Fred's Inc. Annual Report 2005

FY2005 Annual Report · Fred's Inc.

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2 0 0 5 A n n u a l R e p o r t

Planning For
GROWTH

Focused On CUSTOMER
SATISFACTION

COMPANY PROFILE
COMPANY PROFILE

Founded in 1947, Fred's operates 645 discount general merchandise stores, including 24 franchised Fred's stores, mainly in the
southeastern states. 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.

NUMBER OF COMPANY-OWNED
AND FRANCHISED STORES BY STATE

108

107

FINANCIAL HIGHLIGHTS
FINANCIAL HIGHLIGHTS

(in thousands, except per share amounts)
OPERATING DATA, FOR THE YEAR ENDED
Net sales
Operating income
Net income
Net income per share - diluted
Weighted average shares outstanding - diluted

BALANCE SHEET DATA, AS OF
Working capital
Total assets
Long-term debt (including capital leases)
Shareholders' equity
Long-term debt to equity

Net Sales

$2,000

(in millions)

1,500

1,000

500

January 28,
2006

January 29,
2005

1,589,342
40,081
26,094
0.66
39,772

214,020
498,141
6,815
339,595

1,441,781
39,426
27,952
0.71
39,532

206,417
465,224
24,212
314,546

2.0%

7.7%

Comparable Store Sales Increase

Diluted Net Income Per Share

12%

$1.0

0.8

0.6

0.4

0.2

Store Count

Selling Space (Square Footage)

Sales Per Square Foot

800

700

600

500

400

300

200

100

(end of period)

10,000

(in thousands)

8,000

6,000

4,000

2,000

200

150

100

Company-owned Stores
Pharmacies

1
FRED’S
A N N U A L
R E P O R T

LETTER TO SHAREHOLDERS
LETTER TO SHAREHOLDERS

As we began 2005, we considered our plan for the year
to be solid and our roadmap effective to achieve growth
and improved profits. Our refrigerated foods initiative
was set to extend chain-wide in 2005, broadening our
appeal and convenience to customers and helping
overcome the significant and growing drag on the
economy – and consumer spending – caused by higher
energy costs, particularly the run-up in gasoline prices.
In fiscal 2004, our pharmacy department, a key
competitive distinction for Fred's, registered sales gains
in excess of our store average and was poised for
continued growth in 2005. With these and other
technology and operational initiatives in place for the
year, we expected Fred's to post sales and earnings
growth in 2005. That was before another spike in gas
and energy prices, before sweeping changes to the
Medicaid program in two of our key pharmacy states,
before the margin impact from the implementation of
Medicare Part D, and before Hurricanes Katrina, Rita
and Wilma.

These challenges clearly affected us in 2005, restraining
comparable store growth and resulting in lower earnings –
and the lingering effects have continued into 2006.
Addressing these short-term challenges is a key
component of our goal to expand our operating margin to
5% during fiscal 2008 and extend those benefits into fiscal
2009. Everyday low pricing is no longer an optional
industry driver – it's a necessity, and successful retailers
must go well beyond mere price competition. We believe
that to grow profitably over the next five years, we must
devote more attention than ever to our customers.

To ensure we are doing so, we have developed two
initiatives: the merchandising refresher program and our
"Service with a New Shine" (SWANS) program, as
highlighted in this report. Our plan for 2006 has taken
into consideration the current known pharmacy issues,
along with anticipated improvement in traffic. We
began our merchandising refresher program last year,

changing out approximately 4.5% of our store selling
space by introducing coolers for our refrigerated foods
program, with a goal toward refreshing an additional 4%
of our selling space in 2006 and in each future year.

The expected boost from these programs, and the
lapping of cuts in Medicaid programs in Mississippi and
Tennessee, are essential to our forecasted 14%-22%
increase in net income next year.

Financial and Operational Review
Sales for 2005 increased 10% to $1.589 billion from
$1.442 billion in fiscal 2004. The increase reflected a
greater amount of selling space resulting from new store
and pharmacy openings and 1.2% higher comparable
store sales for the year. On a comparable store basis,
customer transactions declined 0.3% during 2005 while
the average customer purchase increased 1.5%.

These results were below our expectations, with the
changes in the state Medicare programs accounting for
the majority of the drop in our comparable store
performance. Net income for the year was $26.1 million
or $0.66 per diluted share, down 7% from $28.0 million
or $0.71 per diluted share for fiscal 2004. Although
gross profit and operating income for 2005 both
improved slightly over the preceding year despite the
unusual challenges we faced, our operating margin
declined to 2.5% from 2.7% in 2004, primarily because
of higher fuel costs, utilities, and hurricane-related
repairs and maintenance.

Store Expansion
The majority of our sales increase in 2005 was driven by
the opening of 65 new stores and 20 pharmacies, both of
which met our original expectations for the year. We
also closed seven stores during the year, three of which
had pharmacies. The net number of openings for the
year increased our selling space to just over nine million
square feet, up 10% from 2004.

2
FRED’S
A N N U A L
R E P O R T

MERCHANDISING
REFRESHER PROGRAM
FRED’S REFRIGERATED
FOODS
PROGRAM IS THE FIRST STEP
IN ALIGNING AND

REFRESHING OUR

PRODUCT MIX TO MEET THE
INTERESTS OF OUR

CUSTOMERS.

SERVICE

WITH A NEW SHINE
AT FRED’S, CUSTOMERS
VOTE WITH THEIR
POCKETBOOKS AND RETURN

BECAUSE OF FRIENDLY,
ATTENTIVE SERVICE.

Continuing to take advantage of the capacity offered by
our distribution center in Dublin, Georgia, most of our
store growth during 2005 occurred in Georgia,
Alabama, and the Carolinas. West of the Mississippi,
we expanded the reach of our Memphis distribution
center into Oklahoma during 2005 and increased our
presence in Texas.

Of course, one of the most significant events of 2005
came in late August in the form of Hurricane Katrina.
Although three major hurricanes affected the Gulf
Coast states during the year, Katrina was the big one.
With about 150 of our stores in close proximity to
Katrina's landfall and impact zone, approximately 90
stores were closed for some period of time – up to 10
days – for storm preparation, evacuation, clean-up and
repairs. Three stores, included among those as closed in
2005, were completely destroyed.

In the coming year, we expect to open 60-70 new stores
and 20-25 new pharmacies. Net of anticipated store and
pharmacy closings, we expect that this expansion will
increase our total retail selling space in the range of 8%-
10% in 2006.

Challenges and Plans
Though 2005 was a difficult year, we consider the year's
challenges to be short-term and believe that 2006 will
show meaningful improvement. Although devastating,
Hurricane Katrina nonetheless represented only a
temporary disruption to our business. As an act of
nature, it perhaps was the easiest to grasp in terms of
impact and duration. Other issues in 2005, especially
those dealing with pharmacy reimbursements, require us
to cycle through their impact.

A most pervasive industry issue affecting Fred's has to
do with consumers, who are dealing with high gas
prices, increased energy bills, and rising interest costs.
As a result, discretionary spending has been oriented

toward lower-margin basic consumables. Although this
has had an impact on our target market, it also has made
consumers at all income levels focus on value shopping,
thus expanding our value-oriented customer base.

To take advantage of this opportunity, we implemented
a number of initiatives during 2005 and into 2006. The
merchandising refresher program is Fred's plan to make
sure we can grow our store and continue to build basic
traffic for the next five years. This program uses
category management as a centerpiece for determining
how our customers are voting on the merchandise we
offer at Fred's. By using both contribution per foot and
sales per foot, we even the playing field among lines to
determine which categories our customers believe are
important and which should be traded out. The most
prominent refresher effort to date has been our
refrigerated foods initiative, the rollout of which we
totally new
completed
merchandise category in about 3% of our space. From
the outset, this initiative has achieved sales expectations,
driving traffic and helping increase our average ticket
total. Our merchandise refresher program is planned to
improve the quality of our product mix, leading to a
change or update of 20% to 25% of the merchandise
selection in our stores over a four-year period.

last October,

adding a

Along with our merchandising refresher program, we
have continued our emphasis on store training for better
operations and customer service. This includes incentive
programs for store management that reward exemplary
performance at the store level and our SWANS program
to help ensure great service for our customers. When
married to an Everyday Low Pricing strategy, this
tandem of the refresher program, which focuses on what
the customer wants in our store, and the SWANS
program, which focuses on how the customer is treated,
we believe these initiatives are key to giving Fred's an
edge in winning customers.

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FRED’S
A N N U A L
R E P O R T

tangible benefits. In 2005, inventory turnover improved
to 3.8 times from 3.7 times. This solid inventory
flow,
management helped strengthen our cash
contributing to increased store expense leverage and
allowing us to reduce long-term debt by $17 million or
68% during the year. We expect these initiatives to
remain positive for us in 2006, in conjunction with other
new programs intended to drive down supply chain
costs even further.

Outlook
Although the past year was not up to our expectations,
we are confident that the
initiatives we have
implemented will produce positive results for us in 2006.
Fred's has a unique niche in the retail market. As the
big-box retailers continue to expand, they open up
additional markets for the alternative shopping trip
providers, like Fred's. We believe customers will choose
the shopping environment that responds best to their
demand for service, value pricing, and the products they
expect. We intend to listen and react to make sure they
choose FRED'S!

Thank you for
your continued support.

Michael J. Hayes
Chief Executive Officer

Last year, we also confronted several regulatory issues
affecting our pharmacy operations, including cuts to
Medicaid programs in two key states – Mississippi and
Tennessee. In January 2005, the last month of our fiscal
year, an additional challenge arose for us with the
implementation of the new Medicare program, with its
new Part D that required those covered by state
Medicaid programs to move to the new, lower-margin
Medicare program. This shift in dual-eligible customers
affected us more than our competitors, since our
customer base has a substantially greater percentage of
Medicaid customers than do the larger national chains.
Going forward, however, we expect the margin impact
of this regulatory change will be offset by an increase in
prescription counts and the introduction of new generic
drugs, which carry higher gross margins. Consequently,
we expect a net positive impact on our pharmacy
department performance by the end of the coming year.
What remains unknown is the margin impact, if any,
from the introduction of an Average Manufacturer's
Price program for generic drugs in 2006.

these regulatory changes will create
Obviously,
additional pressures on small, independent pharmacists.
We believe this shifting, uncertain environment may
lead to increased acquisition opportunities for Fred's.
The recently renegotiated supply contract with our
primary pharmaceutical wholesaler will be in effect for
all of 2006 and carries better pricing on both generics
and name-brand drugs.

In the face of higher costs, most notably rising interest
expense and energy costs, we have taken many steps to
improve our store performance, boost return on
investment, and reduce supply chain costs. New
technology, such as point-of-sale systems upgrades and
the widespread implementation of radio frequency
devices for inventory control and planning, along with
aggressive labor management, already are producing

6
FRED’S
A N N U A L
R E P O R T

THE

PHARMACY DISTINCTION
FRED’S PHARMACY

MEANS CONVENIENT, FAST

AND FRIENDLY SERVICE.
FOURTH FRIDAYS

AT FRED’S AND

TOWN HALL MEETINGS
TURN DIFFICULT PROBLEMS INTO
EASIER DECISIONS.

SELECTED FINANCIAL DATA
SELECTED FINANCIAL DATA

Our selected financial data set forth below should be read in connection with “Managements Discussion and Analysis of Financial
Condition and Results of Operation” and the Consolidated Financial Statements and Notes thereto included elsewhere in the
Annual Report.

(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:1

Basic
Diluted

Cash dividend paid per share1

Selected Operating Data:
Operating income as a percentage of sales
Increase in comparable store sales 2
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

2005

2004

2003

2002

2001

$ 1,589,342 $ 1,441,781 $ 1,302,650 $ 1,103,418
41,487
41,284
13,793
27,491

40,081
39,255
13,161
26,094

39,426
38,633
10,681
27,952

49,100
48,702
15,907
32,795

910,831
31,022
29,411
10,226
19,185

0.66
0.66
0.08

2.5%
1.2%
621

0.71
0.71
0.08

2.7%
2.2%
563

0.85
0.83
0.08

3.8%
5.7%
488

0.72
0.70
0.08

3.8%
11.2%
414

0.54
0.53
0.08

3.4%
10.5%
353

498,141 $
1,053
6,815
339,595

465,224 $
684
24,212
314,546

408,793 $
743
7,289
286,350

342,785
905
2,510
247,433

281,986
1,240
1,320
216,295

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

effected on July 1, 2003.

