format, which is a
centerpiece of our shopper-friendly
focus. Second, we have kept a
sharp eye on merchandise categories
that appeal to our growing customer
base. In 2001, we had great
success with home furnishings

success in leveraging our selling,
general and administrative expenses
over a larger sales base, as well as
reduced interest expense. On a diluted-
per-share basis, and adjusted for a
five-for-four stock split in June 2001
and a three-for-two stock split in
February 2002, earnings increased
25% to $0.81 from $0.65 in 2000.

Net sales for the year increased 17%
to a record $911 million versus $781
million in 2000, but like a year ago,
year-to-year results are not readily
comparable because of a difference
in the number of weeks included in
the periods. Fiscal 2001 was a 52-week
period versus 53 weeks in fiscal 2000.
Adjusting for the extra week last year,
net sales for 2001 increased 19%
compared with $768 million for the
pro forma 52-week period last year.
Comparable store sales for 2001
increased 10.5% over the pro forma
fiscal 2000 period.

Underlying our improved sales
performance for the year were
ongoing gains in key sales metrics.
Our transaction volume increased
5.7% while the average ticket rose
4.8%. Sales per square foot increased
4% to $197.

During 2001, we also continued to
strengthen our balance sheet.
Following the events of September 11,
we were the first company in the
retail sector to complete a public stock
offering. This secondary offering of

freds2001arREV 5/31/02 10:42 AM Page 7

F R E D S 2 0 0 1 A N N U A L R E P O R T

Merchandising = Growth

The results of our merchandising initiatives were
reflected in our sales growth for the year, our higher
sales per square foot of selling space, and our increasing
transactions and average purchase amounts.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

We have spent considerable time and effort in building our
management team, getting the right people in the right
positions, and giving them the proper incentives to deliver
improved results on both the top line and the bottom line.

Focus = Growth

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F R E D S 2 0 0 1 A N N U A L R E P O R T

long-range growth plans. During
2001, we increased our chain to 353
company stores, up from 320 in
2000, which pushed our total retail
selling space 13% higher to
approximately 4.9 million square feet.
Most of the new stores for 2001
contained pharmacies – which is
always our preference when site,
lease and market considerations
permit – and they were increasingly
developed with a view toward our
successful prototype format. Next
year, we will accelerate our store
growth by opening approximately 60
new Fred's stores, increasing our
retail sales space by 15% to 18%.
We expect this expansion will be
aided by the general economic
slowdown that has occurred over the
past year, which has placed pressure
on many retail concepts and forced
others into reorganization.

To help support this growth and
augment the capacity provided by
our Memphis distribution center, we
recently announced our plans to
construct a new multi-million-dollar,
600,000-square-foot distribution
center in Dublin, Georgia. The new
distribution center will provide us
with the capacity to increase our
chain to 750 stores over the next few
years and, because of its location, is

positioned to serve Fred's growing
presence in Alabama, Georgia,
northern Florida, North Carolina, and
South Carolina, as well as its expected
growth into other markets in the
future. The new center should open
during the first quarter of 2003.

The Future
As exciting as the past 10 years
have been, and as gratifying as our
growth and financial progress have
been, we think the best years for
Fred's are still ahead. Our plans to
accelerate growth will lead to the
opening of up to 60 new stores in
2002, then 70 in 2003, followed by
80 more in 2004. That represents
an increase in our chain of more
than 50% over the next three years.
Couple that with our planned annual
average growth in comparable store
sales of between 6% and 8%, and
underpin those aspirations with
expanded, highly automated
distribution capabilities, and you can
quickly seize the scale of our abiding
dreams for Fred's. It's easy to see
that the next stop for this train will
be the billion-dollar mark for sales in
2002, but we think our final destination
is well beyond that.

Higher sales, of course, would be a
hollow victory for us if we were not
able to manage that growth and
convert it into greater profitability for
our shareholders. Consequently, we
have spent considerable time and

effort in building our management
team, getting the right people in the
right positions, and giving them the
proper incentives to bring those
results from the top line to the bottom
line. With this increased focus on
quality management – and managing
for quality – we think it's important
to target ongoing gains in our operating
margins over the next three years as
we strive to raise them steadily
through increased expense leverage.

Put these drivers together – solid top
line growth and improving operating
profitability – and you can understand
why we think the best is yet to
come. We hope you enjoy the ride.

In closing, let me say that the
excitement felt throughout our
organization in 2001 was tempered
somewhat for me by the loss in
December of David Gardner, our
managing director and my friend
and partner for 30 years. David
succumbed to muscular dystrophy
after a hard-fought battle. He was
an extraordinary person who
brought sun into every room he
entered. We will sorely miss his
astute observation of what was and
his unswayable faith in what might
be. We know how much he would
have loved to be here when we
break through the billion-dollar
mark. The Company and I will miss
him dearly.

Michael J. Hayes
Chief Executive Officer

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Selected Financial Data
(dollars 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:3

Basic
Diluted

Selected Operating Data:
Operating income as a percentage of sales
Increase in comparable store sales 4
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

2001

2000 1

1999

1998 2

1997

$ 910,831
31,751
30,140
10,511
19,629

$ 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

.83
.81

.66
.65

.48
.47

.40
.39

.45
.44

3.5%
10.5%
353

3.3%
9.2%5
320

2.9%
5.2%
293

2.4%
5.6%
283

3.2%
8.3%
261

$ 284,059
1,240
1,320
218,907

$ 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

Results for 2000 include 53 weeks.
Results for 1998 include the effect of the 1998 adoption of LIFO for pharmacy inventories.