2 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.

8
FRED’S
A N N U A L
R E P O R T

MANAGEMENT’S DISCUSSION AND ANALYSIS
MANAGEMENT’S DISCUSSION AND ANALYSIS

GENERAL ACCOUNTING PERIODS

The following information contains references to years 2005, 2004, and 2003, which represent fiscal years ended January 28,
2006, January 29, 2005, and January 31, 2004, each of which was a 52-week accounting period. This discussion and analysis
should be read with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto. Our
discussion should be read in conjunction with the Forward-Looking Statements/Risk Factors disclosures included herein.

EXECUTIVE SUMMARY

Throughout 2005, Fred’s continued to focus our merchandising and store direction on maintaining a competitive
differentiation within the $25 shopping trip. Our unique store format and strategy combine the attractive elements of a discount
dollar store, drug store and mass merchant. In comparison, the discount dollar stores average $8-$9 and chain drugs and mass
merchants average in the range of $40-$80 per transaction. Our stores operate equally well in rural and urban markets. Our
product selection is enhanced by a private label program and opportunistic buys. Our everyday low pricing strategy is
supplemented by 14 promotional circulars per year. In the fourth quarter, we invested in more aggressive television and radio
advertising to help drive sales in our highly competitive markets.

In 2005, the Company continued the strategic growth direction to grow its store base. We opened 65 new stores and 20 new
pharmacies in 2005. We closed seven stores and three pharmacies during the year. The majority of the new store and pharmacy
openings were in Alabama, Georgia, Texas, and North Carolina. We have now entered into Oklahoma with the opening of one
new store in 2005. The Company’s selling space increased 10% to 9.1 million square feet at the end of this year, as compared to
8.3 million square feet at the end of last year.

A new initiative in 2005 was the addition of our new refrigerated foods program, which has added a totally new merchandise
category in our stores. The rollout of the coolers was completed on time and under budget. This rollout greatly enhanced the
convenience of our stores. The program is seen as a sound traffic generator while lifting our comparable store average customer
transaction amount. Stores equipped with the refrigerated foods program accept government assistance cards.

Inventory initiatives during 2005 resulted in a per store average reduction of 4% year-over-year. Overall increases in inventory
levels related to elevated levels at the distribution centers to support new allocation and sorting programs. Improvements in
purchasing and more effective inventory systems have helped to minimize inventory throughout the stores, resulting in better
cash flow and inventory turnover and store labor expense leveraging. At the end of 2005, long-term indebtedness was $6.8
million compared with $24.2 million at the prior year-end, a reduction of $17 million. Inventory turns improved from 3.7 to 3.8
times. In 2005, store labor expense improved by 0.4% over the prior year.

During the year, the Company saw continued payback on key technology initiatives we implemented. These initiatives include
store point of sale systems upgrades, allocation system upgrades, and radio frequency devices in the stores to facilitate scanning
in-store deliveries and correct inventory counts.

In 2005, while the Company made important strides internally on productivity initiatives, the external economic environment
in which we operate was very challenging. We experienced a continued product mix shift toward basic and consumable products
because customers changed their shopping habits as they adapted to reduced discretionary income due to rising energy costs. The
pharmacy department business was affected by two key events. On August 1, 2005, the State of Tennessee initiated significant
cuts to its “TennCare” Medicaid program, eliminating approximately 230,000 recipients and reducing the allowed prescriptions
for all other enrollees from an unlimited number to just five per month. This action has had a dramatic impact on the pharmacy
sales of our almost 100 stores in the state. The impact of this sales loss to earnings was approximately two cents per diluted share
in each of the third and fourth quarters. On January 1, 2006, the Medicare Part D program, which impacts eligible seniors and
disabled customers, became effective which required those covered by Medicaid programs to move to that new, lower margin
program. The movement of prescriptions transferred was greater than expected and reduced earnings by an additional one cent
(post tax) per diluted share in the fourth quarter.

9
FRED’S
A N N U A L
R E P O R T

MANAGEMENT’S DISCUSSION AND ANALYSIS
MANAGEMENT’S DISCUSSION AND ANALYSIS

Additionally, in 2005 Hurricanes Katrina and Rita impacted the Gulf Coast, affecting a large part of our service area. The
storms caused the temporary closure of up to 90 stores for up to 10 days at the peak of Hurricane Katrina, and resulted in the
complete destruction of three stores. The most significant losses caused by the storms were inventory and fixed assets, in the form
of store fixtures and improvements. These losses were partially offset by insurance proceeds, and the Company expects to record
additional insurance proceeds as they are received. While business interruption was experienced during the storms, the Company
did not receive and did not record any business interruption insurance proceeds as revenue and will not do so until the business
interruption claims are substantially settled.

In 2006, the Company plans to open 60-70 new stores and 20-25 new pharmacies, with the net effect being an increase in
selling space in the range of 8% to 10%. Increased selling space will help drive increases in total sales, while comparable store
sales increases will be driven by our continued focus on merchandising, with initiatives such as our Merchandise Refresher
program. Additionally, our newly implemented cooler program will continue to drive increases in comparable store sales. The
Company will continue in 2006 with capital investment in infrastructure, including new store expansion, distribution center
upgrades and further development of our information technology capabilities.

Key factors that will be critical to the Company’s future success include managing the growth strategy for new stores and
pharmacies, including the ability to open and operate effectively, maintain high standards of customer service, maximizing
efficiencies in the supply chain, controlling working capital needs through improved inventory turnover, and increasing the
operating margin through improved gross profit margin and leveraging operating costs, and generating the adequate cash flow to
fund the Company’s expansion.

In 2006, other factors that will affect Company performance include the managing the impacts of the implementation of
Medicare Part D which has a negative effect on gross margin with a partial positive offset from increasing Part D scripts,
implementation of the federally approved change in pricing of generic pharmaceuticals to Average Manufacturer’s Price (AMP)
which could negatively affect gross margin and the implementation of Financial Accounting Standard No 123R, “Share Based
Payments” which increases compensation expense.

CRITICAL ACCOUNTING POLICIES

The preparation of Fred’s financial statements requires management to make estimates and judgments in the reporting of
assets, liabilities, revenues, expenses and related disclosures of contingent assets and liabilities. Our estimates are based on
historical experience and on other assumptions that we believe are applicable under the circumstances, the results of which form
the basis for making judgments about the values of assets and liabilities that are not readily apparent from other sources. While
we believe that the historical experience and other factors considered provide a meaningful basis for the accounting policies
applied in the Consolidated Financial Statements, the Company cannot guarantee that the estimates and assumptions will be
accurate under different conditions and/or assumptions. A summary of our critical accounting policies and related estimates and
judgments, can be found in Note 1 to the Consolidated Financial Statements and the most critical accounting policies are as
follows:

Inventories. Warehouse 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 (“RIM”). Under RIM,
the valuation of inventories at cost and the resulting gross margin are calculated by applying a calculated cost-to-retail ratio to
the retail value of inventories. RIM is an averaging method that has been widely used in the retail industry due to its practicality.
Also, it is recognized that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are
Inherent in the RIM calculation are certain significant
currently taken as a reduction of the retail value of inventories.
management judgments and estimates including, among others, initial markups, markdowns, and shrinkage, which significantly
impact the ending inventory valuation at cost as well as resulting gross margin. These significant estimates, coupled with the fact
that the RIM is an averaging process, can, under certain circumstances, produce distorted or inaccurate cost figures. Based upon
our historical information we have not experienced any significant change in our cost valuation for the years 2005 and 2004.
Management believes that the Company’s RIM provides an inventory valuation which reasonably approximates cost and results

10
FRED’S
A N N U A L
R E P O R T

MANAGEMENT’S DISCUSSION AND ANALYSIS
MANAGEMENT’S DISCUSSION AND ANALYSIS

in carrying inventory at the lower of cost or market. For pharmacy inventories, which are approximately $35.5 million and $35.1
million at January 28, 2006 and January 29, 2005, respectively, cost was determined using the retail LIFO (last-in, first-out)
method in which inventory cost is maintained using the RIM method, then adjusted by application of the Producer Price Index
published by the U.S. Department of Labor for the cumulative annual periods. The current cost of inventories exceeded the LIFO
cost by approximately $12.2 million at January 28, 2006 and $9.7 million at January 29, 2005. The LIFO reserve increased by
approximately $2.5 million, $1.9 million, and $1.6 million, during 2005, 2004, and 2003, respectively.

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

Building and building improvements
Furniture, fixtures and equipment
Leasehold improvements
Automobiles and vehicles
Airplane

Estimated Useful Lives
8 - 30 years
3 - 10 years
3 - 10 years or term of lease, if shorter
3 - 5 years
9 years

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

In the fourth quarter of 2004, the Company changed the estimated lives of certain store fixtures from five to ten years. Based
on the Company’s historical experience, ten years is a closer approximation of the actual lives of these assets. The change in
estimate was applied prospectively. Expenses for the fourth quarter of 2004 were favorably impacted by approximately $1.3
million pretax ($.02 per diluted share) as a result of this change. Expenses for 2005 were favorably impacted by approximately
$4.5 million pretax ($.07 per diluted share) as a result of this change.

Vendor rebates. The Company receives vendor rebates for achieving certain purchase or sales volume and receives vendor
allowances to fund certain expenses. The Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting by a Customer
(including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”) is effective for arrangements with
vendors initiated on or after January 1, 2003. EITF 02-16 addresses the accounting and income statement classification for
consideration given by a vendor to a retailer in connection with the sale of the vendor’s products or for the promotion of sales of
the vendor’s products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in
prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying
the consideration for treatment as reimbursement of specific, identifiable incremental costs. The provisions of this consensus have
been applied prospectively. During the quarter ended October 29, 2005, the Company renewed its contract with its primary
pharmaceutical wholesaler, AmerisourceBergen Corporation. As noted in prior public filings, the renewal of this contract would,
and did impact the Company’s financial statements because of the application of the provisions of EITF 02-16, Accounting by
a Customer (Including a Reseller) for Certain Consideration Received from a Vendor. The effect on the financial statements,
which occurred during the third quarter, was a deferral of the associated rebates against cost of sales of $2.2 million pretax
(estimated at $0.03 per diluted share, after tax). This change in timing had no effect on cash flow for the quarter. While the
contract was not due to mature until January 31, 2006, the renewal terms were positive to overall earnings and will benefit the
Company through better pricing.

For vendor funding arrangements that were entered into prior to December 31, 2002, and have not been modified subsequently,

the Company recognizes a reduction to selling, general and administrative expenses or cost of goods sold when earned.

11
FRED’S
A N N U A L
R E P O R T

MANAGEMENT’S DISCUSSION AND ANALYSIS
MANAGEMENT’S DISCUSSION AND ANALYSIS

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 future claims cost and incurred
but not reported claims. Estimates for future claims costs would include costs and other factors such as the type of injury or claim,
required services by providers, healing time, age of claimant, case management costs, location of the claim, and governmental
regulations. If future claim trends deviate from recent historical patterns, the Company may be required to record additional
expense or expense reductions which could be material to the Company’s results of operations. Additional insurance coverage
exists for excessive or catastrophic claims.

Stock-based compensation. The Company grants stock options having a fixed number of shares and an exercise price equal
to the fair value of the stock on the date of grant to certain executive officers, directors and key employees. Through January 28,
2006, the Company had accounted for stock option grants in accordance with Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations. Under APB No. 25, compensation
expense is generally not recognized for plans in which the exercise price of the stock options equals the market price of the
underlying stock on the date of grant and the number of shares subject to exercise is fixed. Had compensation cost for the
Company’s stock-based compensation plans been determined based on the fair value at the grant date for awards under these
plans consistent with the methodology prescribed under SFAS No. 123, net income and earnings per share would have been
reduced to the pro forma amounts indicated in the following table: (in thousands, except per share amounts)

Net income:

As reported
Less pro forma effect of stock option grants
Pro forma

Basic earnings per share:

As reported
Pro forma

Diluted earnings per share:

As reported
Pro forma

2005

2004

2003

26,094
386
25,708

0.66
0.65

27,952
838
27,114

0.71
0.69

32,795
900
31,895

0.85
0.82

0.83
0.80

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R which requires all companies
to measure compensation cost for all share-based payments (including employee stock options) at fair value. The FASB
concluded that companies can adopt the new standard in one of two ways: the modified prospective transition method, in which
the company would recognize share-based employee compensation from the beginning of the fiscal period in which the
recognition provisions are first applied as if the fair-value-based accounting method had been used to account for all employee
awards granted, modified, or settled after the effective date and to any awards that were not fully vested as of the effective date;
or the modified retrospective transition method, in which a company would recognize employee compensation cost for periods
presented prior to the adoption of SFAS No. 123R in accordance with the original provisions of SFAS No. 123 “Accounting for
Stock-Based Compensation,” pursuant to which a company would recognize employee compensation cost in the amounts
reported in the pro forma disclosures provided in accordance with SFAS No. 123. The Company will adopt SFAS No. 123R
during the first quarter of fiscal 2006 and will use the modified prospective transition method.