3 Adjusted for the 5-for-4 stock split effected on June 18, 2001 and the 3-for-2 stock split effected on February 1, 2002.
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.
The increase in comparable store sales for 2000 is computed on the same 53-week period for 1999.

freds2001arREV 5/31/02 10:43 AM Page 11

Management’s Discussion
and Analysis

Significant Accounting Policies

F R E D S 2 0 0 1 A N N U A L R E P O R T

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 applicable under the circumstances, the results of which form the basis for
making judgments about the 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 dif-
ferent conditions and/or assumptions. A summary of our critical accounting policies and related estimates and judgments, can be
found in Note 1 to the consolidated financial statements.

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 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

Fiscal 2001 Compared to Fiscal 2000

2001
100.0%
72.6
27.4
23.9
3.5
0.2
3.3
1.1
2.2%

2000
100.0%
72.5
27.5
24.2
3.3
0.4
2.9
1.0
1.9%

1999
100.0%
71.8
28.2
25.3
2.9
0.4
2.5
0.9
1.6%

Sales
Net sales increased 16.6% ($129.6 million) in 2001. Approximately $54.0 million of the increase was attributable to the addition
of 33 new or upgraded stores, and 7 pharmacies during 2001, together with the sales of 31 store locations and 16 pharmacies
that were opened or upgraded during 2000 and contributed a full year of sales in 2001. During 2001, the Company closed 3
pharmacy locations. Comparable store sales, consisting of sales from stores that have been open for more than one year,
increased 10.5% in 2001.

The Company's front store (non-pharmacy) sales increased approximately 15.5% over 2000 front store sales. Front store sales
growth benefited from the above mentioned store additions and improvements, and solid sales increases in categories such as
home furnishings, floor coverings, bath, giftware, small appliances, photo finishing, girl’s apparel, missy ready-to-wear, infants
and toddler apparel, beverages, food and snacks.

Fred's pharmacy sales grew to 34.4% of total sales in 2001 from 33% of total sales in 2000 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
21.2% over 2000, with third party prescription sales representing approximately 85% of total pharmacy sales, compared with
83% of total pharmacy sales in 2000. 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.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Management’s Discussion
and Analysis

Sales to Fred's 26 franchised locations decreased approximately $.8 million in 2001 and represented 3.7% of the Company's total
sales, as compared to 4.0% in 2000. 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 27.4% in 2001 compared to 27.5% in 2000. The decrease in gross margin is a result
of margin reduction in the pharmacy department partially offset by margin improvements in general merchandise departments.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were 23.9% of net sales in 2001 compared with 24.2% of net sales in 2000. Labor
expenses improved in the stores and pharmacies as a result of the strong sales coupled with store productivity initiatives.
Distribution center labor expense also improved as a percentage of volume processed. Corporate communications expense
improved as a result of installing new technology that reduced expenses.

Operating Income

Operating income increased approximately $6.0 million or 23.5% to $31.8 million in 2001 from $25.7 million in 2000.
Operating income as a percentage of sales increased to 3.5% in 2001 from 3.3% in 2000, due to the above-mentioned reasons.

Interest Expense, Net

Interest expense for 2001 totaled $1.6 million or .2% of sales compared to net interest expense of $3.2 million or .4% of sales in
2000. The significant reduction results from the funds raised from our public offering of 1,585,000 company shares in
September 2001(unadjusted for 3-for-2 stock split completed February 1, 2002), lower interest rates, and improved inventory
turnover and expense control.

Income Taxes

The effective income tax rate increased to 34.9% in 2001 from 34.0% in 2000, due to increased income levels which eliminated
the benefit of graduated tax rates.

At February 2, 2002, the Company has certain net operating loss carryforwards which were acquired in reorganizations and pur-
chase transactions which are available to reduce income taxes, subject to usage limitations. These carryforwards total approxi-
mately $43.9 million for state income tax purposes, and expire at various times during the period 2003 through 2023. If certain
substantial changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carryfor-
wards which can be utilized.

Net Income

Net income for 2001 was $19.6 million (or $ .81 per diluted share) or approximately 32.2% higher than the $14.8 million (or
$.65 per diluted share) reported in 2000.

freds2001arREV 5/31/02 10:43 AM Page 13

Management’s Discussion
and Analysis

Fiscal 2000 Compared to Fiscal 1999

Sales

F R E D S 2 0 0 1 A N N U A L R E P O R T

1 1

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, bev-
erages, 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 pur-
chasing 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.

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.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Management’s Discussion
and Analysis

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 organi-
zational structure during the fourth quarter of 1998 and the implementation of a federal program to generate employment relat-
ed 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 cer-
tain 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 sub-
stantial 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 $.65 per diluted share) or approximately 39% higher than the $10.7 million (or $.47
per diluted share) reported in 1999.

Liquidity and Capital Resources

Fred's primary sources of working capital have traditionally been cash flow from operations and borrowings under its credit facility.
In October 2001 the Company raised proceeds of $38.2 million from a secondary offering of 1,585,000 Company shares (unad-
justed for 3-for-2 stock split completed on February 1, 2002). The Company had working capital of $138.4 million, $110.5 mil-
lion, and $79.7 million at year-end 2001, 2000 and 1999, respectively. Working capital fluctuates in relation to profitability, sea-
sonal inventory levels, net of trade accounts payable, and the level of store openings and closings.

Cash and cash equivalents were $15.9 million at year-end 2001, $2.6 million at year-end 2000, and $3.0 million at year-end
1999. Short-term investment objectives are to maximize yields while minimizing company risk and maintaining liquidity.
Accordingly, limitations are placed on amounts and types of investments.

Net cash flow provided by operating activities totaled $26.4 million in 2001 compared to $27.1 million in 2000 and cash used in
operations of $.8 million in 1999.

In fiscal 2001, cash was primarily used to increase inventories by approximately $14.3 million during the fiscal year. This increase
is primarily attributable to our adding 33 new stores, upgrading six stores and adding a net of 4 new pharmacies, as well as sup-
porting the improved comparable store sales. Accounts payable and accrued liabilities increased by $3.5 million due primarily to
higher inventory purchases. Income taxes payable decreased by approximately $2.4 million as a result of required income tax
payments.

Year-end 2000 cash was primarily used to increase inventories by approximately $ 8.7 million during the fiscal year. Also,
accounts receivable increased $4.6 million due to increased pharmacy sales involving third party carriers. Accounts payable and
accrued liabilities increased by $5.1 million due primarily to higher inventory purchases. 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 store and pharmacy growth. Accounts payable
were impacted by the accelerated repayment of $7.5 million.

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1 3

Management’s Discussion
and Analysis

Capital expenditures in 2001 totaled $17.4 million compared with $15.8 million in 2000 and $14.0 million in 1999. The 2001
capital expenditures included approximately $13.5 million of expenditures associated with upgraded, remodeled, or new stores
and pharmacies. Approximately $3.8 million in expenditures related to technology upgrades, distribution center equipment,
freight equipment, and capital maintenance. The 2000 capital expenditures included approximately $12.2 million of expenditures
associated with upgraded, remodeled, or new stores and pharmacies. Approximately $3.6 million in expenditures related to tech-
nology upgrades, distribution center equipment, freight equipment, and capital maintenance. The 1999 capital expenditures
included approximately $11.7 million of expenditures associated with upgraded, remodeled, or new stores and pharmacies.
Approximately $2.3 million in expenditures related to technology upgrades, distribution center equipment, freight equipment,
and capital maintenance. Cash used for investing activities also includes $1.0 million in 2001, $2.8 million in 2000, and $.8 mil-
lion in 1999 for the acquisition of customer lists and other pharmacy related items.

In April, 2000, the Company and a bank entered into a new Revolving Loan and Credit Agreement. 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 (weighted average interest rate of 5.2% on 2001 outstanding borrowings). The credit capacity is used
to accommodate the Company's continued growth and seasonal inventory needs. Under the most restrictive covenants of the
Agreement, we are required to maintain specific shareholders’ equity and net income levels. We are required to pay a commit-
ment 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 credit commitment extends to April 3, 2003. There were no borrowings outstanding under this
agreement at February 2, 2002 and $22.6 million outstanding borrowings at February 3, 2001. The reduction in borrowings
from the prior year results from cash flow from current operations, continued focus on asset management, and from the pro-
ceeds of the secondary public offering completed during the fiscal year.

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 2001, the outstanding principal balance on the term loan was approximately $ .7 million compared with $1.3
million at year-end 2000.

In May, 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 bore interest of 6.82% per annum and
would have matured on November 1, 2005. The Company used the proceeds of the public offering to pay off the Agreement
and the borrowings outstanding under the Agreement at February 3, 2001 totaled $8.8 million.

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

Off-Balance Sheet Arrangements

The Company has no off-balance sheet financing arrangements.

Contractual Obligations and Commercial Commitments

As discussed in Note 6 of consolidated financial statements, the Company leases certain of its store locations under noncance-
lable 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 addi-
tion, the Company leases various equipment under noncancelable operating leases and certain transportation equipment under
capital leases. The future minimum rental payments under all operating and capital leases as of February 2, 2002 are $87.7 mil-
lion and $2.4 million, respectively.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Management’s Discussion
and Analysis

As discussed in Note 10 of the consolidated financial statements, the Company had commitments approximating $9.1 million at
February 2, 2002 on issued letters of credit which support purchase orders for merchandise. Additionally, the Company had out-
standing letters of credit aggregating $6.8 million at February 2, 2002 utilized as collateral for their risk management programs.

Recent Accounting Pronouncements

In June 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No. 141 supercedes Accounting Principles Board
Opinion ("APB") No. 16, Business Combinations, and SFAS No. 38, Accounting for Preacquisition Contingencies of Purchased
Enterprises. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after
June 30, 2001 and for all business combinations accounted for by the purchase method for which the date of acquisition is after
June 30, 2001. The Company does not expect the adoption of SFAS No. 141 to have a material impact on its financial statements.