The Company also periodically awards restricted stock having a fixed number of shares at a purchase price that is set by the
Compensation Committee of the Company’s Board of Directors, which purchase price may be set at zero, to certain executive
officers, directors and key employees. The Company also accounts for restricted stock grants in accordance with APB No. 25 and
related interpretations. Under APB No. 25, the Company calculates compensation expense as the difference between the market

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MANAGEMENT’S DISCUSSION AND ANALYSIS

price of the underlying stock on the date of grant and the purchase price, if any, and recognizes such amount on a straight-line
basis over the period in which the restricted stock award is earned by the recipient. The Company recognized compensation
expense relating to its restricted stock awards of approximately $509,000, $110,000, and $28,000 in 2005, 2004, and 2003,
respectively. (See Note 7 to the Consolidated Financial Statements for further disclosure relating to stock incentive plans).

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 (1)
Gross profit
Selling, general and administrative expenses (2)
Operating income
Interest expense, net
Income before taxes
Income taxes
Net income

January 28,
2006
100.0%
71.8
28.2
25.7
2.5
0.1
2.4
0.8
1.6%

For the Year Ended
January 29,
2005
100.0%
71.9
28.1
25.4
2.7
0.1
2.6
0.7
1.9%

January 31,
2004
100.0%
71.8
28.2
24.5
3.7
0.0
3.7
1.2
2.5%

(1) Cost of goods sold includes the cost of the product sold, along with all costs associated with inbound freight.
(2) Selling, general and administrative expenses include the costs associated with purchasing, receiving, handling, securing, and
storing the product. These costs are associated with products that have been sold and no longer remain in ending inventory.

FISCAL 2005 COMPARED TO FISCAL 2004

Sales

Net sales increased 10.2% ($147.6 million) in 2005. Approximately $130.7 million of the increase was attributable to a net
addition of 58 new stores, and a net addition of 17 pharmacies during 2005, together with the sales of 81 store locations and 17
pharmacies that were opened or upgraded during 2004 and contributed a full year of sales in 2005. During 2005, the Company
closed seven stores and three pharmacy locations. Comparable store sales, consisting of sales from stores that have been open for
more than one year, increased 1.2% in 2005, which accounted for $ 16.9 million in sales.

The Company's front store (non-pharmacy) sales increased approximately 12.8% over 2004 front store sales. Front store sales
growth benefited from the above mentioned store additions and improvements, and sales increases in certain categories such as
food direct (cooler program), beverages, paper and chemicals, tobacco, greeting cards, prepaid products, electronics, and hardware.
Fred's pharmacy sales were 31.3% of total sales in 2005 and 32.6% of total sales in 2004 and continue to rank as the largest
sales category within the Company. The total sales in this department, including the Company's mail order operation, increased
5.7% over 2004, with third-party prescription sales representing approximately 88% of total pharmacy sales, a decrease from 89%
in the prior year. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing
prescription files from independent pharmacies and the addition of pharmacy departments in existing store locations.

Sales to Fred's 24 franchised locations increased approximately $1.5 million in 2005 and represented 2.2% of the Company's
total sales, as compared to 2.3% in 2004. The increase in sales to franchised locations results primarily from the sales volume
increases experienced by the remaining franchise locations during the year. It is anticipated that this category of business will
continue to decline as a percentage of total Company sales since the Company has not added and does not intend to add any
additional franchisees.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

Gross Margin

Gross margin as a percentage of sales increased to 28.2% in 2005 compared to 28.1% in 2004. The increase in gross margin
results primarily from higher initial margin in pharmacy products through greater conversions of branded to generic
pharmaceuticals.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were 25.7% of net sales in 2005 compared with 25.4% of net sales in 2004. The
increase for the year results from fuel price increases affecting distribution costs ($3.2 million), higher utilities ($3.3 million) and
store repairs and maintenance ($2.2 million). Depreciation expense for 2005 was favorably impacted by approximately $4.5
million from the change in estimated lives of certain store fixtures from five to 10 years in late 2004.

Operating Income

Operating income increased approximately $0.7 million or 1.7% to $40.1 million in 2005 from $39.4 million in 2004.
Operating income as a percentage of sales was 2.5% in 2005 down from 2.7% in 2004, due primarily to the above-mentioned
increases in selling, general and administrative expenses.

Interest Expense, Net

Net interest expense for 2005 totaled $0.8 million or 0.1% of sales, the same as in the prior year.

Income Taxes

The effective income tax rate increased to 33.5% in 2005 from 27.6% in 2004. The lower tax rate for 2004 resulted primarily from
realization of income tax credits that originated in 2003 and 2004 related to the Company’s distribution center in Dublin, Georgia.
In 2004, $1.7 million of these credits were recognized. These tax credits will continue to benefit the Company in future years.

State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $112.6 million for state income tax purposes and expire at various times during the period 2006 through 2025. If
certain substantial changes in the Company’s ownership should occur, there would be an annual limitation on the amount of carry-
forwards that can be utilized. We have provided a reserve for the portion believed to be more likely than not to expire unused.

The Company’s estimates of income taxes and the significant items resulting in the recognition of deferred tax assets and
liabilities are described in Note 4 to the Consolidated Financial Statements and reflect the Company’s assessment of future tax
consequences of transactions that have been reflected in the Company’s financial statements or tax returns for each taxing
authority in which it operates. Actual income taxes to be paid could vary from these estimates due to future changes in income
tax law or the outcome of audits completed by federal and state taxing authorities. We maintain income tax contingency reserves
for potential assessments from the federal or other taxing authority. The reserves are determined based upon the Company’s
judgment of the probable outcome of the tax contingencies and are adjusted, from time to time, based upon changing facts and
circumstances. Changes to the tax contingency reserve could materially affect the Company’s future consolidated operating
results in the period of change.

Net Income

Net income for 2005 was $26.1 million (or $0.66 per diluted share) or approximately 6.6% lower than the $28.0 million (or

$0.71 per diluted share) reported in 2004.

FISCAL 2004 COMPARED TO FISCAL 2003

Sales

Net sales increased 10.7% ($139.1 million) in 2004. Approximately $111.6 million of the increase was attributable to a net
addition of 81 new stores, and a net addition of 17 pharmacies during 2004, together with the sales of 74 store locations and 25

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MANAGEMENT’S DISCUSSION AND ANALYSIS

pharmacies that were opened or upgraded during 2003 and contributed a full year of sales in 2004. During 2004, the Company
closed six stores and two pharmacy locations. Comparable store sales, consisting of sales from stores that have been open for more
than one year, increased 2.2% in 2004 which accounted for $ 27.5 million in sales.

The Company's front store (non-pharmacy) sales increased approximately 10.9% over 2003 front store sales. Front store sales
growth benefited from the above mentioned store additions and improvements, and sales increases in certain apparel categories
such as ladies, girls, and infants and toddler apparel, food, beverages, tobacco, greeting cards, prepaid products, pets, lawn and
garden, electronics, automotive, hardware and small appliances.

Fred's pharmacy sales were 32.6% of total sales in 2004 from 32.4% of total sales in 2003 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
11.6% over 2003, with third party prescription sales representing approximately 89% of total pharmacy sales, an increase from the
86% as the prior year. The Company's pharmacy sales growth continued to benefit from an ongoing program of purchasing
prescription files from independent pharmacies and the addition of pharmacy departments in existing store locations.

Sales to Fred's 25 franchised locations decreased approximately $1.5 million in 2004 and represented 2.3% of the Company's
total sales, as compared to 2.7% in 2003. The decrease in sales to franchised locations results primarily from the closing of one
franchise store. It is anticipated that this category of business will continue to 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 decreased to 28.1% in 2004 compared to 28.2% in 2003. The decrease in gross margin
results primarily from a product mix shift during the third and fourth quarters of the year towards more basic and consumable
product categories which typically have lower gross margins than other more discretionary categories such as apparel and home
products. We believe a primary reason for this product mix shift was the impact of rising fuel prices on our low-to-middle income
shopper. The impact of this product mix shift on the initial margin was approximately 0.3% for the year. This reduction was offset
by the positive impact of better store shrinkage control.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were 25.4% of net sales in 2004 compared with 24.5% of net sales in 2003. The
increase for the year results from labor expenses and occupancy costs in the stores, higher corporate professional fees associated
with our Sarbanes-Oxley 404 internal control compliance work, insurance costs, and fuel price increases affecting distribution
costs. During the fourth quarter the Company changed the estimated lives of certain store fixtures from five to ten years. This
change resulted in the favorable impact on expenses by approximately $1.3 million.

Operating Income

Operating income decreased approximately $9.7 million or 19% to $39.4 million in 2004 from $49.1 million in 2003.
Operating income as a percentage of sales was 2.7% in 2004 from 3.7% in 2003, due primarily to the above-mentioned increases
in selling, general and administrative expenses.

Interest Expense, Net

Interest expense for 2004 totaled $0.8 million (or 0.1% of sales) compared to expense of $0.4 million (less than 0.1% of sales)
in 2003. The increase in interest expense was attributed to higher inventory levels throughout the year and, to a lesser extent,
increases in the bank prime rate.

Income Taxes

The effective income tax rate decreased to 27.6% in 2004 from 32.7% in 2003. The lower tax rate for 2004 resulted primarily
from realization of income tax credits that originated in 2003 and 2004 related to the Company’s distribution center in Dublin,
Georgia. These credits recognized in 2004 amounted to $1.7 million. These tax credits will continue to benefit the Company in
future years.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

State net operating loss carry-forwards are available to reduce state income taxes in future years. These carry-forwards total
approximately $94.5 million for state income tax purposes and expire at various times during the period 2005 through 2024. If
certain substantial changes in the Company’s ownership should occur, there would be an annual limitation on the amount of
carry-forwards that can be utilized.

Net Income

Net income for 2004 was $28.0 million (or $0.71 per diluted share) or approximately 15% lower than the $32.8 million (or

$0.83 per diluted share) reported in 2003.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s principal capital requirements include funding new stores and pharmacies, remodeling existing stores and
pharmacies, maintenance of stores and distribution centers, and the ongoing investment in corporate information system
technology. Fred's primary sources of working capital have traditionally been cash flow from operations and borrowings under its
credit facility. In June 2003, the Company raised proceeds of $5.5 million from the offering of 150,000 Company shares. The
Company had working capital of $214.0 million, $206.4 million, and $164.9 million at year-end 2005, 2004, and 2003,
respectively. Working capital fluctuates in relation to profitability, seasonal inventory levels, net of trade accounts payable, and
the level of store openings and closings. Working capital at year-end 2005 increased by approximately $7.6 million from 2004.
The increase was primarily attributed to inventory purchased for new store openings scheduled for the first quarter of 2006. The
Company plans to open 17 new stores and four new pharmacies during the first quarter of 2006.

Net cash flow provided by operating activities totaled $48.5 million in 2005, $18.4 million in 2004, and $36.2 million in

2003.

In fiscal 2005, cash was primarily used to increase inventories by approximately $30.9 million, or 10%, during the fiscal year.
This increase is primarily attributable to our adding a net of 58 new stores, upgrading 12 stores and adding a net of 17 new
pharmacies, as well as supporting the increase in comparable store sales. Accounts payable and accrued expenses increased by
$12.7 million due primarily to increase in inventory and higher accrued payroll expenses. Income taxes payable increased by
approximately $6.2 million due to the increase in the effective tax rate.