In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 supercedes APB No. 17,
Intangible Assets, and its provisions are effective for fiscal years beginning after December 15, 2001. SFAS No. 142 requires that:
1) goodwill and indefinite lived intangible assets will no longer be amortized; 2) goodwill will be tested for impairment at least
annually at the reporting unit level (reporting unit levels to be determined upon adoption); 3) intangible assets deemed to have
an indefinite life will be tested for impairment at least annually; and 4) the amortization period of intangible assets with finite
lives will no longer be limited to forty years. As of February 2, 2002, the Company has intangible assets, net of accumulated
amortization, of $4.8 million and has recognized amortization expense of approximately $1.8 million during the year February 2,
2002. The Company will continue to amortize intangible assets in accordance with its existing policy and accordingly does not
anticipate a material impact on adoption of SFAS No. 142.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective for
years beginning after December 15, 2001. This Statement supercedes SFAS No. 121, Accounting for the Impairment of Long-
Lived Assets to Be Disposed of, but retains the fundamental provision of SFAS 121 for recognition and measurement of the
impairment of long-lived assets to be held and used and measurement of long-lived assets to be held for sale. The statement
requires that whenever events or changes in circumstances indicate that a long-lived asset's carrying value may not be recover-
able, the asset should be tested for recoverability. The statement also requires that a long-lived asset classified as held for sale
should be carried at the lower of its carrying value or fair value, less cost to sell. The Company is evaluating the potential impact
the provisions of SFAS 144 could have on it's financial statements but does not believe there will be a material effect on the
financial statements upon adoption.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

1 5

Management’s Discussion
and Analysis

Cautionary Statement Regarding Forward-looking Information

Statements, other than those based on historical facts that the Company expect or anticipate may occur in the future are for-
ward-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. Our abili-
ty to achieve such results is subject to certain risks and uncertainties, including:

• Economic and weather conditions which affect buying patterns of our customers;
• Changes in consumer spending and our ability to anticipate buying patterns and implement appropriate inventory strategies;
• Continued availability of capital and financing;
• Competitive factors;
• Changes in reimbursement practices for pharmaceuticals;
• Governmental regulation; and
• Other factors affecting business beyond our control.

Consequently, all of the forward-looking statements are qualified by this cautionary statement and there can be no assurance
that the results or developments anticipated by us will be realized or that they will have the expected effects on our business or
operations. Actual results, performance or achievements can differ materially from results suggested by this forward-looking
statement because of a variety of factors. We undertake no obligation to update any forward-looking statement to reflect events
or circumstances arising after the date on which it was made.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

Consolidated Statements of Income
(in thousands, except share and per share amounts)

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

February 2,
2002
$ 910,831
661,110
249,721

For the Years Ended
February 3,
2001
$ 781,249
566,115
215,134

217,970
31,751

189,414
25,720

3,226
22,494

7,645
14,849

1,611
30,140

10,511
19,629

.83
.81

$
$

January 29,
2000
$ 665,777
478,138
187,639

168,696
18,943

2,504
16,439

5,737
$ 10,702

.66
.65

$
$

.48
.47

Weighted average shares outstanding

Basic
Diluted

23,553
24,197

22,382
22,869

22,176
22,635

See accompanying notes to consolidated financial statements.

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F R E D S 2 0 0 1 A N N U A L R E P O R T

1 7

Consolidated Balance Sheets
(in thousands, except for number of shares)

Assets
Current assets:

Cash and cash equivalents

Receivables, less allowance for doubtful accounts of $657
($516 at February 3, 2001)
Inventories
Deferred income taxes
Other current assets

Total current assets

Property and equipment, at depreciated cost
Equipment under capital leases, less accumulated amortization of

$1,849 ($1,305 at February 3, 2001)

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
Deferred tax liability
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, 25,361,112 shares

issued and outstanding (22,628,471 shares at February 3, 2001)

Retained earnings
Deferred compensation on restricted stock incentive plan

Total shareholders' equity
Total liabilities and shareholders' equity

See accompanying notes to consolidated financial statements.

February 2,
2002

February 3,
2001

15,906

2,569

15,705
163,560
1,790
2,499
199,460

15,430
149,602
2,022
2,306
171,929

78,225

76,360

1,533
–
4,841
$ 284,059

1,387
98
5,021
$ 254,795

43,747
562
678
14,228
1,866
61,081

141
696
1,179
2,055
65,152

$ 40,432
2,175
503
14,012
4,278
61,400

30,475
–
1,230
2,003
95,108

110,508
108,462
(63)
218,907
$ 284,059

68,557
91,342
(212)
159,687
$ 254,795

freds2001arREV 5/31/02 10:43 AM Page 20

1 8

F R E D S 2 0 0 1 A N N U A L R E P O R T

Consolidated Statements of
Changes in Shareholders’ Equity
(in thousands, except share data)

Common Stock

Balance, January 30, 1999
Stock split - (Note 7)
Stock split - (Note 7)
Cash dividends paid ($.11 per share)
Issuance of restricted stock
Cancellation of restricted stock
Other issuances
Exercises of stock options
Amortization of deferred compensation
on restricted stock incentive plan
Tax benefit on exercise of stock options
Net income
Balance, January 29, 2000
Cash dividends paid ($.11 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
Proceeds from public offering
Cash dividends paid ($.12 per share)
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, February 2, 2002

Shares
11,946,772
2,986,693
7,466,732

18,562
(10,687)
3,213
66,732

Amount
$ 66,951

124
(118)
30
296

22,478,017

$ 67,326

7,125
(54,510)
197,839

57
(218)
1,079

313

22,628,471
2,377,500

$ 68,557
38,156

(15,185)
55,980
314,346

(63)
937
2,165

756

See accompanying notes to consolidated financial statements.

Retained
Earnings
$ 70,596

Deferred
Compensation

(564)

Total
$ 136,983

(2,396)

10,702
$ 78,902
(2,409)

14,849
$ 91,342

(2,509)

(124)
118

255

(315)

(57)
15

145

(212)

137

(2,396)

30
296

255
43
10,702
$ 145,913
(2,409)
-
(203)
1,079

145
313
14,849
$ 159,687
38,156
(2,509)
(51)
937
2,165

137
756
19,629
$ 218,907

25,361,112

$110,508

19,629
$ 108,462

(63)

freds2001arREV 5/31/02 10:43 AM Page 21

F R E D S 2 0 0 1 A N N U A L R E P O R T

1 9

Consolidated Statements of
Cash Flows
(in thousands)

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 provided by (used in) 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 public offering, net of expenses
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

See accompanying notes to consolidated financial statements.

February 2,
2002

For the Years Ended
February 3,
2001

January 29,
2000

19,629

14,849

$ 10,702

17,846
142
642
1,026

137
(52)
756
–

(416)
(14,291)
(194)

3,532
(2,411)
52
26,398

(17,372)
–
(986)
(18,358)

(9,892)
(22,623)
–
38,156
2,165
(2,509)
5,297
13,337

2,569
15,906

1,775
11,000

691
937

$
$

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

$
$

freds2001arREV 5/31/02 10:43 AM Page 22

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F R E D S 2 0 0 1 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 merchan-
dise through its 353 retail discount stores located in eleven states 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 sub-
sidiaries. 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 2001, 2000 and 1999, as used herein, refer to the years ended February 2, 2002, February 3, 2001, and January 29, 2000,
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 con-
tingent 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 20% and 19% of the retail inventories at February 2, 2002 and February 3, 2001, respectively,
cost was determined using the LIFO (last-in, first-out) method. The current cost of inventories exceeded the LIFO cost by approxi-
mately $4,603,000 at February 2, 2002 and $3,961,000 at February 3, 2001.

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
2, 2002 and February 3, 2001, no material adjustments to the carrying value of such assets were necessary.

Selling, general and administrative expenses. The Company includes buying, warehousing, distribution, depreciation 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 peri-
od. Advertising expense for 2001, 2000, and 1999 was $12,079,000, $10,166,000, and $8,926,000 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 fran-
chised 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. 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

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F R E D S 2 0 0 1 A N N U A L R E P O R T

2 1

Notes to Consolidated
Financial Statements

and administrative expenses. Total franchise income for 2001, 2000, and 1999 was $1,764,000, $1,806,000, and $1,761,000
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. During the year
ended February 2, 2002, the Company issued 55,980 (split-adjusted) shares for pharmacy acquisitions. These intangibles, net of
accumulated amortization, totaled $4,778,000 at February 2, 2002, and $4,945,000 at February 3, 2001. Accumulated amorti-
zation for 2001 and 2000 totaled $5,272,000 and $3,490,000, respectively. Amortization expense for 2001, 2000, and 1999 was
$1,795,000, $1,421,000, and $1,307,000, respectively.

Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments which are subject to
market fluctuations and 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 for which there was no excess amounts at February 2, 2002 and
$5,823,000 at February 3, 2001.

Financial instruments. At February 2, 2002, 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 indebt-
edness, approximates fair value. The following methods and assumptions were used to estimate fair value of each class of finan-
cial 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 avail-
able to the Company for bank loans with similar terms and average maturities.

Insurance reserves. The Company is largely self-insured for workers compensation, general liability and medical insurance. The
Company’s liability for self-insurance is determined based on known claims and estimates for incurred but not reported claims.

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.

Comprehensive income. Comprehensive income does not differ from the consolidated net income presented in the consolidat-
ed statements of income.

Reclassifications. Certain prior year amounts have been reclassified to conform to the 2001 presentation.

Recent Accounting Pronouncements. In June 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No. 141
supercedes Accounting Principles Board Opinion ("APB") No. 16, Business Combinations, and SFAS No. 38, Accounting for
Preacquisition Contingencies of Purchased Enterprises. SFAS No. 141 requires that the purchase method of accounting be used
for all business combinations initiated after June 30, 2001 and for all business combinations accounted for by the purchase
method for which the date of acquisition is after June 30, 2001. The Company does not expect the adoption of SFAS No. 141 to
have a material impact on its financial statements.

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F R E D S 2 0 0 1 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
Total property and equipment, at depreciated cost

2001
$ 69,217
103,889
173,106
(99,121)
73,985
4,240
78,225

2000
$ 67,068
89,152
156,220
(84,100)
72,120
4,240
$ 76,360

Depreciation expense totaled $15,507,000, $12,407,000, and $10,168,000 for 2001, 2000 and 1999, respectively.