In fiscal 2004, cash was primarily used to increase inventories by approximately $37.6 million, or 15%, during the fiscal year.
This increase is primarily attributable to our adding a net of 75 new stores, upgrading 30 stores and adding a net of 17 new
pharmacies, as well as supporting the increase in comparable store sales. Accounts payable and accrued expenses increased by
$2.3 million due primarily to higher accrued expenses. Income taxes payable decreased by approximately $.9 million.

In fiscal 2003, cash was primarily used to increase inventories by approximately $47.9 million during the fiscal year. This increase
is primarily attributable to our adding a net of 74 new stores, upgrading 26 stores and adding a net of 25 new pharmacies, as well as
supporting the improved comparable store sales. Accounts payable and accrued expenses increased by $16.4 million due primarily
to higher inventory purchases. Income taxes payable increased by approximately $.9 million and the net deferred income tax liability
increased by approximately $6.0 million primarily as a result of first-year depreciation allowance for income tax purposes.

Capital expenditures in 2005 totaled $27.8 million compared with $31.8 million in 2004 and $48.0 million in 2003. The 2005
capital expenditures included approximately $18.3 million for new stores and pharmacies, $7.1 million for upgrading existing

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MANAGEMENT’S DISCUSSION AND ANALYSIS

stores and $2.4 million for technology, corporate and other capital expenditures. Rather than purchase the equipment for our
refrigerated foods program, the Company decided to enter into operating leases. The 2004 capital expenditures included
approximately $22.5 million for new stores and pharmacies, $1.8 million for upgrading existing stores, $5.0 million for the
Memphis and Dublin distribution center and $2.5 million for technology, corporate and other capital expenditures. The 2003
capital expenditures included approximately $23.2 million for new stores and pharmacies, $3.4 million for existing stores, $9.0
million related to the completion of the new Georgia distribution center that was completed in April 2004, $2.2 million for the
Memphis distribution center and $10.2 million for technology, corporate and other capital expenditures. Cash used for investing
activities also includes $3.2 million in 2005, $2 million in 2004, and $.9 million in 2003 for the acquisition of prescription lists
and other pharmacy related items.

In 2006, the Company is planning capital expenditures totaling approximately $34.6 million. Expenditures are planned
totaling $22.2 million for upgrades, remodels, new stores and pharmacies. Planned expenditures also include approximately $6.5
million for technology upgrades, and approximately $2.8 million for distribution center equipment and capital maintenance.
Technology upgrades in 2006 will be made in the areas of financial reporting software, stores POS systems, and pharmacy. In
addition the Company also plans expenditures of $3.1 million in 2006 for the acquisition of prescription lists and other pharmacy
related items.

Cash and cash equivalents were $3.1 million at the end of 2005 compared to $5.4 million at the end of 2004, compared to $4.7
million at year-end 2003. Short-term investment objectives are to maximize yields while minimizing company risk and
maintaining liquidity. Accordingly, limitations are placed on the amounts and types of investments the Company can select.

On October 10, 2005, the Company and Regions Bank, successor in interest to Union Planters, entered into a Seventh
Modification Agreement of the Revolving Loan and Credit Agreement to provide a temporary increase of commitment of $20
million and increasing the available credit line to $70 million. The term of the agreement was from October 10, 2005, until
December 15, 2005. On December 15, 2005, the available credit line reverted to $50 million. All terms, conditions and
covenants remained in place for the Note and credit facility.

On July 29, 2005, the Company and Regions Bank, successor in interest to Union Planters, entered into a Sixth Modification
Agreement of the Revolving Loan and Credit Agreement (the “Agreement”) dated April 3, 2000, to increase the commitment
from the bank from $40 million to $50 million and to extend the term until July 31, 2009. The Agreement bears interest at 1.5%
below the prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company is required
to maintain specified shareholders’ equity (which was $273.5 million at January 28, 2006) and net income levels. The Company
is required to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the unutilized portion of the revolving
line commitment over the term of the Agreement. There were $5.7 million and $23.1 million of borrowings outstanding under
the Agreement at January 28, 2006, and January 29, 2005, respectively.

On October 19, 2004, the Company and Union Planters providing the credit facility entered into a Fifth Modification
Agreement of the Revolving Loan and Credit Agreement to provide a temporary increase of commitment of $10 million and
increasing the available credit line to $60 million. The term of the agreement was from October 20, 2004 until December 15,
2004, superseding the expiration of the Fourth Modification. On December 15, 2004, the available credit line reverted to $40
million. All terms, conditions and covenants remained in place for the Note and credit facility.

On July 31, 2004, the Company and Union Planters Bank, N.A. (“Union Planters”) entered into a Fifth Modification
Agreement of the Revolving Loan and Credit Agreement. All terms, conditions and covenants remained in place for the Note
and credit facility to replace the April 3, 2000 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 the prime
rate or a LIBOR-based rate. The term of the Agreement extends to July 31, 2006.

On June 28, 2004, the Company and Union Planters providing the credit facility entered into a Fourth Modification
Agreement of the Revolving Loan and Credit Agreement to provide a temporary increase in commitment of $10 million and
increasing the available credit line to $50 million. The term of the agreement was from June 28, 2004 until December 28, 2004.
All terms, conditions and covenants remained in place for the Note and credit facility.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

sale in the conduct of our business. On June 6, 2003, the Company raised proceeds of $5.5 million from the offering of 225,000
shares. On September 3, 2003, the Company sold 75,000 shares in common stock for $2.6 million with the intention of purchasing
an airplane. Later, the Company decided not to purchase the airplane, whereupon the Company purchased and retired $2.6 million
of common stock from the CEO. A Limited Liability Company (LLC) of which the CEO is the sole member purchased the
airplane for $4.7 million. The Company entered into a dry lease agreement with the LLC for its usage at the annualized rate of
2.5%. On December 30, 2003, the Company purchased the LLC for $4.7 million. As of January 28, 2006, the Company has
301,866 shares of Class A common stock available to be issued from the March 6, 2002 Registration Statement.

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.

OFF-BALANCE-SHEET ARRANGEMENTS

The Company has no off-balance-sheet financing arrangements.

EFFECTS OF INFLATION AND CHANGING PRICES

The Company believes that inflation and/or deflation had a minimal impact on its overall operations during fiscal years 2005,

2004 and 2003.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

As discussed in Note 5 to the Consolidated Financial Statements, the Company leases certain of its store locations under
noncancelable operating leases expiring at various dates through 2029. Many of these leases contain renewal options and require
the Company to pay contingent rent based upon percent of sales, 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.

The following table summarizes the Company’s significant contractual obligations as of January 28, 2006, which excludes the

effect of imputed interest:

(Dollars in thousands)
Contractual Obligations
Capital Lease obligations (1)
Revolving loan (2)
Operating leases (3)
Equipment leases (4)
Inventory purchase obligations (5)
Industrial revenue bonds (6)
Miscellaneous financing

Total

1,143
5,998
171,704
6,996
134,439
34,587
1,142

Payments due by period
1-3 yrs

3-5 yrs

< 1 yr

628
–
41,979
1,211
132,920
–
510

515
5,998
65,956
2,413
1,519
–
617

–
–
34,736
2,413
–
–
15

>5 yrs

–
–
29,033
959
–
34,587
–

Total Contractual Obligations

$ 356,009

$ 177,248

$ 77,018

$ 37,164

$ 64,579

(1) Capital lease obligations include related interest.
(2) Revolving loan represents principle maturity for the Company's revolving credit agreement and includes estimated interest of

$0.292 million on $5.706 million at 5.04% for 1 year.

(3) Operating leases are described in Note 6 to the Consolidated Financial Statements
(4) Equipment leases representing cooler program.
(5) Inventory purchase obligations represent open purchase orders and any outstanding purchase commitments as of January 28, 2006
(6) Industrial revenue bonds are described in Note 3 to the Consolidated Financial Statements.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

As discussed in Note 9 to the Consolidated Financial Statements, the Company had commitments approximating $12.0 million
at January 28, 2006, on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had
outstanding letters of credit aggregating $12.9 million at January 28, 2006, utilized as collateral for their risk management programs.
The Company financed the construction of its Dublin, Georgia, distribution center with taxable industrial development revenue
bonds issued by the City of Dublin and County of Laurens development authority. The Company purchased 100% of the bonds
and intends to hold them to maturity, effectively financing the construction with internal cash flow. The Company has offset the
investment in the bonds ($34.6 million) against the related liability and neither is reflected in the consolidated balance sheet.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, which requires all companies
to measure compensation cost for all share-based payments (including employee stock options) at fair value. The FASB
concluded that companies can adopt the new standard in one of two ways: the modified prospective transition method, in which
the company would recognize share-based employee compensation from the beginning of the fiscal period in which the
recognition provisions are first applied as if the fair-value-based accounting method had been used to account for all employee
awards granted, modified, or settled after the effective date and to any awards that were not fully vested as of the effective date;
or the modified retrospective transition method, in which a company would recognize employee compensation cost for periods
presented prior to the adoption of SFAS No. 123R in accordance with the original provisions of SFAS No. 123 “Accounting for
Stock-Based Compensation,” pursuant to which a company would recognize employee compensation cost in the amounts
reported in the pro forma disclosures provided in accordance with SFAS No. 123. The Company will adopt SFAS No. 123R
during the first quarter of fiscal 2006 and will use the modified prospective transition method. We estimate the effect of $.03
per diluted share relating to the expensing of stock options.

In October 2005, the FASB issued FASB Staff Position FAS 123 (R)-2, “Practical Accommodation to the Application of
Grant Date as Defined in FASB Statement No. 123(R)” (FSP 123(R)-2). SFAS No. 123 (R) (FAS No. 123R) requires companies
to estimate the fair value of share based payment awards when the award has been granted. One of the criteria for determining
that an award has been granted is that the employer and its employees have a mutual understanding of the key terms and
conditions of the award. Under FSP 123 (R)-2, a mutual understanding is assumed to exist on the date the award is approved by
the Board of Directors and the key terms and conditions of the award are expected to be communicated to the individual within
a relatively short time period from the date of approval. This FSP 123 (R)-2 is applicable upon initial adoption of SFAS No. 123
(R) or for companies who have already adopted SFAS No. 123R, the first reporting period after the FSP is posted to the FASB
website. The Company will adopt the application of this pronouncement in the first quarter of fiscal 2006.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets—an amendment of APB Opinion
No. 29, Accounting for Nonmonetary Transactions. This Statement amends APB Opinion No. 29 Accounting for Nonmonetary
Transactions, based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets
exchanged. Certain of the disclosure modifications are required for fiscal periods beginning after June 15, 2005. The adoption of
SFAS No. 153 did not have a material effect on the Company’s financial statements.

In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, “Inventory Costs, an Amendment of
ARB No. 43, Chapter 4” (“SFAS 151”). The purpose of this statement is to clarify the accounting of abnormal amounts of idle facility
expense, freight, handling costs and waste material. ARB No. 43 stated that under some circumstances these costs may be so abnormal
that they are required to be treated as current period costs. SFAS 151 requires that these costs be treated as current period costs
regardless if they meet the criteria of “so abnormal.” The provisions of SFAS 151 shall be effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Although the Company will continue to evaluate the application of SFAS 151, management
does not believe adoption will have a material impact on its results of operations or financial position.

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MANAGEMENT’S DISCUSSION AND ANALYSIS

reasonably estimated, certain disclosures are required about the unrecognized asset retirement obligations. FIN 47 was adopted by the
Company in fiscal 2005. Adoption of this statement did not have a material impact on the Company’s consolidated financial position.
In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections — a replacement of APB
Opinion No. 20 and FASB Statement No. 3” (“SFAS No. 154”). This Statement replaces APB Opinion No. 20, “Accounting
Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and changes the
requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary
changes in an accounting principle and to any changes required by an accounting pronouncement in the unusual instance that
the pronouncement does not include specific transition provisions. SFAS No. 154 requires that all voluntary changes in
accounting principles are retrospectively applied to prior financial statements as if that principle had always been used, unless it
is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections occurring in fiscal years
beginning after December 15, 2005. Although the Company will continue to evaluate the application of SFAS No. 154,
management does not believe adoption will have a material impact on its results of operations or financial position.