NOTE 3 - ACCRUED LIABILITIES

The components of accrued liabilities are as follows (in thousands):

Payroll and benefits
Sales and use taxes
Insurance
Other
Total accrued liabilities

NOTE 4 - INDEBTEDNESS

2001
$ 6,727
2,694
1,753
3,054
14,228

2000
$ 5,136
2,000
2,497
4,379
$ 14,012

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 a 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 no borrowings outstanding under the Agreement at February 2, 2002 and the borrowings outstand-
ing under the Agreement at February 3, 2001 totaled $22,623,000.

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2 3

Notes to Consolidated
Financial Statements

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 main-
frame 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
$703,000 and $1,265,500 borrowings outstanding under the Agreement at February 2, 2002 and February 3, 2001, respectively.
The principal maturity under this Agreement for debt outstanding at February 2, 2002 is as follows: $562,500 in fiscal 2002 and
$140,500 in fiscal 2003.

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 bore interest of 6.82% per annum and
would have matured on November 1, 2005. The Company used the proceeds of the public offering to pay off the Agreement
and the borrowings outstanding under the Agreement at February 3, 2001 totaled $8,762,000.

Interest expense for 2001, 2000, and 1999 totaled $1,611,000, $3,226,000, and $2,504,000, 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

2001

2000

1999

9,485
–
9,485

907
119
1,026
10,511

5,642
–
5,642

1,679
324
2,003
7,645

3,224
–
3,224

2,116
397
2,513
5,737

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F R E D S 2 0 0 1 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):

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 (liability) asset

2001

2000

530
1,060
357
933
76
2,956
(289)
2,667
(877)
1,790

1,532
799
73
1,768
4,172
(1,243)
2,929

(3,598)
(27)
(3,625)
(696)

627
768
310
1,200
26
2,931
(289)
2,642
(620)
2,022

1,685
760
82
1,769
4,296
(1,267)
3,029

(2,904)
(27)
(2,931)
98

The ultimate realization of the current deferred tax liability 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 valua-
tion allowance is based upon management’s conclusion that certain tax carryforward items will expire unused. During 2001 the
valuation allowance decreased ($24,000) and during 2000 the valuation allowance increased $135,000. The Company was able
to use net operating loss carryforwards in certain states during 2001 as compared to the Company generating additional net
operating loss carryforwards in certain states during 2000.

At February 2, 2002, the Company has certain net operating loss carryforwards which were acquired in reorganizations and pur-
chase transactions which are available to reduce income taxes, subject to usage limitations. These carryforwards total approxi-
mately $43,939,000 for state income tax purposes, and expire at various times during the period 2003 through 2023. If certain
substantial changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carryfor-
wards which can be utilized.

freds2001arREV 5/31/02 10:43 AM Page 27

F R E D S 2 0 0 1 A N N U A L R E P O R T

2 5

Notes to Consolidated
Financial Statements

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
Surtax Exemptions
Other

NOTE 6 - LONG-TERM LEASES

2001
35.0%
0.1
–
(0.2)
34.9%

2000
35.0%
0.9
(1.0)
(0.9)
34.0%

1999
35.0%
1.6
(1.0)
(0.7)
34.9%

The Company leases certain of its store locations under noncancelable operating leases that require monthly rental payments pri-
marily at fixed rates (although a number of the leases provide for additional rent based upon sales) 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 oper-
ating leases was $22,207,000, $17,465,000, and $15,329,000 for 2001, 2000, and 1999, respectively. Amortization expense on
assets under capital lease for 2001, 2000, and 1999 was $544,000, $449,000, and $355,000, respectively.

Future minimum rental payments under all operating and capital leases as of February 2, 2002 are as follows:

2002
2003
2004
2005
2006
Thereafter
Total minimum lease payments

Imputed interest

Present value of net minimum lease payments, including

$678 classified as current portion of capital lease obligations

NOTE 7 - SHAREHOLDERS’ EQUITY

Operating

Leases

Capital

Leases

20,611
18,112
15,072
12,280
8,869
12,789
87,733

914
536
428
315
173
28
2,394

(537)

1,857

The Company has 30 million shares of Class A voting common stock authorized. The Company’s authorized capital also consists
of 11.5 million shares of Class B nonvoting common stock, of which no shares have been issued. In addition, the 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 (a "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 enti-
ty 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.

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2 6

F R E D S 2 0 0 1 A N N U A L R E P O R T

Notes to Consolidated
Financial Statements

On May 24, 2001, the Company announced a five-for-four stock split of its common stock, Class A voting, no par value. The
new shares, one additional share for each four shares held by stockholders, were distributed on June 18, 2001 to stockholders of
record on June 4, 2001. All share and per share amounts included in the accompanying financial statements have been adjusted
to reflect this stock split.

In October 2001, the company completed a secondary stock offering of 1,585,000 company shares (unadjusted for 3-for-2 stock
split completed on February 1, 2002) raising net proceeds to the Company of $38.2 million dollars.