In June 2005, the Emerging Issues Task Force (EITF) released No. 05-6, “Determining the Amortization Period for Leasehold
Improvements,” was issued. Which provides guidance on determining amortization periods for leasehold improvements
purchased after lease inception or acquired in a business combination. Leasehold improvements acquired in a business
combination should be amortized over the shorter of the useful life of the assets or a term that includes required lease periods
and renewals that are deemed to be reasonably assured at the date of acquisition. Leasehold improvements that are placed in
service significantly after and not contemplated at or near the beginning of the lease term should be amortized over the shorter
of the useful life of the assets or a term that includes required lease periods and renewals that are deemed to be reasonably assured
at the date the leasehold improvements are purchased. Effective for leasehold improvements purchased or acquired in reporting
periods beginning after June 29, 2005. As discussed in Note 2 to the Company’s Consolidated Financial Statements contained
in the Company’s Annual Report on Form 10-K for the year ended January 29, 2005, the Company has already adopted this
accounting guidance based on the letter issued by the Office of the Chief Accountant of the SEC to the American Institute of
Certified Public Accountants in February 2005.

In October 2005, the FASB issued FASB Staff Position (FSP) FAS 13-1, “Accounting for Rental Costs Incurred during a
Construction Period.” The FASB concludes in this FSP that rental costs associated with ground or building-operating leases that
are incurred during a construction period should be expensed. FASB Technical Bulletin (FTB) No. 88-1, Issues Relating to
Accounting for Leases, requires that rental costs associated with operating leases be allocated on a straight-line basis in accordance
with FASB Statement No. 13, Accounting for Leases, and FTB 85-3, Accounting for Operating Leases with Scheduled Rent
Increases, starting with the beginning of the lease term. The FASB believes there is no distinction between the right to use a
leased asset during the construction period and the right to use that asset after the construction period. As discussed in Note 2
to the Company’s Consolidated Financial Statements contained in the Company’s Annual Report on Form 10-K for the year
ended January 29, 2005, the Company has already adopted this accounting guidance based on the letter issued by the Office of
the Chief Accountant of the SEC to the American Institute of Certified Public Accountants in February 2005.

20
FRED’S
A N N U A L
R E P O R T

CONSOLIDATED STATEMENTS OF INCOME
CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)

Net sales
Cost of goods sold
Gross profit

Depreciation and amortization
Selling, general and administrative expenses

Operating income

Interest income
Interest expense

Income before income taxes

Income taxes
Net income

Net income per share:

Basic
Diluted

Weighted average shares outstanding:

Basic
Diluted

January 28,
2006

For the Years Ended
January 29,
2005

January 31,
2004

1,589,342
1,141,105
448,237

1,441,781
1,036,474
405,307

1,302,650
934,665
367,985

27,755
380,401
40,081

(176)
1,002
39,255

13,161
26,094

0.66
0.66

39,632
39,772

$
$

28,148
337,733
39,426

(10)
803
38,633

10,681
27,952

0.71
0.71

39,252
39,532

$
$

26,709
292,176
49,100

(45)
443
48,702

15,907
32,795

0.85
0.83

38,754
39,652

$
$

See accompanying notes to consolidated financial statements.

21
FRED’S
A N N U A L
R E P O R T

CONSOLIDATED BALANCE SHEETS
CONSOLIDATED BALANCE SHEETS

(in thousands, except for number of share)
ASSETS

Current assets:

Cash and cash equivalents
Inventories
Receivables, less allowance for doubtful accounts of $698 and

$629, respectively

Other non trade receivables
Prepaid expenses and other current assets

Total current assets

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

$4,203, and $3,722, respectively

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 expenses and other
Deferred income taxes
Income taxes payable

Total current liabilities

Long-term portion of indebtedness
Deferred income taxes
Long-term portion of capital lease obligations
Other noncurrent liabilities
Total liabilities

Commitments and contingencies (Notes 2,5 and 9)

Shareholders’ equity:

Preferred stock, nonvoting, no par value, 10,000,000 shares

authorized, none outstanding

Preferred stock, Series A junior participating nonvoting,

no par value, 224,594 shares authorized, none outstanding

January 28,
2006

January 29,
2005

3,145
303,800

5,365
275,365

20,622
11,181
10,790
349,538

19,449
11,821
9,802
321,802

139,134

136,467

765
8,704
498,141

78,491
510
543
31,449
18,329
6,196
135,518

6,338
10,494
477
5,719
158,546

1,245
5,710
465,224

70,503
18
666
26,708
17,490
–
115,385

23,181
7,701
1,031
3,380
150,678

–

Common stock, Class A voting, no par value, 60,000,000 shares authorized,

39,860,188 shares and 39,692,091 shares issued & outstanding, respectively

134,218

132,511

Common stock, Class B nonvoting, no par value, 11,500,000

shares authorized, none outstanding

Retained earnings
Unearned compensation

Total shareholders' equity

Total liabilities and shareholders' equity

–
207,643
(2,266)
339,595
498,141

–
184,732
(2,697)
314,546
465,224

See accompanying notes to consolidated financial statements.

22
FRED’S
A N N U A L
R E P O R T

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

Common Stock

(in thousands, except share and per share amounts) Shares
Balance, February 1, 2003
Cash dividends paid ($.08 per share)
Issuance of restricted stock
Amortization of unearned compensation
Other issuances
Other cancellation
Exercises of stock options
Income tax benefit on exercise of stock

38,509,888
–
1,406
–
304,167
(75,000)
365,178

options
Net income
Balance, January 31, 2004
Cash dividends paid ($.08 per share)
Issuance of restricted stock
Amortization of unearned compensation
Other cancellation
Exercises of stock options
Income tax benefit on exercise of stock

options
Net income
Balance, January 29, 2005
Cash dividends paid ($.08 per share)
Issuance of restricted stock
Issuance of shares under

employee stock purchase

Amortization of unearned compensation
Other cancellation
Exercises of stock options
Income tax benefit on exercise of stock

–
–
39,105,639
–
175,969
–
(12)
410,495

–
–
39,692,091
–
476

32,583
–
(5,016)
140,054

Amount

117,209
–
7
–
8,110
(2,646)
2,276

1,474
–
126,430
–
2,807
–
–
2,297

977
–
132,511
–
78

469
–
–
1,026

Retained
Earnings

Deferred
Compensation

130,252
(3,127)
–
–
–
–
–

–
32,795
159,920
(3,140)
–
–
–
–

–
27,952
184,732
(3,183)
–

–
–
–
–

(28)
–
–
28
–
–
–

–
–
–
–
(2,807)
110
–
–

–
–
$ (2,697)
–

431
–
–

Total
247,433
(3,127)
7
28
8,110
(2,646)
2,276

1,474
32,795
286,350
(3,140)
–
110
–
2,297

977
27,952
314,546
(3,183)
78

469
431
–
1,026

options
Net income
Balance, January 28, 2006

–
–
39,860,188

134
–
134,218

–
26,094
207,643

–
–
$ (2,266)

134
26,094
339,595

See accompanying notes to consolidated financial statements.

23
FRED’S
A N N U A L
R E P O R T

CONSOLIDATED STATEMENTS OF CASH FLOWS
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 increase
Deferred income tax expense
Amortization of unearned compensation
Issuance (net of cancellation) of restricted stock
Income tax benefit upon exercise of stock options
(Increase) decrease in operating assets:

Receivables
Inventories
Other assets

Increase (decrease) in operating liabilities:
Accounts payable and accrued expenses
Income taxes payable
Other noncurrent liabilities

Net cash provided by operating activities

Cash flows from investing activities:

Capital expenditures
Asset acquisition(primarily intangibles)

Net cash used in investing activities

Cash flows from financing activities:

Payments of indebtedness and capital lease obligations
Proceeds from (repayments of ) revolving line of credit, net
Proceeds from public offering, net of expenses
Repurchase of shares
Proceeds from exercise of stock options and issuances under

employee stock purchase plan

Dividends paid

Net cash (used) provided by 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 financial activities:

Assets acquired through term loan

January 28,
2006

For the Years Ended
January 29,
2005

January 31,
2004

26,094

27,952

32,795

27,755
69
2,493
3,632
431
78
134

(1,550)
(30,928)
(1,011)

12,730
6,196
2,339
48,462

(27,757)
(3,154)
(30,911)

(694)
(17,392)
–
–

1,498
(3,183)
(19,771)
(2,220)

5,365
3,145

985
–

1,058

$
$

28,148
(808)
1,942
10,106
110
–
977

(3,291)
(37,559)
(10,449)

2,250
(930)
(55)
18,393

(31,784)
(2,006)
(33,790)

(734)
17,598
–
–

2,297
(3,140)
16,021
624

4,741
5,365

757
6,400

–

$
$

26,709
462
1,640
5,992
28
–
1,474

(5,992)
(47,882)
3,668

16,428
930
(14)
36,238

(48,020)
(916)
(48,936)

(883)
5,500
8,110
(2,646)

2,276
(3,127)
9,230
(3,468)

8,209
4,741

417
7,600

–

$
$

See accompanying notes to consolidated financial statements.

24
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

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 retail discount stores and full service pharmacies. In addition, the Company sells general merchandise
to its 24 franchisees. As of January 28, 2006, the Company had 621 retail stores and 275 pharmacies located in 15 states mainly
in the Southeastern United States.

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 2005, 2004, and 2003, as used herein, refer to the years ended January 28, 2006, January 29, 2005, and January 31, 2004,
respectively, all of which had 52 weeks.

Use of estimates. The preparation of financial statements in accordance with accounting principles generally accepted in the
United States of America 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 and such differences could be
material to the financial statements.

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 and cash equivalents. Included in
accounts payable are outstanding checks in excess of funds on deposit, which totaled $16,490 at January 28, 2006 and $17,851 at
January 29, 2005.

Allowance for doubtful accounts. The Company is reimbursed for drugs sold by its pharmacies by many different payors
including insurance companies, Medicare and various state Medicaid programs. The Company estimates the allowance on a payor-
specific basis, given its interpretation of the contract terms or applicable regulations. However, the reimbursement rates are often
subject to interpretations that could result in payments that differ from the Company's estimates. Additionally, updated regulations
and contract negotiations occur frequently, necessitating the Company's continual review and assessment of the estimation process.
Senior management reviews accounts receivable on a quarterly basis to determine if any receivables are potentially uncollectible.
The Company includes any accounts receivable balances that are determined to be uncollectible in our overall allowance for
doubtful accounts. After all attempts to collect a receivable have failed, the receivable is written off against the allowance account.

Inventories. Warehouse 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 (“RIM”). Under RIM, the
valuation of inventories at cost and the resulting gross margin are calculated by applying a calculated cost-to-retail ratio to the
retail value of inventories. RIM is an averaging method that has been widely used in the retail industry due to its practicality.
Also, it is recognized that the use of the RIM will result in valuing inventories at lower of cost or market if markdowns are
Inherent in the RIM calculation are certain significant
currently taken as a reduction of the retail value of inventories.
management judgments and estimates including, among others, initial markups, markdowns, and shrinkage, which significantly
impact the ending inventory valuation at cost as well as resulting gross margin. These significant estimates, coupled with the fact
that the RIM is an averaging process, can, under certain circumstances, produce distorted or inaccurate cost figures. Management
believes that the Company's RIM provides an inventory valuation which reasonably approximates cost and results in carrying
inventory at the lower of cost or market.

For pharmacy inventories, which are $35,542 and $35,105 at January 28, 2006 and January 29, 2005, respectively, cost was
determined using the RIM LIFO (last-in, first-out) method in which inventory costs are maintained using the RIM, then
adjusted by application of the producer price index published by the U.S. Department of Labor for the cumulative annual periods.
The current cost of pharmacy inventories exceeded the LIFO cost by $12,213 at January 28, 2006 and $9,720 at January 29, 2005.
The LIFO reserve increased by $2,493, $1,942, and $1,640, during 2005, 2004, and 2003, respectively.

25
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

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

Building and building improvements
Furniture, fixtures and equipment
Leasehold improvements
Automobiles and vehicles
Airplane

Estimated Useful Lives
8 - 30 years
3 - 10 years
3 - 10 years or term of lease, if shorter
3 - 5 years
9 years

Leases. Certain operating leases include rent increases during the initial lease term. For these leases, the Company recognizes the
related rental expense on a straight-line basis over the term of the lease (which includes the pre-opening period of construction,
renovation, fixturing and merchandise placement) and records the difference between the amounts charged to operations and amounts
paid as a rent liability. Rent is recognized on a straight-line basis over the lease term, which includes any rent holiday period. Some
of our leases provide for contingent rent payments. The Company accrues for contingent rents in the period they become probable.
The Company occasionally receives reimbursements from landlords to be used towards construction of the store the Company
intends to lease. The reimbursement is primarily for the purpose of performing work required to divide a much larger location
into smaller segments, one of which the Company will use for its store. This work could include the addition or demolition of
walls, separation of plumbing, utilities, electric work, entrances (front and back) and other work as required. Leasehold
improvements are recorded at their gross costs including items reimbursed by landlords. The reimbursements are initially recorded
as a deferred credit and then amortized as a reduction of rent expense over the initial lease term.

Impairment of Long-lived assets. The Company's policy is to review the carrying value of all long-lived assets annually and
whenever events or changes indicate that the carrying amount of an asset may not be recoverable, the Company adjusts the net
book value of the underlying assets if the sum of expected future cash flows is less than the book value. The adjustment is
computed as the difference between estimated fair value and net book value. Assets to be disposed of are adjusted to the fair value
less the cost to sell if less than the book value. Based upon the Company's review as of January 28, 2006 and January 29, 2005,
no material adjustments to the carrying value of such assets were necessary.

Vendor rebates and allowances. The Company receives vendor rebates for achieving certain purchase or sales volume and receives
vendor allowances to fund certain expenses. The Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting by a
Customer (including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”) is effective for arrangements
with vendors initiated on or after January 1, 2003. EITF 02-16 addresses the accounting and income statement classification for
consideration given by a vendor to a retailer in connection with the sale of the vendor's products or for the promotion of sales of
the vendor's products. The EITF concluded that such consideration received from vendors should be reflected as a decrease in
prices paid for inventory and recognized in cost of sales as the related inventory is sold, unless specific criteria are met qualifying
the consideration for treatment as reimbursement of specific, identifiable incremental costs. The provisions of this consensus have
been applied prospectively.

During the quarter ended October 29, 2005, the Company renewed its contract with its primary pharmaceutical wholesaler,
AmerisourceBergen Corporation. As noted in prior public filings, the renewal of this contract would, and did impact the
Company's financial statements because of the application of the provisions of EITF 02-16. The effect on the financial
statements, which occurred during the third quarter, was a deferral of the associated rebates against cost of sales of $2.2 million
pretax (estimated at $0.03 per diluted share, after tax). This change in timing had no effect on cash flow for the quarter. While
the contract was not due to mature until January 31, 2006, the renewal terms were positive to overall earnings and will benefit
the Company through better pricing.

26
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

For vendor funding arrangements that were entered into prior to December 31, 2002 and have not been modified subsequently,

the Company recognizes a reduction to selling, general and administrative expenses or cost of goods sold when earned.

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 period.
Advertising expense for 2005, 2004, and 2003, was $21,844, $18,084, and $16,956, 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, rent, preopening advertising, store supplies and other expendable items.

Revenue Recognition. The Company markets goods and services through Company owned stores and 24 franchised stores as
of January 28, 2006. 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 layaway sales are recorded upon delivery of the merchandise to the customer.

The Company also sells gift cards for which the revenue is recognized at time of redemption. The Company records a gift
card liability on the date the gift card is issued to the customer. Revenue is recognized and the gift card liability is reduced as the
customer redeems the gift card. The Company will recognize as revenue when the likelihood of the gift card being redeemed is
remote (gift card breakage). The Company has not recognized any revenue from gift card breakage since the inception of the
program in May 2004.

In addition, the Company charges the franchised stores a fee based on a percentage of their purchases from the Company.
These fees represent a reimbursement for use of the Fred's name and other administrative costs incurred on behalf of the
franchised stores and are therefore netted against selling, general and administrative expenses. Total franchise income for 2005,
2004, and 2003 was $1,891, $1,869, and $1,964, respectively.

Other intangible assets. Other identifiable intangible assets, which are included in other noncurrent assets, primarily represent
customer lists associated with acquired pharmacies and are being amortized on a straight-line basis over five years. Intangibles,
net of accumulated amortization, totaled $6,097 at January 28, 2006 and $4,115 at January 29, 2005. Accumulated amortization
at January 28, 2006 and at January 29, 2005 totaled $8,012 and $10,686, respectively. Amortization expense for 2005, 2004, and
2003, was $2,180, $1,804, and $1,664, respectively. Estimated amortization expense for each of the next five years is as follows:
2006 - $2,076, 2007 - $1,689, 2008 - $1,255, 2009- $811, and 2010 - $250.

Financial instruments. At January 28, 2006, 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. Most of our indebtedness is under variable interest rates.

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 future claims cost including
incurred but not reported claims. Estimates for future claims costs would include costs and other factors such as the type of injury
or claim, required services by providers, healing time, age of claimant, case management costs, location of the claim, and
governmental regulations. If future claim trends deviate from recent historical patterns, the Company may be required to record
additional expense or expense reductions which could be material to the Company's results of operations.

27
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

expense is generally not recognized for plans in which the exercise price of the stock options equals the market price of the
underlying stock on the date of grant and the number of shares subject to exercise is fixed. Had compensation cost for the
Company's stock-based compensation plans been determined based on the fair value at the grant date for awards under these
plans consistent with the methodology prescribed under SFAS No. 123 “Accounting for Stock-Based Compensation,” as
amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” net income and earnings
per share would have been reduced to the pro forma amounts indicated in the following table.

Net income:

As reported
Less pro forma effect of stock option grants
Pro forma

Basic earnings per share:

As reported
Pro forma

Diluted earnings per share:

As reported
Pro forma

2005

2004

2003

26,094
386
25,708

0.66
0.65

27,952
838
27,114

0.71
0.69

32,795
900
31,895

0.85
0.82

0.83
0.80

The Company also periodically awards restricted stock having a fixed number of shares at a purchase price that is set by the
Compensation Committee of the Company's Board of Directors, which purchase price may be set at zero, to certain executive
officers, directors and key employees. The Company also accounts for restricted stock grants in accordance with APB No. 25 and
related interpretations. Under APB No. 25, the Company calculates compensation expense as the difference between the market
price of the underlying stock on the date of grant and the purchase price, if any, and recognizes such amount on a straight-line
basis over the period in which the restricted stock award is earned by the recipient. The Company recognized compensation
expense relating to its restricted stock awards of approximately $509, $110, and $28, in 2005, 2004, and 2003, respectively. (See
Note 7 for further disclosure relating to stock incentive plans).

Income taxes. The Company reports income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under
SFAS No. 109, the asset and liability method is used for computing future income tax consequences of events, which have been
recognized in the Company's Consolidated Financial Statements or income tax returns. Deferred income tax expense or benefit
is the net change during the year in the Company's deferred income tax assets and liabilities.

Business segments. The Company's operates in a single reportable operating segment.

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

28
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

Reclassifications. Certain prior-year amounts have been reclassified to conform to the 2005 presentation.

Recent Accounting Pronouncements. In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
No. 123R which requires all companies to measure compensation cost for all share-based payments (including employee stock
options) at fair value, effective for public companies for interim or annual periods beginning after June 15, 2005. The FASB
concluded that companies can adopt the new standard in one of two ways: the modified prospective transition method, in which
the company would recognize share-based employee compensation from the beginning of the fiscal period in which the
recognition provisions are first applied as if the fair-value-based accounting method had been used to account for all employee
awards granted, modified, or settled after the effective date and to any awards that were not fully vested as of the effective date;
or the modified retrospective transition method, in which a company would recognize employee compensation cost for periods
presented prior to the adoption of SFAS No. 123R in accordance with the original provisions of SFAS No. 123 “Accounting for
Stock-Based Compensation,” pursuant to which a company would recognize employee compensation cost in the amounts
reported in the pro forma disclosures provided in accordance with SFAS No. 123. The Company will adopt SFAS No. 123R
during the first quarter of fiscal 2006 and will use the modified prospective transition method.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets-an amendment of APB Opinion
No. 29, Accounting for Nonmonetary Transactions. This Statement amends APB Opinion No. 29, Accounting for Nonmonetary
Transactions, based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets
exchanged. Certain of the disclosure modifications are required for fiscal periods beginning after June 15, 2005. The adoption of
SFAS No. 153 did not have a material effect on the Company's financial statements.

In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, "Inventory Costs, an Amendment
of ARB No. 43, Chapter 4" ("SFAS 151"). The purpose of this statement is to clarify the accounting of abnormal amounts of idle
facility expense, freight, handling costs and waste material. ARB No. 43 stated that under some circumstances these costs may be
so abnormal that they are required to be treated as current period costs. SFAS 151 requires that these costs be treated as current
period costs regardless if they meet the criteria of “so abnormal.” The provisions of SFAS 151 shall be effective for inventory costs
incurred during fiscal years beginning after June 15, 2005. Although the Company will continue to evaluate the application of
SFAS 151, management does not believe adoption will have a material impact on its results of operations or financial position.

In March 2005, the FASB issued Interpretation No. 47 (FIN 47) to clarify the guidance included in SFAS No. 143, “Accounting
for Asset Retirement Obligations.” FIN 47 requires companies to recognize a liability for the fair value of a legal obligation to
perform asset retirement activities that are conditional on a future event if the amount can be reasonably estimated. If amounts
cannot be reasonably estimated, certain disclosures are required about the unrecognized asset retirement obligations. FIN 47 was
adopted by the Company in fiscal 2005. Adoption of this statement did not have a material impact on the Company's consolidated
financial position.

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections-a replacement of APB
Opinion No. 20 and FASB Statement No. 3” (“SFAS No. 154”). This Statement replaces APB Opinion No. 20, “Accounting
Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements,” and changes the
requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary
changes in an accounting principle and to any changes required by an accounting pronouncement in the unusual instance that
the pronouncement does not include specific transition provisions. SFAS No. 154 requires that all voluntary changes in
accounting principles are retrospectively applied to prior financial statements as if that principle had always been used, unless it
is impracticable to do so. SFAS No. 154 is effective for accounting changes and error corrections occurring in fiscal years
beginning after December 15, 2005. Management does not believe adoption will have a material impact on its results of
operations or financial position.

In October 2005, the FASB issued FASB Staff Position FAS 123(R)-2, “Practical Accommodation to the Application of Grant
Date as Defined in FASB Statement No. 123(R)” (FSP 123(R)-2). SFAS No. 123(R) (FAS No. 123R) requires companies to
estimate the fair value of share based payment awards when the award has been granted. One of the criteria for determining that
an award has been granted is that the employer and its employees have a mutual understanding of the key terms and conditions
of the award. Under FSP 123(R)-2, a mutual understanding is assumed to exist on the date the award is approved by the Board
of Directors and the key terms and conditions of the award are expected to be communicated to the individual within a relatively
short time period from the date of approval. This FSP 123(R)-2 is applicable upon initial adoption of SFAS No. 123(R) or
for companies who have already adopted SFAS No. 123R, the first reporting period after the FSP is posted to the FASB website.
The Company will adopt the application of this pronouncement in the first quarter of fiscal 2006. Management does not believe
adoption will have a material impact on its results of operations or financial position.

29
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 - DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS

(in thousands, except share and per share amounts)

Property and equipment, at cost:
Buildings and building improvements
Furniture, fixtures and equipment

Less accumulated depreciation and amortization

Construction in progress
Land

Total property and equipment, at depreciated cost

2005

2004

113,861
210,978
324,839
(190,306)
134,533
325
4,276
139,134

104,779
193,162
297,941
(166,321)
131,620
571
4,276
136,467

Depreciation expense totaled $25,094, $25,791, and $24,418, for 2005, 2004, and 2003, respectively. In the fourth quarter of
2004, the Company changed the estimated lives of certain store fixtures from five to ten years. Based on the Company's historical
experience, ten years is a closer approximation of the actual lives of these assets. The change in estimate was applied prospectively.
Depreciation expenses for the fourth quarter of 2004 were favorably impacted by approximately $1.3 million pretax ($.02 per
diluted share) as a result of this change.

Depreciation expenses for 2005 was favorably impacted by approximately $4.5 million pretax ($.07 per diluted share).