On January 15, 2002, the Company announced a three-for-two stock split of its common stock, Class A voting, no par value.
The new shares, one additional share for each two shares held by stockholders, were distributed on February 1, 2002 to stock-
holders of record on January 25, 2002. All share and per share amounts included in the accompanying financial statements have
been adjusted to reflect this stock split.

NOTE 8 - EMPLOYEE BENEFIT PLANS

Incentive stock option plan. The Company has a long-term incentive plan under which an aggregate of 2,191,409 shares may
be granted. These options expire five years from the date of grant. Options outstanding at February 2, 2002 expire in 2002
through 2006.

A summary of activity in the plan follows:

Outstanding at beginning of year
Granted
Forfeited/ canceled
Expired
Exercised
Outstanding at end of year
Exercisable at end of year

2001

2000

1999

Weighted
Average
Exercise
Price
$ 8.16
9.39
9.22

6.82
8.65
8.32

Options
1,242,415
288,219
(292,253)
–
(314,346)
924,035
356,068

Weighted
Average
Exercise
Price
$ 7.01
8.03
5.88

4.63
8.16
5.67

Weighted
Average
Exercise
Price
$ 7.15
6.31
7.89
6.05
4.47
7.01
4.86

Options
919,009
256,405
(48,939)
(3,270)
(66,730)
1,056,475
317,461

Options
1,056,475
647,824
(264,046)
–
(197,838)
1,242,415
288,871

The weighted average remaining contractual life of all outstanding options was 2.8 years at February 2, 2002.

The following table summarizes information about stock options outstanding at February 2, 2002:

Range of
Exercise Prices
$ 3.15 to $ 3.84
$ 6.14 to $ 8.64
$ 10.67 to $18.53

Number
Outstanding at
February 2, 2002
37,068
743,474
143,493
924,035

Options Outstanding
Weighted
Average
Remaining
Contractual
Life
(in Years)
0.8
2.4
2.2

Weighted
Average
Exercise
Price
$ 3.76
$ 7.57
$ 13.62

Options Exercisable

Number
Exercisable at
February 2, 2002
33,429
243,858
78,781
356,068

Weighted
Average
Exercise
Price
$ 3.75
$ 6.90
$13.61

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F R E D S 2 0 0 1 A N N U A L R E P O R T

2 7

Notes to Consolidated
Financial Statements

The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related inter-
pretations in accounting for its plans. Accordingly, no compensation expense has been recognized for its stock-based compensa-
tion. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant date for
awards in 2001, 2000, and 1999 consistent with the method prescribed by SFAS No. 123, Accounting for Stock-Based
Compensation, the Company’s operating results for 2001, 2000, and 1999 would have been reduced to the pro forma amounts
indicated below:

(in thousands, except per share data)
Net income

As reported
Pro forma

Basic earnings per share

As reported
Pro forma

Diluted earnings per share

As reported
Pro forma

2001

2000

1999

$ 19,629
19,245

$ 14,849
14,260

$10,702
10,363

0.83
0.82

0.81
0.80

0.66
0.63

0.65
0.62

0.48
0.47

0.47
0.46

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the fol-
lowing weighted-average assumptions using grants in 2001, 2000 and 1999, respectively:

Average expected life (years)
Average expected volatility
Risk-free interest rates
Dividend yield

2001

2000

1999

3.0
41.9%
2.6%
1.6%

3.0
39.0%
5.6%
1.3%

3.0
43.3%
4.8%
1.5%

The weighted average grant-date fair value of options granted during 2001, 2000,and 1999 was $6.90, $2.08, and $2.22,
respectively.

Restricted Stock. During 2001, 2000, and 1999, the Company issued (forfeited/ cancelled) a net of (15,185),(47,385), and
7,875 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 com-
pletion 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 2, 2002, February 3, 2001, and January 29, 2000 were $117,000, $100,000, and $96,000, respectively.

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2 8

F R E D S 2 0 0 1 A N N U A L R E P O R T

Notes to Consolidated
Financial Statements

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:

(in thousands)
Benefit obligation at beginning of year
Service cost
Interest cost
Participant contributions
Amendments
Actuarial (gain) loss
Benefits paid
Benefit obligation at end of year

A reconciliation of the Plan’s funded status to accrued benefit cost follows:

(in thousands)
Funded status
Unrecognized net actuarial gain
Unrecognized prior service cost
Accrued benefit costs

February 2,
2002

For the Year Ended
February 3,
2001

1,617
140
123
1
–
(74)
(21)
1,786

1,377
132
116
–
–
68
(76)
1,617

January 29,
2000
1,252
127
91
–
–
(17)
(76)
1,377

February 2,
2002
(1,786)
(380)
(5)
(2,171)

February 3,
2001
(1,617)
(322)
(5)
(1,944)

January 29,
2000
(1,377)
(406)
(6)
(1,789)

The medical care cost trend used in determining this obligation is 11.0% effective December 1, 2000, decreasing annually before
leveling at 5.5% in 2012. 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 $259,000. The discount rate used in
calculating the obligation was 7.25% in 2001, 7.5% in 2000 and 7.75% in 1999.

The annual net postretirement cost is as follows:

(in thousands)
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.