Other non-trade receivables:
Landlord receivables
Vendor receivables
Income tax receivable
Insurance receivable
Other

Total non trade receivables

2005

2004

477
6,912
225
1,928
1,639
11,181

1,008
5,309
4,911
-
593
11,821

Insurance receivable represents the balance due from our insurance carrier for property damage due to Hurricane Katrina.

Claims pending for business interruption coverage will not be recognized until substantially settled.

Prepaid expenses and other current assets:
Prepaid advertising
Prepaid insurance
Prepaid rent
Supplies
Other

Total prepaid expenses and other current assets

Accrued expenses and other:
Payroll and benefits
Sales and use taxes
Insurance
Other

Total accrued expenses and other

2005

2004

1,724
942
3,672
3,424
1,028
10,790

2005

7,544
5,470
8,467
9,968
31,449

2,309
788
3,174
2,835
696
9,802

2004

5,821
3,682
7,887
9,318
26,708

30
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

NOTE 3 - INDEBTEDNESS

On October 10, 2005, the Company and Regions Bank, successor in interest to Union Planters, providing the credit facility
entered into a Seventh Modification Agreement of the Revolving Loan and Credit Agreement to provide a temporary increase
of commitment of $20 million and increasing the available credit line to $70 million. The term of the agreement was from
October 10, 2005 until December 15, 2005, superseding the expiration of the Sixth Modification. On December 15, 2005, the
available credit line reverted to $50 million. All terms, conditions and covenants remained in place for the Note and credit facility.
On July 29, 2005, the Company and Regions Bank, successor in interest to Union Planters, entered into a Sixth Modification
Agreement of the Revolving Loan and Credit Agreement (the “Agreement”) dated April 3, 2000 to increase the commitment
from the bank from $40 million to $50 million and to extend the term until July 31, 2009. The Agreement bears interest at 1.5%
below the prime rate or a LIBOR-based rate. Under the most restrictive covenants of the Agreement, the Company is required
to maintain specified shareholders' equity (which was $273.5 million at January 28, 2006) and net income levels. The Company
is required to pay a commitment fee to the bank at a rate per annum equal to 0.15% on the unutilized portion of the revolving
line commitment over the term of the Agreement. There were $5.7 million and $23.1 million of borrowings outstanding under
the Agreement at January 28, 2006 and January 29, 2005, respectively.

The Company has other miscellaneous financing obligations at January 28, 2006, totaling $1,142, which relate primarily to
independent pharmacy acquisitions. The Company's indebtedness under miscellaneous financing matures as follows: 2006 -
$510; 2007 - $593; 2008 - $24; and 2009 - $15.

The Company financed the construction of its Dublin, Georgia, distribution center with taxable industrial development
revenue bonds issued by the City of Dublin and County of Laurens Development Authority. The Company purchased 100% of
the issued bonds and intends to hold them to maturity, effectively financing the construction with internal cash flow. Because a
legal right of offset exists, the Company has offset the investment in the bonds ($34.6 million) against the related liability and
neither is reflected on the consolidated balance sheet.

NOTE 4 - INCOME TAXES

The provision for income taxes consists of the following:

Current:

Federal
State

Deferred:
Federal
State

2005

10,666
(1,137)
9,529

3,272
360
3,632
13,161

2004

2,399
(1,824)
575

11,102
(996)
10,106
10,681

2003

9,960
(45)
9,915

6,222
(230)
5,992
15,907

31
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

The income tax effects of temporary differences that give rise to significant portions of the deferred income tax assets and

deferred income tax liabilities are presented below:

Deferred income tax assets:

Accrual for incentive compensation
Allowance for doubtful accounts
Insurance accruals
Net operating loss carryforwards
Postretirement benefits other than pensions
Restructuring costs
Amortization of intangibles
Total deferred income tax assets
Less: valuation allowance

Deferred income tax assets, net of valuation allowance

Deferred income tax liabilities:

Property, plant, and equipment
Inventory valuation
Prepaid expenses

Total deferred income tax liability

Net deferred income tax liability

2005

2004

121
28
3,020
4,685
911
19
3,128
11,912
(888)
11,024

(18,348)
(21,433)
(66)
(39,847)

132
344
2,425
3,940
933
32
2,619
10,425
(430)
9,995

(14,795)
(19,907)
(484)
(35,186)

(28,823)

(25,191)

The net operating loss carryforwards are available to reduce state income taxes in future years. These carryforwards total
approximately $112.6 million for state income tax purposes and expire at various times during the period 2006 ($3.8 million)
through 2025.

During 2005, the valuation allowance increased $458, and during 2004, the valuation allowance decreased $150. Based upon
expected future income, management believes that it is more likely than not that the results of operations will generate sufficient
taxable income to realize the deferred tax asset after giving consideration to the valuation allowance.

A reconciliation of the statutory federal income tax rate to the effective tax rate is as follows:

Income tax provision at statutory rate
Tax credits, principally jobs
State income taxes, net of federal benefit
Permanent differences
Change in valuation allowance
Other

Effective income tax rate

NOTE 5 - LONG-TERM LEASES

2005
35.0%
(2.6)
(0.6)
0.5
1.2
–
33.5%

2004
35.0%
(6.0)
(1.3)
0.2
(0.3)
–
27.6%

2003
35.0%
(1.9)
(0.1)
(0.2)
(0.2)
0.1
32.7%

The Company leases certain of its store locations under noncancelable operating leases that require monthly rental payments
primarily at fixed rates (although a number of the leases provide for additional rent based upon sales) expiring at various dates
through 2029. 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 $48,400, $41,573, and $34,770, for 2005, 2004, and 2003, respectively. Total contingent rentals included in operating
leases above was $1,247, $1,319, and $1,253, for 2005, 2004, and 2003, respectively. Amortization expense on assets under capital
lease for 2005, 2004, and 2003 was $481, $553, and $627, respectively.

32
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

Future minimum rental payments under all operating and capital leases as of January 28, 2006 are as follows:

2006
2007
2008
2009
2010
Thereafter
Total minimum lease payments

Imputed interest
Present value of net minimum lease payments, including

$543 classified as current portion of capital lease obligations

Operating
Leases

Capital
Leases

43,190
38,335
30,033
22,150
14,998
29,994
178,700

628
386
129

–
–
1,143

(123)

1,020

The gross amount of property and equipment under capital leases was $4,967 at January 28, 2006 and January 29, 2005.
Accumulated depreciation on property and equipment under capital leases at January 28, 2006 and January 28, 2005, was $4,203,
and $3,722, respectively.

NOTE 6 - SHAREHOLDERS' EQUITY

In 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 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,
in October 2008.

On March 6, 2002, the Company filed a Registration Statement on Form S-3 registering 750,000 shares of Class A common
stock. The common stock may be used from time to time as consideration in the acquisition of assets, goods, or services for use
or sale in the conduct of our business. On June 6, 2003, the Company raised proceeds of $5.5 million from the offering of
225,000 shares. On September 3, 2003, the Company sold 75,000 shares of common stock for $2.6 million with the intention
of purchasing an airplane. Later, the Company decided not to purchase the airplane, whereupon the Company purchased and
retired $2.6 million of common stock of the CEO. A Limited Liability Company (LLC) of which the CEO is the sole member
purchased the airplane for $4.7 million. The Company entered into a dry lease agreement with the LLC for its usage at the
annualized rate of 2.5%. On December 30, 2003, the Company purchased the LLC for $4.7 million. As of January 28, 2006,
the Company has 301,866 shares of Class A common stock available to be issued from the March 6, 2002 Registration Statement.
On June 5, 2003, 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 July 1, 2003 to stockholders of
record on June 26, 2003. All share and per share amounts included in the accompanying financial statements have been adjusted
to reflect this stock split.

NOTE 7 - EMPLOYEE BENEFIT PLANS

Incentive stock option plan. The Company has a long-term incentive plan under which an aggregate of 2,425,389 shares as
of January 28, 2006 (2,535,902 shares as of January 29, 2005) are available to be granted. These options expire five years to seven
and one-half years from the date of grant. Options outstanding at January 28, 2006 expire in 2006 through 2012.

Under the plan, stock option grants are made to key employees including executive officers, as well as other employees, as
prescribed by the Compensation Committee (the “Committee”) of the Board of Directors. The number of options granted is
directly linked to the employee's job classification. Options, which include non-qualified stock options and incentive stock
options, are rights to purchase a specified number of shares of Fred's common stock at a price fixed by the Committee. The
exercise price for stock options issued under the plan that qualify as incentive stock options within the meaning of Section 422(b)
of the Code shall not be less than 100% of the fair value as of the date of grant. The option exercise price may be satisfied in

33
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

cash or by exchanging shares of Fred's common stock owned by the optionee for at least six months, or a combination of cash
and shares. Options have a maximum term of five to seven and one-half years from the date of grant. Options granted under the
plan generally become exercisable ten percent during each of the first four years on the anniversary date and sixty percent on the
fifth anniversary date. The plan also contains a provision that if the Company meets or exceeds a specified operating income
margin during the most recently completed fiscal year that the annual vesting percentage will accelerate from ten to twenty
percent during that vesting period. The plan also provides for annual stock grants at the fair value of the stock on the grant date
to non-employee directors according to a non-discretionary formula. The number of shares granted is dependent upon current
director compensation levels.

A summary of activity in the plan follows:

2005

2004

2003

Weighted
Average
Exercise
Price
$16.35
15.38
18.50
7.33
16.92
16.09

Options
1,287,762
244,000
(143,714)
(140,054)
1,247,994
433,869

Weighted
Average
Exercise
Price
$12.61
17.41
6.86
5.60
16.35
13.08

Weighted
Average
Exercise
Price
$7.71
17.69
7.81
6.27
12.61
7.65

Options
1,207,799
669,401
(40,753)
(365,178)
1,471,269
740,568

Options
1,471,269
307,315
(80,327)
(410,495)
1,287,762
461,916

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

The weighted average remaining contractual life of all outstanding options was 5.4 years at January 28, 2006.
The following table summarizes information about stock options outstanding at January 28, 2006.

Range of
Exercise Prices

$8.00 to $14.88
$15.27 to $20.60
$23.05 to $34.48

Number
Outstanding at
January 28, 2006
354,227
807,630
86,137
1,247,994

Options Outstanding
Weighted
Average
Remaining
Contractual
Life
(in Years)

5.0
5.7
4.2

Weighted
Average
Exercise
Price
$ 13.45
$ 17.55
$ 25.48

Options Exercisable

Number
Exercisable at
January 28, 2006
196,422
201,260
36,187
433,869

Weighted
Average
Exercise
Price
$ 12.53
$ 18.07
$ 24.34

Pro forma information regarding net income and earnings per share, as disclosed in Note 1, has been determined as if the
Company had accounted for its employee stock-based compensation plans under the fair value method of SFAS No. 123. The
weighted average fair value of options granted during 2005, 2004, and 2003 was $7.35, $5.61, and $6.68, respectively. The fair
value of each stock option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the
following assumptions:

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

2005
5.3
46.6%
4.3%
0.5%

2004
5.7
41.1%
1.3%
0.3%

2003
5.0
35.7%
1.1%
0.3%

The Black-Scholes option model was developed for use in estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions
including the expected stock volatility. Because the Company's employee stock options have characteristics significantly different

34
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

from those of traded options, and because changes in the subjective assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee
stock options.

Restricted Stock. During 2005, 2004, and 2003, the Company issued a net of 476 and 175,969 and 1,406 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 and the plan owns
278,507 shares of Company stock. All shares are included in shares outstanding for computation of net income per share.

Employee Stock Purchase Plan. The 2004 Employee Stock Purchase Plan, which was approved by Fred's stockholders, permits
eligible employees to purchase shares of our common stock at 85% of its fair market value by payroll deductions up to certain
limits. The number of shares of common stock initially reserved for issuance under the Employee Stock Purchase Plan was
1,000,000 shares. As of January 28, 2006, there were 967,415 shares available.

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 six years of service. The Company's contributions for 2005, 2004, and
2003 were $142, $175, and $207, respectively.

Postretirement benefits. The Company provides certain health care benefits to its full-time employees that retire between the
ages of 58 (effective January 1, 2004 this was changed to 62) 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
Plan amendments
Actuarial gain
Benefits paid
Benefit obligation at end of year

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

January 28,
2006

January 29,
2005

583
41
39
–
93
(25)
731

January 28,
2006

(731)
(1,404)
(171)
(2,306)

759
28
34
(195)
(11)
(32)
583

January 29,
2005

(583)
(1,586)
(185)
(2,354)

The medical care cost trend used in determining this obligation is 9.0% effective December 1, 2004, decreasing annually before
leveling at 5.0% in 2015. To illustrate the trend rate used, increasing the health care cost trend by 1% would increase the effect
on the total of service cost and interest cost by $10 and the accumulated postretirement benefit obligation (“APBO”) by $67.
Decreasing the health care cost trend by 1% would decrease the effect on the total of service cost and interest cost by $8 and the
APBO by $60. The discount rate used in calculating the obligation was 5.75% in 2005 and 2004. There was no reduction in

35
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

APBO related to benefits attributed to past service and the effect on the measurement of the net periodic postretirement benefit
cost was $14 as of January 28, 2006. The net periodic benefit cost decreased in 2004 due to changes in actuarial assumptions
regarding turnover, participation in the plan, the medical inflation rate and the rate of contribution by participants. The reduction
in APBO related to benefits attributed to past service was $115 and the effect on the measurement of the net periodic
postretirement benefit cost was $13 as of January 29, 2005.

The annual net postretirement cost is as follows:

Service cost
Interest cost
Amortization of prior service cost
Amortization of unrecognized prior service cost
Net periodic postretirement benefit cost

January 28,
2006

For the Years Ended
January 29,
2005

January 31,
2004

41
39
(13)
(90)
(23)

28
34
(14)
(103)
(55)

36
45
(1)
(107)
(27)

The Company's policy is to fund claims as incurred.
Information about the expected cash flows for the postretirement medical plan follows:

Expected Benefit Payments
(net of retiree contributions)
2006
2007
2008
2009
2010
2011 - 2015

NOTE 8 - NET INCOME PER SHARE

Postretirement
Medical Plan
$

44
49
58
58
63
383

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 to issue common stock were exercised 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:

January 28, 2006

For the Years Ended
January 29, 2005

January 31, 2004

Income
$ 26,094

Shares
39,632

Per
Share
Amount
$ 0.66

Income
$

27,952

Shares
39,252

Per
Share
Amount
$0.71

Income
$ 32,795

Shares
38,754

Per
Share
Amount
$0.85

$ 26,094

140
39,772

$ 0.66

27,952

280
39,532

$0.71

$ 32,795

898
39,652

$0.83

Basic EPS
Effect of
Dilutive
Securities
Diluted EPS

36
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share amounts)

Options to purchase shares of common stock that were outstanding at the end of the respective fiscal year were not included
in the computation of diluted earnings per share when the options' exercise prices were greater than the average market price of
the common shares. There were 89,404 and 94,028 such options outstanding at January 28, 2006 and January 29, 2005. There
were no such options outstanding at January 31, 2004.

NOTE 9 - COMMITMENTS AND CONTINGENCIES

Commitments. The Company had commitments approximating $12.0 million at January 28, 2006 and $12.6 million at
January 29, 2005 on issued letters of credit, which support purchase orders for merchandise. Additionally, the Company had
outstanding letters of credit aggregating approximately $12.9 million at January 28, 2006 and $10.8 million at January 29, 2005
utilized as collateral for its risk management programs.

Litigation. The Company is a party to several pending legal proceedings and claims arising 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 financial statements as
a whole. However, litigation involves an element of uncertainty. Future developments could cause these actions or claims to have
a material adverse effect on the results of the financial statements as a whole.

NOTE 10 - SALES MIX

The Company manages its business on the basis of one reportable segment. See Note 1 for a brief description of the

Company's business. As of January 28, 2006, all of the Company's operations were located within the United States.

The Company's sales mix by major category during the last 3 years was as follows:

Pharmaceuticals
Household Goods
Apparel and Linens
Food and Tobacco Products
Health and Beauty Aids
Paper and Cleaning Supplies
Sales to Franchised Fred's Stores
Total Sales Mix

January 28,
2006
31.3%
25.0%
13.8%
11.2%
8.0%
8.5%
2.2%
100.0%

For the Years Ended
January 29,
2005
32.6%
23.7%
14.1%
10.7%
8.6%
8.0%
2.3%
100.0%

January 31,
2004
32.4%
23.6%
14.2%
10.2%
8.8%
8.1%
2.7%
100.0%

37
FRED’S
A N N U A L
R E P O R T

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 11 - QUARTERLY FINANCIAL DATA (UNAUDITED)

(in thousands, except share and per share amounts)

The Company's unaudited quarterly financial information for the fiscal years ended January 28, 2006 and January 29, 2005 is

reported below:

YEAR ENDED JANUARY 28, 2006
Net sales
Gross profit
Net income
Net income per share

Basic
Diluted

Cash dividends paid per share

YEAR ENDED JANUARY 29, 2005
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

382,738
109,029
6,722

0.17
0.17
0.02

341,486
96,794
7,202

0.18
0.18
0.02

373,319
104,731
3,483

0.09
0.09
0.02

340,850
93,970
2,922

0.07
0.07
0.02

376,754
108,812
6,321

0.16
0.16
0.02

349,139
101,249
7,416

0.19
0.19
0.02

456,531
125,664
9,568

0.24
0.24
0.02

410,306
113,294
10,412

0.27
0.27
0.02

38
FRED’S
A N N U A L
R E P O R T

REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders
Fred’s, Inc.
Memphis, Tennessee

We have audited the accompanying consolidated balance sheets of Fred's, Inc. as of January 28, 2006 and January 29, 2005
and the related consolidated statements of income, stockholders' equity, and cash flows for each of the two years in the periods
ended January 28, 2006 and January 29, 2005. We have also audited the schedule listed in the accompanying index. These financial
statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements and schedule are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements and schedules, assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall presentation of the financial statements and schedule. We believe
that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial
position of Fred's Inc at January 28, 2006 and January 29, 2005, and the results of its operations and its cash flows for each of the
two years in the period ended January 28, 2006, in conformity with accounting principles generally accepted in the United States
of America.

Also, in our opinion, the schedules present fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States),
the effectiveness of Fred's Inc.'s internal control over financial reporting as of January 28, 2006, based on criteria established in
Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) and our report dated April 12, 2006 expressed an unqualified opinion thereon.

Memphis, Tennessee
April 12, 2006

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REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

We have audited the accompanying consolidated statements of income, shareholders' equity, and cash flows of Fred's, Inc. and
subsidiaries (the “Company”) for the year ended January 31, 2004. 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 audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. We were not engaged to perform an audit of the Company's internal control over financial
reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures
that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's
internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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 audit
provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of the
Company's operations and its cash flows for the year ended January 31, 2004 in conformity with U.S. generally accepted accounting
principles.

Ernst & Young LLP
Memphis, Tennessee
April 5, 2004,
except for the effect of the matters described in Note 2, Restatement of Financial Statements, to the consolidated financial
statements included in the Annual Report (Form 10-K) for the year ended January 29, 2005 (not presented herein), as to which
the date is April 29, 2005

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MANAGEMENT’S ANNUAL REPORT
MANAGEMENT’S ANNUAL REPORT
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Fred's, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting
as defined in Rule 13a - 15(f ) under the Securities Exchange Act of 1934. Fred's, Inc. internal control system was designed to
provide reasonable assurance to the company's management and board of directors regarding the fair and reliable preparation and
presentation of the Consolidated Financial Statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined

to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

The management of Fred's, Inc. assessed the effectiveness of the company's internal control over financial reporting as of
January 28, 2006. In making its assessment, the Company used criteria set forth by the Committee of Sponsoring Organizations
of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on its assessment, management has
concluded that the Company's internal control over financial reporting is effective as of January 28, 2006.

Our assessment of the effectiveness of internal control over financial reporting as of January 28, 2006 has been audited by BDO
Seidman, LLP, the independent registered public accounting firm who also audited our Consolidated Financial Statements. BDO
Seidman's attestation report on management's assessment of internal control over financial reporting is included herein.

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FRED’S
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Board of Directors and Stockholders
Fred's, Inc.
Memphis, Tennessee

We have audited management's assessment, included in the accompanying Management's Report on Internal control Over
Financial Reporting, that Fred's, Inc. (the “Company”) maintained effective internal control over financial reporting as of
January 28, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (the “COSO control criteria”). The Company's management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion of the effectiveness of
the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain responsible assurance about whether effective internal control
over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of
internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of
the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that
could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or procedures my deteriorate.

In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of
January 28, 2006, is fairly stated, in all material respects, based on the COSO control criteria. Also, in our opinion, the Company
maintained, in all material respects, effective internal control over financial reporting as of January 28, 2006, based on the COSO
control criteria.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States),
the consolidated balance sheets of the Company as of January 28, 2006, and the related consolidated statements of operations,
stockholders' equity, and cash flows for each of the two years in the periods ended January 28, 2006, and January 29, 2005, and our
report dated April 12, 2006 expressed an unqualified opinion on those consolidated financial statements.

April 12, 2006
Memphis, Tennessee

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Michael J. Hayes
Chairman and 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

DIRECTORS AND OFFICERS
DIRECTORS AND OFFICERS

Board of Directors

Roger T. Knox
President Emeritus
Memphis Zoological Society
Former Chairman of the Board and
Chief Executive Officer
Goldsmith's Department Stores
(retailing)

B. Mary McNabb
Retired
Former Chief Executive Officer
Garden Ridge
(retailing)

John D. Reier
President
Fred’s Inc.

Thomas J. Tashjian
Private Investor

Gerald E. Thompson R.Ph
Retired
Former Senior Vice President
of Pharmacy Services
Eckerd Corporation

Michael J. Hayes
Chief Executive Officer

John D. Reier
President

Jerry A. Shore
Executive Vice President and Chief
Financial Officer

Executive Officers

Douglas J. Tate
Executive Vice President –
Chief Operating Officer

John A. Casey
Executive Vice President –
Pharmacy Acquisitions

James R. Fennema
Executive Vice President
and General Merchandise Manager

Rick A. Chambers
Senior Vice President –
Pharmacy Operations

Dennis K. Curtis
Executive Vice President –
Store Operations

Charles S. Vail
Corporate Secretary, Vice President – Legal
Services and General Counsel

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

Web Address
www.fredsinc.com

Transfer Agent
American Stock Transfer
& Trust Company

59 Maiden Lane
New York, New York 10038
(800) 937-5449

Independent Registered
Public Accounting Firm
BDO Seidman, LLP
Memphis, Tennessee

Outside General Counsel
Baker, Donelson, Bearman,
Caldwell & Berkowitz, P.C.
Memphis, Tennessee

CORPORATE INFORMATION
CORPORATE INFORMATION

Annual Report on Form 10-K
Shareholders of record may obtain a
copy of the Company's Annual Report
on Form 10-K for the year ended
January 28, 2006, as filed with the
Securities and Exchange Commission,
without charge upon written request to
Jerry A. Shore, Executive Vice President
and Chief Financial Officer. In
addition, we make available free of
charge through our website at
www.fredsinc.com annual reports on
Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and
all amendments to those reports filed
with or furnished to the SEC. The
reports are available as soon as
reasonably practical after we
electronically file such material with the
SEC, and may be found using "Stock
Links" under the "Investor Relations"
section of our website.

Annual Meeting of Shareholders
The 2006 annual meeting of
shareholders will be held at 6:00 p.m.
Eastern Daylight Time on Wednesday,
June 21, 2006, at the Holiday Inn
Express, 2192 S. Highway 441, Dublin,
Georgia. Shareholders of record as of
April 28, 2006, are invited to attend this
meeting.

Stock Market Information
The Company's common stock trades
on the NASDAQ National Market
under the symbol FRED (CUSIP No.
356108-10-0). At April 28, 2006, the
Company had an estimated 19,000
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.

Dividends
Low Per Share

High

$ 17.38 $ 14.42
$ 19.41 $ 11.84
$ 19.96 $ 13.92
$ 18.86 $ 14.31

$ 0.02
$ 0.02
$ 0.02
$ 0.02

$ 19.86 $ 15.27
$ 18.82 $ 13.89
$ 23.50 $ 17.28
$ 28.65 $ 18.37

$ 0.02
$ 0.02
$ 0.02
$ 0.02

2005
Fourth
Third
Second
First

2004
Fourth
Third
Second
First

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4300 New Getwell Road
Memphis, Tennessee 38118