February 2,
2002

For the Year Ended
February 3,
2001

January 29,
2000

140
123
(17)
1
247

132
116
(17)
1
232

127
91
(17)
1
202

freds2001arREV 5/31/02 10:43 AM Page 31

Notes to Consolidated
Financial Statements

NOTE 9 - NET INCOME PER SHARE

F R E D S 2 0 0 1 A N N U A L R E P O R T

2 9

Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weight-
ed-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.

A reconciliation of basic earnings per share to diluted earnings per share follows (in thousands, except per share data):

February 2, 2002

Year Ended
February 3, 2001

January 29, 2000

Income
$ 19,629

Shares
23,553

Per
Share
Amount
$ .83

Income
$ 14,849

Shares
22,382

Per
Share
Amount
$ .66 $ 10,702

Income

Basic EPS
Effect of Dilutive

Securities

Restricted stock
Stock options

Diluted EPS

$ 19,629

69
575
24,197

$ .81

$ 14,849

146
341
22,869

$ .65 $ 10,702

Per
Share
Amount
.48
$

.47

Shares
22,176

203
256
22,635

NOTE 10 - COMMITMENTS AND CONTINGENCIES

Commitments. The Company had commitments approximating $9,133,000 at February 2, 2002 and $5,082,000 at February 3,
2001 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had outstanding let-
ters of credit aggregating $6,838,000 at February 2, 2002 and $2,552,000 at February 3, 2001 utilized as collateral for its 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.

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3 0

F R E D S 2 0 0 1 A N N U A L R E P O R T

Notes to Consolidated
Financial Statements

Note 11 – QUARTERLY FINANCIAL DATA (UNAUDITED)

Year Ended February 2, 2002
Net sales
Gross profit
Net income
Net income per share (1)

Basic
Diluted

Cash dividends paid per share

Year Ended February 3, 2001
Net sales
Gross profit
Net income
Net income per share (1)

Basic
Diluted

Cash dividends paid per share

(1) Per share data adjusted for stock split (Note 7).

First
Quarter

Second
Quarter

Third
Quarter

Fourth
Quarter

(in thousands, except per share data)

$ 207,359
57,758
4,159

$ 210,278
56,781
2,114

$ 219,242
62,038
5,128

$ 273,952
73,144
8,228

0.18
0.18
0.027

0.09
0.09
0.027

0.22
0.22
0.027

0.34
0.32
0.027

$ 176,132
48,990
3,345

$ 180,353
49,060
1,654

$ 180,141
51,850
3,829

$ 244,623
65,234
6,021

0.15
0.15
0.027

0.07
0.07
0.027

0.17
0.17
0.027

0.27
0.26
0.027

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F R E D S 2 0 0 1 A N N U A L R E P O R T

3 1

Report of Independent Accountants

To the Board of Directors and Shareholders of Fred’s, Inc.

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 2, 2002 and February 3, 2001, and the results of their operations and
their cash flows for each of the three years in the period ended February 2, 2002, 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 princi-
ples used and significant estimates made by management, and evaluating the overall financial statement presenta-
tion. We believe that our audits provide a reasonable basis for our opinion.

PricewaterhouseCoopers LLP
Memphis, Tennessee
March 15, 2002

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3 2

F R E D S 2 0 0 1 A N N U A L R E P O R T

Directors and Officers

Board of Directors

Executive Officers

Michael J. Hayes
Chief Executive Officer
Fred's, Inc.

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

Michael J. Hayes
Chief Executive Officer

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

freds2001arREV 5/31/02 10:43 AM Page 35

F R E D S 2 0 0 1 A N N U A L R E P O R T

Stock Market Information
The Company's common stock trades on the Nasdaq
Stock Market under the symbol FRED (CUSIP No.
356108-10-0). At May 3, 2002, the Company had an
estimated 16,500 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. All
amounts have been adjusted for a 5-for-4 stock split
distributed in June 2001 and a 3-for-2 stock split
distributed in February 2002.

High

Low

Per Share

2000
First
Second
Third
Fourth

2001
First
Second
Third
Fourth

SIC 5331

$ 8.53
$ 11.23
$ 13.33
$ 12.63

$ 7.54
$ 8.00
$ 10.00
$ 9.14

$ 13.89
$ 17.20
$ 22.70
$ 28.73

$ 10.87
$ 12.91
$ 15.99
$ 20.77

Dividends

$ 0.027
$ 0.027
$ 0.027
$ 0.027

Corporate Information

Corporate Offices
Fred's, Inc.
4300 New Getwell Road
Memphis, Tennessee 38118
(901) 365-8880

Transfer Agent
American Stock Transfer & Trust Company
59 Maiden Lane
New York, New York 10038
(800) 937-5449

Independent Accountants
PricewaterhouseCoopers LLP
Memphis, Tennessee

General 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 2, 2002, 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 2002 annual meeting of shareholders will be held
at 10:00 a.m. local time on Wednesday, June 26, 2002,
at the Memphis Marriott Hotel, 2625 Thousand Oaks
Boulevard, Memphis, Tennessee. Shareholders of
record as of May 3, 2002, are invited to attend this
meeting.

freds2001arREV 5/31/02 10:43 AM Page 36

4300 New Getwell Road
Memphis, Tennessee 38118